Article Investment approach

Building a business-owner mind-set

Perspectives Montréal,
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In this article published in the FCLT Global1 Perspectives on the Long term magazine, Michael Sabia outlines CDPQ’s investment approach based on a business-owner mind-set. This means making investments based on long-term fundamentals rather than short-term volatility and focusing on quality assets rooted in the real economy.

By definition, long-term investors have a stake in the long-term health of the economy. Measured over years and decades, their performance is tied to the innovation, productivity, and growth of the companies in which they invest and, more broadly, to economic prosperity as it grows over time. These investors have good reason to focus on the business fundamentals of the companies and projects they invest in, on important policy choices, and on the broader fundamentals of the economy itself. In a word, long-term investors need to be builders.

Short-term investors have a different frame of mind. Fundamentally, they are traders. Their business depends on the hourly, weekly, or quarterly price swings of a stock, which can be completely disconnected from the underlying condition of companies or the state of the economy. Profit can be generated in good or bad times, based on the short-term movements of interchangeable stocks.

In today’s financial system, the problem is that too many—far too many—investors have become traders who treat companies like commodities. But companies are not commodities. They play critical roles in allocating resources, determining levels of investment, fostering innovation, creating jobs, and contributing to productivity and prosperity. When we treat companies as commodities— that is, when we trade them rather than invest in them—we run the risk of undermining the long-term growth prospects of our economy.

Why? Because as traders press for shortterm performance, CEOs have no choice but to focus their strategies on quarterly performance, to the detriment of long-term investment plans that might be costly in the near term but often enhance growth potential. Spread across the breadth of our economy, this dynamic contributes to the sort of slow growth we are experiencing globally today.

Many share this concern. In fact, the importance of investing with a long-term perspective is now much discussed, as the Focusing Capital on the Long Term1 initiative demonstrates. The beginnings of a consensus for change seem to be taking shape.

This being said, the truth is that long-term investing is difficult. Especially today, when information circles the planet in minutes, the pressure for short-term results has never been greater, and financial intermediaries have become omnipresent, increasing complexity, risk, and costs.

In today’s financial system, the problem is that too many—far too many— investors have become traders who treat companies like commodities.

These are significant headwinds. To navigate such an environment successfully, long-term investors require independent governance, a renewed focus on culture and process, sound risk management, and, of course, the right people. Above all, they must return to the roots of asset ownership: investing in the real economy with a businessowner mind-set.

Investing like an owner

What does it mean to invest with a businessowner mind-set? What are the distinctive traits of business owners? What distinguishes them from traders?

The first part of the answer is knowledge— deep knowledge. Business owners are not satisfied with secondhand reports or periodic reviews of P&L statements; they know and understand the fundamentals of the company or asset they invest in. They are intimately familiar with its culture, people, operations, and strengths and weaknesses. They understand the industry and know the competition. And they have a deep sense–impervious to short-term market fluctuations or flights of fancy–of their business’s intrinsic value.

This expertise is not passive or detached: business owners engage with management. They exercise their judgment and make considered decisions based on rigorous analysis. They have a clear idea of where their business is heading.

Finally, business owners display loyalty to their company, but not at any cost. In return, they expect performance and work hard, with management, to achieve it. They are independent minded. While they are aware of what others may think, they are ready to look beyond it. They are prepared to make tough decisions and work through difficult times. Of course, all this serves as a metaphor. Institutional investors are not business owners, and they should not actually start running companies. That said, we do believe the business-owner mind-set is a useful inspiration for the successful pursuit of long-term investing.

Of course, all this serves as a metaphor. Institutional investors are not business owners, and they should not actually start running companies. That said, we do believe the business-owner mind-set is a useful inspiration for the successful pursuit of long-term investing.

Instilling the mind-set

For 50 years, Caisse de dépôt et placement du Québec (la Caisse) has been managing public-pension and insurance funds. We have more than CAD 215 billion (USD 189 billion) in assets under management, more than 90 percent of which is managed internally. Coming out of the 2008–09 crisis, la Caisse began working to instill a businessowner mind-set throughout the organization. Here’s how that mind-set plays out across various asset classes

Real Estate

At la Caisse, we do not simply invest in real estate: we own and operate it. With more than CAD40 billion in assets, our Ivanhoé Cambridge subsidiary has become one of the leading operators of real estate in the world, with 1,700 employees and properties in Asia, Europe, Latin America, and North America.

Fundamental research is a better way to manage risk than a simple reliance on technical tools, tracking of benchmark deviation, or the wisdom of crowds.

When making investment decisions, Ivanhoé Cambridge is not focused on how to dispose of acquired properties in a three- to five-year horizon or on the financial engineering underlying the transaction. Instead, it analyzes the tenant base, potential longterm disruptions, and opportunities for operational improvements to the property’s management.

Developing such a deep understanding of assets—including at the operational level—presents a number of advantages. It provides a rigorous and independent sense of the value and potential of an asset, which increases resilience in the face of turmoil. Fundamental research is also, we believe, a better way to manage risk than a simple reliance on technical tools, tracking of benchmark deviation, or the wisdom of crowds. Deep knowledge is a prerequisite for investors willing to take more concentrated positions instead of the usual practice of hedging their bets and diversifying across the investment landscape.

This focus on deep knowledge has become a cornerstone of our investment approach.

Infrastructure

Infrastructure is a natural asset class for the long-term investor. Typically illiquid, long term in nature, and resistant to easy benchmarking, infrastructure-investment decisions must rely on a rigorous understanding of intrinsic value and risk.

As with our real-estate portfolio, applying a business-owner mind-set to our infrastructure investments requires us to answer a number of questions: Is the project economically important and, hence, is it viable for the long term? Do we understand it well? Is the expertise available to manage it through good times and bad? What operational improvements can we make? La Caisse aims to provide unambiguous and durable responses to these questions, as we normally approach infrastructure acquisitions with little or no consideration for the date of resale.

Public Markets

We have also decided to expand the businessowner mind-set to our public-markets team. This represented a radical departure from the status quo.

In 2013, we launched a high-quality global equities portfolio built on the core principles outlined earlier. The portfolio is worth CAD 25billion, concentrated in about 70 companies, with an annual turnover rate of about 10 percent. Stocks are selected on the basis of proprietary fundamental research, which also serves as an essential risk-management tool.

Crucially, it is a benchmark-agnostic portfolio: while its performance is measured against an index over a long horizon, it is not built around a benchmark and is not expected to track one. This is a near-complete reversal of our previous strategy. Adopting a business-owner mind-set has meant letting go of indexes.

We are now in the process of expanding this approach to other major equities portfolio. By the end of 2015, CAD 50 billion of assets will have been shifted away from our previous, benchmark-driven strategy to one that, we are convinced, will deliver far more durable results.

Even though equity portfolios don’t always allow for the same kind of engagement as real estate or infrastructure, we’ve tried to import the same overarching principles: deep research, a focus on intrinsic value as opposed to benchmarks, fundamental risk assessment, and resilience in the pursuit of long-term objectives.

Private Equity

The business-owner mind-set also appears ideally suited to private-equity investments. Importing the principles outlined above to la Caisse’s current and future private-equity operations represents the next frontier in our plan.

Once again, the point is not to operate companies directly. Instead, we will be striving, along with our partners, to be an active (but not activist) investor, not bound to any specific benchmark, seeking only to invest in businesses we believe in. These may be companies that are performing well but are underpriced, or they may be companies in which we see opportunities for sustainable performance improvement.

La Caisse is developing this level of engagement and ownership one transaction at a time—occasionally taking board seats, making recommendations, and using our influence—as we learn from past successes and failure.

The elements of a long term culture

All institutions hoping to keep their focus on the long term face challenges. Public markets in particular are awash with distractions. While no one is completely immune to the anxieties of market volatility, holding steadfast to a few principles and practices may help to navigate turbulent seas.

Independent Governance

Investors hoping to remain committed to their principles must be able to withstand pressure from government, other institutions, and public opinion.

In practice, this requires three things: truly independent governance, shielded from interference from political actors and outside interests; an ability to resist public criticism or impatient calls for a change in direction; and freedom to set compensation policies adapted to the marketplace. A number of guidelines exist to achieve these objectives, and they should be adopted, in letter and spirit, by all investors serious about making and maintaining their own decisions.

Talent

For any institution, the first priority is finding individuals who understand its philosophy and values and who are willing and able to further them. Compensation structure and processes help to align individual incentives with institutional objectives but cannot serve as a magical cure for fundamental differences of perspective.

For la Caisse, the combination of a business-owner mind-set and a focus on longterm risk assessment has meant hiring people with broad horizons, diverse backgrounds, operational experience, and a willingness to engage with the management of portfolio companies. Our search for experienced business operators has often led us far beyond the traditional recruitment pool of the Financial industry. We have hired engineers, geologists, and executives with operating experience in mining, consumer products, and IT, among many other areas. We want people who have a clear understanding of how value is created in a sector—because we believe durable value is created through excellent operations, not financial engineering.

Culture and Process

What is an organization’s culture? In our minds, ultimately, it is how work gets done. It is the fabric that brings together the individual skills of our people. Building a culture that resists the temptation to follow the crowd and seek immediate results has been one of our toughest challenges. We still have a long way to go.

We are trying to build an institutional culture that values the kind of knowledge, independence, and patience that lead to deep convictions. That means striving to understand companies and assets as deeply as a business owner, truly engaging with the companies we invest in, and weighing fundamental, long-term risks.

Building a culture that resists the temptation to follow the crowd and seek immediate results has been one of our toughest challenges.

When making investment decisions, we place a great deal of emphasis on the pooling of knowledge across the organization to marshal our best insights. This has meant breaking down the silos that have historically separated one asset class from another and investing in information-management systems that facilitate collaboration.

This deliberate pooling of knowledge has been an important ingredient in our move to a more collective approach to investment decision making. Our new process relies on the value of debate as the best way to get the real issues on the table. For example, we don’t have an investment committee. We have an investment-risk committee. The distinction is important because it implies that in a discussion of any investment proposal, we expect a debate between our investment and risk teams. We regard this as a key part of developing the deep convictions we need to take large positions and hold them for the longer term.

With that same goal in mind, we are also trying to adopt a more strategic approach to investment decision making. Every year, we ask each asset-class team to develop and present to our board a four-year plan that identifies its investment priorities and where it intends to take its “business” over the coming period. Throughout the year, individual investment decisions are evaluated against those four-year priorities.

Compensation

Indispensable to our strategy is an ability to pay our investment professionals on a commercially competitive basis. Without it, we would not have access to the talent we need. That being said, how we pay our people is as important as how much. Four years ago, we put in place a new compensation program built on a number of principles that aim to support our long-term business-owner mind-set:

  • We offer pay for performance over a fouryear rolling period.
  • Individual, team, and la Caisse–wide performance counts for everyone.
  • Risk management is everyone’s responsibility.
  • We try to make investment decisions as if we were investing our own money—to that end, as an example, our senior executives are required to invest more than half of their annual bonus in la Caisse’s portfolio.
Risk

Equally important is a robust assessment of risk. Should we be concerned about fluctuations in asset value, deviations from a benchmark, or permanent loss of capital? Should we focus on financial factors, broader determinants of risk, or both?

La Caisse has adopted a pragmatic approach: risk is assessed from a number of perspectives, each providing its own insights. But our priorities have shifted.

We are now mainly concerned about deep risk and permanent loss of capital, and we give extensive consideration to both financial and nonfinancial risk factors. Like business judgment, risk management is both an art and a science. To that end, we are working to pool expertise and encourage open (and at times vigorous) debate.

While we continue to track volatility using all available tools, la Caisse no longer sees this measure as the be all and end all of risk management. Our focus is firmly placed on deep research and stress testing the performance of both individual assets and our overall portfolio. We are gradually moving away from certain tools, like VaR, that often obscure more than they reveal.

To put it simply: the criteria that figure into an evaluation of risk over a 30-day window are of limited relevance to a 30-year investment horizon. When thinking about value over multiple years or decades, near-term fluctuations fade in importance next to core strengths and weaknesses, fundamental movements in demography and technology, and the stability of economic and political systems.

When thinking about value over multiple years or decades, near-term fluctuations fade in importance next to core strengths and weaknesses.

Why is all this important? Beyond catchphrases and good intentions, is there fundamental value in long-term investing with a business-owner mind-set?

We deeply believe so.

Long-term investing creates a virtuous circle that improves risk-adjusted returns over time. It encourages corporations to adopt longer-term objectives, invest in innovation, and focus on building superior longer-term performance. At scale, it can stabilize and improve capital markets. And it helps to reduce the noise and distractions that often lead markets to irrational turbulence. In a fast-paced world, taking a step back makes sense.

As large, global investors, our ability to meet our clients’ long-term expectations depends on markets that ultimately reward responsible and creative decisions.

We believe all institutions that have the ability to break free from the tyranny of short-termism should consider the broadly shared benefits of investing for the long term. If we all chase the market based on one another’s movements, we are really all just chasing our tails. Surely, we can do better than that.


1 Focusing Capital on the Long Term is a global initiative bringing together a number of institutional investors, multinational corporations and portfolio managers seeking to promote a long-term investment approach in a concrete manner. This article was initially published as part of a summit held in New York City on March 10, 2015. For more information, visit www.fclt.org.

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