DARDEN IDEAS TO ACTION investinginsights insights in this e-book are culled from the Darden School...

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DARDEN IDEAS TO ACTION

The insights in this e-book are culled from the Darden School of Business’ thought leadership website, Ideas to Action. For

more insights from Darden faculty, please visit ideas.darden.virginia.edu.

For additional insights into investing, we encourage you to

attend the 2015 University of Virginia Investing Conference, hosted at the Darden School of Business by the Richard A.

Mayo Center for Asset Management.darden.virginia.edu/uvic

http://ideas.darden.virginia.edu/?utm_source=ebook&utm_medium=owned&utm_campaign=uvic

http://www.darden.virginia.edu/uvic/?utm_source=ebook&utm_medium=owned&utm_campaign=uvic

INVESTMENT STRATEGIES FOR A LOW-RETURN WORLD featuring Lawrence Kochard, CEO and Chief Investment Officer, University of Virginia Investment Management Company

MAKING IT EASY TO CATCH FISH: TIPS FOR INVESTING IN THE CHINESE MARKETfeaturing Pedro Matos, Associate Professor of Business Administration, University of Virginia Darden School of Business

BUY LOW-GROWTH FIRMSfeaturing Michael J. Schill, Professor of Business Administration, University of Virginia Darden School of Business

WATCH OUT FOR FAIRY TALE RETURNSfeaturing Richard B. Evans, Associate Professor of Business Administration, University of Virginia Darden School of Business

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CONTENTS

2#uvainvest15 l +1-434-924-3900 l darden.virginia.edu/uvic l ideas.darden.virginia.edu

INVESTMENT STRATEGIES FOR A LOW-RETURN WORLD


Lawrence Kochard2 | by Jay Hodgkins





The Richard A. Mayo Center for Asset Management will

host the 2015 University of Virginia Investing Conference

at the Darden School of Business 12–13 November, where

financial experts from around the United States will discuss

the theme, “Investing in a Low-Return World.” University of

Virginia Investment Management Company (UVIMCO) CEO

and Chief Investment Officer Lawrence Kochard provided

a sneak preview of what investors are facing in the current

environment at a 2015 Financial Panel in New York City

hosted by the University of Virginia Club of New York and

the Darden New York Alumni Chapter.





Know thyself (when it comes to active versus passive investing). UVIMCO seeks active sources of returns through top managers it has invested with in the past and by investing globally. By taking an active investment approach, UVIMCO is able to deliver returns in the current environment at around 7.5 percent with the same level of risk as passive

indices that are only delivering 4 percent returns. However, not all investors are capable of executing an active investment strategy, particularly individuals but also many institutions. Investors that are better suited making passive investments should adjust their planning to expect lower returns from their mix of bonds and equities.

Focus on the micro.Kochard said 9-11 ushered in the rise of “macroinvesting,” in which investors focus heavily on macroeconomic trends like terrorism or tax policy. However, too much focus on macroeconomic headwinds can paralyze investors. UVIMCO, instead, invests through managers “who are extraordinary at security selection” and tries to ignore the headwinds.

“One of the big challenges right now is that we are in a very low-return world. I don’t think everyone necessarily realizes that,” Kochard said 17 June during the panel.

The question, though, is how can investors prosper — or at least tread water — while this low-return world persists. Kochard provided his insights on navigating the challenge.





Keep an eye on technology. While many sectors are stuck within the paradigm of a low-return world, some sectors are poised to soar. Kochard singled out technology as a promising sector and said finding those few “winner take all” tech companies early can provide strong returns.

Don’t overpay for return certainty. Kochard sees a bubble

in the demand for certainty that

bonds and bond-like investment

instruments provide. Through this

demand, investors are bidding up

prices for these yielding assets,

which carry more risk than U.S.

Treasurys while providing very little

extra in return. UVIMCO elects to

keep it simple by limiting its bond

investments solely to Treasury

bonds. As with virtually all bond

and bond-like instruments in the

current low-return world, Treasurys

are generating a negative real return

when factoring in inflation and costs

of capital, but allow UVIMCO to

avoid taking on more risk for little

additional return.

Take note of companies buying back their own stock. Many companies have turned to this strategy to use capital due to a lack of confidence in making other investments. Kochard said share buybacks

are not necessarily bad for investors who own stock in those companies, and can actually be a strong positive when companies have a history of spending their capital poorly.



MAKING IT EASY TO CATCH FISH: TIPS FOR INVESTING IN THE CHINESE MARKET

by Pedro Matos6



One such opportunity might be the Chinese media market, with a potential audience of more than 1.3 billion people. But government restrictions on direct foreign ownership and on content mean that investors must invest in Chinese-based companies.

A recent Darden case study on Focus Media Holding Ltd. presents a good illustration of the challenges and nuance faced by foreign investors in mainland China. Building on its success as the leading digital media network in China, Focus Media went public in 2005 in the largest initial

public offering (IPO) of a Chinese company on NASDAQ up to that time. At the peak of the wave in 2010, China-based firms represented more than 25 percent of all IPOs listed on U.S. stock exchanges.

In 2011, Muddy Waters, a U.S. short-seller fund and equity research firm, accused Focus Media of overstating the size of its business and of deliberately overpaying for acquisitions. Muddy Waters had been involved in some of the most high-profile cases of fraud allegations in China and four of its first five target firms had to delist. The fund was

named after the Chinese proverb “muddy waters make it easy to catch fish,” which suggests that non-transparent markets allow for opportunistic behaviors.

Focus Media’s stock price fell sharply at first but then rebounded as the company countered the attacks. In 2012, the U.S. Securities and Exchange Commission (SEC) launched its own investigation and pressured Focus Media to amend some of its filings. Focus Media was taken private in a deal valued at more than $3.7 billion — China’s largest-ever buyout. In the following months,

China has emerged as the world’s second-largest economy, but does this momentum necessarily translate into investment opportunities for foreign investors?





several Chinese companies followed suit and delisted from the NASDAQ. As of 2015, the private equity investors are looking to exit from the deal and going public in Hong Kong appears to be the preferred option, but the situation remains murky.

Situations such as Focus Media, and the challenges and opportunities surrounding Alibaba’s high-profile IPO in 2014, illustrate how attention to corporate governance and an understanding of regulatory differences will continue to be a priority for investors in the Chinese market.

Investors should keep several considerations in mind:

Don’t:

Do: Be careful about basing an investment decision purely on the favorable-looking economic or GDP-based growth characteristics of a country or region.

Understand governmental and regulatory restrictions on ownership as part of your research and be sure to understand exactly what you’re investing in (for example, a variable interest entity can be a workaround for investing in Chinese Internet or media companies such as Focus Media or Alibaba and is based on contractual agreements between entities, rather than an outright equity stake).

Make the assumption that financial statements and filings can’t be changed; in some cases, fraudulent practices, in any country, do not become obvious for some time.



BUY LOW-GROWTH FIRMSMichael J. Schill9 | by Carlos Santos


BUY LOW-GROWTH FIRMS

How could that be? Schill, an expert in corporate finance and investments, knew the observation seemed weird.

“It’s counterintuitive, but the market seemed to be enamored with firm growth to its detriment. So we began testing,” he says.

His research began with a simple question, “Do we see firms that are expanding their assets, expanding their balance sheets, doing any better or worse than those firms who are not or who are contracting? You’d expect that those expanding are the best investment and those contracting are the worst.”

“The headline finding is, that’s exactly

wrong,” says Schill, “And it’s to the tune of big money.”

Schill’s research shows that, on average, from 1968 to 2008, high-growth firms that expanded their balance sheets earned about a 4 percent return annually — or just about the same as U.S. Treasury bills.

Firms that expanded the least — or even contracted — earned the most — a whopping 24 percent annually. The stock market’s average yearly return is about 8 percent.

“So you’ve got this massive 20 percent spread if you bet on low-growth firms instead of high-growth ones,” says Schill. “I’m not saying all growth is bad, but that the

Darden Professor Michael Schill set out to hunt down the answer to an odd phenomenon he noticed:

Companies that were growing — with expanding assets — appeared to be a bad investment.





market systematically misprices it

… the market gets too giddy about

capitalizing a firm’s growth.”

Schill calls it “the absolute easiest

trading strategy imaginable. Imagine

starting a hedge fund and you work

one day a year, on June 30. You

download all the asset numbers for

the firms in the U.S. You sort them

into two baskets by comparing this

year’s numbers to last year’s. Doing

that over that 40-year window would

get you fabulous returns. Just buy

contracting firms and sell growing

firms.”

Contracting firms often shrink

for good reasons: because of

efficiency, a reduction in inventory

or just working to do more with less.

Growing companies often grow for

the wrong reasons.

“My view is that the market is

enamored with growth. Investors

systematically under-appreciate the

incentive managers have to ‘empire

build,’” Schill says. “Managers like to

grow firms by acquisition or by green

field investments — like building

a new factory. The problem is,

investors also like growth.”

Schill says that “the biggest variable

MY VIEW IS THAT THE MARKET IS ENAMORED WITH GROWTH. INVESTORS SYSTEMATICALLY UNDER-APPRECIATE THE INCENTIVE MANAGERS HAVE TO ‘EMPIRE BUILD.’





to explain how well a manager is

paid is how big the firm is. Size

dominates anything else, including

performance. Managers at big firms

get paid more whether they do well

or do poorly.”

“Certainly you get paid better if you

perform better, but size dominates

performance in corporations, so that

creates this perverse incentive to

grow your firm,” he says.

It’s well known that acquisitions

are bad all around. It’s good for the

target, bad for the acquirer. The

reasons are usually very simple. “If

you’re a firm acquiring another,

you’re probably paying too much or

are too optimistic in how you think it

will all pan out,” he says.

For example, earlier this year,

Verizon grabbed Verizon Wireless

from Vodafone for $130 billion using

Verizon stock to make the buy. The

German software company SAP paid

$4.4 billion last year to acquire US

Ariba so it could push into Cloud-

based software solutions.

“Both firms appear to be trailing

their respective index by a large

margin post-acquisition,” says

Schill. But Schill’s research shows

that while growth by acquisition is

systematically bad, it’s not uniquely

bad. “That observation is true for any

growth, including organic growth.





“Past research shows that acquisitions tend to be especially onerous if the acquiring company pays with stock or has a high valuation multiple. But what we find in reality, is these characteristics proxy for the size of expansion. If you control for asset growth, none of the other characteristics matter. Another way of saying it is, stock deals without much asset growth don’t tend to underperform.”

A market blinded by growth will be inefficient, a fact Schill wants to

emphasize. “One of our research goals is to highlight this so that hedge funds learn to trade on it. And there’s some anecdotal evidence some already do. As they do trade on it, we hope the market gets better in pricing and removes this inefficiency.”

Schill’s startling findings can help the small investor, too. “It’s a good sorting variable. When considering an investment, check to see if the balance sheet is expanding. If it is, it’s a red flag.”




WATCH OUT FOR FAIRY TALE RETURNS


Richard B. Evans14 | by Carlos Santos





The company told him the funds were incubating,

an answer that launched a curious graduate student

into landmark research that would bring light to a

murky corner of the mutual-fund world. In time, Evans

discovered that only the highest-performing incubating

funds would be open to the public. Their target? The

mom and pop investor. The returns? Unbelievable — as

in a fairy tale.

Evans says the story of how incubating funds work

teaches caution to investors. “The best solution to these

types of problems is not regulation; rather, it’s to help

the investor make good decisions, to teach people the

right metrics.”

Evans, a Darden School of Business professor whose research deals broadly with investment decisions, says that “retail investors tend to pay more attention to good historical returns.” Past performance, however, doesn’t tell you much at all, a disclaimer that every fund shares with investors.

But some investors — especially less sophisticated ones — gravitate to past performance. And so evolved the clever strategy of incubation, in which mutual funds are managed quietly — and in private — for several years, using the money from the fund family itself.

“The funds are essentially private because they don’t have tickers and often aren’t reported to Morningstar, CRSP,

Richard Evans first heard the word “incubation” while a Ph.D. student at the Wharton School. As part of his dissertation, he sought to understand how some mutual funds generated fantastic returns but weren’t open to the public for investing. He called one of the investment management companies running the funds to inquire.





Lipper or other mutual fund data providers until the fund sponsor is ready to open them to the public,” Evans says.

But incubating funds can’t be kept totally secret because in order to use a “track record” to promote a fund, the performance has to be filed with the SEC. That’s where Evans unearthed the information he needed.

Because the funds are hidden from the general public and the funds are essentially using house money, fund managers can invest in riskier assets and have more concentrated portfolios, increasing the odds that one or two funds will show great

returns. Money also doesn’t flow in and out of incubating funds — unlike public funds — simplifying the financial landscape and increasing their odds of higher returns.

Eventually the fund managers pluck those few incubated funds with the best returns to offer to the public and “kill off” the many funds which failed to produce good returns. That selective reporting makes the chosen funds look like much better investments than they are, says Evans. “Even if each fund’s performance is random, if you start enough funds, at least one of them will be good,” he says. “You take 10 funds, one is going to hit.” In other words, the fund manager, using

incubation, contrives the return.

For example, one privately owned investment management firm set up a dozen or so funds to percolate in incubation. The historical returns reached an astonishing 30 percent

EVEN IF EACH FUND’S PERFORMANCE IS RANDOM, IF YOU START ENOUGH FUNDS, AT LEAST ONE OF THEM WILL BE GOOD.





for one of those funds. Investors mesmerized by the huge return flocked to the heavily publicized fund without understanding it was incubated, says Evans. The fund’s overall performance, once in public, was mediocre. But investors stuffed the fund with over $2 billion in assets.

“Funds in incubation outperform nonincubated funds by 3.5 percent, risk-adjusted, and when they are opened to the public they attract higher flows,” says Evans. “Post-incubation, however, this outperformance disappears.”

Evans did the first major study on mutual fund incubator bias. The study covered a 10-year period from 1996 to 2005. In summary, he found:

• Managers incubated almost 25 percent of new funds.

• Incubated funds attracted higher net-dollar flows, as the public believed these were superior funds.

• The outperformance disappeared post-incubation.

• The performance reversal imparted an upward bias to returns that was difficult to correct.

• The bias resulted in risk-adjusted alphas being overstated by 0.84 percent on an equal-weighted basis.





“The bottom line is that many fund families are creating fairy tales to intentionally mislead investors,” he says. “While most funds’ prospectus disclosures include a statement that past performance is not related to future performance, for incubated funds past performance is related to future performance … negatively related. On average, incubated funds underperform their prior track record once they are opened to the investing public.”

But since his eye-opening findings, Evans found that some fund

managers using the incubation

strategy have shifted to hedge funds

or private investment vehicles.

So what is a smart investor to do?

Stay away from funds that show a big

jump in assets. That could mean the

fund just emerged from incubation,

he says. Evans also cautioned against

chasing past performance. “You’ll

be better off buying an index fund.

Keep a broadly diversified portfolio.

Balance it on occasion.”

“It may be a boring way to invest, but

it works.”

THE BOTTOM LINE IS THAT MANY FUND FAMILIES ARE CREATING FAIRY TALES TO INTENTIONALLY MISLEAD INVESTORS.




If you’ve enjoyed the ideas in this e-book, we invite you to continue the conversation.

GET MORE INSIGHTS: JOIN US AT THE DARDEN SCHOOL FOR THE 2015 UNIVERSITY OF VIRGINIA INVESTING CONFERENCE.Early-bird registration is open. Learn more and register at darden.virginia.edu/uvic.

INVESTING IN A LOW-RETURN WORLD? GAIN EXPERT INSIGHT.In the past year, U.S. equity valuations have reached new highs. At the same time, there is a

growing chorus of investors warning that, at best, low returns are ahead and, at worst, a bubble

may be forming. The events of 2001 and 2008 are a painful reminder that such a warning may

have merit. At the end of the day, what is an investor to do?

WHEN YOU ATTEND THE 2015 UVA INVESTING CONFERENCE, YOU WILL:• Explore the current economic landscape, opportunities in a diverging global monetary

setting and implications for investors and risk managers.

• Gain expert insights from financial analysts, portfolio managers, economists and industry

executives.

• Network with professional investment managers, financial officers, academics, private

investors and industry leaders as they seek to identify and analyze the way forward.

darden.virginia.edu/uvic

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