Applying AI to Traditional Industries

Image by sujin soman from Pixabay 

By Kurt Wiese, Guest Contributor

When people think of artificial intelligence, or AI, and machine learning, images of autonomous driving, virtual reality, and other high-tech, start-up–dominated fields that didn’t exist a decade ago typically come to mind.

However, in our continuous search for durable growth drivers, we are finding that AI has open-ended potential across many areas, including those that currently depend on labor- and time-intensive research and development processes. Companies with technology platforms that can solve for challenges across multiple applications are interesting in any industry. One such company is Codexis, a leader in protein engineering.

At the recent William Blair CONNECTIVITY conference, John Nicols, president and CEO of Codexis, described how companies are using technology to tackle previously insurmountable research and development (R&D) challenges in the food and pharmaceuticals industries.

Faster, Cheaper, Sweeter

Stevia, a sweetener extracted from the leaves of a plant native to South America, has gained some popularity as a sugar-alternative because it’s non-caloric and natural. But many consumers experience a bitter aftertaste, which limited its historical market acceptance.

Codexis collaborated with a U.K.-based food ingredient company to engineer an enzyme process that eliminates the bitter aftertaste by extracting 95% pure Reb M glycoside, as opposed to the bitter but higher-yielding Reb A.

Researchers have known what part of the plant they needed for years, but until recently, the time and labor required to develop the extraction process had not been economically viable.

New machine-learning platforms allow for this by processing information faster than we could previously imagine. Projects that once took about 20 scientists and up to two years of labor to complete now can take a few scientists a matter of months.

Bending the Healthcare Cost Curve Downward

The healthcare sector faces many risks and uncertainties, including pressure to reduce drug pricing. As a healthcare analyst, I’m especially interested in companies that can maintain healthy margins and robust R&D pipelines in the face of lower prices.

We believe that AI is already ushering in a new era of innovation in the healthcare industry. By dramatically streamlining the drug development and testing process, AI tools have the potential to yield tremendous benefits for society, both in terms of reducing costs and unlocking better ways to treat diseases and patients. For example, thanks to next-generation sequencing, blood samples can be used instead of tissue biopsies in some cancer diagnostics, improving the speed, accuracy, and ease of detection and treatment.

A mega-cap pharmaceutical company uses a machine learning derived enzyme to manufacture one of its most-prescribed drugs, which treats diabetes. The production process provides a better yield to meet the growing global demand, which allowed it to gain higher production efficiencies and avoid additional capital investments. It has also allowed the pharmaceutical company to move to a more environmentally friendly production process.

When evaluating a research-driven company’s ability to create sustainable value for investors, partnerships can be very important. Companies that are able to understand the R&D challenges facing their clients and do the front-end work to create innovative solutions to those roadblocks should have a growing and highly defensible position in the value chain—regardless of industry.

Innovating for Profitability—and Sustainability

One of the biggest challenges facing manufacturers across industries is determining how to create a product with the same or higher quality at the same or lower cost—and with a smaller impact on the environment. This trend is being driven not just by regulators, but by consumers who are increasingly conscious of the environmental impact of their purchase decisions.

AI is playing a leading role in solving this engineering challenge. For example, by streamlining the drug development and manufacturing process or by increasing the yield from plants, AI is lessening the need for energy, water, chemicals, and other resources throughout the supply chain.

Across industries, companies that recognize the quickly evolving regulatory, competitive, and consumer demand environments and enlist innovative solutions to enhance the speed, quality, and sustainability of their R&D efforts will likely be among the longer-term winners.

References to specific securities and their issuers are for illustrative purposes only and are not intended as recommendations to purchase or sell such securities. William Blair may or may not own any securities of the issuers referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. It should not be assumed that any investment in securities referenced was or will be profitable.

Kurt M. Wiese

About the Author:
Kurt M. Wiese is a research analyst for William Blair Investment Management. He focuses on U.S. small-cap healthcare companies. Before joining the research team in 2001, he was a member of William Blair’s corporate finance healthcare team, where he was engaged in all aspects of transaction execution. Before joining William Blair in 2000, Wiese worked in the Chicago audit practice of PricewaterhouseCoopers for two years. He is actively involved in the Chicago community through his philanthropic work at the Chicago Jesuit Academy, a full-scholarship, college-prep middle school for underprivileged boys on Chicago’s West Side. Wiese received a B.S. in accounting and finance from Indiana University and an M.B.A. from the University of Chicago’s Booth School of Business. He was also a participant at the Center for Japanese Language and Culture at Nanzan University in Nagoya, Japan.

The Fed’s 'Financial Conditions' Conundrum

By Jason Brady, Guest Contributor

First-quarter returns marked a spectacular rebound from the December 26 lows, when investors were fleeing risk exposures. Many markets saw their best quarter in a decade. We’re back!

Not so fast. Markets and the U.S. Federal Reserve face a multifaceted conundrum: Where exactly are we in the economic cycle? Can we be late cycle but still have room to grow? Ex-energy, have we reached inflation targets, or is deflation still the concern? Is the labor market tight, as former Fed Chairwoman Janet Yellen recently said, or does significant slack still exist, as some current Fed officials assert? Excesses have built up, including corporate leverage and re-compressed yields, amid renewed investor risk appetite. After the selloff and subsequent rebound, should investors expect less volatility, or more?

Toward the end of her tenure, Yellen called out the excesses, but they haven’t become less spicy since current Fed Chairman Jerome Powell took over in early 2018. Risk markets suffered after the Fed hiked four times in 2018 and steadily shrank its still-bloated balance sheet. But since Powell’s end-2018 policy U-turn, the Fed’s focus now appears trained more on ebbing, albeit still decent, global growth and especially “financial conditions,” which nowadays means equity markets.

Stock prices are higher thanks to the Fed, not because earnings are better or growth is terrific. Ironically, U.S. blue-chip earnings rose last year, and price/earnings ratios declined. This year, it’s the inverse. Too often investors extrapolate the latest Fed signal out to the long run. That’s why we’re skeptical about the Fed’s about-face, which engendered hope its still-accommodative stance will long continue amid above-trend growth.

The Fed’s liquidity injections—not to mention those of the other major central banks—have fended off some problems. But they won’t produce higher growth if we can’t push credit creation further, a challenge when debt levels are running high globally. Typically, when the Fed is finished hiking, a relief rally ensues. Yet the close of an economic cycle isn’t good news.

Valuations don’t offer much support to equities or fixed income. When rates rose in 2018, it caused risk assets to falter because we are now dependent on ever-lower interest costs with debt burdens of corporations and governments quite high. The U.S. 10-year Treasury yield’s 80-basis-point fall helps. But most of the world is at the zero lower bound. Curves are flat or inverted not because there is imminent doom. Rather, markets expect medium-term rates to be lower to deal with a future downturn. Ultimately, this cycle won’t die of old age. It will die because we have borrowed and pulled forward growth, creating conditions for “Minsky Moment” instability.

Markets adjusting to better reflect current fundamentals and future prospects shouldn’t be cause for Fed capitulation amid above-trend growth. Nor should investors want rising valuations from easy money, absent improving fundamentals. Spotting the difference is crucial for successful investing.

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

About the Author:

Jason Brady

Jason Brady is president and CEO of Thornburg Investment Management. He is responsible for the company’s overall strategy and direction. He is also the head of the firm’s global fixed income investment team and a portfolio manager on multiple strategies. He joined the firm in 2006, was made portfolio manager and managing director in 2007, and president and CEO in 2016. His book, "Income Investing: An Intelligent Approach to Profiting from Bonds, Stocks and Money Markets," is a step-by-step guide to income investing. Brady holds a bachelor's degree with honors in English and environmental biology from Dartmouth College, and an master's degree with concentrations in analytical finance and accounting from Northwestern’s Kellogg Graduate School of Management. He is a CFA charterholder. Prior to joining Thornburg, Brady was a portfolio manager with Fortis Investments in Boston, and has held various positions at Fidelity Investments and Lehman Brothers.

Double Digit Equity Returns 2019 YTD

 How do you protect your equity position for the rest of the year?

By Thomas Cassara and Ryan McGlothlin, Guest Contributors

With both international and US equity markets up approximately 15% year-to-date reversing most of the 4th quarter 2018 correction, many plan sponsors are asking themselves “should we consider any changes to protect the equity gains that we have received?”

Most pension plan sponsors, however, haven’t seen a strong improvement in their pension funding status since the beginning of the calendar year. This comes as a result of declining discount rates (i.e. declining interest rates and credit spreads) that have increased their liability values. Thus many plan sponsors, especially those on glide paths, may be staying the course as they rely on the plan’s funded status to dictate changes in asset allocation.

So, what are some options for consideration if plan sponsors want to protect their equity position for the year?

One choice would be to reduce the amount of a plan’s equity holdings. Selling now will lock in the gains for that portion of assets being sold. However the choice of where to invest those proceeds will need to be considered. If a plan sponsor is trying to increase their hedge vs. future interest rates movements, then buying additional hedging assets could make sense. However if these assets are still needed to drive growth, investing in fixed income now after the recent sharp decline in long interest rates may not be wise as these assets will lose money if rates were to increase. That would leave cash, alternatives, or other equity segments as potential options, but those may not make sense either.

A second choice would be to use equity options to protect your position. This can be done in many different ways and can be designed in a cost effective way. One such strategy would be to sell off equity upside beyond what a plan may expect or need to purchase some level of down side protection. As an example, a plan sponsor could sell equity returns over 8% from current levels in exchange for protecting the first 10% of downside over the next year for a zero premium today.

Another strategy would be to use equity derivatives to change the effective asset allocation of a portfolio without moving physical assets. For example, one can use futures to change a 70% equity/30% fixed income portfolio into the economic equivalent of a 50%equity /50% fixed income portfolio without incurring the expenses of selling and buying physical assets. Thus the position can be easily reversed if market conditions would warrant a higher equity position.

With uncertainty in the global economy looming, why not lock-in 2019’s positive equity returns now regardless of what discount rates do? Using strategies as described above, pension plan sponsors can effectively protect their equity gains and still leave room for a certain level of additional positive returns. If you’d be happy with a 15% return this year, now is the time to celebrate and lock it in for 2019. It’s important to act quickly as the times can quickly change.

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

About the Authors:
Tom Cassara is a managing director in River and Mercantile’s New York office. In his role, he consults with institutional clients across the investment and actuarial spectrum. This includes defined benefit, defined contribution, not for profit and retiree medical. Cassara works with clients to bring his 30 years of experience across a wide range of institutional organizations to provide custom solutions. Prior to joining River and Mercantile, he was a senior partner with Mercer leading their U.S. East Wealth business in addition to providing strategic investment and actuarial advice to clients. He has consulted to organizations with less than $100M in assets to greater than $5B in assets. Included in his experience is working with corporate, not for profit, church, healthcare and endowments and foundations. He is a Fellow of the Society of Actuaries, an Enrolled Actuary, a CFA charterholder and has a Series 3 license.

Ryan McGlothlin is a managing director in River and Mercantile’s Boston Office. He serves as global head of Strategic Relationships as well as acting as the U.S. Chief Investment Officer. McGlothlin works with all types of institutional investors on customized investment and risk management strategies. He joined River and Mercantile Solutions in 2007 to found its U.S. business. Prior to that, he worked for Barclays in London, helping institutions to structure and execute derivatives transactions. He designed and executed some of the earliest interest rate, inflation and equity hedging programs for United Kingdom defined benefit pension plans. He began his finance career as an investment banker advising on capital raising and M&A transactions. Ryan has 20 years of financial services experience, with most of that time focused on institutional investment and risk management. He is a regular writer and speaker on investment and financial risk management issues. He serves on multiple firm investment committees, including the Global Investment Committee. Ryan also is active in the firm’s product development efforts. 

Modeling the Downside Case

By Linda Chaffin, Guest Contributor


Senior debt is considered the safest investment in the capital structure. Yet every loan has potential risks. Before investing with a private debt manager, it is important to understand how the manager evaluates risk and structures transactions, especially later in the credit cycle.

The loan due diligence process is known as “underwriting,” and its rigor can vary by manager. A strong underwriting process should include modeling downside scenarios to evaluate whether the borrower can generate sufficient cash flow to service debt, support ongoing operations and maintain an acceptable loan-to-value ratio.

How do lenders evaluate loans?

Cash flow lenders use qualitative and quantitative analyses to evaluate each loan opportunity. The qualitative analysis includes assessing the borrower’s competitive positioning, operations and market dynamics. The quantitative analysis includes assessing historical performance and the sustainability of prospective cash flows. As part of this, a best practice is preparing a detailed financial model with multiple scenarios including growth, baseline and downside cases.

Credit committees often focus on the downside case. If things go according to plan, there is generally little concern about loan recovery. If a situation deteriorates, recovery risk may increase.

Evaluating downside scenarios facilitates a constructive discussion about the borrower, quality of earnings, industry and an appropriate capital structure based on the risks inherent in the transaction.

Building a downside case

Creating a downside model begins with identifying a variety of negative events that could affect a company and/or its industry and result in the borrower generating less cash. These might include a recession, loss of a major customer, product obsolescence, new regulations, change in the competitive landscape or lack of expected synergies.

A thorough model includes a five-year review of a borrower’s historical financial performance and five years of projections. A company’s inability to provide this data can be a red flag.

The downside case and investment decisions

Downside analysis helps lenders determine the appropriate amount of debt that will allow a borrower to support debt service and other liquidity needs in a variety of cycle and stress scenarios. It also allows a manager to proactively structure a transaction for protection.

One key financial metric that lenders use to evaluate debt service is the fixed charge coverage ratio (“FCCR”), which is typically calculated as EBITDA less capex, divided by interest + principal payments + taxes + sponsor management fees. FCCR should remain above 1.0x in the downside case after shutting off subordinate debt interest payments and management fees following a default. Changes in loan to value (“LTV”) is another metric that lenders consider.

Armed with an understanding of downside scenarios, a private credit manager should propose a capital structure that results in sufficient FCCR and LTV during a period of stress. This might involve structuring a transaction to include a higher initial cash equity contribution or a lower funded leverage.

Ultimately, a private credit manager’s commitment to detailed underwriting and prudent transaction structuring should result in lower defaults and higher recoveries, which can help offer investors stable returns throughout economic cycles or periods of stress.

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. 

Linda Chaffin

About the Author:
Linda Chaffin oversees NXT Capital’s investor relations activities and fundraising efforts. She is actively involved developing and maintaining investor relationships across the institutional LP community, including insurance companies, public and corporate pension plans, foundations, endowments and consultants. Chaffin brings over 20 years of investor relations, fundraising, private equity, and M&A investment banking experience to NXT.