Value Investing

Aristotle Capital Management 2Q16 Commentary – The Essence

Aristotle Capital Management commentary for the second quarter ended June 30, 2016; titled, “The Essence.”

Aristotle Capital Management – The Essence

The Farmer

A man and his wife owned a small farm in Nebraska. The IRS, upon reviewing their business tax returns, claimed the man was not paying proper wages to his employees and they, in turn, were not paying their fair share of taxes. The IRS sent a representative out to interview the farmer.

“I need a list of your employees and how much you pay them,” demanded the agent.

“Well,” replied the farmer, “I employ only a few people, so may I simply tell you?” The agent nodded his head.

“OK. There’s my farmhand who’s been with me for three years. I pay him $450 a week plus free room and board.

There’s the cook/housekeeper. She has been here for 18 months, and I pay her $375 per week plus free room and board.

Then there’s the half-wit. He works about 18-20 hours every day and does about 90% of all the chores around here. His pay varies but he typically makes about $10 per week, pays his own room and board, and I buy him either a few beers or two glasses of whisky every Saturday night. He also sleeps with my wife on occasion – I don’t mind.”

The agent quickly says, “That’s the guy I want to talk to … the half-wit.”

“That would be me.” replied the farmer. “How may I help you?”

The Owner

While the above (freely available) story is told as a joke in various places, there is much truth to the lessons that may be learned. Note that in this instance, as well as many others, the owner gets paid less than his employees. He, himself, may have the skills to become a farmhand and earn more money, but he chooses to remain self employed, believing the intangible benefits more than offset the self-imposed extra hours. While the business owner farmer “joked” to the IRS about his employees, he likely did so not because he dislikes his circumstances, but because he thought the “investigation” itself was worthy of such a joke. This is not atypical.

The chart on the next page lists some of the regions around the world and their respective employee business ownership. Most of the industrialized world (Europe, North America and countries “down under”) lead in the percentage of workers who own their own businesses. This may be due to a combination of wealth allowing for business ownership and cultural factors making the lifestyle of owning one’s own business desirable. As a side note, we have left off from the chart some of the poorest areas of the world (Sub-Saharan Africa, for instance), as poverty is so prevalent that formal companies are rare and most people make a living in unorthodox ways.

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There is also a political element impacting business ownership. Some parts of the world have less developed, or lesser enforced, property rights laws. Why put one’s heart, soul and family’s wealth into a business, only to be robbed by a big man with a powerful weapon? Thus, regions such as South Asia and parts of the Caribbean have relatively low individual business ownership.

While we are typically loathe to interject political views into our quarterly commentaries, the subject of individual business ownership is one worthy of at least a comment. Note that North America is high on the above list of business ownership. While being “better than others” is admirable, the trend of individual business ownership in the U.S. is not up. While we will not present proof of the cause of this here, we believe that the flattening of the instance of ownership could be partly due to the increasing regulations being placed upon businesses of all sizes. This has been occurring for decades, and through various presidential and political cycles, yet in recent years the complexity of business ownership has most assuredly increased.

Most believe that there should be a level playing field amongst businesses of all types and sizes, yet it is increasingly clear that only larger companies with greater dedicated resources are best capable of navigating the never-ending (and seemingly always-changing) regulatory, legal and other hurdles imposed upon them. We believe there are both political and investment lessons to be learned from the half-wit. Politically, the more “owners” we create, the harder they will work, the greater will be their productivity and the faster society can advance. For business, we have found consistently that those companies that are employee owned and those businesses that empower their employees as “owners” typically fare best. We, at Aristotle Capital, strive to uncover those unique businesses. We also “practice what we preach” by doing the same.

Equities Strategy

In the chart in the previous section, East Asia includes China, Korea and Japan. While Japan and Korea have business employee ownership levels on par with North America, China does not. Rapidly evolving, but coming from a Communist history, most companies in China remain owned by the “state.” Unlike the U.S., however, where the percentage of employees who own a business has plateaued, in China (and its nearby neighbors) the numbers are rising.

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Here are two pie charts representing the share of the world’s growth – one from 1985 and the other from 2015. In 1985, with world GDP at $19 trillion, most of the world’s growth was concentrated in the developed markets of Europe, North America and Japan. In 2015, at $114 trillion, world GDP is six times as large as it was 30 years ago (an overall 5½% annual compounded growth rate during the period). China and the U.S. are about tied for the largest share of global GDP (not depicted in the charts, both at ~16%). But China and its neighbors are growing much faster. Combined, China and emerging Asia (India, Indonesia, Malaysia, Philippines, Vietnam and others) accounted for 63% of the world’s economic growth in 2015. This is a reversal of positions from the earlier period and is consistent with recent years.

With this faster growth (or perhaps partly caused by it), employee ownership of businesses has skyrocketed in China and emerging Asia – albeit from a standing start near zero over the past 30 years. These trends may have far more room to run. For those believing that China may have seen its best days, we have a stately bridge in Brooklyn to sell to you. The following two pictures illustrate the continuing progress being made in that country.

Aristotle Capital Management 2Q16 Commentary - The Essence

Above we present two views from the same vantage point overlooking the Pudong District in the city of Shanghai – one from 1985 and one from today. The city itself is the home of the world’s newest (and some say grandest) Disneyland. Depicted in the picture is Pudong – literally “The East Bank of the Huangpu River” sitting across from Shanghai’s Old City. The area was originally farmland and only slowly developed, with warehouses and wharves near the shore administered by the districts of Puxi on the west bank. Today, in the bottom picture, note the district packed with skyscrapers, including the iconic Oriental Pearl TV Tower, seen on the left.

Pudong, while today the most populous district in Shanghai with more than five million inhabitants (one-quarter of the population of Shanghai), is still one of its fastest growing. By some accounts, largely due to immigration from other parts of China, Pudong’s population is growing more than 10% annually.

While we consider most domestically domiciled Chinese companies as not yet fully proven through cycles or tested in times of adversity, we believe this could change. We also believe that many Chinese companies are destined to become global players, either now or soon, competing around the world. For these reasons, and as part of our long-term process, we shall keep a watchful eye on the country and its growing number of employee-owned enterprises.

Investment Activity

We would now like to highlight a recent addition to any or all of Aristotle Capital’s equity investment strategies:

Danaher, a diversified industrial company, was highlighted to us at the time of its recent acquisition of Pall Corp., a high-quality business we have long followed. Danaher is in the final stages of transforming itself by splitting into two entities. Fortive will contain more cyclical (yet good margin) businesses such as test & measurement (including Fluke and Tektronix), fuel dispensing equipment and automotive tools (Matco). The remaining “new” Danaher (to be led by most of its current top management team) will encompass the company’s life sciences, diagnostics and water quality businesses, as well as several other divisions that tend to be less cyclical and more consumable/recurring in nature. New Danaher will include Pall Corp. as well as Beckman Coulter, its medical laboratory instruments business. We view the two new separate companies as more focused than previously, capable of growing market share and improving profitability, while generating significant excess capital. Danaher has a unique long-term track record of creating shareholder value and we believe this separation may allow both pieces to further accelerate the process.

Fixed Income Strategy

Many signs reinforce our belief that U.S. interest rates could rise slowly and modestly over the next several years. But there is an increasing risk of an unintended “effective” snap back to its Normal Order. The following graph, presented by Torsten Slok of DB Research, shows the Federal funds interest rate (Fed funds) from 1985 to 2015.

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The black and red lines overlap until 2010. The red line is the actual rate. The black line is the Fed funds “shadow” rate, through 2015, as adjusted for the extraordinary quantitative easing (QE) that has been enacted. While the Fed funds rate remained between 0.00% and 0.25% between November 2008 and December 2015, the shadow rate moved much lower as it accounts for Fed moves in addition to its setting of short-term rates. When short rates effectively hit zero and the Fed wanted to ease still further, it enacted these alternative strategies – including QE, the purchase of longer-dated securities. As the Fed now wants to move towards a Normal state, all of its strategies (not merely the stated Fed funds rate) may now have to be unwound.

Thus far the Fed has raised rates once, by 0.25%. But it has also already cut back on its QE policies. Mr. Slok is saying that at some point QE must be completely unwound, the longer-dated securities previously purchased by the Fed could be sold and the Fed’s balance sheet returned to its Normal Order. The green line shows the calculation that today’s “shadow” Fed funds rate would be 6% if QE were unwound. While we doubt that the Fed will enact these unwinding policies so quickly (particularly if international economies remain seemingly moribund), we are mindful of the current unnatural state of its policies.

In summary, we find that current interest rates may be artificially and unsustainably low across the yield curve. While we cannot predict precisely when rates will normalize – and it may be that the Normal Order for interest rates for the coming decade is lower than in prior decades (shadow rates notwithstanding) – we continue to manage the fixed income portion of Aristotle Capital’s portfolios with an abundance of caution, choosing to be (perhaps) too safe than sorry.

The characters described and stories told herein are often, but not always, based on true incidents. Poetic license is taken to dramatize a point about an investment topic. Not all securities mentioned herein are necessarily owned in all Aristotle Capital portfolios. Differences due to restrictions, tax considerations, cash flows and other factors may have impacted the decisions to buy and/or sell certain securities at specific times. Inclusion does not imply that investments in these securities have been profitable. A list of at least five contributors to and five detractors from performance is available upon request.

Conclusion

The bulk of this quarter’s report was penned prior to the “” vote whereby a referendum in the United Kingdom has put the country on a path to leave the European Union (EU). As always, our investment process will reflect this new information, but will change little in terms of how we go about our daily routine of studying unique and value-additive businesses the world over. One of the reasons given by many who voted for the exit is the increasingly unaccountable regulations imposed by the EU on its members, including the U.K. While not necessarily forecasting this outcome, it turns out that our topic this quarter is quite timely.

We began this quarter’s edition of The Essence with a “joke” about a small farm owner replying to a query from the IRS. The farmer referred to himself as the “half-wit” of his operation as he does 90% of the work for less than 10% of the pay. The investment lesson is that he owns his own business and is therefore motivated to be the most productive person on his team.

Throughout history, the world over, ownership is synonymous with caring. While we rarely take political views on topics, we feel compelled to point out that the most advanced and productive countries are those that promote (and protect) small business ownership. We are carefully monitoring those policies (such as over-burdensome regulations) that may have contributed to a plateau in the percentage of people who own their own businesses in many developed economies (including the U.S.) At the same time, parts of the world, including China and other countries, while previously having very restrictive business practices, appear to be loosening them, leading to significant expansion of their economies.

Within individual countries, companies may adopt “owner-like” employee policies. We, at Aristotle Capital, seek out those businesses as potential investments. We also “practice what we preach” by promoting such an ownership approach within our own firm.

We wish you a pleasant summer, wherever you may be and however you may choose to spend it.

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