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William W. Priest - Steven D. Bleiberg


Subtitle: The Essential roles of culture, philosophy, and technology, Wiley, 2016, 306 pgs., index, tables


Reviewer comment
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 linked above.
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 conditions".
"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 industry?


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 performance.)

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.


Part II
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"
"Price-Earnings Ratios"
"The Historical Makeup of Stock Returns"


Chapter 4 - The Great Investment Debate: Active or Passive Management?
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".

No kidding

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.

"Reality Intrudes"
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 this.


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.

"Loss Aversion"
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 loss aversion".

Another fundamental fact easily observed throughout history, but the errors are much more than this. Nevertheless, the authors proceed to model this factor.

"Mental Accounting"
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).

"Minimizing Regret"
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 market behavior.
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 markets".

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 Expectations
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 Empirical Case
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 itself.
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.

"Manager Style"
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 rules.

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 Stock Prices

"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 generate.


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 market environments".


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 tgechnology".


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 Binge.


Appendix B - Financial Asset Valuation


Appendix C - Feathered Feast: A Case


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