Active Investing — Tips for Success
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OSAM Director of Research & Senior Portfolio Manager Chris Meredith joins Bloomberg Markets co-anchors Carol Massar1 and Cory Johnson2 during his visit to their daily radio program in October.3

This interview4 offers a helpful and concise look at OSAM Research’s process…

“Bloomberg Markets: OSAM’s Chris Meredith on Successful Active Investing” transcript:

(Bloomberg Radio, Wednesday 4:05 pm, October 4, 2017)

Cory Johnson (BBR2): Chris Meredith joins us right now (Senior Portfolio Manager at OSAM) to talk about investing and Active investing. So much a focus on a past investment makes people, aspiring stock pickers like me, crazy. And yet, it’s hard to get away from this great argument — Active stock picker Warren Buffett put it as plainly as anyone — that indexing, because the fees are so low, can work out so great for investors.

Chris Meredith, CFA (Chris): I would say that indexing can work out great for investors if they’re basically individual investors that aren’t committed to a process and don’t have the right perspective on what they need to do in order to be a successful investor. At O’Shaughnessy, we spend a lot of time thinking through how to build successful investment strategies, and we’ve spent a lot of our time realizing that a key aspect of this is educating people on how to build a successful investment strategy, not just using our strategies, but having the discipline themselves to go through and be a long-term investor.

Carol Massar (BBR): Yeah, Jim O’Shaughnessy has spent some time with us, kind of explaining your methodology. Talk to us a little bit about the kind of key metrics that you guys focus on.

Chris: Sure, I mean the metrics are one thing, the data points that we look at. Really, Jim’s been doing a lot of work recently with some posts at our website,, and some blog topics. Really, he’s been talking a lot more about the mental perspective people need to have to be a long-term investor.

There’s obviously a portion of us where we are not traders; we’re not looking at short term — you know, “Got a hunch, buy a bunch” — and do one trade to try to make a “double” or a “triple” along the way. We build strategies for the long term, where we’re looking for people with investment objectives over decades. And what you want to do is … once you have that perspective of being an investor, then it’s about building a process.

I also teach at Cornell and, with students, the very first thing I say on the first day of class is, “Being successful investors, you have to separate your process from the results.” And the idea is that — when you’re teaching students and they have a program where they’re running money, they have, essentially, 9 months with me where they’re learning how to do this — and the idea is you build a successful process, but over a 9-month period —

BBR: But nothing’s ever successful 100% of the time. So when do you determine that the process that you’ve got in place … after what chunk of time do you say, “Well, wait a minute. This process has got to change a little bit.”

Chris: We give a very long period of time, because you can wind up being successful. The average successful investor is right, on a quarterly basis, probably about 6 times out of 10. Which means 40% of the time, you’re looking at yourself in the mirror and saying, “This quarter didn’t work.”
It’s a really challenging perspective to have. Where your quarter, you’re behind —

BBR2: Well, I mean when I was on the buy side, you’d try to talk about short-selling to someone that didn’t short stocks, and even among us who did, I worked at a short only fund for a while, and ran a big chunk of money there, and you’d talk to someone that didn’t short stocks, and say, “Well, what’s your timing on this?” Well, I don’t know what it’s like, I’ve got a notion, but it’s gonna be wrong. The stock’s gonna go up before it goes down. I don’t know the last day the stock’s gonna be up. It’s not worth what it’s supposed to be today, so it should start going down any second now, but probably won’t.

Chris: Which is the important part about building a process. At OSAM, what we do is we build quantitative strategies and take emotion out of the process. The hard part is, if you’re going through and you’re working through your brain, and through all the emotions that we have hardwired to make reactions at the wrong times, you can wind up having difficulty. Hence, this is why passive investing does work for some people that don’t have that [requisite] long-term perspective or discipline.

BBR: Well, yeah, because I know our tease into today’s interview was how the “mad rush by investors into passive products” is an opportunity for Active investors. But Active investors can get thrown by their emotions?

Chris: Absolutely.

BBR: And make bad decisions at the wrong time. So why not continue the kind of, stay with, the passive mode where you kind of take, hopefully, emotions out of it?

Chris: Because you’re giving up the opportunity for upside, right? You have the ability to —

BBR: And down. Yeah, but you’re also maybe protecting yourself on the downside.

Chris: What you’re doing is you’re basically setting your bar and saying that, “I’m gonna get market-level returns,” right? And you’re saying, “If I’m gonna try to build an allocation for myself, I’m gonna sit there and have my equity fixed income,” and that’ll be the only lever you have [in order] to meet your investment goals.

The point is: If you can go through and build an Active strategy within that allocation, and you have successful tools, or you can hire somebody who has the successful tools, you can wind up adding to that overall performance. Yale’s Endowment is a good example of that, where they generated 5% excess return. Half their excess return basically came from that manager selection component, and half of it came from the asset allocation. If they had only gone with the allocation, and gone passive with the rest, they would have given up half their upside.

BBR: I’m playing with you a little bit. But, you know, you bring up the endowments. A lot of university endowments have had a tough time actively making investment choices.

Chris: Recently, it’s been a tough, challenging environment for Active investing —

BBR: Several years.

Chris: Overall, yes. But if you look at the long-term data, there have been long periods of times where Active management has struggled. You look at the 1998, 1999 timeframe, looking at this now, where it’s a long period of time, but it is not one that’s out of the norm for the longer cycle of when Active management has worked and has not worked.

BBR2: It’s interesting, too, that I think it’s really sort of about the “quality” of the managers. I mean, I’m not saying this so you’ll put some money in my firm, the firm that I worked at, as well. But it really is about the quality of the managers, and the average return from a hedge fund, or the average return to investor, isn’t good because [to begin with] they’re average.

But the better ones — and everyone thinks they’re doing that when they’re picking a stock — they think they’re picking a better stock. They think they’re picking a better mutual fund. They think they’re picking a better hedge fund. They think they’re picking a better sector for their ETF or their index. But they’re not.

Chris: The important thing for us is if you have a process. Where you’re going to the bottom, and you’re saying, how are you building these?” And having a repeatable methodology for identifying investments, we think you have a better idea of how you’re going to build a portfolio than if you’re sitting there and trying to identify trends every time through.

If you’re trying to keep on top of the market and say, you know, I think right now it’s gonna be this type of style that will work, or this time this style will work, that is less successful than having one style overall and keeping it.

BBR: You guys are Buy & Hold?

Chris: Yes.

BBR: For a while, I’m just curious, in the recent environment … are there any changes that you have potentially made to some of your positions?

Chris: We’re always looking to improve on our strategies, and our positions will rotate through based on characteristics, but the philosophies are the same ones that Jim started with back in 1996, when he wrote What Works On Wall Street,5 and that’s identifying stocks based on characteristics like valuation, momentum, and yield. And those are still the same bedrock principles we use today.

BBR: Hard to, though, ignore the momentum that we see in the broader market. Again, going back to the index.

Chris: Yes. It’s one where the index has proven Active management wrong for, now, 5 out of the last 6 years, right? So, it’s been a challenging environment but, again, not one that makes us sit there and say we should give up on the idea of Active management in total.

BBR2: So, how’s your last year been?

Chris: It’s been good. We’re actually —

BBR2: Define “good”.

Chris: Our large value strategy is outperforming 6.5%, almost 7%, year to date. We’ve had a strong rally in the past 12 months, and we’ve been doing fine.

BBR2: So, let’s get to that process a little bit. Describe a key component of some of the tough decisions you’ve made in that process.

Chris: Yeah, so our large value strategy is one that identifies companies based on the return of capital. And it’s the idea that the Shareholder Yield, where you’re —

BBR2: Return invested capital?

Chris: Return of capital through dividends and share repurchases.

BBR2: Okay. Share repurchases, really? I have a hard time seeing that having value. I have a hard time getting my head around that idea.

Chris: The idea is that these are companies that are making strong capital reinvestment within their own companies, but they have excess capital out there and they’re giving it back to shareholders. It’s actually —

BBR2: But is it really giving it back to shareholders?

Chris: It is. Through the repurchase of shares — it’s a methodology where they’re recouping the shares that are out of the market — it consolidates it and goes through. The example I would give is Boeing. Right? Boeing has gone through, and in the last 3 years, it’s generated $32 billion in operating cash flow. It’s taken $20 billion of that and done it on share repurchases.

Now that’s a portion where what happens is, it embeds a secondary growth rate inside of the stock, so where it’s been where, even though the sales have been flat, they’ve improved a little bit on their operating margin, but they’ve gone through and had their EPS grow from 6.7 up to 11.4, essentially. So, $11.38.

BBR2: But that’s also a company that sees sales had been up/down 2% last year. But I look at other companies, like IBM, that have borrowed money to fuel (to pay for) a lot of share reacquisition —

BBR: Buybacks, yeah.

BBR2: Earnings per Share (EPS) is going up, but the business is shrinking massively. And, while the stock’s done well in the last year, it’s done terribly over the previous few years.

Chris: There are some portions of these that are gonna be contrarian, but the important part for our strategy, again, is that we’re identifying the characteristics we’re using to build portfolios. We also believe that you build investment strategies on probabilities. Right? The idea is that we are sitting there and saying that, on average, the stocks are going to outperform more than not. And it’s one that’s built a successful track record over time.

BBR2: So would your strategy then also buy some IBM, even though the company is doing poorly? Or is there something that screens out a company like IBM, where it’s got shrinking revenue, shrinking operating profits, but also a shrinking share count.

Chris: Our overall process takes in other characteristics as well, to try to go in and identify companies —

BBR2: So what’s the one that corrects for the mistake I’m pointing out?

Chris: Earnings Growth is one that we look at to see precipitous declines in earnings, poor return on invested capital —

BBR2: So net income, not just earnings per share?

Chris: Correct. And that’s when we’re looking at, also, we have Financial Strength, to look at the leverage on the balance sheet, the direction that it’s headed in, the quality of the earnings to check the representation of how a company is presenting itself, and whether it’s conservative or aggressive.

BBR2: Quality of earnings, meaning what? Tell me what a bad earnings quality looks like compared to a good earnings quality.

Chris: If its net income is higher than its cashflow, and you’re winding up seeing it where it’s —

BBR2: Right, thank you.

Chris: That’s one that would be a poor quality of earnings, because it’s basically boosting its earnings through accounting choices.

BBR2: And we see that a lot.

Chris: You can see that. It’s about 15% of the companies out there.

BBR: We gotta leave it there. Fun conversation, thank you so much, say hi to Jim.

Chris: Will do!

BBR: Chris Meredith, head of research, and Senior Portfolio Manager at O’Shaughnessy Asset Management (roughly $6 billion in AUM, based in Stamford CT) in our Bloomberg 1130 AM radio studio.

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  3. For more insight on this topic of investors and mental fortitude, see this Blog’s previous post “Humans are Unreliable Experts, Getting in the Way of Outstanding Performance”.
  4. For other recent interviews with members of the OSAM Research Team, visit our Blog’s interview archives.
  5. What Works On Wall Street is now in its 4th edition. 1996 is the 1st EZdition.