"Steve Forbes Interview: How Epoch’s Bill Priest Reaps Rewards With Less Risk"

STEVE FORBES

Steve Forbes: Bill, good to have you with us.

Bill Priest: It’s my pleasure, Steve.

Bill Priest, CEO of Epoch Investment Partners

Forbes: We live in a volatile world. We live in a market — certainly the U.S. — that has been going sideways for years. But you believe that by following a certain disciplined approach to investing, you can take big, stodgy old companies and do very nicely. Describe your 9% solution.

Priest: Well, the 9% solution stems in part from analysis of what really drives returns in the stock market. There are only three variables that matter: You have dividends, you have earnings and you have P/E ratios. So, if you take the dividend yield plus the change in earnings plus the change in PE ratios, over a period of time that will be the total return of the market as a whole.

Now many investors really got used to the ’80s and ’90s. And the ’80s and ’90s were remarkable in the sense that in that period, one dollar invested in S&P 500 Index Fund became $25 in 2000. You compounded at 17.6% for 20 years. But half of that came from P/E expansion.

Well, that’s all behind us with interest rates where they are now. They really can’t go lower. If anything, interest rates are likely to go up, which will be a bit of a headwind for P/Es. So your growth in equities is going to come from dividends and earnings. And they come from one place; they come from cash flow. When you look at cash flow growth rate and what is possible, cash flows essentially have components that are built are around five possibilities.

If you have a dollar free cash flow, you can do a cash dividend, you can buy back shares, you can pay down debt, you can make an acquisition or you can reinvest it in your business. The gating item is your cost of capital. If you can earn your cost of capital or higher, you should reinvest in your business or make acquisitions. But if you can’t, you should give that money back to your shareholders.

It’s entirely possible to build a collection, globally, of very large companies that have these characteristics that will sum to 9%. You can put together a set of large companies that have a 4.5% cash yield, which will also give you another 150 basis points in dividends in the form of share buybacks and debt pay-downs. We call the sum of 4.5% a 1.5% shareholder yield. Add to that – there’s a growth rate of at least 3%.

Actually, history would suggest the number’s even bigger than that. But if you can collect 4.5%, 1.5%, 3%, that will get you to your 9%. 9% that doesn’t compare well with the ’80s and ’90s, but it’ll compare very well with the future we see going forward.

Forbes: Double every eight years isn’t the worst thing in the world.

Priest: Correct.

Forbes: And so, let’s get down to it. How do you define free cash flow?

Priest: Right. Free cash flow to us is the cash available for distribution to shareholders, after all cash taxes and all capital expenditures. We don’t distinguish between maintenance cap-ex and incremental cap-ex. But it is the sum of those two that is then deducted from what we view as operating cash flow to get at our free cash flow number.

Mind the GAAP

Forbes: Now, you’re a great doubter about GAAP accounting in terms of enlightening investors. You have also taken shots against EBITDA, which a new word we’ve learned in the last 20 years. First, quickly, why do you think GAAP is no good — or not no good, but certainly no substitute for looking at cash? And why EBITDA, especially the “E” part of it, do you think is not very helpful to investors?

Priest: Well, accounting and someone you’ll remember from a long time ago, Lou Rukeyser. I was on Lou’s show, 1989, so that would be 20 years ago. And Lou asked me a question. He said, “Bill, you’re a CPA. Is that helpful in being a security analyst portfolio manager?” And it was one of the best straight lines I was ever given.

I said, “Lou, accounting is like a bathing suit. What it reveals is interesting but what it conceals is vital.” And the point behind that is, accounting is a set of assumptions. And you can do just about anything you want with those assumptions and not violate general accepted accounting principles.

But cash is cash. And if you can understand how any business works, the best way to see that is through a cash flow analysis. Watch the dollar revenues come in at the top line and see what comes out the bottom. And follow the cash. If you can’t follow the cash, there’s probably a reason. The company has either deliberately, or maybe accidentally, created a way in which there’s no transparency to how the business works.

But most businesses — when you actually run them, it is all about cash. And I think this has been evident in many of the scales we’ve had, certainly in the financial world. When Bear Stearns went broke, they had $60 of book value. But a day later, it was obviously worthless until JP Morgan made their offer.

Accounting, in many ways, obfuscates reality. It obfuscates reality because of all the assumptions made about revenue recognition, inventories, capital expenditure depreciation. It doesn’t tell you what’s going on. We’ve written a couple of papers on comparing accounting to financial realities. You can go broke and still report lots of earnings. And for that reason, I think you’ll see this decade more from accounting-based statements to more financial-based.

And the other point is that if you talk to a company and ask them how they allocate their free cash flow, capital budgeting is about cash. It’s about stream of expected cash to discount the cost of capital plus something to take into account the riskiness of the projects. And private equity talks cash. Only Wall Street uses accounting language. And frankly, it’s not very helpful.

Calculating Depreciation

Forbes: You also make the point on depreciation that you have to take account of interest rates, you have to take account of inflation.

Priest: Correct. The principal behind depreciation in the accounting world is the allocation of a use of the life of the asset, over its so-called useful life. But there are different ways to do this. You can have some so-called straight line depreciation, double declining balance, sum of the year’s digits. Frankly, most of this is done in companies to minimize cash taxes, as it should be.

If you run a business for cash, that’s how you’re going to maximize the value of the enterprise. The depreciation assumptions can vary quite a bit. Again, there are a number of examples — we’ve written about them — where companies made certain assumptions about the life expectancy of a capital investment only to find out a year later it was basically worthless. They were reporting earnings, but in reality, the economic use that asset had been reduced to zero.

Forbes: You also cite airplanes, a much longer useful life than ten to 15 years.

Priest: Yes, airplanes — until today’s paper, The New York Times, which indicated 737s may not last as long as they thought — the air frames usually last forever. You have to replace the engines and whatnot. But generally, planes can last 40 years or more. But yet the depreciation’s taken over ten or 20 years. But again, that’s really to maximize the cash flow from the investment.

Forbes: Now, when you get your list of possible companies, where do you go, what do you ask management? How do you gauge whether they really know what they’re doing? How do you gauge if they have a real fix on their own internal cost of capital? What process do you go to to pick the ones that get in your portfolio?

Priest: When our team interviews a company, the very first question I ask is, “How do you guys allocate capital? What criteria do you use to allocate your free cash flow?” The first thing we do is try to understand if, indeed, they have a definition of free cash flow. It might not be our definition. But it’s usually pretty close.

Very often, a company will say to us, “Well, we’re a growth company. We reinvest every dollar of free cash into our business.” That’s actually a terrible answer. A better answer would be, “Well, our cost of capital is 6%, 7%, 8%, 9%” — whatever the number is. “To that, we add something to reflect the riskiness of what our investments might be internally or an acquisition might be considering.”

And that number may turn out to be 14%, 15%, 20%. It doesn’t really matter, except it’s important that they have the discipline. Then they will say to us, “Well, what we do is we take all the projects or acquisition potentials and we basically will buy or invest in those two choices down to our return hurdle. And then we give the rest of the money back to our shareholders through cash dividends, share buybacks or debt pay-downs.”

That’s a great answer. They may not be able to do that every time. But from an architectural standpoint, the design is proper. All of us portfolio managers, Epoch included, fail from time to time at execution. But the trick is to make sure that the design behind anything we do – or frankly a capital allocation policy by a company — is sound.

The Patterns Today

Forbes: Now, one of the challenges of buybacks, certainly in the 90s, was they’d buy the shares and then give them out in stock options. What’s the pattern today?

Priest: Well, a couple of things have happened since then, but your point is well taken. It’s the net share buyback; you really want the shares bought back to effectively be retired. Now, usually what happens is they’re put into treasury stock and then not reissued. You don’t want them to be reissuing the stock. So our definition of share buybacks would be net of any option exercise. But actually, options have become a much less used device today.

Forbes: Well, this gets to your dividends, right?

Priest: It gets to the dividends in some respects. Because we have substituted so-called RSUs, or restricted stock units, for options. And very often management had choice. If they held a lot of options and they had lots of excess cash, they could say, “Well, why don’t we invest in Company X or Project Y because if it works it’ll have a high return, our stock prices will go up and our options will obviously go up quite a bit.” But most companies have moved to this RSU, where –

Forbes: The problem, then, is that they pay their dividend but the stock price doesn’t go up.

Priest: That’s true. Now, if you have an RSU, a restricted stock unit — if you’re an IBM employee, for example, they have the same stock that you and I have, except there are vesting restrictions. Now, it varies from plan to plan and I’m not familiar with the IBM plan but my guess is that the unvested stock held by IBM employees is entitled to the dividend.

So, essentially, when the RSUs are rewarded, even if they have a vesting schedule, the dividend is paid on both the vested and unvested. Now, management benefits by that now. And I think there’s a lot more thought given to capital investing versus return of capital.

Managements, good managements, will always do the right thing. If they can earn their cost of capital or higher, they should reinvest. But when there are personal incentives that might encourage you to speculate on acquisitions, rather than pay money back to the shareholders, that incentive has been taken away today.

Forbes: This gets to tax issues; the dividend tax, personal tax, is 15%, at least for another two years. If that went up to 39% or 40%, the management would have much less incentive to pay that out, wouldn’t they?

Priest: That’s true, on a personal basis. However, most stocks are held in some form of tax exempt structure, 401(k). It will have an effect, but it should be much, much less. And frankly, I think companies will take that into account. Taxes are a significant factor in capital allocation. And if you’re going to effectively raise taxes on something paid out, what you’ve really done is lower the barrier for reinvestment of capital. It makes the reinvestment more attractive. And I think managements will just work this into their strategies, quite honestly.

Big Party Portfolio

Forbes: Now, you have a lot of securities. Some managers say you can know — Buffett and others — a handful and do very well. You seem to have the attitude, “The more the merrier. I want this party to be big.”

Priest: Well, let’s take a look at what managers are charged with doing. In a broad sense of the word, almost all money managers are charged with doing one of two things. You can either maximize return per unit of risk or minimize risk per unit of return sought. Most money managers are trying to beat some index. It’s a relative gain. But if you turn that inside out and you want to minimize risk per unit of return sought, it becomes more of an absolute return game.

So, for example, if our goal is to get a 9% return, what we want to do is shrink the dispersion around that 9% objective. The way to do that is to add as many names as we can. If you can put together a set of securities that lead to 9% — 10 probably isn’t sufficient, 50 is too few, 70 is better, 100 is better. As you add names, you have more diversification, but you’re not hurting the goal you’re seeking.

If I could have a thousand names, it would be better than about 105, which we have. But at some point, what you try to do is you want to diversify the portfolio as much as possible, but still capture the 4.5%, the 1.5% and the 3%. And that 9% return will serve investors well if you buy another set of assumptions. And this goes back to something we talked about earlier.

If we were to build a model for the markets going forward, let’s start with these assumptions that we can deal with: The yield on the S&P today is less than 2%. The yield on the MSCI is about 2.4% or something today.

To that, we add a number for earnings growth. Well, earnings grow about the same rate as nominal GDP over a long period of time. Nominal GDP is probably going to grow 4% to 6% globally. So, the 2.25%, plus the 4% to 6%, gives something in the area of 6% to 8% before we deal with P/E ratios.

Now, we’re just agnostic on P/Es. The level today doesn’t seem crazy to us. On the other hand, if interest rates were to trickle up, the P/Es might come down a little bit. But a 6% to 8% world, I think is a very reasonable forecast for equities.

And by the way, that’s 4% over what you get from a bond today. Equity earnings yields are about 400 basis points over bonds. That’s terrific. And the point you made earlier, even at 7%, that doubles in ten years. That’s pretty good. It’s not the ’80s and ’90s, but it’s a heck of a lot better than the first decade of this century.

Forbes: Now, you stay fully invested.

Priest: In this strategy, we do. It’s important. Market timing can be very dangerous. And there are very few people who are good at it. And I would not profess to be one of those.

Forbes: Do you know anyone who’s good at timing on a consistent basis?

Priest: I know personally of no one. I know people who claim they’ve done well. But that, I’m a disbeliever –

Missing Emerging Markets?

Forbes: Now, your approach. It seems to be biased, obviously, to big caps, developed countries. How do you respond to that, or do you say it’s irrelevant, as long as you get your 9%? The emerging market boom and all that kind of thing.

Priest: Well, in this strategy, to some extent that’s true. But think about it — the companies that pay dividends are large companies. They’re also mature companies. They have big market shares. Almost inevitably, they’re going to be in the developed world. But if you look at some examples, if you take a company like Nestle, a big company, located in Switzerland for headquarters. But it is a dominant company it its business.

If you look at their cash flow and where they spend it — they pay out a significant amount in dividends and share buybacks. There’s not much debt there to pay down. But look at where they spend their free cash flow. It’s all in emerging markets. It’s all building out. That’s where they see the growth.

So, essentially, by buying these large — global champions would be a phrase that I would use — you get very good management. They’re mature, so they have cash flow that they have no choice but to give some of it back. But they’re very wise in their allocation. And most of it goes to the emerging markets.

And, in fact, if you don’t invest in the emerging markets, either directly or indirectly through these vehicles, you’re going to miss the relative growth rates coming up in the world. In about 18 months, more than half of the global GDP will come from emerging markets.

Forbes: Is your approach also biased against a company like Apple? They don’t pay a dividend even though they have mountains of cash. But they certainly seem to know how to invest their cash. And they certainly are growing like crazy.

Priest: Well, in the strategy we’ve discussed, what we call our global shareholder yield strategy, Apple does not fit. We cannot get them into that strategy. On the other hand, for our relative return strategies, we’ve owned Apple since it was $6 a share. And it fits in a total return, relative performance strategy.

But in this dividend strategy, it really is more of an absolute return strategy than a relative return strategy. The beta, or volatility, of this strategy is .75. In other words, it’s about 75%. Now, on the down side this is good. On the up side, it’s less good. This strategy will perform relatively well in any down-market. And it will perform well in an up-market up to mid-double digits and then it’ll start to lag. But if you actually look at “Are we going to have 15% a year markets going forward?” We would argue it’s highly unlikely.

You aren’t going to have the wind from P/E expansion at your back. If anything it’ll be a slight headwind. If you take that away, I think the 6% to 8% is a reasonable proxy of the market, in general. This strategy, with a 9% aspirational return with a beta of .75 and half the return coming to you in cash, that to me will be a winning strategy.

Forbes: M&A. That seems like the kind of companies you have, since they know their internal rate of return, if they can find something they will go after it.

Priest: I think that’s true. If you are a CEO in a company today, particularly in a mature market, and your organic growth is low, 1%, 2%, the board wants to know how you’re going to grow. That’s why you have that job. And if you have cash in your balance sheet — and we have the best corporate balance sheets in 50 years — what are you going to do with that? As long as you can earn the cost of capital, you will be heavily incented to make acquisitions. And I think you’re going to see a substantial increase in M&A activity.

Now it’s a little confusing today because some people don’t know what the rules are in investing in America. But if you are one of these large global companies domiciled outside the U.S., the U.S. is on sale today. If you look at our dollar, and you’re in Europe, the organic growth in the U.S. is a lot better than organic growth in Europe. And if you’re in Europe with the Euro at $1.42, the U.S. is on sale. It’s got a big “For Sale” sign. I would have thought we’d have seen much more in the acquisition world. But I think it’ll come.

Companies Bill Owns

Forbes: So, what are some of the companies you like right now? Would Diageo still be on your list?

Priest: Yes, we do. We own that in the shareholder yield fund. Nestle would be a company that we own. There are some oil companies we would own that would fill that bill, Exxon in particular. Exxon, in the oil industry, is incredibly good at capital allocation. They’ve been superb. A lot of questions came up a year or so ago about their acquisition of XTO, the natural gas company. But it sure looks smart today.

Forbes: Sure. New York Life. You cut a deal with New York Life. What does that mean for your firm now?

Priest: Well, Epoch is a firm that’s about seven years old. We started with $600 million under management. And we just released our first quarter AUM, which was just under $16 billion. We’ve grown very rapidly. We are essentially institutional managers. We are not really mutual fund managers, in the sense that we want to manage the mutual fund business. So, what we did is basically create an arrangement with New York Life where they would assume the four mutual funds that we had started under our own name. And they have now been rebranded MainStay Epoch Mutual Funds.

We have a close relationship with New York Life in managing those funds. But we also have other serious sub-advisory relationships, as well. And we’re happy to provide the money management activity. We just can’t provide the supporting activities of wholesalers, separate boards. It’s just too expensive for a firm of our size.

Scandalous ETFs

Forbes: What’s your view of ETFs?

Priest: ETFs, it depends on which ones we’re talking about. I think there’s probably a scandal at some point, embedded in some of the ETF structures — particularly the ones involving commodities. Because when you actually look at the performance of these ETFs, relative to the commodity, you didn’t get the performance of the commodity. And it’s the rollover risk and the rollover assumptions that are made very often.

ETFs continue to grow, though, in terms of the use by financial advisors. It’s a fact of life. I think in the end, you would prefer to have a portfolio of real companies managed by real people. Obviously, I have a self-interest in saying that. But it’s something I actually believe.

Forbes: You mentioned some companies earlier. Others come to mind now? Things like Diageo have moved up. Philip Morris has moved up.

Priest: We would still continue to own those. One of the things in what we call the global shareholder yield strategy is we don’t sell names. In other words, as long as the companies are doing what they say they’re going to be doing and they still qualify as meeting our screens of 4.5%, 1.5%, and 3% — and remember, not every name has to be that way. We own a company that doesn’t even pay a cash dividend.

So, how does that fit a dividend strategy? It fits it if there’s a big stock buyback net. A company that comes to mind is a company like DaVita. DaVita is a kidney dialysis company. The management has been superb. If you look at the history of what they’ve done, it’s been a fantastic stock to own for a long period of time.

But when you look at the business on the surface, it would not appear very attractive. No one is going to sign on for dialysis unless you really need it, so demand is very inelastic in economics term. Prices are heavily regulated by the federal government. You can’t just put a new unit out in the middle of nowhere and expect people to sign up for it. There has to be natural demand. It’s heavily regulated. It doesn’t seem like a business you’d want to be in.

But as it turns out, it’s a business of necessity. You run these businesses 24 hours a day, seven days a week. DaVita’s a very good operator. But what they’ve done in terms of their cash flow is for the most part, early on, they did nothing but buy back stock. So revenues grew at mid-single digits. Earnings grew faster because they were good operators, but nothing exceptional. But per share earnings and per share cash flow growth rates went through the roof because they kept buying back stock.

So, they meet the test of share buybacks. Now, they then went out and they bought one of their competitors and they used debt. Well, it’s a subtlety, but when you pay down debt there’s a wealth transfer that goes on from the debt holder to the equity holder. And that is effectively a dividend. And Modigliani and Miller, ages ago, won a Nobel Prize by basically showing that the value of the firm is independent of the capital structure, if you disregard taxes.

I think there are many opportunities in that world where companies will lever up. And if you start to look at the pieces of cash dividend, share buybacks and debt pay-downs and you start to see the debt pay-down might be as much as 9% a year. That’s a dividend. There’s a significant wealth transfer that goes on.

So once we find a company that’s doing what they’re supposed to do, we can own it forever. The turnover of this portfolio is about 25% a year. And frankly, that turnover reflects three things. We will sell anything where there’s been a change in thesis, but in this strategy, that is rare. We sometimes have to rebalance the fund because some go up, some come down; we have to rebalance it for a portfolio construction issue. And sometimes it’s taken over. And interestingly enough, this strategy offers you a free call on M&A activity.

If you go back and look at what was happening in ‘06, ‘07 and ‘08, there were a lot of takeovers of companies we own, through private equity putting on debt. We’ve had about 20 takeovers, I think, in the five-plus years we’ve had this strategy. We don’t factor that in to what we’re doing, but it’s an inevitable outcome because most of these companies have room for debt. They’re very well run from a business operating standpoint but arguable from a financial leverage standpoint, if there’s more debt.

Forbes: If Apple did a share buy-in, it would be a DaVita in your mind.

Priest: Apple could overnight qualify, in a sense, by paying a substantial dividend, special dividend; they could pay a dividend of 3% or 4% and they would start to meet the standards for this strategy. Right now, we just can’t get the sum of the factors to add up to what we need for Apple.

The Passion For The Puzzle

Forbes: And one final thing — I guess it’s generational. Security analysts today, you don’t think they’re of the same breed as when you went in the business.

Priest: Well, I don’t know if they’re the same breed. When you look at my generation — and there’s a few of us around — we went into the business because it was fascinating. I don’t think my generation thought we’d make any real money. That proved to be naïve if you stayed around long enough. On the other hand, I would argue that if you were in the business in 1980 and you were approximately 40 years old, you had the wind at your back for 20 years. You had to be an idiot not to make money in the ’80s and ’90s.

And a lot of people think they were geniuses. Frankly, they were lucky. They were in the right spot at the right time. But today, I think as far as finding people who have a passion for the puzzle, because I think security analysis is a puzzle — if you have a passion for figuring out the puzzle, without respect for own income, that’s a great set of attributes to have.

We just hired someone last week and I won’t use his name. But to me, he has the passion, he has the intelligence. He doesn’t leave the office until eight or nine o’clock at night. So do I. And if you build that passion for the business, I think you can build a winning strategy.

Forbes: Bill, thank you.

Priest: Thank you. Pleasure being here, Steve.

source: forbes.com

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