#128 - Sarah Ketterer: Temporary Setbacks, Durable Businesses

28:18We're often used as a source of cash when clients need money, but we're engaged in a process with our portfolio companies that is, I think, quite intense. Maybe not private equity intense, but not too far away from that for many of the companies in the portfolio, because that's what it takes in order to, in a very efficient global marketplace, to get from where we are today, where the market doesn't like the stock, to where the market sees what we saw a year ago.

28:49Sarah Ketterer:And also, many clients may become overly benchmark sensitive. And so you talked about having, you know, low tracking error to a benchmark, but you also constrain your potential value add by doing that. And if you're trying to add more value, you may have wider bands around the benchmark. And that can also create challenges for clients holding on for the whole right. I agree. And especially in emerging markets where macro is so important. So that's why quantitatively, we're very careful to work around bands. In developed markets, that's less generally less of an issue. the country risk, because so many of our companies are globally competitive in their country of listing.

29:36Often it isn't even where they do any business at all. So their economic risk is elsewhere. We recognize the benchmark has its weight. From a fundamental perspective and emerging and global value, we work entirely from the bottom up. So the stocks compete with each other and our risk model keeps us diversified. And if it turns out our portfolio looks nothing like the benchmark, which is most often the case, clients have to understand that. If they want something that looks like the benchmark, then they need to choose a different strategy. We have a global systematic that's much closer than what we do in global fundamental.

30:19Sarah Ketterer:When you evaluate management teams, what do you listen for that rarely shows up in earnings calls or investor decks? We want to know that management has skin in the game. And this is a very accepted practice in the U.S. In fact, taken entirely for granted that management teams are totally motivated by total shareholder return, including the share price itself. that's less the case outside the u.s much less albeit it's improving and it isn't just financial skin in the game we want them to be reputationally tied to the outcomes that they're going to deliver for shareholders so that i think is number it's in my book it's number one i want to make sure because we're not running the business they are that the management team is aligned and and it has to be far more than just lip service.

31:16Sarah Ketterer:Yeah, and you can listen to what they say, but you also need evidence to back that. Some of our best investments have been with a more senior CEO and or CFO brought in and it's his or her last job. Early 60s, this is it. This is reputationally the capstone of their career. And they're often, they're just phenomenal. They already have an incredible track record, so you know they're capable. But reputationally, it's so important for these individuals to lead this legacy that it's just very exciting to invest alongside. That's really interesting because you're looking at it from a real-world perspective, and you're thinking about the motivations and the capabilities of the people leading the charge.

32:04Sarah Ketterer:and so you're thinking about it from in some ways like a behavioral perspective rather than what you can just find in the data i think people justifiably especially senior management have egos and they want to protect them and they want to know that their career finished as you know with this in the penultimate fireworks of success there's no way they want to go into the history books as having sunk the business. I'm being a little extreme, but complacency disappears when it's the last chapter. They go for it. Right. Because this is a way for them to demonstrate all of their learnings throughout their career and bring it all together to have one last great success before they sail off into the sunset.

32:54I think so. Their situations all are slightly different, But I don't mean to say that there aren't great, much younger management teams as well. This is sort of a judgment call. But it does help us fundamentally to understand where that CEO has come from and what he or she has done in the past because it de-risks for us the bet we're taking. That person is clearly capable. Maybe in a completely different industry. They could have come from autos and now they're in luxury goods. But if they know how to run a business efficiently, that's three quarters of the way there.

33:40Sarah Ketterer:You highlighted earlier that you often invest in companies experiencing temporary setbacks because you can find value there. How do you think about resilience and what allows a business to survive the trough without losing its long-term trajectory? Well, resilience, even though the business itself may be struggling, comes from the balance sheet. And if we ever get into trouble, fundamentally, it's because we underestimated balance sheet deterioration. Because what we don't want to be in a situation where the company is facing all kinds of operational headwinds and the business isn't growing, might be shrinking.

34:20They have management's restructuring. I mean, it's going through a pretty serious operational changes. And so there's operating leverage and then there's financial leverage, too. That's usually quite toxic. So we we look carefully to make sure that there is plenty of interest cover. If we can be the net cash position in the business, even better. if there are assets to sell, if there are non-core assets that the company has that could be divested if needed, although maybe not ideal in a time-pressed kind of environment, but it creates a little bit of safety for us. So that's, if we make mistakes, it's because we underestimated how rapidly the balance sheet would deteriorate.

35:08And where we've been successful have been situations where the balance sheet starts to improve dramatically, which has been great for the equity and or the balance sheet was so strong that the company could engage in some very significant restructuring and the business could be under a lot of duress and yet no concerns about ultimately rewarding shareholders. Because if they're debt holders, they get paid first and based on the capital stack. So we want to make sure that there's ultimately, as we've seen banks for bank stocks when they no longer have to reserve in any over reserve and their cost or risk falls and the regulator gets off their back.

35:54There's a lot of money for shareholders, which is great. And the market loves this.

35:59Sarah Ketterer:What is the most common behavioral mistake you've seen even sophisticated clients make when a style, a region, or your strategy goes out of favor? The most common is extrapolating the present into the future. At least every 90 % of the clients I've ever worked with in my career do this. I think 90 % of investors do this because what we see, the present, so compelling. Right now, this is what's happening in AI and this concern about software as a service stocks, SaaS stocks being put out of business or certainly seeing their growth rates diminish rapidly because we have so much evidence that this is going to happen.

36:45But we also have increasing amounts of evidence it won't happen or not in the way that seems likely today. So extrapolating the present isn't, we can explain all we like to clients that look, this environment, this really difficult environment for these companies is just a cycle. But cycles get forgotten. People really like linear. They very much think along those lines of everything is different this time. And it almost never is.

37:22Sarah Ketterer:You know, this is something that I think about a lot because I see it as well from the advisory side. And I think part of it is that most of the world actually does work linearly, meaning past performance is indicative of future results. You have an employee who's a strong performer in the past. They'll probably be a strong performer in the future. But markets can be very different, right? They tend to be cyclical. It's, you know, past performance. Even the warning is past performance is not indicative of future results, but that warning often goes ignored. Well, this is, I mean, it's very pertinent to the market today because there's so much momentum and it's so, US market is so extraordinarily, it's not long we have a couple of Asian markets So credibly concentrated in very specific in this AI transformation.

38:07And there's a lot of credibility there. There's a lot of infrastructure spend, as we know. But there are other parts of the market that have been just completely left for dead as if they will never, ever see the light of day, would never recover, not see anything that looks like earnings growth. So the value manager, that's sort of interesting. The flip-sided concentration is what's left, the long tail. So I think as long as people and investors continue to extrapolate the past into the present, that gives us, from a fundamental value perspective, an opportunity. That's one of the great inefficiencies that lurks in markets.

38:51Sarah Ketterer:And you saw it firsthand when you launched your firm in the early 2000s, where you had a narrow market, the internet stocks at the time, and the timing couldn't have been better in terms of when you went live. Our timing was excellent, and it was particularly helpful to have a few years before we hit 2008, which wasn't. yeah so you talked about interest rates earlier so as interest rates change the cost of money in a meaningful way what becomes newly true about valuation and what becomes newly dangerous zero rates and negative rates are dangerous and they don't help our quantitative colleagues either there's nothing about investing where a zero cost a risk zero risk-free rate makes sense nothing And that situation is an indication of a very unhealthy macro environment.

39:51And the other side of that, coming out of that, as we've seen, is a tremendously large central bank balance sheet, a lot of fiscal strain, a huge amount of monetary liquidity, so lots of asset price inflation. I can't imagine we're going to return, whether we're referring to the U.S. or Europe or Japan or any other of the developed markets to that environment, because inflation has returned. But it was really difficult. There just can't be an environment where risk-free rate is nothing. It doesn't make any sense. It's incredibly perplexing and it encourages so much speculation because I said earlier, one is indifferent between cash today and cash five years from now.

40:44I mean, there's just this idea that there's no cost of money. Now we've been several years into our inflationary higher rate environment from March of 22. And this, everyone thinks it's totally logical, but if you roll back, even, you know, in the COVID years, nobody was talking about rates. I mean, why have them? We were all about modern monetary theory and governments could spend all, at least those who had their own sovereign currency, as much as they wanted. Not the case. So rates, especially positive real rates, very useful from a value perspective. We know what sort of cash flows we're working with.

41:28We know how to calculate our discount rate. We have a pretty good idea of the weighted average cost of capital of the business because we know what the business's risk profile looks like. And we can work with the tools as opposed to be cast adrift.

41:45Sarah Ketterer:So in that regard, how do you think about the long period of fiscal deficits, rising government debt, and highly accommodative central banks? And do you expect the future to differ materially from the past? looking at clues from voters and elections it appears that there's at least for now voters seem to want to have for the same lots of physical intervention they they want it i think that the strain that's happening in europe now is indicative of this in these aging populations that have had a kind of organ rejection against too much immigration. The welfare spend is enormous, and yet the GDP growth is pitiful, if even present.

42:34And it's not sustainable. That social welfare spending at that magnitude is not sustainable. And there is also a very significant infrastructure spend required ahead. Lots of spend on green energy, not to mention and defense and energy. I don't know what the Europeans are going to do, but I had to guess is that voters will end up recognizing that they need to invest in the future, that can't have it all today. And that to me is the trade-off is voters and democracies. Are they going to expect that they're going to raid the bank entirely today or put some money away for the future? And that takes great leadership and government officials who can explain that articulately.

43:22So we'll see. That's what I would like to happen. The worst case is much more in the way of wealth inequality and gap and resentment and what will be, unfortunately, some real setbacks to GDP growth, with a lot more in the way of redistribution and less in the way of investment. It's investment that's so desperately needed. And at present, at least in the U.S., a very significant portion of capital expenditure is going into data centers and related ecosystems. But for the rest of the world, they have that plus everything else they need to do. And all of us face the need for better grid infrastructure and much improved energy generation and distribution.

44:18Sarah Ketterer:And oftentimes when it comes to policy, the status quo could remain. And one of the factors that could change it is the markets. And you can look at things like inflation where it's starting to push back on these massive deficits. So I think that'll be interesting to watch as well. yes the inflation is a miserable tax on lower income and we've seen asset price inflation for years now central banks from 2008 have been very accommodated with the fed leading the pack consumer price inflation is horrible and we need a little bit of it but beyond two percent it starts to eat away and when people have negative real incomes they become very resentful either they get the increase in wages that they need or they they look to vote for some alternative and this is what we're we're facing this in the west in particular well i'd say facing it in japan a bit too where there's some reluctance to raise rates which you know to quell inflation and there's a fair amount of negative wage growth there real wage growth there as well Yeah, so you have growing wealth and income inequality, rising inflation pressures.

45:41Sarah Ketterer:It seems like we don't know when the inflection point is, but it seems like we're getting closer to the point where a policy will have to change. Yeah, perhaps. This is where the future gets very murky. And our team at Causeway, from a fundamental perspective, we're having an offsite just to think about how this massive technological revolution with AI at the forefront will impact not only our portfolio companies, the industries and the sectors that we invest in. we thought about it from our own perspective because we we may be in a really difficult and I mentioned this is society overall environment where there's some job displacement so people who are fired from one job but then maybe hired for something else but in that interim it's it's highly uncertain our education system may not be keeping up with are the needs for hiring.

46:44I think that's probably very likely. And that, again, creates a very angry electorate. But will this prosperity that comes from all this productivity gain that we're promised in the future get here soon enough to mollify a very angry voter? I don't know. that's why balance sheets are so important because there could be some rough seas cash flow keep looking for that cash flow wherever you can get it as ai accelerates

47:19Sarah Ketterer:access to information for everyone what will still differentiate great investors from just the average ones there's so much we'd like to automate there's so much of information gathering and assimilating and organizing a research agenda and stripping a company down to its bare bones and determining an investment thesis that's durable. And yet there's that extra, that's something else that really great experience portfolio managers and senior analysts bring to a fundamental discretionary research process that can't be replicated by AI. I haven't, And I try to think about as all the AI masters speak on these podcasts about how incredibly even more intelligent the software will become.

48:12But it's just, I can't even put it into words. I couldn't for the talent that we have on our team. I couldn't through prompts or in any way using natural language explain what it is they do. That's something extra. that recognition of i've seen this before this management team can do it i just have this sense it's very intuitive and that's where the art and the science meet because the science is all quantitative and it's here are the numbers here's the valuation here here's the scenario analysis but then even if it starts to go wrong initially hanging in there to your earlier question comes from a level of experience that's sort of deep into the psyche of the human, of the great portfolio manager that I have yet to see, and I very much doubt that will be automated.

49:08Sarah Ketterer:If you think about how much has been automated today relative to 50 years ago, and people are still adding value, And it seems like it just raises the bar on the human input that is needed to generate excess returns. And you can imagine the same thing 20 years into the future. Yes. And that's why I'm very confident in our team. What we do quantitatively is just powered by innovation. Just the ideas that come out of our analysts are so incredible. And some of it is from what we do fundamentally. So we inspire them. But as I mentioned earlier, fundamental value investing is hard work. It's active.

49:53It's roll up the sleeves, get involved with management, understand what's going on at the governance level, the board, push for what we want, hold them accountable, keep in touch and make sure we understand where the peers are going. It would be very difficult to assign that to machine. Yeah.

50:10Sarah Ketterer:And then you also have to trust what the machine says. So that's another level. That's one of the reasons why in these early days of experimentation with different models and applications on top of the models, we check everything. Because any inaccuracies make it all sort of pointless. We could have built it ourselves. If we have to go back and check everything, it's the same amount of time, in fact, more. So developing a level of trust and understanding the origins of data and the validity of it is really important. But I know we'll get there. And I'm not worried about it. I'm only concerned about retaining and motivating the human talent that does something that the AI can't do.

50:59Sarah Ketterer:A little bit earlier, we talked about a potential inflection point in terms of the investment landscape. What do you see as the most important investment implications if we actually do go through a major inflection point here? well they're all good because markets don't go up uh linearly they u.s market though i have to admit it's delivered returns if i you take me back 15 years and you told me that we're going to get a 14 to 15 percent annualized return in u.s dollars from the u.s market for the 10 last 10 or 15 years I would have said impossible. That's crazy. Way too high. So it's been an amazing ride.

51:47But a pullback and a reset, especially if we do have runaway inflation, that brings multiples down. There's just no way around that. And maybe we'll have some really good nominal earnings growth. But a reset is usually quite healthy to get back in the game, so to speak, into companies that might have been over, in our view, overpriced or there just wasn't enough return remaining and upgrade the portfolio in terms of quality. So I think it's healthy and a sign of normal equity market activity where sort of an inexorable rise isn't. it's, you know, it's, it's great. It's just underlying that is a level of asset price inflation that is probably not sustainable.

52:33Yeah.

52:34Sarah Ketterer:I think also you, well, you have to look at returns within the context of the environment that happened to transpire. And we had zero rates for a decade or longer, highly accommodative central banks. And, you know, anytime there was a whiff of a downturn. There was even more stimulus monetarily and fiscally. And so given that backdrop and starting valuations that weren't particularly high coming out of the GFC, it's understandable that market returns were high. But when you look ahead, it's hard to imagine having the same backdrop. The optimists, I like being an optimist, but I have to be careful in this statement because I can't prove it, would say that the productivity gains ahead are going to be so tremendous that it'll create a whole new level of growth.

53:23Perhaps we just need to get there quickly because between here and there, it could be, as I said earlier, a period of disruption and changes in employment that make voters, if you combine that with inflation, extremely unhappy.

53:40Sarah Ketterer:Sarah, you've been very generous with your time. I just have one last question. when you think about legacy what matters more to you the numbers the institution you built or the people and careers you helped shape and why i don't i can't i have to put them make them because they're all interrelated the numbers create the institution without numbers we don't have clients and therefore we don't have assets and then we don't can't pay anyone and the people and their careers are all part of creating the numbers and motivating each other. But having an enduring firm, one that goes on long after I'm hiking all day long or whatever I'm going to do when I'm ancient, that would be very exciting.

54:27Leaving something behind that's still growing, that's still adapting and clients still find very satisfying, that would be as good as it gets.

54:38Sarah Ketterer:That's wonderful. Sarah, I appreciate you joining us and sharing all your insights with us. Thank you. Thank you, Alex. It was my pleasure.

55:06Sarah Ketterer:Opinions expressed by participants are their own and do not necessarily reflect the views of the Evoque Advisors Division of MAI Capital Management, LLC, or Evoque, its affiliates, or any companies mentioned. Information shared has not been independently verified by MAI or its affiliates. MAI Capital Management, LLC, or MAI, is registered with the U.S. Securities and Exchange Commission, SEC, which does not imply any particular level of skill or training. Certain information contained herein has been obtained from third-party sources and such information has not been independently verified. No representation, warranty, or undertaking expressed or implied is given to the accuracy or completeness of such information by any person.

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56:23Sarah Ketterer:Decisions should be based on individual objectives, risk tolerance, and circumstances. Statements herein are general and may not reflect an individual's or entity's specific circumstances or applicable laws, which vary by jurisdiction. Further, speakers' views are personal and may differ from Evoke and MAI recommendations and are not specific investment advice, and do not consider client objectives, risk tolerance, and diversification. Guests may have current or past relationships with Evoke and MAI, its affiliates, or the host, including as clients, service providers, or business partners. Participation does not constitute an endorsement or testimonial.

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