Energy midstream undergoing transformative shift

Report provided by Salient Capital Advisors LLC

When it comes to crude oil and natural gas, boring is better… except when talking about the notable changes occurring within the midstream industry today. Then, we can say that “exciting” is a good thing.  Energy midstream is currently undergoing a transformative shift between two mutually-exclusive models. 

Graphic: Bloomberg, Salient Capital Advisors LLC, July 2018. For illustrative purposes only. Click image to enlarge.

On the one hand, there is the traditional, high-yielding Master Limited Partnerships (MLPs) with a General Partner (GP) that serially issue equity to fund growth projects. In return for a higher-yield, MLPs have expected to have ready access to capital whenever it was needed. On the other hand, there is the new model, in which midstream companies have prioritized a simplified corporate structure, reduced cost of capital, and self-funding of equity needs.

One of the primary ways in which these changes are being expressed is through the corporate structure. In short, MLPs are complicated. MLPs can be prone to misalignment of incentives between investors and management, and cash payments to GPs through Incentive Distribution Rights (IDRs) can place a large cost of capital burden on the MLP. The new midstream model, in contrast, is about better shareholder alignment and reduced cost of capital.

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To achieve these goals, many MLPs are consolidating, simplifying, or converting into a C-Corp structure. Not including the potential for Initial Public Offerings (IPOs) or buyouts, the graphic included here shows just how much these potential changes could affect the makeup of the marketplace over the next several years.

Why should our friends and partners at TEXPERS care about these changes? One reason why these changes are so significant is because they are partly designed to increase the appeal of midstream to a broader investor base, namely, institutions. Eyeing midstream companies’ simplified structures and greater visibility into their future growth potential, institutions have been making up an increasing source of outstanding midstream ownership.  Only a few years ago institutions owned roughly 30% of the space. Today that figure is about 50%, and we believe that trend will only continue, according to recent PricewaterhouseCoopers LLP and Wells Fargo Securities LLC partnership reports.

Another reason we feel these changes are so important is the increasing capital needs of energy midstream. In a recent report, the Interstate Natural Gas Association of America (INGAA) has illustrated the need for $55B-$70B in midstream infrastructure spending every year for the next 20 years. This level of potential spending is substantial, and, in our view, midstream companies will need healthy balance sheets and large institutional partners to fund the necessary growth projects.  We believe that those companies that adopt the new model are a better fit for the future of the industry and have the potential to thrive in this environment.

The final reason why these changes are so important is that, in our view, they improve the investment outlook for the space. As suggested above, we believe there will likely be some winners and losers over the next few years as the transition to the new model progresses, but, as evidenced by a positive macroeconomic backdrop and quarter-over-quarter earnings beats, the future appears bright for those who can navigate their way through.  

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Salient or TEXPERS. 

China’s quest for artificial intelligence

By Daniel J. Graña, a guest columnist

China is rapidly making a name for itself in the AI space. The buzz around this new digital frontier has been growing over the past year, and the government is working with the country’s tech industry, from start-ups to established firms, to promote AI research and infrastructure.

During a recent visit to China, we were surprised but enthusiastic to meet so many innovative, hardware technology companies focused on AI-enhanced tools. The offerings included machine vision — a rapidly growing branch of AI that aims to give machines sight comparable to our own. We were also shown industrial automation, voice recognition devices, and mobile chipsets designed to better tackle machine-learning tasks. China’s tech sector benefits from a pool of Western-educated engineers and local graduates, along with a wealth of government assistance. 

Eyeing high-income status

Spurred by concern that China imports $200 billion in semiconductor chips, President Xi Jinping’s government views the development of the tech industry as a key ingredient in moving the country from middle-income to high-income status. The trade rift with the United States, with its possible implication of lost access to high-end U.S. technology, is deemed a national security threat.

China has put in place a robust plan for state funds and localization targets. At this stage, there is a gap between the proposals and action. While success isn’t guaranteed, the medium-term targets include some chip makers and telecommunications companies in the United States, South Korea, and Japan.

Embracing surveillance and facial recognition

There is a multitude of possible AI applications, but the companies we met with are concentrating on two end markets: surveillance and autonomous vehicles. A systems integrator, a maker of optical-related products, and a startup that focuses on facial recognition are among companies that have carved a niche in this space. Given the lack of concern about privacy in the country, Chinese companies are likely to be global leaders in AI-enhanced surveillance and facial recognition technologies going forward.

China currently regulates traditional and social media, including television and online posts. Surveillance technology backed by AI promises to cement the government’s ability to control and influence every aspect of society and the activities of its more than one billion people.

The autonomous vehicles race

Nowhere is the enthusiasm for self-driving vehicles more apparent than in China, the world’s largest car market. Domestic companies are working with overseas vehicle makers to develop a platform for autonomous vehicles for the Chinese market. Pedigreed venture capital firms are investing in Chinese robotics companies. 

With China’s demand for cars showing no signs of slowing down, it is likely the country will be among the first to make the transition from traditional automobiles to autonomous forms of transport.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Putnam Investments or TEXPERS.  

About the Author:
Daniel J. Graña is the portfolio manager of Putnam Emerging Markets Equity Fund. He also manages an institutional portfolio of Asian ex-Japan equities. Previously at Putnam, he was an analyst in the Equity Research group, covering emerging markets with a focus on the financial and consumer goods sectors, from 1999 to 2002. Graña joined Putnam in 1999 and has been in the investment industry since 1993.

Private credit EBITDA add backs – what do they mean and why should investors care?

By Linda Chaffin, guest columnist

A common question among investors, credit managers and consultants is: “Where are we in the credit cycle?” While credit markets will ebb and flow, most believe we are presently at the more competitive end of the spectrum. And in a competitive market, pressure on financing structures and documentation can be expected. In my view, a key challenge is a current shift in the magnitude and type of EBITDA add backs that are being used to justify higher debt levels and valuations.

EBITDA (earnings before interest, tax, depreciation, and amortization) is a proxy for cash flow to service debt and used to value a company by applying a multiple, such as 8x EBITDA. Since this metric is a key driver for company valuation and financing capacity, it is not surprising that investment bankers and company owners seek to maximize EBITDA.

From a credit perspective, EBITDA addbacks are not a new concept. It gets tricky when borrowers propose more subjective add backs that are intended to justify debt issuance that is not prudent. 

The types of EBITDA adjustments may include:

EBITDA Adjustment Type	Description
Transaction Related	Seen in most financings, these common adjustments are for one-time deal-related costs, sponsor management fees, non-cash or non-recurring compensation and severance costs
Potential Cost Savings	Add backs for anticipated savings such as modified compensation, reduced rents and headcount reductions are more complex. To evaluate these, a quality of earnings report can be obtained to analyze the proposed adjustments. These can be allowed as an EBITDA add back with proper review and documentation
Run-Rate EBITDA	Later in a credit cycle, borrowers may propose addbacks that are extrapolations of recent performance. For example, a borrower may propose annualized credit based on a short period of recent performance (three-month EBITDA multiplied by four to calculate an annual rate). In these cases, it’s best to look to the borrower’s history of achieving projected outcomes as well as considering seasonal impacts
Maturity Credits	In certain industries, a borrower may request adjustments for future expected performance. For example, if new offices have been opened in a medical practice, the borrower may seek credit for a mature patient load. Quantifying and approving these adjustments requires significant work
Incremental Expenses	Corporate carveouts and family-owned businesses may need to build in costs for additions to staff, systems, and facilities

For any lender, getting to an accurate EBITDA amount is important for making appropriate credit decisions as well as setting financial covenants, specifically, the maximum permitted leverage ratio (funded debt / EBITDA). For lower middle-market companies, a miss of the leverage covenant is often the triggering event bringing borrowers and lenders to the table for discussion. In most cases, getting to the table earlier helps to preserve value.

Unjustified addbacks can hide the true level of leverage so astute lenders should know how to analyze and challenge EBITDA adjustments line by line to ensure they understand the borrower’s ability to service debt. To gauge portfolio risk, it is important for investors to understand a private credit manager’s philosophy around and process for evaluating EBITDA add backs.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of NXT Capital' or TEXPERS. 

About the Author:
Linda Chaffin oversees NXT Capital’s investor relations activities and fundraising efforts. She is actively involved in raising third-party funds and developing and maintaining investor relationships across the institutional LP community, including insurance companies, public and corporate pension plans, foundations, endowments and consultants. Chaffin brings more than 20 years of investor relations, fundraising, private equity, corporate finance and M&A investment banking experience to NXT. Before joining NXT Capital in 2017, she was senior vice president for Pathway Capital Management where she was responsible for raising new capital and developing and maintaining investor relationships for both private equity and private debt strategies. Prior to joining Pathway, Chaffin was vice president of Finance and Investor Relations at Marwit Capital where she led the firm’s fundraising efforts. Before joining Marwit Capital, she served as a senior vice president in GE Capital’s Beverly Hills office and held numerous roles within J.P. Morgan’s M&A, Asset-Backed Securities and Healthcare groups in New York. She began her career with various corporate finance roles at Huntington National Bank and Stern Stewart. Chaffin earned a bachelor's degree in Business Administration from The Ohio University and a master's degree in business administration from The University of Chicago Booth School of Business.

You invest in factors, just make sure 

they’re the right ones

By Michael Hunstad, guest columnist

Active or passive, fundamental or quantitative, domestic or international, developed or emerging, the result is the same. Whether you know it or not, your portfolio contains factor exposure.  Even if your equity lineup consists of one simple allocation to the S&P 500 Index, you are still very much a factor investor.

THE OPPOSITE OF GOOD IS BAD

Today, much of the investment community recognizes that factors such as small size, high value, high momentum, low volatility, high quality, and high dividend yield have historically outperformed cap-weighted benchmarks. But, somewhat surprisingly, the converse has not been widely received — that large size, low value, low momentum, high volatility, low quality and low dividend yield logically underperformed these same cap-weighted benchmarks.

This oversight is not insignificant. Exhibit 1 details the factor exposure of the S&P 500 Index, with the color coding indicating if it is positively (green) or negatively (red) compensated. As a large-cap benchmark, the S&P 500 has a large size bias with a 0.23 exposure to size but, as noted above, this large size bias has been a drag on performance. Over the long-term, this degree of exposure has drained about 45 basis points of annual return versus a portfolio with a neutral size exposure.

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The story gets worse. Exhibit 2 details the exposures of the Russell 1000 Growth Index, a common component of core equity portfolios but also a reasonable proxy for active growth managers. Here we see a lot of red bars indicating substantial negatively compensated factor exposure including large size, low value, low quality and low dividend yield.  Collectively, the performance drag of these exposures exceeds 170 basis points annually versus a portfolio which neutralizes these biases. While this index has outperformed the Russell 1000 benchmark in recent years, these factor exposures detracted from total return.

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WHAT TO DO ABOUT THOSE LURKING FACTORS

Of course, the problem is not isolated to passive and growth managers. Value, core, income, sector-specific, long-short, all types of equity investments have some, potentially quite extensive, factor exposure. To optimize performance you must be cognizant of these unintended risks and manage them appropriately. Fortunately, you don’t need access to a risk model to gauge factor content. Exhibit 3 details readily available factor proxies that can serve as a guide in determining factor exposure. 

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To address the negative factor biases inherent in the Russell 1000 Growth Index, we might pair it with a strategy aimed at higher quality, higher dividend yield, lower volatility, higher value and smaller size. The goal is to create a blend of strategies to produce a portfolio with positive exposure to all factors. That would eliminate the drag of negatively compensated factor exposure and maximize positively compensated biases.

GAUGE YOUR EXPOSURE

All investors are factor investors — the key is to recognize factor exposures have major implications for investment outcomes. With the tools detailed above, asset owners can quickly and easily gauge the factor content of their portfolios and identify complementary strategies that help maximize the good and minimize the unintended risks.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust Asset Management or TEXPERS. 

About the Author:
Michael Hunstad is the head of Quantitative Strategies at Northern Trust Asset Management. Prior to joining Northern, Hunstad was head of research at Breakwater Capital, a proprietary trading firm and hedge fund. Other roles included the head of quantitative asset allocation at Allstate Investments, LLC and quantitative analyst with a long-short equity hedge fund. Michael holds a doctorate in mathematics, a master's degree in economics and a master's degree in quantitative finance.

Dynamic portfolio management and tools for building risk-adaptive portfolios

By James Perry, guest columnist

In the current environment of low yields, pricey equity markets and lower expectations for portfolio returns, institutional investors may find it challenging to meet their return objectives over the next several years. The traditional approach to institutional investing begins with setting a long-term strategic asset allocation, hiring managers and periodically rebalancing back any portfolio drift to the SAA weights. This approach could be described as a "beta-driven" approach as the bulk of the risk of these portfolios is derived from the beta of the portfolio. By contrast, "risk-focused" portfolios seek to find the best reward per unit of risk from both pure beta exposures as well as active managers and strategies and hence require reallocation dynamically to the best opportunity.

Many investment programs utilize a beta-driven portfolio approach with a focus on tracking error, mean-variance optimization, benchmarks and cost minimization. Reputational risk from running a portfolio with this type of structure is limited as when markets go up, the plan participates well and when markets go down, losses can be attributed to these shifts. Over time the upward bias of the market provides these investment programs with a combination of risk premiums over cash which provide the basis for the growth of their investments.

When volatility begins spiking and bear markets occur, however, a risk-focused portfolio not only helps protect capital but also enables the dynamic investor to seize opportunities. Having a diversified, cash flow focused portfolio that is less impacted by market volatility can provide an investor with the confidence and portfolio liquidity necessary to take advantage of market dislocations and more attractive long-term investment opportunities when they occur.

Dynamic Portfolio Management

Despite the sustained bull run in equities, many pension funds are still underfunded and require a high future rate of return on their assets. Long bull markets make it easier for pension plans and other institutional investors to meet their immediate target return objectives, but the higher priced assets also lead to lower expected returns in the future.

Investment programs with a greater focus on market risk and valuations that dynamically adjust their portfolios to adapt to the market environment will likely fair better in the next market downturn. This process of varying risk exposures to adapt to the market environment is a discipline that is sometimes referred to as Dynamic Portfolio Management. With a greater focus on capital protection and opportunistic investing, DPM can offer tools to enhance the probability of realizing more attractive returns over time and increasing the possibility of achieving investment return objectives.

DPM empowers CIOs and their teams with a set of tools that may be used to complement their existing portfolio structure and enhance their risk adjusted performance. Despite the many benefits of DPM, it does add layers of complexity to a portfolio. 

This creates the need for enhanced portfolio transparency, analysis, monitoring and reporting. This process can be further enhanced with the right set of strategic partners to help drive the dynamic aspects of a portfolio’s asset allocation and to create market intelligence and insight from a portfolio’s data, offering the potential of allowing plans to meet their long-term investment objectives in the lower return environment that we may all soon be facing. Visit Maples Fund Services’ website for more information on the principles of DPM and the benefits it can afford allocators. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Maples Fund Services or TEXPERS. 

 About the Author

James Perry is head of Institutional Investor Solutions at Maples Fund Services where he is responsible for shaping the firm’s offerings and enhancing its service delivery to institutional investors. He brings more than 20 years of investment management experience including senior investment roles overseeing portfolios of public assets in California and Texas. Perry is a recognized thought leader in the investment industry, as evidenced through a number of awards, including being named as one of the Top 30 Pension Fund Chief Investment Officers (Trusted Insight, 2016) and receiving the Investor Intelligence Award for Innovation (Institutional Investor, 2014). 

Global landscape continues to evolve in

 the wake of Morrison decision

By Mike Lange, guest columnist

The global scope of venues for group securities litigation continues to expand since a 2010 U.S. Supreme Court case ended two kinds of securities class-action claims that had propagated in the prior years. 

Morrison v. National Australia Bank was a Supreme Court case concerning the extraterritorial effect of U.S. securities legislation. The case ended class-action “foreign-cubed” claims, in which foreign plaintiffs sued foreign issuers for losses on transactions on foreign exchanges, and “foreign-squared” claims, brought by domestic plaintiffs against foreign issuers for losses on transactions on foreign exchanges.

Prior to the Morrison decision in June 2010, the U.S.’s jurisdiction over shareholder class actions was so broadly defined that complaints could be filed in U.S. courts on behalf of foreign companies, that involved trading foreign securities on foreign exchanges (so-called f-cubed cases). Only the most tenuous connection to the U.S. was required to grant U.S. jurisdiction. This opened the door for international investors to seek recoveries for their damages in U.S. courts, which historically have been more sympathetic to investors than some other countries.

However, in the years following Morrison, investors have been forced to seek out foreign jurisdictions as venues for their complaints. Suits brought under non-U.S. law in foreign courts have therefore become a prominent component in the effort to maximize recoveries from shareholder litigation.

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Accordingly, the global scope of venues for group securities litigation continues to expand. Many countries routinely host group actions, with the bulk of actions occurring in Australia and Taiwan. However, other jurisdictions have increasingly allowed such lawsuits. While each jurisdiction has its own nuances in how it allows its class action regime to operate, the majority of shareholder litigation matters outside the U.S. and Canada involve opt-out class actions or jurisdiction risk profiles comparable to U.S. passive claim filing.

With increased interest from investors in participating in global actions, fiduciaries have begun to view considering these cases an as an obligation to their clients. Excluding Taiwan, 75% of all non-U.S. matters between 2015-2017 either had claim filing processes, similar to the U.S., or were filed in countries with jurisdictional risk profiles comparable to that of the U.S. This has allowed institutions to establish policies and procedures to streamline the majority of matters while focusing time and effort on just those jurisdictions with higher risk profiles where more evaluation is appropriate before action is taken.

There are mechanisms to help institutions automate their participation in these matters, minimizing the amount of time and effort needed by investors to recover in lower risk jurisdictions. This leaves clients free to focus on the legal mechanisms for handling group actions in higher-risk, more complex jurisdictions with complicated structures for developing group actions, where it is necessary for investors to thoughtfully evaluate participation.

Download a full report to learn why it is important for investors to understand the nuances of their trading jurisdictions in order for them to begin to develop internal policies for foreign actions.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Financial Recovery Technologies or TEXPERS. 

About the Author

Mike Lange, securities litigation counsel at Financial Recovery Technologies, is the senior member of FRT’s Legal & Research team responsible for global, direct, and antitrust case analysis and legal research. He has spent more than 20 years in practice. Before joining FRT, Lange was a Partner at Berman DeValerio & Pease, one of the country’s leading law firms prosecuting securities, consumer, and antitrust litigation. He personally identified and initiated cases recovering more than $200 million for investors. Lange led the firm’s business development, marketing, and government affairs efforts and was its primary media strategist and spokesperson, handling press calls and interviews. He was principal contact for a number of institutional investor clients, advising them on case merits, damages calculations, lead plaintiff or other involvement, and related strategies. He negotiated and oversaw settlements, working closely with administrators on all aspects, from allocation plans and claims notification through processing and distribution.

Under the Hood of the MSCI EM Index

By Tom Shingler, guest columnist

Remember the BRIC countries? The acronym was coined in 2001 by Goldman Sachs economist Jim O’Neill for the economies of Brazil, Russia, India, and China to convey that their relative economic growth would continue to exceed that of the so-called Group of 7 (Britain, Canada, France, Germany, Italy, Japan, and the United States) and thus their increasing global economic importance should be recognized by the G-7.

We don’t have to look back that far to see how much times have changed in the emerging markets from the heyday of the BRICs. Both Brazil and Russia have experienced recessions in the past decade, while India and China have continued to grow, and their stock markets have experienced much stronger returns than those of Brazil and Russia.

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China, in particular, has become an increasingly large part of the emerging markets, and that has driven changes in both the country and sector weights in the MSCI Emerging Markets Index. Ten years ago, China was 13.9% of the index, and that weight has now more than doubled to 29.9%. Conversely, Brazil and Russia’s weights have both plummeted—Brazil’s by nearly half and Russia’s by more than half.

With the inclusion of China A-shares in the MSCI EM Index in 2018, China’s relative index weight is expected to grow. China not only has the world’s second-largest economy but also its second-largest equity market, after the U.S. ($12 trillion versus $26 trillion as of March 31, 2018). Initially, the China A-share stocks included in the index will account for only 0.73% of the EM index. However, China’s weight within the EM Index, including the addition of A-shares and overseas-listed Chinese companies, is expected to swell from roughly 30% to over 40%. China, South Korea, and Taiwan are already 56.8% of the MSCI EM Index. In 2008, the top three countries of Brazil, China, and South Korea represented only 42.1% of the index.

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Sector weights have also changed drastically in the past 10 years, with an overall shift to new economy sectors from cyclical, commodity sectors. Information Technology (26.7%), Financials (24.7%), and Consumer Discretionary (8.6%) now comprise 60% of the MSCI EM Index. A decade ago, the market was relatively less concentrated (the top three sectors represented 53.9% of the index), and two of the three largest sectors were energy and materials.

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What does all this change mean for asset owners investing in emerging market equities?

• Start with a review of your emerging market exposure. If you have active emerging market managers, consider their country and sector exposures relative to the index.
• For instance, some active emerging market managers have been structurally underweight in China for reasons that include valuations and governance concerns. Managers should be able to explain the rationale of their China positioning.
• In a multi-manager structure, country and sector positioning are factors to consider when reviewing whether manager exposures are complementary.
• If your exposure to emerging markets is purely passive, consider the increasing level of concentration by country and sector, and whether exposure to emerging markets should be structured differently to mitigate these concentration risks.
• As we look to the next decade, asset owners with large emerging market equity portfolios may consider having dedicated China exposure given the size and growth of the market.

One cautious note: As the diverging path of the BRIC economies and stock markets has shown us, past performance is no guarantee of future returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Callan or TEXPERS. 

About the Author

Thomas H. Shingler is a senior vice president in Callan's New Jersey Fund Sponsor Consulting office and works with a variety of fund sponsor clients, including public and corporate defined benefit and defined contribution plans, endowments and foundations, and insurance companies. His responsibilities include strategic planning, investment implementation, manager evaluation, education, and special projects. Shingler is a member of Callan's Manager Search, Emerging Manager, and ESG Committees and is a shareholder of the firm. He earned an master's degree in business administration from the University of Pennsylvania Wharton School and a BA in History from Princeton University.

Not all short-duration strategies are created equal

By David Nagle, guest columnist

Today’s fixed income investors face a number of formidable challenges. Interest rates remain low by historical standards but appear poised to rise (or continue rising) amid a favorable economic backdrop and shifting global monetary policy. At the same time, credit spreads remain fairly tight across many fixed-income sectors, meaning investors are often not being adequately rewarded for taking on credit risk. 

This environment has left many investors strapped for yield and return, potentially forcing them to step outside their normal risk tolerance to pursue their investment objectives. For example, some investors may have either gone down in credit quality or reached for yield at the longer end of the yield curve, which is more sensitive to interest rate movements. In so doing, investors may be exposed to significantly more credit or duration risk than they realize (in other words, more vulnerable to market volatility and possible capital depreciation going forward). 

An appropriate strategic allocation to a high-quality, actively managed short-duration bond strategy may allow these investors to reenter their comfort zone—not only today but for the long term as well. This type of strategy can potentially play three distinct roles in investor portfolios. 

1. SUBSTITUTE FOR LONG/INTERMEDIATE ALLOCATION: Faced with today’s fixed income headwinds, many investors have been rethinking their allocation to the long end of the yield curve. For core bond investors seeking an attractive balance of risk and reward, the solution may be an actively managed intermediate- or short-duration strategy that is designed to mitigate market volatility without meaningfully sacrificing return.
2. AN ALTERNATIVE TO MONEY MARKET FUNDS: For investors with short-term cash needs, capital preservation is paramount, often making low-yielding (albeit ultralow-risk) money market funds the vehicle of choice. Investors seeking a better risk-adjusted return, while still retaining a high degree of liquidity and principal stability, may find a high-quality short-duration bond strategy to be a viable alternative.
3. SHORT-DURATION BOND ALLOCATION: In general, short-term fixed income instruments are acknowledged as being less sensitive to interest rate movements than their longer-term counterparts. Thus, a short-duration bond strategy may provide fixed-income investors with enhanced diversification across the bond maturity spectrum, along with a natural hedge against the potentially negative impact of rising rates. 

A Vast Universe of Short-Duration Strategies 

Many investors mistakenly think of the short-duration bond universe as a monolithic group of strategies that all share one key characteristic—the ability to help protect against rising rates or, more generally, to help reduce portfolio volatility.

In reality, the universe is large and quite diverse, with notable differences among individual strategies. For example, passive duration strategies, in particular, may not supply much of a rate hedge because many do not attempt to actively manage interest rate risk, while some higher-risk active duration strategies may have oversized allocations to lower-quality credits. And of course, yield and performance can vary widely from one strategy to another.

As with any portfolio allocation, it’s important to consider your options carefully before choosing a short-duration bond strategy.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Barings or TEXPERS. 

About the Author

David Nagle is the Head of Barings Multi-Strategy Fixed Income Group. He is responsible for the portfolio management of the firm’s investment grade strategies. Nagle has worked in the industry since 1986 and his experience has encompassed multi-sector portfolio and risk management, and asset allocation. Dave holds a bachelor's degree in Economics and Finance from Lafayette College and is a member of the CFA Institute.

Are US Companies Investing Enough for the Future?

By Frank Caruso & Chris Kotowicz, guest columnists

Corporate investments are the cornerstone of future growth. Yet shareholders are often seduced by buybacks and dividends. Equity investors should always make sure companies strike the right balance between deploying cash flows for short-term shareholder rewards and strategic reinvestment. 

Running a company can be a messy business. CEOs of large, publicly listed firms often must choose between achieving near-term financial commitments and delivering long-term value creation. In our view, to create strong long-term return potential, companies must actively invest in new ideas designed to build a better business or generate long-term growth.

The Corporate Dilemma: Returns for Shareholders vs. Returns to Shareholders

US companies don’t look constrained by funding limitations. Our research shows that the top 25 US nonfinancial large-cap companies deployed more cash toward share buybacks and dividend payouts combined than on capital expenditures in 2017 (Display). 

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If funding is available, what keeps companies from spending more? Many companies don’t have enough good ideas to fund, while others lack vision. Bureaucratic governance structures may also hinder timely investment. Of course, tax reform could spur companies to launch new investment initiatives. However, many companies strive to grow earnings annually, which can also influence how they prioritize capital allocation and detract from their ability to sustain future profitability. In our view, many companies might be choosing not to fund good ideas because it’s simply easier to buy back stock, which flatters short-term EPS growth rates. 

What’s wrong with that? The challenge is that maintaining high profitability often requires an intelligent trade-off between managing expenses while funding business model improvements and future growth opportunities. 

Sustained investment is always vital to future shareholder value creation—especially in a world that’s rife with technological disruption. That’s why we believe investors should scrutinize companies for signs of underinvesting. Companies that underinvest might look healthy today, but their high margins may mask an underlying weakness: a lack of readiness for looming threats to a business model.

The Investor’s Dilemma: Is High Profitability Good or Bad? 

This presents a conundrum for investors. High profitability, typically measured by margins, is usually seen as an attractive trait in a company. So how can you know when it’s really an Achilles’ heel? We think the following signs of underinvestment can help investors distinguish between companies with sustainably high profitability and high-risk companies with limited reinvestment opportunities: 

• Declining R&D or selling expenses—in absolute terms or as a percent of revenue, suggest that a company may be too focused on short-term margins at the expense of the future
• Rising talk of “targeted investments”—especially in combination with declining spending levels, is often an implicit admission that a company is actively choosing not to invest in potential opportunities. Such narrow, tactical moves afford less tolerance for an investment miss. Don’t be fooled by the jargon. 
• Slow organic sales growth—especially if it lags peers, could indicate that a company’s core current product lines are falling behind and require increased future investment
• Acquisition fever—is perhaps the biggest and most damaging sign of cumulative underinvestment. A company on a buying spree may be trying to catch up with peers. While some takeovers help a company improve its market position, they can be a sign that the company is underinvested in key markets, made the wrong investments, or both. In extreme cases, acquisition fever could signal that a company is lacking innovation or has damaged governance. 

Takeovers generally demonstrate clear strategic intent and are accretive to earnings. But investors tend to focus too much on earnings accretion and too little on return on invested capital (ROIC)—an important driver of stock returns, in our view. The expected long-term benefits of acquisitions don’t always materialize and the high premiums typically paid for deals often structurally dilute ROIC, especially compared to organic investment.

GE’s Breakup Reflects Cumulative Investment Missteps 

GE’s recent decision to break itself up into three fully separate, more focused companies presents an excellent example. Since 2005, the company spent $64 billion on acquisitions designed to reposition itself (Display). It also returned a net $171 billion to shareholders since 2005. Much of it was funded by liquidations at GE Capital. 

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But GE was stretched trying to deliver attractive financial metrics while also supporting a heavy dividend. That’s why we think GE moved toward targeted investments (including some large ones, such as its Predix software platform). And as the company’s bureaucratic management structure struggled with timely capital allocation, several core franchises steadily eroded, which led to the breakup decision. 

In contrast, Nike has embraced the disruption that is reshaping consumer sectors. The footwear maker has shifted toward automated technologies and is investing in bringing customized products closer to consumers. By saving money on shipping costs, duties and tariffs, Nike has been able to maintain high levels of profitability.

Innovation and Investment Are Keys to the Future 

The pace of disruption is accelerating everywhere. In a rapidly changing world, acquiring companies at expensive valuations to drive growth is usually not a compelling strategy for success, in our view. Instead, we think companies must boost organic investment in products and services to create a durable business model for the future. Investors should look beyond quarterly results and quick cash returns to shareholders to find companies with innovative ideas and a successful investment track record to confront disruption and deliver bona fide long-term growth. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams or TEXPERS. 

About the Authors

Frank Caruso is a senior vice president and chief investment officer of U.S. Growth Equities, a position he has held since 2012 at AB. He has led investment teams since 2004 and was a portfolio manager from 1995 to 2004. Caruso joined the firm in 1993 when it acquired Shields Asset Management, where he had been director of Equities. Previously, he was a managing director at Shearson Lehman Advisors, as well as CIO for Shearson Lehman Asset Management’s Directions and Capital Management businesses. Caruso was also formerly the lead portfolio manager for Shearson’s family of growth and income mutual funds and a senior member of Shearson Lehman Advisors’ Investment Policy Committee. He holds a BA in business economics from the State University of New York, Oneonta, and is a member of the CFA Society New York and the CFA Institute. He is a CFA.

Chris Kotowicz joined AB in 2007 and is a senior vice president and senior research analyst responsible for covering capital goods and life science tools in the U.S. He was previously a sell-side analyst at A.G. Edwards, where he followed the electrical equipment and multi-industry group for four years. Prior to that, Kotowicz worked in the industrial sector, mostly in a technical sales and business development capacity, for Nooter/Eriksen and Nooter Fabricators, each a subsidiary of CIC Group. He holds a BS in civil engineering from the University of Missouri, Columbia, and an MBA (with honors) from the Olin School of Business at Washington University. He is a CFA charterholder.