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
Thematic Investing Performs Posted in: Uncategorized - Thematic investing at Chevy Chase Trust is a progressive departure from common Wall Street practice. It examines how the world is changing, determines which companies will be advantaged and invests accordingly.
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- Food for Thought: 3 Common Mistakes Investors Make Posted in: Noteworthy, Video - Want to avoid common mistakes that many investors make?
Want to avoid common mistakes that many investors make?
- Fourth Quarter, 2019 Posted in: Insights, Investment Update, Latest News, Noteworthy - 2019 was a good year for almost all asset classes. The S&P 500 total return of 31.5% was the second best in the last 20 years.
A Good Year — 2019 was a good year for almost all asset classes. The S&P 500 total return of 31.5% was the second best in the last 20 years. U.S. bonds performed well, with 10-year Treasuries returning 8.8% for the year. Non-U.S. equities, gold and oil, all had positive returns.
But stepping back, the S&P return looks less impressive and the outlook less than inspiring. The 2019 rise followed a sharp 2018 drop from a peak in January 2018. The S&P 500 has averaged a more modest 8.4% annual return over the nearly two years. Calendar returns are noteworthy but other periods, some longer and some shorter, can be more meaningful.
Financial Conditions: “As Good As It Gets”
U.S. equity returns were poor in 2018 when the market was digesting four Federal Reserve rate hikes and expecting two or three more in 2019. The yield curve flattened as short-term rates rose and credit spreads widened on fears of a recession. Consumer net worth declined 13% as asset values fell. Global manufacturing slowed.
What changed in 2019? Central banks massively increased liquidity. The Fed pivoted from tightening to easing, cutting the Fed Funds rate three times, and returning to balance-sheet expansion in October. The European Central Bank resumed open- ended quantitative easing in November. Because Japan’s central bank never stopped quantitative easing, the three largest central banks in the developed world were printing money in unison, the first time since 2010.
With 85% of central banks easing at year-end, the highest level since 2010, and up from just 35% in early 2019, global short rates fell to near record lows, foreign exchange reserves grew, and money aggregates grew faster than credit across major advanced economies. Conditions have rarely been this easy, particularly in the absence of a recession.
Easy financial conditions are generally bullish for equity markets. But, as the display below shows, it will be hard for financial conditions to get much better from here.
Financial Conditions Have Only Been Better Than Today’s Levels Twice:
2000 Tech Bubble and 2017 U.S. Corporate Tax Cuts
Markets tend to do well when financial conditions are easing for three related reasons. First, investors expect falling interest rates to stimulate spending and investing, fueling economic and earnings growth. Second, lower rates reduce the discount rate applied to future earnings, increasing their present value. Third, falling rates make bonds and cash less attractive alternatives to stocks.
In the past year, the Fed and other central bank policies drove the S&P 500 price/earnings multiple from 15.5x to 20x. With component earnings only 1% above their 2018 level, more than 95% of the Index price gain in 2019 was from P/E expansion, not earnings growth.
Short rates have little room to fall from current low levels. Level matters, but change matters more. With interest rates near historic lows and liquidity near historic highs, there’s also little room for further P/E expansion. The Fed’s commitment to maintaining easy financial conditions should support stocks and risk assets generally, but multiples are unlikely to rise significantly.
Recession Spotting and Timing Turns
Economists and investment strategists have a dismal record predicting recessions and market turns. Many who claim to have predicted the 2008 global financial crisis were either bearish long before the collapse or remained bearish long after the recession ended. The difficulty in anticipating recessions stems from two factors. First, economic data is only known after the fact and is not predictive. Second, precipitous market declines generally coincide with falling outputs, leaving little time to exit risk assets.
Making predictions is easy. Making accurate predictions is hard. Acting on predictions can be costly. Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” Below are some noteworthy investor warnings that proved too early or wrong.
“There are some parts of the global economy that are now at the risk of a double-dip recession. From here I see things getting worse.” Nouriel Roubini; May 20, 2010
“Another recession is coming, and soon… [I am] 99% sure we will have another recession by the end of next year.” David Rosenberg; June 4, 2011
“I think we could have a global recession in Q4 or early 2013. That’s a distinct possibility.” Marc Faber; May 25, 2012
“I see real tremendous problems ahead and I don’t think we are handling it right and nobody really wants to talk [it] out… We are headed toward strong correction and possibly a complete meltdown but not systematic like 2008. It won’t threaten the system, it’s just going to threaten your livelihood and net worth… I do think you are in a very massive bubble and when it bursts it isn’t going to be pretty, it could be a bloodbath.” Carl Icahn; September 29, 2015
“Global markets are facing a crisis and investors need to be very cautious… China has a major adjustment problem. I would say it amounts to a crisis. When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008.” George Soros; January 7, 2016
Investors who sold equities based on these warnings would have missed much of a great bull market. The display below shows the opportunity cost for a dollar shifted from equities to a diversified bond portfolio after each warning. For example, after Rosenberg’s mega-bearish commentary in June 2011, bonds underperformed the S&P 500 by almost 60%.
The Consequences of Listening to the Armageddonists
If there are trouble spots or even bubbles that could precede a downturn, where could they be? Three possibilities are FAANG stocks, private equity, and the U.S. relative to the rest of the world.
- FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have dominated market returns for the past decade. As we showed in last quarter’s commentary, no group of market leaders has dominated for two consecutive decades (though a few individual stocks have). And for each of the past five decades, underweighting the prior decade’s leaders added alpha over the subsequent decade. While it is too early to say FAANG stocks have peaked, we do not believe the group will lead the coming decade.
- Private equity was one of the best performing asset classes over the past 20 years. As a result, many investors, particularly institutional investors, have significantly increased allocations to this asset class. Private equity assets soared from $500 billion in 2000 to almost $6 trillion in 2018, while the number of listed stocks on U.S. exchanges plunged from about 8,500 to 5,500. One result is that public equities have lost their comparative liquidity premium. Today, private equity valuations are significantly higher than public equity valuations in many sectors.
Money has also poured into venture capital. WeWork is an example of how such investments can go wrong when investors become too bullish. Public funds invested alongside private capital in WeWork’s last rounds of financing, ahead of its anticipated initial public offering and before WeWork’s valuation collapse.
- Finally, U.S. equities have outperformed non-U.S. equities by an unprecedented margin since 2008. About half of the gap is due to higher growth in sales per share in the U.S.; another third, to more growth in U.S. profit margins; the balance due to greater U.S. P/E expansion. As a result, equity markets now appear more reasonably priced outside the U.S. than inside.
The Divergence Between US & Ex-US Equities
We think non-U.S. markets may soon be performance leaders. The MSCI World Index, excluding the U.S., has been essentially flat since 2006. Reaccelerating global growth, a weaker U.S. dollar, favorable valuations and generally improving corporate governance should provide support for many foreign markets in 2020 and beyond.
Our current view is neutral to slightly defensive. In our view, the U.S. stock market was expensive at its January 2018 peak and it is expensive now. While stock markets could continue to rise in the near-term, primarily from global stimulus and low recession odds, long-term returns are likely to be low. A downturn will inevitably come, even if it doesn’t come soon.
The adage that valuations are usually useless as a short-term timing tool has truth. Valuations by themselves offer little guidance on where the stock market is going in the short run. But if there’s a catalyst for change, valuations can have a big impact on subsequent returns. When stocks are inexpensive, unexpected good news can cause prices to surge. When stocks are expensive, as now, unexpected bad news can be the catalyst for sharp declines.
Heading into 2020, we expect to increase allocation to non-U.S. stocks and decrease allocation to U.S. stocks. We are favorably inclined toward Europe. Net profit margins among companies in the STOXX Europe 600 Index are about three percentage points below S&P 500 margins. This gives many European companies opportunities to grow earnings.
We will continue to trim FAANG stocks and FAANG-related holdings, which populate our Heterogeneous Computing, Cultural Convergence and Wealth Concentration themes. We are finding attractive opportunities in Molecular Medicine in both the U.S. and Europe. We believe the broader healthcare sector is well-positioned to outperform in 2020, after underperforming in 2019. We are also researching new opportunities in our Automation theme in the U.S., Europe and Japan.
More and more investment firms are using “thematic” to describe their investment approach. In many ways it is becoming a buzzword with little definition and few commonalities. Most common are single theme exchange-traded funds; there are now more than 120 U.S. listed funds and the number is growing. Almost equally common are actively managed products that refer to favored industries or geographies as investment themes.
Here is our foundational definition:
Thematic investing seeks investable ideas that stem from economic or technological changes powerful enough to influence corporate performance across multiple industries.
To amplify this definition, we expand on three key terms.
- “investable ideas” – 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 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 in 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 begin to expect it.
- “corporate performance” – Our approach focuses on changes most likely to have a profound influence on corporate performance, seeking companies that will be beneficiaries of thematic tailwinds and avoiding 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, 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.
- “multiple industries” – 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. We organize research analysts by theme, not industry. Each analyst is tasked with thinking about his or her themes holistically and uncovering relevant investment opportunities regardless of industry or geography.
This framework for thematic investing is then executed using a four-step process.
1) Identifying Long-term Secular Themes – The research team focuses on disruptive changes that span multiple industries. Special attention is paid to new technologies or business models, industry leaders, disruptors and high barriers to entry. The evolution of a theme is as important as the development of a new theme.
2) Individual Company Research – The thematic research process identifies companies that are participating directly or indirectly in thematic change. We seek companies positioned to capitalize on the change or disruption over a multiyear timeframe. Fundamental company research considers thematic exposure, financials, management and valuation.
3) Macroeconomic Overlay – The investment team constructs a macro view of the global economy including tax, trade, fiscal, monetary and governmental policies. While our themes unfold over the longer-term, cyclical factors can have shorter-term but important impacts on market weightings.
4) Portfolio Construction and Risk Management – Thematic portfolios consist of 40 to 50 stocks across five to seven themes. Individual holdings and the overall portfolio are continuously analyzed for portfolio characteristics, including beta, price/earnings multiples, factor exposures, and company, sector and geographic concentrations and diversification.
We adhere to our structured thematic investment process. It’s the constant we carry into 2020.
Bond yields have been particularly volatile the last few years. The 10-year Treasury yield rose to 3.24% in November 2018 and then fell to a low of 1.46% in September of 2019, for a 55% decline in just ten months. The yield subsequently rebounded to end the year at 1.92%, still well below its 2.9% average for 2018.
While central bank easing is succeeding in stimulating economic growth, it is also prompting a borrowing boom. Total global debt topped $250 trillion in 2019, as debt in the U.S. and China ballooned to levels never seen before. Global debt is now three times as large as global GDP and about three times the value of world equity markets.
We find the U.S. government’s trillion-dollar deficit in the eleventh year of an expansion worrisome. We’re also concerned the U.S. business sector, forced to deleverage after the credit crisis, is again taking on high debt loads. Recent corporate bond issues have generally been covenant light, suggesting that corporate borrowers, not lenders, are getting the better deals.
With yields low, we fear that many investors are chasing incremental yield. We think it likely that capital is being misallocated and money will be lost. We expect bond yields to be range-bound to modestly higher in the short to medium term. In this setting, our portfolios continue to be dominated by relatively short duration, high-quality debt instruments.
- Ashley G. Hall featured in Washington Business Journal’s People on the Move Posted in: Noteworthy, People - Ashley Hall has Joined Chevy Chase Trust as Vice President, Wealth Advisor/Relationship Manager. She advises clients in the areas of investment management, financial and estate planning, and trust administration.
- Amy Raskin featured on CNBC’s Fast Money Halftime Report – September 20, 2019 Posted in: Noteworthy, Video - Amy Raskin, Chief Investment Officer, appeared on CNBC's Fast Money Halftime Report on September 20, 2019, to discuss current market conditions and what they mean for investors.
Amy Raskin, Chief Investment Officer, appeared on CNBC’s Fast Money Halftime Report on September 20, 2019, to discuss current market conditions and what they mean for investors.
- Food for Thought: Maximizing Your Charitable Donations Posted in: Latest News, Noteworthy, Video - Chevy Chase Trust shares ideas about how to maximize your giving strategy.
Chevy Chase Trust shares ideas about how to maximize your giving strategy.
- Chevy Chase Trust supports Greater Washington Community Foundation Posted in: Community, Events, Noteworthy - On Monday, December 12th, 2019, Chevy Chase Trust proudly sponsored the Greater Washington Community Foundation’s Montgomery County Celebration of Giving at the Round House Theatre.
On Monday, December 12th, 2019, Chevy Chase Trust proudly sponsored the Greater Washington Community Foundation’s Montgomery County Celebration of Giving at the Round House Theatre. The network of donors and partners, and local nonprofit grantees were celebrated for growing the spirit of giving and collectively giving more than $120 million to nonprofits serving Montgomery County. This year Lawrence P. Fisher II, Susan Freed, Deb Gandy, Paula Landau, Laura Marsh, Stacy Murchison, Craig Pernick, and Peter M. Welber were honored to attend the Community Foundation’s celebration of the 2019 Montgomery County Philanthropists of the Year, Hope Gleicher and Andy Burness.
- Chevy Chase Trust | Washingtonian’s Best 2019 Posted in: Noteworthy, People - In November 2019, Chevy Chase Trust was featured as Marylands’s Best Financial Advisers in Washingtonian Magazine.
In November 2019, Susan Freed, Michael Gildenhorn and Leslie Smith of Chevy Chase Trust were selected by their peers as top Fee-Only Financial Planners in Washingtonian Magazine’s “Maryland’s Best Financial Advisers.” Read more.
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As thematic investors, we study secular trends, disruptive innovations and economic forces with the potential to reshape the world. Personalized medicine is a case in point.
The Human Genome Project and developments it has spawned are transforming our understanding of each person’s unique molecular and genetic profile. More important, as more whole human genomes are sequenced, over 1.5 million to date, increased data is yielding new knowledge linking genetic profiles to specific diseases. This is advancing the frontiers of diagnosis and treatment.
While many medications today activate or suppress the immune system, cell and gene therapies operate at a more granular level, introducing live cells or altering a person’s genetic code. Rather than manage the symptoms of a condition, cell and gene therapies can address the root cause, offering the potential to treat previously untreatable, and even cure previously incurable, diseases.
A Well-Timed Pivot to Rare Diseases
Concurrent with the rise of genomics, traditional drug development has reached a choke point. Bringing a new drug to market now takes on average 15 years with a cost of $2.6 billion. Large-cap biopharma companies in 2018 earned only 1.9% on their research and development investment, down from 10.1% in 2010. At the same time, late-stage pipeline assets have fallen by 23%. Compounding and confounding this slowdown, drugs that do reach the market often prove ineffective for many patients.
Drug developers have been shifting attention to rare diseases. Defined as conditions that affect fewer than 200,000 people, rare diseases include conditions such as Leber congenital amaurosis, an eye disorder that only affects two to three newborns per 100,000, and spinal muscular atrophy, which affects one per 8,000 to 10,000 people worldwide. In recent years, approvals of “orphan” drugs that treat these rare diseases have increased dramatically.
As over 80% of rare diseases have a known monogenic (single-gene) cause, rare diseases are particularly good candidates for personalized medicine. Our research estimates there are approximately 1,700 cell or gene therapies in various stages of clinical trials. From an investment standpoint, this shift to molecular/genomic medicine is opening up areas of opportunity beyond the drug therapies themselves.
Focusing on Genomic Enablers
It’s difficult to predict whether a drug in development will come through the pipeline, which of those that do will be commercially viable, much less which might become blockbusters. The technologies that facilitate development and logistics have more certainty and are the growth engines of a nascent field.
The processes and infrastructure used in cell and gene therapies are fundamentally different than those used in traditional medicine. We believe that a historic opportunity in personalized medicine lies less in identifying the next blockbuster drug and more from researching and understanding contributors in the genomic supply chain.
Identifying the Picks and Shovels of a New Frontier
As genomics disrupts the pharmaceutical and healthcare industries, the evolving ecosystem presents opportunities for infrastructure companies along the supply chain. Here are three very different facilitators – one in diagnostics, one in development and one in distribution.
Illumina is the global leader in DNA sequencing. The firm provides an integrated range of instruments, consumables and services that are essential in the identification and understanding of genetic variations.
Led by Illumina, the cost of sequencing the human genome has declined faster than Moore’s Law, from $13 billion in 2003, to $1,000 in 2014, and broaching a $100 genome today with the recent introduction of Illumina’s NovaSeq sequencer. At a lowering cost of accessibility, genome sequencing should have broad application in clinical diagnostics, particularly oncology and reproductive health.
We believe Illumina operates with a strong moat, owning 70% of the sequencing market and having generated over 90% of the world’s sequencing data. Illumina is to DNA sequencing what Google is to Internet search, but in its early stages with virtually no alternatives. A person only needs to have his or her whole genome sequenced once during a lifetime. But, if a genetic test can diagnose cancers before symptoms appear, healthy people might get a liquid biopsy as part of annual exams. We are at a tipping point in genomic sequencing as it moves from science to discoveries to applications to routine consumer genetic tests.
Horizon Discovery is the global leader in the design, manufacture and application of gene editing and gene modulation. Horizon Discovery creates genetic models of human disease that biopharma companies and labs use in drug development. Once these models are created, they become part of Horizon Discovery’s library of cell lines, currently the largest in the world at over 23,000. Customers are provided cells in pairs, one with genetic change attributable to a disease and one a normal version. Adopting gene editing to identify and validate biological targets for precision medicine offers faster, cheaper and more effective drug development.
On average, drugs now take 15 years to develop and cost $2.6 billion. The main component of the $2.6 billion is funding the cost of previous drug candidate failures, estimated to be 90% of the total. Horizon Discovery’s products help pharma and biotech companies fail poor drug candidates earlier in development. Horizon Discovery’s cell engineering platform allows these companies to understand the exact effect that genetic differences within a disease or patient will have on the efficacy of a drug.
Horizon Discovery should benefit from long-term trends to rationalize drug R&D, develop more personalized medicines and outsource components of drug development. This is particularly true of gene engineering where outsourcing is quicker and cheaper than developing resources and capabilities in-house.
Cryoport provides temperature controlled logistics solutions for the shipment of cell and gene therapies. Use of dry ice packing is no longer suitable for many new therapies because temperatures only average -80º Celsius with standard deviation up to 14 degrees. Samples used to develop CAR-T therapies must be kept below -136° Celsius and within a stable range of two to eight degrees. This requirement exists whenever therapies involve the shipment of living cells. Cryoport packaging can keep samples as low as –190° Celsius.
Cryoport’s competitive advantage includes a proprietary cloud-based tracking system that receives pings from cryogenic packages every seven minutes to report temperature, pressure, orientation, shock and humidity. It also includes chain of custody and compliance information providing end-to-end traceability of cellular drug products. This technology assures a very low failure rate giving confidence to shippers and receivers.
Since rare diseases by definition only affect a small number of people in any given region, shipping globally adds cost and complexity. Cryoport has worked in over 100 countries. Its first mover advantage, industry leading technology and global reach position it well in a growing market for cell and gene therapies requiring commercial transportation.
Molecular/genomic drug development should accelerate exponentially. As traditional drugs continue to take more time and money to produce, personalized medicine is coming of age in a favorable regulatory environment. Incentives in the Orphan Drug Act include market exclusivity for seven years, tax credits up to 25%, waiver of prescription drug user fees and grant programs. Further, because of the interconnected nature of the human genome, biopharma companies are able to leverage investment in one drug into the development of others. All of this helps ensure the growth of a robust industry infrastructure as more genomes are sequenced, more data is gathered, more diseases become treatable and new and better drugs come to market.
We recently sat down with Laly Kassa, who helps high-net-worth individuals, foundations, and non-profits with financial strategy at Chevy Chase Trust.
Tell us a little bit about your role here at CCT.
I am responsible for financial planning, so I work with clients to examine just about everything that touches their financial lives. At CCT, we devote a lot of time to planning because it lays the groundwork for the work we do on the investment management side. Planning gives us a full picture of the client’s background, current situation, and future goals so that we can be good stewards of assets we are entrusted with managing.
Tell us a little bit about your background.
I am from Ethiopia. I went to UC Santa Barbara for my undergraduate degree in Economics, and went to Columbia where I earned my Master’s in International Affairs. I always thought I would end up at some sort of nongovernmental organization; however, when I was in graduate school the first internship that was available was at a large bank. I was convinced I would hate it – but I loved it. I loved working with all the numbers and working with individuals, so I just went on from there.
Initially my role was very specific, looking at how clients were impacted by interest rates and foreign exchange and hedging that risk for them so that their balance sheets would not get whipped around because of changes in those markets. Over time my position grew into looking at clients’ full financial picture.
What do you enjoy most about your work?
It’s almost like being a detective. As you get to know a family, there are layers of things to uncover. You have a discussion with your client, you are given some documents, and you have to figure out what’s the impact of each piece on the family. It’s fun to decipher all of the elements and contemplate how we can be useful.
What makes Chevy Chase Trust different from other places you’ve worked?
That’s easy: the first thing is, we are not limited in the amount of planning, time, or resources we can spend on one particular client. Every client is afforded the same amount of expertise, so you feel like you can truly do a thorough job and address clients’ needs without the clock ticking. I don’t really believe that happens anywhere else. Additionally, we are face to face with the clients we work for and do the work ourselves. We don’t send the work to planners in a remote location that never get to know the client; many firms use that delivery model and it just doesn’t work, all the intangibles get missed. It is also important to me to work in a place with a deep bench and colleagues who have a tremendous amount of expertise. Maybe most important of all, this business is built in a way that avoids conflicts of interest so the client comes first.
This environment attracts people who are really smart, want to do well by their clients, and enjoy it. It makes this a very fun place to work.
What would you do if not this?
I have to admit that it changes all the time. When my children were little, I thought I’d like to own a toy and book store because I was in that kind of place so often and loved it. I thought I could be good at finding games that challenge the mind and books that ignite the imagination.
Currently, I’m helping my kids with non-profit work and I could easily do that too. Helping kids identify needs and use their technology and social media skills to harness the communities’ resources, or help children harness their classmate’s resources. There is much to be done and it is so empowering for kids to be involved in things that are bigger than they are.
What do you like to do outside of the office?
Now that my children are in high school and I have more time, I love to read, cook and travel. Travelling with the kids has been a lot of fun as they have gotten older – nothing beats watching that sense of wonder as they discover new countries and cultures.
I also like to learn languages, I’m learning Spanish right now – off and on, unfortunately.
What is your favorite book?
My favorite book of all time is called A Suitable Boy by Vikram Seth. It is set in India and, on the surface, it’s about a mother’s search for a suitable boy for her daughter but there is so much in these extended families that reminds me of my own culture and family members. The book I just finished is The Hired Man by Aminata Forna – although it is set in Croatia, it also reminds me of Ethiopia, with its tumultuous past that is evident only to those that have been through it.
What advice would you give to someone considering a career path similar to yours?
I’d say you have to enjoy being a jack of all trades and master of none. You aren’t the sole expert, whether it’s estate planning, insurance, or investments; you need to know enough to be helpful, but also know when to call in the experts. If you like working with people, problem solving, and working across lots of different disciplines, this is a great career path.