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.

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