Subtitle: The Essential roles of culture,
philosophy, and technology, Wiley, 2016, 306 pgs., index, tables
This is an interesting book - quite the opposite in many ways from Baruch Lev's
End of Accounting. The subject is the
management of the methods for determining what to recommend in an investment
advisory business. The authors separate that from the management of the
business itself as a business, which they defer for another day. They want to
focus on the business of managing client assets. In other words how do they
select the stocks and bonds - mostly stocks - to include in investment
portfolios. What is their philosophy and beliefs about what creates 'value' in
a business and its current and future market prices. What they mean also is
what has created 'value' in their own business.
They strongly advocate 'active management' as opposed to 'passive management' -
meaning evaluating and selecting individual stocks rather than passively
investing in index funds. And for specific variables they strongly weight free
cash flow. But from reading the book I get the idea that they have not embraced
the analysis methods and assessment criteria advocated by Lev in the book
So both books are mainly focused on advice for professional investment
management. But they both also do believe that their insights will be valuable
for individual investors.
Actually, this one is the better reads for managers of any type of business. It
can be read on two levels - 1 the description of how they conduct their own
business from a management point of view provides some worthwhile advice for
managers of any other business. and 2 their description and argument about why
they believe in the 'active' versus 'passive' method as the best way to invest
does provide some useful information about how to evaluate stocks.
But read the appendices.
The authors do note that active management of investor portfolios has declined
in recent years in comparison with increases in passive use of index funds. And
they agree that the performance of many active managers has not been equal to
market averages. They give their views on the reasons for this. They comment:
"However, the markets have not changed inalterably, at least not in our
view. The essence of active management is a well-designed investment process
that measures the relative value of individual stocks, and takes advantage of
the many mispricings that result from less-than-optimal actions of investors,
both individuals and professionals". But Baruch Lev and his group believe
that the markets HAVE changed dramatically - the factors which create value for
businesses have changed greatly and traditional standard accounting methods do
not capture these changes. So going through the book we need to watch and
compare the methods used by Mr. Priest and company with those dramatically new
methods advocated by Mr. Lev.
The authors propose that "To be successful, an investment firm must clear
three hurdles - its clients must reap superior investment performance, its
employees must find desirable long-term employment, and its owners must earn
fair financial returns". The authors seek to describe what are the
'required and essential elements to achieve these goals".
"The first element is firm culture, which is the bedrock of success for
any firm"... This is the subject focus of the first section.
The "second section offers background on the debate over the merits of
active management versus passive alternatives and points out that active
investment managers have been challenged by an array of difficult market
"The second section also discusses Epoch's (his company) views of the
investment world, and what the firm sees as the most effective investment
process for outperforming the general equity market". The company believes
that the main source of 'value' in a company is its free cash flow. In the
third section the author focuses on the role and impact of information
technology in the analytical process.
But what about the great role and impact of information technology in the
process of creating value by the businesses being studied by the investment
Part I Culture
Chapter 1 - Culture at the Core
The author correctly notes that every organization had its particular culture
and that this is a central aspect of that organization which so strongly
influences its success. He describes in some detail how culture is so important
to a "knowledge transfer business" of which of course investment
management is one.
"The Original Organizational Culture: Command-and-Control"
The author writes that this form of business organization predominated in the
past, but has "drawbacks" now.
He recommends "An Alternative Culture for Knowledge Businesses" now.
And this can be created in "The Partnership Culture Model" He devotes
sections to describe "Support" - "Shared Interest"
"Justice and Fairness"
Chapter 2 - Culture in Investment Management
The author begins with: "Investment managers present a puzzle to
understanding the prospective value of their work, even when compared to other
services businesses". By this he is considering what metrics are best for
motivating and then evaluating managers and analysts. And this becomes even
more difficult when attempting to predict their future performance".
(Don't forget the standard pitch - past performance is not indicative of future
He moves to a section on
"Values" "Underlying an investment firm's culture is a set of
values - beliefs and principles that guide its employees in their work, and its
leaders in their strategic decisions for the organization". He then
describes Epoch's values. Next he turns to
This brings him to discuss fiduciary accountability and some examples of
failure in this respect. Then comes:
Clearly an essential value. Again ,he describes Epoch's efforts to insure this.
In the remainder of the chapter he focuses on several other aspects of the same
general topic of developing a proper organizational culture.
Philosophy and Methodology Some interesting statistics: Total assets managed in
North America estimated at $31 trillion in 2014, generating revenues for the
year of $111 billion. Does this mean revenues for the asset management
industry? The management was by 138 large firms, but there were 11,000
registered investment advisers.
Chapter 3 - The Nature of Equity Returns This chapter is a
primer describing some basic financial concepts -
"The Real Economy and the Financial Economy"
"Components of stock Returns"
"The Historical Makeup of Stock Returns"
Chapter 4 - The Great Investment Debate: Active or Passive
In the course of arguing 'active' versus 'passive' the authors introduce
several more basic concepts.
"An Elegant Theory: The Capital Asset pricing Model"
Some academic economist professors developed what is termed "Modern
Portfolio Theory MPT" The first basis for this is the "Capital Asset
Pricing Model - CAPM"
The authors note that: "The CAPM is an elegant theory, the objective of
which is to describe the relationship between risk and reward for financial
assets, and it offers a simple design for thinking about markets".
They continue: "One of its key tenets is particularly relevant to the
debate about active, versus passive investing. The CAPM starts from the
assumption that all investors define risk in the model's terms - the
variability of returns".
Then they proceed to claim "that MPT demonstrates that there is one
optimal portfolio of stocks which, when combined with cash, will provide the
highest return possible for a given level of risk".
After going through several steps the conclusion is that: "CAPM relies on
the logical inference: investors will all want to hold the optimal portfolio,
but the only portfolio that is possible for every investors to hold
simultaneously is a miniature replica of the overall market, so the market must
be the optimal portfolio".
But this is the genius of the index funds.
"Further Elegance: The Efficient Market Hypothesis"
This is the second basis that supports the MPT. This theory claims that stock
prices always reflect all available information about the economy, markets and
companies, and that all investors interpret that information in the same
rational way, resulting in rational prices for securities".
Of course if this is true it is futile to attempt to outguess the market.
The authors rely on Professor Schiller, another Nobel Prize winner like those
other guys, for quotations about the flaws that soon appeared in this MPT. They
continue by describing 'alpha' and 'beta'. Just skip these.
"The Problem with MPT"
The authors ask: "Why have the elegant theories that make up MPT proven to
be poor descriptors of the real world of markets?"
Well, the assumptions at the basis of MPT are false. (Indeed, I have books and
books about this.) People do not think in the manner the MPT guys presume. I
could never understand how any person (even an academic) could fail to realize
Chapter 5 - A More Human Description of Investors and
Markets: Behavioral Finance
In this chapter the authors introduce the relatively recent intervention of
behavioral economists who take into consideration the psychology of individual
investors. So this is a new academic conception.
The authors again: "MPT dictates that all investors make identical,
dispassionate evaluations of investments based solely on expected return and
volatility, but this assumption ignores the impact of a phenomenon known as
Another fundamental fact easily observed throughout history, but the errors are
much more than this. Nevertheless, the authors proceed to model this factor.
The authors describe this psychological phenomena as investors having more than
one view - opinion - of a stock and the market simultaneously. (Apparently like
the Red Queen).
They claim MPT is incomplete in that it does not take investor behavior into
account. But behavioral finance theory claims that real investors seek both the
maximize returns and to minimize regret, but these objectives clash.
Another typical mistake by investors who are to confident in their own ideas
and skills. They believe they know more than their really do. Two results are
buying the wrong investments and trading too much.
"Extrapolation and Reversal"
Individuals tend to see patterns in data where none really exists.
"Investor Behavior in Action"
The authors present examples of the above psychological generating errors in
They comment: "While academics and investors have know about these
tendencies for decades, the market apparently has not bid them away".
And further: 'These points are important to active investment managers, as
investors' reaction, overreactions and missteps lead to the mispricing of
securities, and create some inefficiencies and opportunities in the
What they are claiming is that the errors of others create the opportunities
they use because they are not subject to these same errors. While 'passive'
investment is also not subject to these errors directly they are built into the
market, simply buying the market does mean that the passive investor subjects
himself to the results from common errors that are inherent in the market while
also missing out on the opportunity to take advantage of them. (if he is smart
of course - or better yet has a smart advisory firm working for him.)
"MPT Still Lives"
Yes, the rational behavior camp still exists. Despite authors such as Justin
Fox - The Myth of the Rational
Market - And David Kahmenan Thinking
fast and slow. and Douglas Hubbard - The
Failure of Risk Management. And William Bernstein - Rational
For this the authors discuss the publications of Professors Eugene Fama and
Kenneth French who continue to modify their Efficient Market Hypothesis.
Chapter 6 - Active versus Passive Management: The
The empirical case means the authors want to base their preference for active
management on real data. Their conclusion of course: "Given the debate of
the past 50 years, we conclude that what might have started off as an ironclad
theoretical case for passive management has been worn down by the real-life
insights of the behavioral economists". "A large and diverse
investment industry works hard to out-perform the broad markets, but the
historical record of returns achieved by active managers is mixed".
The chapter, then, is focused on what forces are involved in determining
whether a manager outperforms or under performs in a given year. Among these
they discuss "Market Regimes", "Correlation and Dispersion"
"The Weight of Cash", Luck versus Skill", and "Investors
Voting with their Dollars".
Chapter 7 - The Case for Active Management
Here they recount a classic debate between Jack Bogle, champion of passive
investing, and Jim Grant, arguing for active investing. They consider what
might happen if either method was adopted 100% - that is if all trades in the
market were the result of passive management or all resulted from active
management. Both systems, if adopted 100% would change the nature of the market
Then they turn to making their case.
"The Case for Active Management". Success in active management
depends on discipline. The manager must
1 understand the forces that create inefficiency
2 capture it by 'casting wide net' and
3 properly structure portfolios to filter out the impact of extraneous factors.
The manager must find a specific misallocation or inefficiency - eliminate the
influence of any other unknown variables - and then find a way to exploit it.
Chapter 8 - Debates on Active Managers' Styles and Methods
In this chapter the authors 'consider the variety of styles and techniques
equity managers apply to their investing, and highlight what they consider to
be the core of their own companies' economic value - free cash flow.
This is mostly either fundamental or quantitative.
"Free Cash Flow is the Measure of Value"
Other than my opinion that 'value' cannot be measured, this section makes a
case that the best metric to use is free cash flow. Check Lev's book for his
opinion on whether this is even properly described with current accounting
Another problem, which they recognize. "The greatest shortcoming of
earnings reported under generally accepted accounting principles (GAAP) is
probably depreciation expense".
Another type of problem. They point out that corporate management can and does
manipulate the data it provides and they provide several examples.
"Research and Development Costs"
Another subject that Lev discusses.
"Why Do Accounting Figures Still Dominate the Discussion?
Again, see Lev's book.
"The CFO Perspective"
"Companies themselves appear to place greater weight on earnings-based
measures than on cash flow". And "The researchers also found that
CFO's as a group believe that as many as 20 percent of companies intentionally
misrepresent their earnings in any given year".
Chapter 9 - The Jump from Company Earnings to
"Flaws in Traditional Valuation Measures"
Here they discuss the problems with price/earnings ratios and with book value.
Again they agree with Baruch Lev.
"Accounting versus Finance: A Case Study"
"For an illustration of the shortcomings of accounting principles, and the
potential peril of measuring a company's performance solely on accounting
earnings, we turn to a classic case study." The study showed that actual
'value' is determined by the future cash flow an asset will be able to
Chapter 10 - Epoch's Investment Philosophy In this chapter
the authors describe their company's (Epoch's) methods. It obviously is based
on the ability to determine a company's actual free cash flow. It is a rather
lengthy chapter as befits the purpose.
Part III Technology
"In this section we look at the rapid evolution of information technology
and innovation in general to consider how investment managers have applied it
over the past several decades and then describe their own applications.
Chapter 11 - High Speed Technology
The authors describe the well known story.
Chapter 12 - Technology in Investing
And this chapter continues the story into the application of AI.
Chapter 13 - The Epoch Core Model
They describe this.
"Factors in the Epoch Core Model"
The Epoch Core Model does not apply in-depth knowledge of companies' business
models or the industries they operate in. Rather, it looks through financial
statements to identify and rank a large number of companies with a preliminary
set of desired financial and valuation characteristics. By ranking individual
companies against their peer groups - rather than setting the bar at absolute
levels of statistics - the model remains flexible and adaptable to a range of
Chapter 14 -Racing with the Machine
In this chapter the authors claim that investing is too important to be left to
robots alone. No argument from me.
The authors write: "Our goal in writing this book has been to describe the
qualities that we think are essential in the creation and perpetuation of
successful asset management firms. We have also tried to describe Epoch
Investment Partners, and to map ou out place in an indusry undergoing rapid
change in its strategies, its channels of distribution, and its use of
Appendix A - Selected Articles and White Papers of Epoch
Investment Partners The first article is economic math.
The second article, however, makes this reader question the author's entire
understanding of political-economy, at least as it was reflected in the market
financial crisis of 2008. It is a commentary presented at the Foreign Policy
Association World Leadershisp Forum in 2009 and titled "The Financial
Crisis: A 'wodunit' perspective". The author states his case thusly:
"This paper will argue that the recent financial crisis occurred at the
intersection of (1) an asymetric compensation system inside banks that
benefited from balance sheet leverage, (2) a deregulated banking system: (3) a
waning memory of crisis past; (4) the promotion of self-regulation by the
financial industry's government authorities; and (5) a near catastrophic
Federal Reverve policy under Greenspan."
While there is much vaildity in the above, especially (5) about the Federal
Reserve, the causes of the financial crisis lie outside the first 4 issues
presented here. But the author completly ignores the political role going back
as far as Presicents Clinton, Carter and BushII in forcing the banking system
to invest in obviously inappropriate home mortgage securities to meet political
demands for more home ownership by their favored friends. See many studies
including Grorgr Melloan's The Great Money
Appendix B - Financial Asset Valuation
Appendix C - Feathered Feast: A Case