Don’t just take our word for it. Posted in: Featured - At Chevy Chase Trust, we specialize in global research and thematic investing informed by careful planning, and it's working. Forbes and RIA Channel recently ranked us among the highest in their Top 100 list, for 2 years running. Important Disclosures
- Amy Raskin featured on CNBC’s Fast Money Halftime Report Posted in: Noteworthy, Video - Amy Raskin, Chief Investment Officer, appeared on CNBC's Fast Money Halftime Report on August 28, 2018 to discuss current market conditions and what they mean for investors.
- Q & A with Ed Dobranetski Posted in: Noteworthy, People - We recently sat down with Ed Dobranetski, a Managing Director at Chevy Chase Trust, to learn more about his background and how he became interested in investment management.
We recently sat down with Ed Dobranetski, a Managing Director at Chevy Chase Trust, to learn more about his background and how he became interested in investment management.
What was your first job out of college?
My career started near the trough of a business cycle, so securing anythingto do with financial markets was important to me. I started as a broker, purely in sales, so I could take the Series 7 exam and have something to differentiate myself. I did various other odd jobs that young people do while they seek opportunities. I washed windows at the Watergate once, for example.
How did you become interested in investment management?
Beginning college as a Political Science major, I changed to Business after a friend convinced me to compete in a national investment challenge game for college students. Other students from my school won by a large margin, so I sought them out to learn what they did. Consequently, I learned everything I could about Options trading that summer and earned all my spending money for the rest of my college days from a few hundred dollars. The next semester I took a class in Futures and Commodities Trading, and passed the appropriate registration exam over winter break. The following semester I started a “Hedge Fund” in the dorm. It was a rollercoaster ride, but fun. In the end, we only had enough for a very small cocktail party.
What do you enjoy most about your career?
What I enjoy most is working in the financial markets, and with clients. It is one of the world’s great laboratories for studying strategy. Every day the landscape changes in some way.
What is the most important lesson you learned from a mentor?
I learned to manage with sincerity. Most of our clients are experts in a field other than investment management. In most cases, all of their savings are in our hands, and they trust us with the latitude appropriate for an expert. Trust and loyalty are a two way street; we both have obligations in the relationship.
And also: “If something said in ten words can be said in five; use five words.” I am still working on that one.
What would you do if not this? Otherwise, I probably would have had a military career, who knows? I have never considered anything else.
What is your favorite place to visit/vacation?
Fifteen years ago, I heard one of my favorite economist/strategists speak about investing in China when it was still very, very early in evolving. He said: “you can’t sit here in your fancy country club and buy ETFs – you have to go there.” I have probably been to Asia fifteen times since, and plan to retire there. We would go to Japan every year, but the dynamic stillness is too intense.
What advice would you give to someone considering a path similar to yours?
We are asked that question a lot. Getting paid to pick stocks is a desirable career, but it’s more than that. I am still learning. It has been almost thirty years in the same industry; if I make it to fifty, I may have it figured out. My advice: Empty your cup and find a good teacher to work for; that is the most important thing.
- Investment Update, Second Quarter 2018 Posted in: Investment Update, Noteworthy - The S&P 500 Index began 2018 with an initial surge from 2,674 to a high of 2,873 on January 26th.
Equity Market Performance — The S&P 500 Index began 2018 with an initial surge from 2,674 to a high of 2,873 on January 26th. It then quickly and sharply pulled back to a low of 2,533 on February 9th. Since then the Index has largely moved sideways, ending the second quarter at 2,718, 5.4% below its high and 7.3% above its low.
Year to date the global equity market represented by the MSCI All Country World Index (ACWI) has been relatively flat. For the first half of 2018, the ACWI generated a slightly negative return of -0.13%. The S&P 500, as the largest component of the ACWI, generated a positive return of slightly less than 3%. Most other regions, including Emerging Markets, Japan and Europe were down.
Last year, the global economy experienced a synchronized expansion. Global real GDP growth accelerated to 3.8% in 2017 from 3.2% in 2016. Euro countries, Japan and many emerging markets moved from laggards to leaders in global growth.
The opposite pattern is occurring in 2018. Global growth has slowed and the U.S. is the only major economy where leading economic indicators are still rising. The latest tracking data suggest that U.S. real GDP growth could reach 4% in the second quarter, more than double most estimates of trend growth.
This lofty pace cannot be sustained. For the first time in over a decade, the U.S. economy has reached full employment. The unemployment rate stands at a 48 year low of 3.75%. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. For the first time in the history of the Bureau of Labor Statistics’ Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers.
In addition, the central bank is raising rates, equity valuations are relatively high and forward earnings estimates are at their highest level in nearly 20 years (see chart below). All of these factors indicate that the U.S. is in the late stages of an expansion.
As the chart shows, even with high expectations, the market can overshoot to the upside and equities may rally to fresh highs before this cycle is over. Given our bias for capital preservation and view that it is the late stage of this business cycle, we think it is prudent to be moderately defensive. However, we do not believe we are on the cusp of a recession. Traditional recession signals that we watch do not suggest a recession is imminent. For example, the spread between yields of 2 year bonds and 10 year bonds is falling, but still positive. This metric tends to turn negative approximately 12 to 14 months before recessions commence. Leading indicators (LEIs) also usually fall below zero when a recession is imminent. The May LEI rose by 6% year over year. Initial claims for unemployment insurance for the week ending June 16th were 24,000 below their reading six months earlier. Typically, a six month increase in unemployment claims of between 75,000 and 100,000 would presage a recession. Absent a recession, equity market corrections tend to be shallow and short-lived.
TRADE WARS, THE ELEPHANT IN THE ROOM
Our rule of thumb in investing is to ignore politics and focus on fundamentals. This has served us well. However, we view trade differently. We believe many investors and politicians may be underestimating the potential consequences of tariffs.
In our opinion, a trade war is one of the greatest risks to the U.S. equity market. The current cycle has not been about top-line growth. In fact, in terms of revenue growth, this has been one of the slowest recoveries on record. This cycle has been defined by the exceptional margin progression of “manufacturers,” defined broadly as companies who make something somewhere.
The S&P’s steady rise in profit margins over the last two decades has been driven by manufacturers. There are currently 182 manufacturers in the S&P 500. Their net margins have risen from 8% in 2000 to 14%, an astounding 75% increase. Roughly half of the manufacturing stocks are drawn from the technology, industrial capital goods and auto sectors, and represent about a quarter of the earnings of the entire S&P 500.
While there have been four primary drivers behind margin expansion: moving production to lower cost regions, lower interest expense, benefits of robotics and automation, and a decline in effective tax rates, globalization has been the gift that just kept on giving. The world operates far differently than it did 20 years ago. Sales from foreign affiliates of U.S. multinationals are roughly $6 trillion, nearly four times the $1.6 trillion of exported U.S. goods. The U.S. trade position with China looks decidedly more balanced when revenues from foreign affiliates of U.S. companies are taken into account.
Trade is no longer a matter of producing goods in one country and selling them to another. Trade is now dominated by intermediate goods. The exchange of goods and services takes place within the context of a massive global supply chain. Automobiles, technology and apparel are produced from components sourced all over the world. Some components cross borders multiple times. As a result, trade in intermediary goods (components) now exceeds both trade in primary goods (raw materials) and finished goods. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60% of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry. The global supply chain is highly vulnerable to even small shocks. We believe the impacts of a global trade war would be seismic by comparison. Given current lofty earnings expectations, a trade war would likely inflict disproportionately more harm on the U.S. equity market than it would on the U.S. economy.
Importantly, many industry reports are minimizing trade war impacts, particularly on equity markets. The analysis laid out in these reports is as follows: a 25% duty on $34 billion worth of products, which represents the amount of the first section 301 tariffs set to be imposed on July 6th, is roughly $8.5 billion, a fraction of the $800 billion in fiscal stimulus expected this year. Even if this amount is raised to include the $16 billion of Chinese imports that are under further review by the USTR and another $200 billion of Chinese goods under consideration for a 10% tariff, it will not approach the amount of stimulus. There is little discussion of the negative impact on companies and financial markets. Nor is there analysis of the implications to supply chains. This underestimation will likely be revealed and its impact felt in financial markets later in the year when quarterly results begin to reflect companies’ increasing inventories on hand in anticipation of new and changing tariff and trade rules. Bottom line, although we have no way of handicapping the odds of a full blown trade war, the risks are clearly up. Like a nuclear standoff, the only thing preventing a trade war is mutually assured destruction.
GROWTH VERSUS VALUE AND THE TECHNOLOGY SECTOR
Things have gone from bad to worse for value investors, with value stocks underperforming in all regions around the world so far in 2018. While the performance gap is reaching an unprecedented level, we still do not see the catalyst to overweight value. Weaker global leading economic indicators and a stronger dollar clearly favor longer-duration growth companies.
Among growth stocks, technology was again one of the market’s best-returning sectors in the first half of 2018, up almost 11% and outperforming the S&P 500 by over 800 basis points (8%), driven entirely by an increase in tech’s relative earnings multiple. Actual earnings growth was relatively muted. Moreover, year-to-date multiple expansion was broad-based across the tech sector, in contrast to last year when it was concentrated in a few stocks. The technology sector now trades at 1.13 times the market’s multiple on a capitalization weighted basis, higher than it has in nearly a decade, but still less than half of the peak reached in 2000.
The risk profiles of technology stocks have become significantly more favorable over the course of this cycle. Free cash flow margins have been rising for 20 years, due in part to a sustained decline in capital intensity. In the last four quarters, tech’s top-line growth rate has been double that of the market. These are fundamental strengths. As important, we don’t see signs of self-undermining excesses. None of the time-tested indicators of systematic risk – price volatility, share turnover, equity issuance, retail flows, or the performance of initial public offerings, are even flashing yellow. Tech’s free cash flow production has become large enough to be crucial to the outlook for the entire market. In 2005, the sector accounted for 20% of aggregate output and now that share tops 30%. In this cycle, the tech sector has been responsible for most of the cash flow generation of the market.
Soon, almost every company will be a tech company in some respect. The leaders in this equity market: Facebook, Apple, Amazon, Netflix and Google, (FAANG), have not only reshaped the investment landscape, they have also reshaped the consumer by capturing their time and their wallets. As a group, they have added over $300 billion in sales over four years. The five FAANG companies now have as much brand equity as the top 50 consumer brands put together. Profits of these five companies now account for a greater share of the U.S. profit pool than all the large capitalization consumer staples companies combined.
We have recently trimmed some of our largest technology winners and will be closely watching for signs of relative weakness. However, leading companies today are nowhere near as “risky” as the leaders were 20 years ago. If the fundamentals remain solid, we will continue to own technology stocks that are some of our highest conviction thematic holdings.
When 2018 began, still-strong global growth and extremely robust earnings led most fixed income analysts to predict that yields would rise across the curve and the U.S. 10 year bond yield would lift towards 3.5%. While the 10 year yield finally did exceed 3% for about ten days during the second quarter, the high point was only 3.11% and it closed the quarter at 2.86%, only 12 basis points (0.12%) higher than at the end of the first quarter.
The Fed has now hiked short rates seven times (175 basis points or 1.75%) and plans on two more this year followed by three next. The Fed’s balance sheet is now down $200 billion from its peak and is set to continue falling at a quickening pace into the fall. The spread between 2 year bond yields and 10 year bond yields fell to 33 basis points at the end of quarter. This is roughly the lowest spread since August 27, 2007. We are closer to an inverted yield curve today than at any point in this cycle.
The Fed’s Summary of Economic Projections suggests a yield curve inversion next year (assuming long rates remain near current levels) and a 100 basis point rise in the unemployment rate, something that has never occurred outside a recession.
Periods when the curve is flat are consistent with much lower excess returns than when the slope is greater than 50 basis points. Given the low potential reward, we believe sticking with a strategy of buying relatively short duration, high quality bonds makes prudent sense.
We expect the 10 year yield will remain in a range between 2.50% and 3.00% until the threat of a trade war either lifts, in which case yields will likely rise across the entire curve, or a trade war causes a rush to safety and long term yields fall below 2.5%.
- Finding Opportunity in Disruptive Change: Retailing and its Supply Chain Posted in: Noteworthy, Video - Today in the retail industry we're seeing that traditional brick-and-mortar stores are struggling despite a relatively healthy economy.
Finding Opportunity in Disruptive Change: Retailing and Its Supply Chain
We’re in the early stages of a revolution in retailing that is creating compelling new investment opportunities.
As thematic investors, we look for phenomena that are transforming cash flows and profitability across multiple industries. Then we seek to identify companies that will benefit, are investable through public equities with ample liquidity, and likely to pay off within three to five years.
Here we discuss one of these phenomena—how the next generation of automation is impacting the retail industry.
See our latest research and what it means for investors.
- Financial Planning and College Savings Posted in: Noteworthy, Video - Every client at Chevy Chase Trust receives comprehensive financial planning.
Smart college planning is the gift that keeps on giving. From UTMA accounts to 529s, Chevy Chase Trust shows clients how to build a legacy of learning through personalized tuition savings strategies that take into account a family’s complete financial picture. Chevy Chase Trust’s Laly Kassa and Leslie Smith share their insights on the best savings strategies for maximizing returns.
- Thematic Investing at Chevy Chase Trust Posted in: Insights, Noteworthy, Whitepapers - In some ways, thematic investing is a throwback to investing in a simpler time.
In some ways, thematic investing is a throwback to investing in a simpler time. Before there were 15,000 mutual funds in 115 different fund categories. Before there were over 8,000 hedge funds and 2,000 ETFs traded daily. Before 17,000 new CFAs were credentialed every year, and before sell-side firms had analysts dedicated to specific sub-industries within each sector. Thematic investing doesn’t fit into any of Morningstar’s 115 fund categories or fit neatly into one of its style boxes.
The modern version of thematic investing emerged 15 to 20 years ago in response to the extreme segmentation of the investment industry. It gained greater visibility in recent years, as institutional investors and consultants, having turned to passive investing for larger and larger portions of assets, sought supplementary equity strategies that could generate alpha in a variety of different market regimes with some degree of reliability.
The term “thematic” is used to describe several different investment approaches, from single theme ETFs to portfolios where specific industries or sectors are deemed thematic. Here ‘s our definition:
Thematic investing seeks investable ideas that stem from economic or technological changes powerful enough to influence corporate performance across multiple industries.
It is instructive to contextualize three of the essential terms in this definition.
Today, most Wall Street research, on both the sell-side and buy-side, is organized by industry, with each analyst tasked with being an expert in his or her niche. The result? Few researchers look at the big picture—or even know how to. This creates an inefficiency.
One of the first people who decided to exploit this inefficiency was Lewis Sanders, when he headed AllianceBernstein. In 2003, Sanders tapped Amy Raskin to run a new research group at AllianceBernstein dedicated to studying strategic changes that spanned multiple industries (essentially, thematic research). Broadband internet service was the first theme the Research on Strategic Change group tackled. The team thought about how this new technology would affect media, entertainment, advertising, video games, retail, and telecom services. It asked who would benefit, who would lose, and which industries would be disrupted. The group went on to study many other themes over the next 10 years, each time learning from its mistakes and refining the process.
Chevy Chase Trust adopted a similar investment philosophy when it acquired an investment boutique in 2001. The boutique’s global, multicap, unconstrained equity strategy invested in secular themes influencing economies and markets around the world. In 2014, when Amy Raskin joined Chevy Chase Trust as its Chief Investment Officer, the firm integrated the best aspects of the two processes. One important and fundamental decision was to organize research analysts by theme, not industry. Each analyst was tasked with thinking about his or her themes holistically and uncovering relevant investment opportunities regardless of industry or geography.
Our approach to investing focuses on changes that are most likely to have a profound influence on corporate performance, seeking to buy companies that will be beneficiaries of thematic tailwinds and avoid companies that will be casualties of creative disruption. We think some thematic investors fail to distinguish between a trend and a potentially profitable investment theme. There are many significant changes occurring across the globe. But, in our vernacular, most of these changes are simply trends and not investment themes because they are not likely to create economic advantages that will result in sustainable profits.
Wireless broadband, known as wi-fi, is one example of a disruptive technological change that would not have been a great investment theme. The top left map below is a Manhattan neighborhood south of Central Park in 2001. There were no wi-fi hotspots. The top right map is the same neighborhood in 2011, where the purple dots indicate how wi-fi hotspots had proliferated. The bottom map shows that in early 2018, wi-fi hotspots are almost everywhere.
It’s amazing how this technology took off. Most people have wi-fi at home and would not think of staying in a hotel without wi-fi access. Coffee shops, restaurants, airports and subways provide it for free. A recent consumer survey ranked wi-fi second only to food in its importance in daily living.
While unit sales of wi-fi router equipment boomed, the profitability of the equipment makers was never impressive. Wi-fi is based on a set of a well-defined standards, so barriers to entry were low, and the number of competitors was high. During the decade of explosive growth, average operating margins for wi-fi equipment makers were in the mid-single digits.
Investors focusing on disruptive change must be cognizant of a basic tenet: more often than not, technological change ends up benefitting consumers far more than the companies enabling it, particularly when barriers to entry are low and competition is intense. Consumers have benefited from virtually ubiquitous access to wi-fi, but the companies that manufactured wi-fi routers didn’t profit enough to be great long-term investments.
Other examples of disruptive technological changes that we see as trends, not investment themes, include high-definition and smart television, activity trackers, streaming music, virtual worlds, home meal kits and ride-sharing services. While some of these may be surprising, the last is probably the most controversial. Here’s why we think ride-sharing would be an unsuccessful investment theme.
Introduced by Uber, the concept of a simple, frictionless car-hire platform that matches riders with drivers fills a compelling consumer need. As the concept was embraced globally, business for Uber and Lyft rose from fulfilling rides worth less than $1 billion in 2013 to almost $40 billion in the 12 months ended September 2017.
But a great service is not necessarily a great business. Most of the ride-sharing revenue, roughly 80%, goes to drivers. Some goes to attracting customers. As a result, Uber and Lyft have been losing money at an accelerating rate, and revenue growth has slowed. Their combined losses were roughly $2 billion in 2015, $3 billion in 2016, and $5 billion in 2017. This is not the hallmark of a sustainable business model.
It might be a good business model if, after attracting drivers and riders, the platforms could retain them with fewer incentives. Unfortunately, Uber, Lyft and similar platforms don’t appear to have a strong hold over either group. Drivers around the world are taking advantage of competitive services that give them a larger share of fares, and customers keep switching to new services with lower prices. Google’s mapping app now offers riders direct price and convenience comparisons between ride-sharing platforms, which may dissolve any customer loyalty that the platforms have created.
Gett, Grab, Via, Ola, Didi, Sidecar, Zimride, BlaBlaCar, Carma, Ridejoy, Easy Taxi, Taxify, YandexTaxi and Careem, are all similar services. Over the past three years, Uber has lost its monopoly position in New York City, where its market share has fallen below 75%, with no sign of stabilization.
We seek themes that are “investable,” which includes two traits. First, there must be enough public companies that are beneficiaries of the theme with sufficient liquidity for us to invest at least 5% of our portfolios in the theme. Water as a scarce resource, nanotechnology and space travel may be fascinating trends that could have major impacts on the world, but they are not among our investment themes because we haven’t found sufficient or appropriate investment candidates.
Second, we must believe that other investors will begin to discount the change or disruption into their valuation models within a reasonable time frame, which for us is three to five years. We don’t have to expect the change or disruption to mature within that time frame, just that other investors will begin to expect it. The market is a discounting mechanism, so company share prices reflect investor expectations, not necessarily current reality. For example, the share price of NVIDIA, which manufactures a key component of self-driving cars, is now discounting widespread future adoption of autonomous vehicles, although only about 700 driverless cars are on roads today.
Having noted two trends, wi-fi and ride-sharing, that we think were not or are not investment themes, two trends that meet our criteria for investment themes are advances in molecular medicine and wealth migration in the U.S.
Molecular medicine is the revolution in medical treatment created by the ability to detect tiny variations in the human genome that can cause disease. Molecular medicine is already providing both diagnostic tools and highly targeted treatments for certain cancers and other genetic diseases. Because almost all disease has some genetic component, the ability to pinpoint specific genetic mutations that can lead to disease and potentially alter or prevent the mutation’s impact, will revolutionize healthcare. Millions of people with devastating diseases will be cured as a direct result of the breakthroughs made possible by the sequencing of the human genome. Yet all of this is relatively new. The first sequencing of a human genome was completed in 2003. It took 13 years and cost about $3 billion. Today, complete human genomes are sequenced in little more than an hour for less than $1,000. The chart below shows the extraordinary decline in sequencing cost. If the decline merely followed Moore’s Law, which posited a 50% decline every two years for semiconductor technology, the cost of sequencing a genome would be 360 times higher than it is today.
The modest profitability of wi-fi equipment makers, despite soaring demand for routers, might lead one to conclude that investments in sequencing technology would also be a poor investment. Not so. Genetic sequencing is extremely complicated. Few companies can make this technology, and the number of competitors has actually declined as the market has grown. We estimate that Illumina, the market leader, now produces nine out of 10 new sequencers sold—and its gross margins have been flat to up over the past five years, averaging near 70%. Demand accelerated, the dominant player gained market share, margins improved and the leader wasn’t buying market share with discount pricing. To us, this is what a great long-term investment opportunity looks like.
We expect stronger demand growth for genomic sequencing and related technologies than many other observers. Our view is that the industry is at the beginning of a steep upward climb in demand driven by new applications for sequencing. Most analysts are focused on the number of research labs, existing machines and remaining capacity, to predict growth. We believe they are missing the bigger picture, which will include applications for agriculture, veterinary care, and other uses still on the horizon.How do we invest in this theme? The opportunity set is broader than sequencing equipment. “Big data” investments are particularly interesting. Each human genome contains three billion base pairs and requires 200 billion bytes of digital storage. Genomics was one of the first fields requiring big data storage and processing solutions.
Taking a holistic, thematic research approach can lead to investments that may not be apparent to sector specific analysts. Few analysts covering healthcare or even life science tools were thinking about the investment opportunities in big data, and few semiconductor analysts were focused on the massive amount of data produced by genomics.
Our molecular medicine theme has also broadened to include investments related to CRISPR, a genomic-editing process, and CAR-T, a form of cellular immunotherapy, both of which may disrupt traditional pharmaceutical companies.
U.S. Wealth Migration
Investment themes aren’t always the result of technological breakthroughs. Another current theme in our portfolios is the massive U.S. wealth migration toward urban areas, which reflects new lifestyle preferences, influenced by social changes, secular changes in the economy, and improved urban planning.
Why does this matter to us as investors? Each year U.S. consumers spend $13 trillion dollars, so understanding shifts in spending is crucial. People in cities spend money differently than people in suburban or rural areas. Urban dwellers spend less on transportation, and more on cosmetics, restaurants and travel. Also, denser neighborhoods attract companies and services, such as GrubHub/Seamless, Instacart, Task Rabbit and Via, that wouldn’t be profitable in less dense neighborhoods. The combination of convenience and choice that such companies provide reinforces the allure and advantages of urban living. There’s a virtuous loop of sorts at work. For more on this theme, see our white paper, “Investing in Disruptive Change: The Great U.S. Wealth Migration.”
It’s always possible to miss a crucial flaw in what seems like an exciting theme or get the timing wrong. This leads to considerations of risk management and portfolio construction, which is underscored by some recent research. In early 2017, an economist named Henrik Bessembinder published research showing that since 1926, four out of seven common stocks in a database of listed U.S. stocks had lifetime buy-and-hold returns lower than the return of one-month Treasuries. He also found that when market returns are stated in terms of lifetime dollar wealth creation, the best-performing 4% of listed companies account for the net gain of the entire U.S. stock market since 1926. All the other stocks collectively matched Treasury returns. Bessembinder concluded that these results “help to explain why poorly-diversified active strategies most often underperform market averages.”
Some people have seized on Bessembinder’s research as another reason to give up on active management in favor of passive. That doesn’t make sense to us. Passive investing requires owning all stocks in the market index all the time. If the future is like the past, passive investors would dedicate virtually all their equity capital to obtain a T-bill like return, to get the upside from the tiny sliver of stocks that do well.
Instead, we conclude that active equity managers need to have a strong basis for selecting stocks with exceptional return potential and to diversify sufficiently to mitigate the impact of being wrong about a theme or an individual stock. We believe that thematic investing informs good stock selection and provides diversification.
The strong basis for stock selection comes from whittling down the thousands of public securities around the world to a manageable group of companies identified through our thematic research. This initial screening process is perhaps the most important part of investing.
Many firms use a quantitative screen, such as low price-to-earnings, or strong return on investment. Most, such as emerging markets growth managers, focus on geography and style. Our investments are largely defined by our themes. We invest almost exclusively in stocks that we think are likely to benefit from disruptive changes, because that’s where we think the risk/reward tradeoff is in our favor.
We don’t need to get everything right to be successful. If the places where we spend the majority our time and energy are even slightly more likely to provide fruitful investments than other areas, our odds of delivering strong performance go up meaningfully. Screening out companies whose business appear likely to be disrupted by new developments also improves our odds of success.
Some thematic ETFs and mutual funds invest in just one theme. But there are often only a handful of companies that have enough exposure to any theme to impact performance significantly. As a result, most single-theme portfolios either have a very small number of holdings, so they lack diversification, or they include every company tangentially related to a theme and, as a result, bear other unintended risks.
Our portfolios, by contrast, typically have about 40 stocks and five to seven themes. Some stocks represent more than one theme; these tend to be our largest positions. We rarely invest more than 25% of the portfolio in any one theme, and we carefully size our positions in each theme, taking into account industry, geographic and factor exposures. Some of our themes, such as molecular medicine, are composed mostly of stocks in classic growth sectors, such as technology and healthcare. Others, like supply chain automation, are more heavily weighted towards value stocks in the industrials and real estate sectors. Our U.S. wealth migration theme is tilted toward consumer discretionary stocks.
Large-caps, small-caps, growth, value and multiple countries are represented both in our opportunity set and in our portfolios. Typically, the largest systematic risk in our portfolios is a skew to the U.S., because, a disproportionate share of innovation and disruptive technology takes place in the U.S. When we put it together, we get a relatively concentrated yet intentionally diversified global portfolio with high active share that generates alpha primarily from stock selection. We’re proud of the results.
- Chevy Chase Trust hosts Spring Reception at the Smithsonian’s Renwick Gallery Posted in: Events, Noteworthy - On April 24, Chevy Chase Trust hosted its annual Cocktail Party and Reception at the Renwick Gallery’s exhibition “No Spectators: The Art of Burning Man.”
On April 24, Chevy Chase Trust hosted its annual Cocktail Party and Reception at the Renwick Gallery’s exhibition “No Spectators: The Art of Burning Man,” based on the maker culture art of the annual festival in Nevada’s Black Rock playa. The Burning Man festival attracts more than 75,000 people each year for a unique celebration of art and music in a temporary man-made city.
Special guest speaker and Lloyd Herman Curator of Craft at the Renwick, Nora Atkinson, introduced the enigmatic exhibition and how she was able to bring it to Washington D.C. “I started off by suggesting it would be just one room and a few pieces of jewelry,” said Atkinson. But eventually, her idea grew into a much larger collection of cutting-edge artwork that takes over the entire building and spills out into the surrounding neighborhood. All 14 installations were either shown at the annual Burning Man festival or were commissioned from Burning Man artists.
Guests at the special event enjoyed interactive installations such as the colorful Shrumen Lumen, large-scale sculptures that respond to human interaction; a 12 seater art deco movie theatre on the back of a red bus; a virtual reality experience; and the transformation of the Grand Salon into a temple of ornately carved wood.
“We appreciated the opportunity to spend an evening with clients and friends of Chevy Chase Trust away from the office and surrounded by the artwork of this exciting exhibition,” said Stacy Murchison, Chief Marketing Officer.
- Investment Update, First Quarter 2018 Posted in: Investment Update, Noteworthy - The S&P 500 Index began 2018 at 2,674. It ended the first quarter at 2,641. After accounting for dividends, the S&P generated a relatively small negative return of -0.76%.
Macroeconomic Outlook — The S&P 500 Index began 2018 at 2,674. It ended the first quarter at 2,641. After accounting for dividends, the S&P generated a relatively small negative return of -0.76%. If you somehow managed to ignore the financial media between January 1st and March 31st and just looked at these numbers, you might think it was a fairly uneventful quarter. Alas, that was not the case. During the first quarter, the S&P 500 saw 23 daily moves of plus or minus 1% or more. This compares to a mere eight in all of 2017.
2018 began with the highest level of bullish investor sentiment since 2010, as tracked by the American Association of Institutional Investors. In 2010, quantitative easing buoyed equity markets. In 2018, tax cuts and strength in the global economy formed the basis for optimism. The quarter began with the best January in eight years, but ended in the red for the first time since 2009. While earnings rose meaningfully, the market’s price-to-earnings multiple fell.
In our opinion, equity market risk has increased in the past 90 days and the risk/reward trade-off for the next 12 months has shifted from favoring risk to a more balanced view. In the near-term, we would not be surprised by more market weakness and higher than normal volatility. Despite our fairly balanced view, we do look for what could go wrong. Below are three near to medium-term risks.
- A peak in global growth coupled with a more hawkish Fed – There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is likely peaking. A more moderate pace of growth, in and of itself, would not be enough to cause an equity market sell-off. However, if it is coupled with a less accommodative monetary back-drop (i.e. continued Fed tightening), equity multiples will likely contract further. In this scenario, the decline in price-to-earnings multiple would likely more than offset positive growth in earnings. Under Janet Yellen’s leadership, it seemed unlikely that the Fed would press ahead with rate hikes if macroeconomic growth slowed appreciably. Under a new Chairman and with several Federal Reserve Board vacancies to be filled, the situation could be different. The Fed, as expected, raised rates in March despite recent financial market turbulence. Federal Open Market Committee participants revised upward their projections for both economic growth and the fed funds rate. Six participants now expect four rate hikes this year compared to only four in December. An overly hawkish Fed is still not our base case. We think when the preponderance of evidence shows economic growth slowing, the Fed will adjust its policy actions accordingly.
- Optimism and financial market instability – As mentioned above, optimism was at an eight year high at the start of the year. A simple word search on the terms “strong global growth” and “weak global growth” illustrates this extreme optimism nicely. Articles mentioning strong global growth shot up in frequency in late 2017, while articles mentioning weak global growth fell to their lowest level in a decade. A picture, or in this case a graph, is worth a thousand words.More recently, euphoria has faded in response to equity market weakness and volatility. Still, a majority of investors and economists seem focused on positive macroeconomic momentum and strong earnings growth, the logic being that bear markets and recessions go hand in hand and leading indicators are not pointing to a recession.While this analysis is sound on the surface, there is a possibility that a sufficient tipping point of financial market weakness and volatility could trigger a recession. Risk assets are now five times greater than global GDP. Causality doesn’t always run from the economy to financial markets. In major downturns, causality can run in reverse. Specifically, the last three economic downturns had their genesis in financial markets. The bursting of the dot.com bubble triggered the downturn of 2001; the large scale mispricing of U.S. mortgages caused the Great Recession of 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession of 2011. We expect volatility to continue to shake out weak equity holders and reduce investor optimism. This will be good for future returns as long as it does not create panic and instability. Again, our base case is that market participants will cope with volatility and avoid a bear market, but the risk that volatility could reach a tipping point has increased.
- Rising protectionism – This risk is harder to analyze. We know President Trump faces few constraints in escalating protectionism. But we do not know whether he will actually pursue what would be a destructive path or if it is simply verbal posturing. A trade war with China would severely damage both countries, and in turn, world growth. Equity markets are likely to continue to negatively react to signs of increasing tensions, and positively react when rhetoric cools.
In conclusion, we expect equity markets to continue to be volatile in the near term. If the Fed recognizes a slowdown in growth and reacts accordingly by slowing the pace of interest rate increases, it is not implausible that the bull market we have enjoyed for the past nine years resumes. However, if the Fed pursues an aggressive trajectory and/or trade tensions escalate, equity markets could drop below the February 9th low of 2,532. This “break” could scare technically focused investors and cause some algorithmic selling. In this scenario, it is possible that the S&P Index could fall 5-7% below the recent low. All other things being equal, we would view this as a buying opportunity.To reflect the increased risks outline above, we have rebalanced portfolios. We trimmed position sizes in several of our biggest winners, mainly technology related stocks, and increased more defensive holdings. This rebalancing has not reduced exposure to our themes and thematic holdings. When volatility rises, concentrating on our highest conviction investment ideas has served us well in the past and we believe it will do so now as well.
The growing importance and systematic undervaluation of intangible assets has been an important and successful theme for Chevy Chase Trust. We have long believed that corporate balance sheets understate intangible investments. For the most part, spending on intangibles is treated as a current rather than a capital expense. In contrast, investments in tangible assets, such as machinery, trucks or warehouses, are capitalized on corporate balance sheets and depreciated over long periods of time. Understatement of intangible investment has led to undervaluation of intangible assets. Many intangibles, like non-public consumer data, research and development and large user networks are increasingly valuable but difficult to measure. These characteristics have provided opportunities to earn excess returns by owning intangible-rich companies.
We recently read an insightful book, “Capitalism Without Capital: The Rise of the Intangible Economy,” by Jonathan Haskel and Stian Westlake. Over the past few decades, the nature of investment in many developed markets, including the U.S., has changed. As shown in the chart below, U.S. investments in intangibles, such as software, research and development, market research and branding, now represent a greater share of economic output than tangible investments.
The authors describe how, in their opinion, intangible assets most critically differ from physical goods.
- Intangible assets do not follow the same set of physical laws as tangible assets. They can generally be used over and over by different people in different locations, often at the same time. They are scalable in a way tangible assets are not. For example, a software package or a drug formulation can be used in offices or labs in multiple countries by multiple users at the same time. The same is not true for a piece of machinery or a delivery truck. Further, once a business has invested in creating or acquiring an intangible asset, it can usually reuse it continually at very little cost. This scalability allows intangible-intensive businesses to grow fast.
- It is hard to recoup money spent on intangible assets if the investment is not successful. Physical assets are often easier to sell or repurpose if things go wrong. In contrast, investments in intangibles often represent sunk costs. This characteristic makes them much harder to finance, particularly with debt.
- Ownership of intangible assets tends to be more difficult to establish legally than ownership of tangible assets. As a result, investments in intangibles are more easily copied by competitors. The company making the investment does not always reap the reward. In economic terms, the original investor may not appropriate the benefits of intangible investment. This characteristic tends to discourage corporate investment spending.
These characteristics of intangibles help explain some perplexing relationships in today’s economy. As the authors explain, “one of the most troubling and widely talked about trends in economics at the moment is secular stagnation: the fact that business investment is stubbornly low despite every indication that it shouldn’t be.” In the past, when interest rates were low, investment spending increased. The greater uncertainty associated with investing in intangibles, and the increased difficulty in funding intangible investments, may at least partially explain the current breakdown in the relationship between interest rates and investment.
Another unusual aspect is that corporate profits in the U.S. and elsewhere are, on average, higher than they have been in decades and seem to be steadily increasing. However, these profits are increasingly unequal. Normally, over time competition levels the playing field between leading and lagging firms, as profit margins regress to the mean and the laggards go out of business. This does not appear to be the case now. In part, this may be due to the scalability of intangibles and the ability of certain very large firms to dominate.
While we value external validation of our thematic research, Capitalism Without Capital and similar articles put a focus on the theme and make it more likely that other investors will begin to fully value intangible corporate assets. When a theme is recognized by other investors, we benefit from being an early investor, but the future opportunity to earn excess returns diminishes. Some of our best performing holdings have been in companies with unique intangible assets. Some have doubled or tripled in price. Today, the valuation gap is smaller than it has been. We still think there are opportunities to invest in companies with undervalued intangible assets, but the opportunities are shrinking.
We often get asked “when and why would we exit a theme?” One of our requirements for a theme is that we believe that other investors will begin to discount the theme in their valuation models within a reasonable time frame, which for us, is three to five years. We would not be surprised if within the next 12-18 months the valuation gap in this theme will have closed and the overall theme will have lost its advantage. Of course, we are always researching potential new themes.
Similar to equity markets, the first quarter of 2018 was tumultuous for fixed income investors. U.S. 10 year bond yields started 2018 at 2.41% and rose rapidly to a high of 2.95% on February 21st. Since late February, equity market volatility and protectionist policies led investors to seek safety in bonds, causing yields to recede about 20bps (0.2%) to close the quarter at 2.74%. Of course, rising yields means falling prices. Interestingly, shorter term bond yields followed a similar trajectory. Two year Treasury yields started the year at 1.88%, rose to 2.34% on March 20th, and receded to close the quarter at 2.26%.
One of the more consensus views beginning the year was that rapid global economic growth would lead to meaningfully higher bond yields. Most economists predicted that 10 year U.S. bond yields would exceed 3.0% or even 3.5% by year-end. We have been more conservative in our estimates (more optimistic on prices), and still believe consensus expectations are too high. That said, a trade war or change in foreign appetites for U.S. debt could meaningfully impact prices. These risks are difficult to handicap.
We continue to view high quality, shorter-term bonds with ample liquidity as the most prudent investment option in volatile markets.
- Q & A with Tap Chibaya Posted in: Noteworthy, People - We recently sat down with Tapfuma Chibaya, an Equity Research Analyst at Chevy Chase Trust, to learn more about his background and what he enjoys most about his career.
We recently sat down with Tapfuma Chibaya, an Equity Research Analyst at Chevy Chase Trust, to learn more about his background and what he enjoys most about his career.
Give us a brief rundown of a typical day for you at Chevy Chase Trust.
I arrive around 8:30 am, before the markets open at 9:30. This gives me time to go through emails and news, and catch up on anything that may have happened overnight. Since we invest internationally, lots can happen overnight.
After that, the first half of my morning is typically research. Checking any new articles that provide new waves of thought that may affect what we are doing here investment wise. Other than these important aspects of my day, it is hard to define a typical day, because there are often many different projects going on at once.
In summation, what is your responsibility for CCT?
To put it simply– my job is to come up with good, investable ideas for Chevy Chase Trust, that will ultimately help our clients meet their investment objectives.
I compile materials to build a case for each idea and then try to convince our research team that it is worthwhile. The best way to do this is just keeping an ear to the ground. I pay attention to all of the trends and have to stay ahead of what’s currently happening.
Tell me a little about your background.
I grew up in Zimbabwe, in a very small community. There were no more than 5,000 people. My dad worked in a mining plant, and that plant was essentially the center of all activity in our town. The plant shut down, but I was fortunate enough to have two working parents, and my mom, a teacher, basically became the breadwinner.
I attribute all of my success to my parents. They made sure to send me and my siblings to great schools, even at a sacrifice to themselves. Education was highly valued by my family, and I benefitted as a result. While still in high school I caught a lucky break, and I was given the opportunity to come to America.
Did you go to college here?
I went to college in Middlebury, Vermont through a program sponsored by the American Embassy in Zimbabwe. The program sought out students who showed promise and assisted us in the entire college application process. They even helped us determine the best schools to apply to, based on tuition assistance knowing that was something we would need. Each year roughly 20-30 students go through the program, and I was fortunate enough to be one of them.
What was college like for you?
Middlebury is a small liberal arts college, and I really enjoyed my time there. I majored in economics, but liberal arts was a new concept for me. In Zimbabwe, you specialize as early as high school, so I had already been on the business track for a few years. In the liberal arts setting, I was taking all kinds of classes… different types of history and music, etc. It was such an interesting experience for me, and if I had to do it all over again, I absolutely would.
I was able to pick up some critical thinking skills that many people may underestimate, and I have an understanding of such a wide range of topics now, thanks to my college studies.
Any courses you had to take that you surprised yourself by really liking?
I ended up taking Spanish to nearly the highest level. There aren’t many African countries that speak Spanish!
What was your first job after college?
My first real job after college was as an equity research analyst at Credit Suisse, which I suppose explains why I am sitting in this seat today. It’s where I cut my teeth in the industry.
Coming out of college I did want to be an investment banker. My finance professor was a former investment banker, and it was such a highly sought after career. I was enamored with the idea of it. But, as an international student, there were limitations on my job opportunities. It came down to finding a company where I fit, but who was also willing to sponsor me as an immigrant.
Did you enjoy the research side more than you expected?
I really did! It is so intellectual and I value that a lot. You can take the research wherever you want. Equity market research specifically fascinates me because it’s all public information—everyone has access to it, so it comes down to piecing together all of these individual parts to establish and support your ideas – i.e. the mosaic theory.
After three years at Credit Suisse, I did test the waters as an investment banker but ultimately decided to come back to research. I personally found it a better fit and more intellectually stimulating for myself.
What do you enjoy most about your career?
Reading and learning new things. I try to learn something new every day or to enhance the knowledge that I already have.
What do you enjoy most about working at Chevy Chase Trust?
The people–especially the team I work on. I can see that my ideas are heard and that my work is valued. Chevy Chase Trust is unlike any place I have ever worked before. There’s also so much room for growth here—career-wise and as a person. It’s really a special place.
What is the best lesson you’ve learned over your career?
Do your work 100%, 100% of the time. Whether you have a small assignment that you feel is a waste of your time, or a big project that you feel will get you noticed. Do your work to the best of your abilities always. Don’t worry about who’s noticing, someone is always noticing.
What is your favorite thing to read outside of work?
Give me a John Grisham book, and I will read it front to back in one sitting!
Tell us about how you spend your time outside of work.
I spend a lot of time with my wife, checking out new restaurants or cooking ourselves. I also love to play soccer and am on a team nearby. Recently, I have been spending a lot of time in the gym just to stay healthy and mentally focused!
- Amy Raskin, featured speaker at Strategas 12th Annual Macro Conference Posted in: Insights, Noteworthy - At the Strategas 12th Annual Macro Conference on March 1, 2018, Chevy Chase Trust’s Chief Investment Officer, Amy Raskin, presented her views on Thematic Investing.
The conference, which highlights important investment trends driving the economy and markets, featured a panel of eight experts in the areas of Thematic Equity Investing, Cryptocurrencies, Japan and Growth Stocks.
Raskin’s presentation focused on “the modern version” of thematic investment approach which has gained visibility in recent years. While thematic investing is just 15-20 years old, Raskin pointed out that it is a throwback to investing in a simpler time—before there were 115 different mutual fund categories. She defines thematic investing as “an investment style that seeks investable ideas that stem from economic or technological changes that are powerful enough to influence corporate performance across multiple industries.”
Distinguishing themes from trends, Raskin emphasized that of the many profound changes occurring around the world, most are trends, not themes, since they are not likely to add to the bottom lines of investable companies. She offered two examples of current themes at Chevy Chase Trust including molecular medicine – the revolution in medical treatment created by detecting small variations in the human genome that can cause disease, and the U.S. wealth migration toward urban areas –the movement of wealthy people in the U.S. to cities, partially reversing the suburbanization trend of the previous 100 years.
In the end, Raskin said her thematic investing approach tends to result in a broadly diversified global portfolio that doesn’t expose clients to big swings in the business cycle and skews to the US, because, for structural reasons, that’s where a disproportionate share of the most innovative and disruptive technologies is created.