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ESG, Shorthand, and Shortcuts

bgregorio — Tue, 05 Dec 2023 17:52:42 +0000

ESG, Shorthand, and Shortcuts bgregorio Tue, 12/05/2023 - 12:52

Long-term, performance-focused investors must carefully consider the challenges and opportunities that may impact businesses in the decades to come. If it were easy to do this, though, it would be automatic by now. Exploring a giant swath of data points, tactics, strategies, and heterogeneous information is simply a large body of work. It also compels a good deal of humility, an acknowledgement of luck, and a desire to always learn more and to turn over more rocks, and to look at more information in order to arrive at investment insights.

Yet a whole slew of relevant environmental, social, and governance-related information has been panned by political agendas that are far removed from the purview of investment managers. Acronyms can sometimes be helpful, but in the U.S. the term ESG has come to mean everything from greenwashing and shortcuts, to saving the planet.

Our use-case at Brown Advisory for environmental, social and governance information, however, can be vastly different from how some clients, regulators, and other stakeholders use the term. Here is an attempt to invoke fundamental investing basics to clarify exactly what we aspire to deliver for our clients.

An unassuming shorthand (from 20 years ago)

A 2004 report published by the United Nations is often given credit for popularizing “ESG” as a shorthand for the myriad issues in environmental, social, and governance categories. It is instructive to re-visit the title and a key take-away, endorsed by the UN and financial institutions from nine countries with $6tn of assets under management at the time (italic emphasis mine):

“Who Cares Wins: Connecting Financial Markets to a Changing World”

The institutions endorsing this report^[1] are convinced that in a more globalised, interconnected and competitive world the way managed is part of companies’ overall management quality needed to compete successfully. Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.

The origin story of the term “ESG” therefore directly ties environmental, social, and governance know-how to:

management quality,
competitive position,
risk management,
shareholder value,
new markets (growth), and
brand reputation.

All of these potential outcomes of a company’s ability to manage its environmental, social, and governance issues should be of interest to investors. The report posits that these outcomes can “at the same time [contribute] to the sustainable development of the societies in which they operate.” In other words, investors prioritizing strict fiduciary duty could focus on ESG information in an effort to make better investment decisions; if other stakeholders are interested in sustainable development, that’s also a win. But ESG information is just that: information. It is not an action nor a movement nor a political statement.

Performance: the signal amidst the noise

Environmental disruption from climate change could be felt in every sector, and investors should benefit from understanding whether companies are being proactive or reactive. Whether it’s elevating key equipment in order to protect coastal infrastructure, or keeping employees safe during extreme heat waves by investing in climate-controlled facilities, or finding alternative agricultural commodities where supply chains are stressed, every business will likely be challenged in one way or another.

Social factors such as access to healthcare, food, and housing can create meaningful risks and opportunities that are directly relevant to a company’s competitive position. Companies that can better manage human capital and support the people and communities surrounding the organization will likely win amidst changing employee, customer, and regulatory expectations around the globe.

Governance agendas are broadening to address consumer and investor pressures and expectations. Directors and corporate leadership are accountable well beyond mere compliance to address issues of transparency, trust, ethics, diversity and inclusion, and stakeholder engagement. Without strong governance and accountability, investors can experience some dismal results (think Wells Fargo or Volkswagen).

In short, the E, the S, and the G matter to performance-focused investors because elevated risks (and the associated opportunities) can lead to winners and losers. It follows that all of these issues should be incorporated into security analysis.

Opportunities

At Brown Advisory, we dive deep into many of the environmental, social, and governance risks mentioned above as part of our due diligence to understand a company’s fundamental financial drivers and future prospects for performance. As there's no shortage of such risks, we also find opportunities to solve these intractable challenges across the entire economy. For example, companies can help their customers save energy (by moving computing workloads to the cloud), save lives (by enabling therapeutic innovations such as cellular genomics), or improve lives (by bringing billions of underbanked populations around the world into the global financial system).

This approach is consistent with active, performance-focused investing principles. Any qualitative or quantitative investment insight, isolated from company fundamentals, is like talking about free cash flow (FCF) in a vacuum - FCF is less interesting if a company doesn't make good capital allocation decisions or reinvest in the business. By the same token, considering ESG criteria as a separate exercise from a fundamental, financial underwriting process is less helpful to investment insights compared to a holistic view of investment risks and opportunities.

The noise

It has been remarkable to observe that the common-sense approach of considering a whole host of risks and opportunities in an investment process has been pegged to an acronym, ESG, that is a useful shorthand in theory, but has become so ambiguous as to be vulnerable for appropriation along narrow ideological lines.

Some now warn that ESG investing contradicts fiduciary duty because it is practiced for the sole purpose of effecting social and environmental impacts. The term has also been appropriated by fossil-fuel protectionists in the United States with the claim that investment portfolios that limit fossil fuel exposure are anti-competitive (for allegedly colluding to boycott investments in fossil fuel companies). ESG legislation is winding its way through political processes in many U.S. states. ESG has often been described as a "movement" in the media. These agendas can fail clients, who have the prerogative to direct how their capital is allocated.

The practical experience of institutional and retail investors alike has been hit-or-miss with, on the one hand, several successful, market-beating investment funds[²], and on the other hand a proliferation of ESG products, some of which have now famously been lambasted by whistle-blowers as fraudulent[³]^,^[4].

Because ESG is just a set of loosely structured (or unstructured) information that means different things to different stakeholders, controversies were almost inevitable. Regulators may need ESG data such as occupational safety and health violations or chemical discharges. Clients who seek to avoid certain industries will regularly seek nonfinancial data. Consumers may demand disclosures in order to assess a company’s marketing claims. Some activists use ESG criteria to buy shares and attempt to force change via shareholder proxy resolutions. And others are performance-focused investors, who use ESG information as part of a holistic due diligence process.

If such wildly different results are expected from one ill-defined term, no wonder political agendas can take over the message. It is safe to say that because messaging around ESG has become so polarized, the vast majority of references to “ESG investing” stand in stark contrast to what performance-focused, active, high-conviction investors do.

Can we all agree on performance?

To cut through this chaos, at Brown Advisory we trust that a focus on performance is where we can agree (at least with our clients).

For our Large Cap Sustainable Growth strategy, the very word “sustainable” can help clients situate our approach. We believe in two meanings for the term “sustainable”: both durable growth (we expect companies and their investors to be rewarded for good work), and “sustainable development” (meeting current needs without sacrificing the ability for future generations to meet their own needs). Isn’t that a fiduciary’s responsibility to clients who have an objective of long-term performance?

To deliver on performance for clients, we rely on a long-standing and successful investment process that does indeed incorporate a lot of environmental, social, and governance information.

No shortcuts

Here’s a perspective on ESG: a label illuminates very little, if anything at all, about an investment approach. It’s like expecting a map to always precisely guide the way. Its usefulness depends on where you want to go, and on whether the navigator has other skills and tools such as orienteering, a compass, or a car. A map is just one of many tools to get you where you want to go, just like a balance sheet is not a complete picture of financial health.

A label such as ESG – or other shorthand labels such as growth or value for that matter – does not dictate a homogeneous investment process. Jumping to conclusions about an investment approach based on a label is antithetical to the intellectual curiosity and hard work that are hallmarks of active management.

As stewards of our clients assets, we take great effort to answer an expanded set of questions about companies to understand if a business is getting stronger, if it has high barriers to entry, if it can attract and retain the right talent, if it has a high-quality management team, if it is doing more with less, and if it is prepared for a world with greater challenges and fewer resources. One could call these ESG issues, or fundamental opportunities, or existential risks. Our results over time have benefited from the fact that we look for information and review data sources that many other investors may ignore.

We hope that communicating this approach without using shorthand terms such as ESG can re-set any expectation that there are shortcuts to finding and making use of information that eludes standard financial disclosures. Every active, fundamental, and high-conviction investor knows that every company and every situation is unique, and investing requires intense and creative research to parse a wide swath of information, and hopefully make winning decisions more often than not.

¹https://www.unepfi.org/fileadmin/events/2004/stocks/who_cares_wins_global_compact_2004.pdf

²https://illuminem.com/illuminemvoices/implications-of-the-outperformance-of-active-sustainable-investing

³https://www.cnbc.com/2021/08/24/blackrocks-former-sustainable-investing-chief-says-esg-is-a-dangerous-placebo.html

⁴https://www.wsj.com/articles/fired-executive-says-deutsche-banks-dws-overstated-sustainable-investing-efforts-11627810380

DISCLOSURES

The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.

_{The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.}

_{All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.}

_{Sustainable investment considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. Sustainable investment analysis may not be performed for every holding in the strategy. Sustainable investment considerations that are material will vary by investment style, sector/industry, market trends and client objectives. Certain Strategies (“Strategies”) seeks to identify companies that it believes may be desirable based on our analysis of sustainable investment related risks and opportunities, but investors may differ in their views. As a result, the Strategies may invest in companies that do not reflect the beliefs and values of any particular investor. The Strategies may also invest in companies that would otherwise be excluded from other funds that focus on sustainable investment risks. Security selection will be impacted by the combined focus on sustainable investment research assessments and fundamental research assessments including the return forecasts. The Strategies incorporate data from third parties in its research process but do not make investment decisions based on third-party data alone.}

Free Cash Flow is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

NOW Podcast Series

achen — Tue, 05 Dec 2023 16:51:49 +0000

NOW Podcast Series achen Tue, 12/05/2023 - 11:51

Visit the NOW Podcast Website

2023 Year-End Planning Letter: Reflections and Perspectives

ajackson — Fri, 01 Dec 2023 13:06:48 +0000

2023 Year-End Planning Letter: Reflections and Perspectives ajackson Fri, 12/01/2023 - 08:06

The end of the calendar year is always a good time to reflect—about the past and what it might mean and about the future and what our best path forward might be. The work we do with our clients is a year-round process, and the end of the year is a good time to look broadly at long-term goals and reassess how changes in the world or in our daily lives impact priorities or adjust the way we feel about advancing our plans.

Of particular concern are the tragic conflicts waging across the globe—in Israel, Gaza and across the Middle East; in Ukraine; and in China, Taiwan and across the South China Sea—where there has been horrible and tragic loss of human life, compromised personal security and significant tension about the future. While these conflicts may be far from home, they give rise to feelings of deep cultural divides that may exist in our own communities. We are keenly aware of our clients’ disquiet over these matters and are here to help clients who want to examine how they can help make a difference.

This year, our letter will focus on some of our clients’ big-picture questions, such as:

Have our priorities changed or shifted in ways that may alter our current strategic plans?
How do I/we:
- help make our family’s relationships stronger and more resilient?
- pass on core principles?
- achieve our goals for our financial, human, intellectual and social capital?
Should we modify existing plans considering changing market conditions?
How do we achieve goals for family capital, considering pending changes in the estate tax laws and, for families with geographically dispersed members, taking into account cross-border legal and tax considerations?
How should business owners prepare for the transition of ownership and management to younger generations?

READINESS PLANNING: When we talk to clients about the eventual transfer of their personal or business assets, they often want to focus on preparing those that follow them for the burden and responsibility of caring for those assets. Frequently, they are as interested in passing on their core values and creating a shared vision as they are in maximizing wealth transfers. This can manifest as dialogue between parents and kids, business owners and new management teams or families and charitable beneficiaries.

We believe that readiness planning must start with good communication. Within a family context, it can be valuable for the heads of the family to articulate their near- and long-term goals and to identify experiences that have shaped their views and philosophies so that future generations better understand why they are upholding certain principles and values. Accompanying this discussion, we encourage families to develop comprehensive financial plans that include robust “capital sufficiency analysis” (i.e., do we have enough) to ensure alignment between the tangible and the more intangible elements of the family’s overarching goals.

In this regard, we often work with families, especially younger families facing these questions for the first time, who have little or no existing structure for thinking about these issues. For those families just embarking on a planning journey, we generally advise them to start with a small set of “boundary-setting” financial decisions, such as how much to set aside each year for retirement accounts, education funds and/or charitable contributions. Ultimately, bringing the family together around the creation of a family mission statement and strategic plan may help create a common purpose and culture and allow for consideration of a broad set of constituencies, extending beyond the immediate family members.

CHANGING MARKET CONDITIONS: This year, clients will have an opportunity to revisit existing plans that were developed during a long era of low interest rates, negligible inflation and lofty asset valuations. Now that some of those core conditions have changed, it may make sense to modify some plans accordingly, to maximize low-risk yield on investment portfolios, to explore strategic elections for corporate executives to enhance wealth accumulation plans and to consider intergenerational transfers in advance of pending tax law changes.

For example, declining valuations in certain sectors may suggest taking action to lock in those lower values for income and gift tax purposes. This could take the form of an early exercise of stock options granted to employees in high-growth businesses, or it could lead a client to use their lifetime gift tax exemption to transfer depressed assets (such as commercial real estate) to dynasty trusts for their family, thereby protecting all future appreciation from wealth transfer taxes indefinitely. Strategies that worked well as ways to defer income taxes or take advantage of volatility in the markets can be replaced by strategies that focus on lowering income taxes and minimizing the use of transfer tax exemptions—both are highly effective as part of a long-term plan. The key here is flexibility and a constant review and revision of plans to meet changing conditions.

THE GREAT WEALTH TRANSFER

The “Boomer” generation (those born between 1946 and 1964) currently controls some $68 trillion¹ in personal and business assets that they will transfer to their heirs and beneficiaries over the next decade or so. What does this “great wealth transfer” mean for our clients and their descendants?

Estate Planning: One important issue involves how to plan around the current augmented estate and gift tax exemption ($10 million indexed for inflation, or twice that amount for a married couple). Adjusted for inflation, a married couple currently may give away up to $25.84 million (or leave that amount to their heirs) without gift or estate tax liability, but under current law, that limit will be reduced by half at the end of 2025. Many families will want to take advantage of the current exemption levels with meaningful gifts, but there are trade-offs, including giving up a stepped-up tax basis at death and the irrevocability of the transfer, so these decisions need to be undertaken with careful deliberation. Because such gifting often involves trusts, family business entities and other complex structures, discussions and planning should begin during 2024—well in advance of the “sunset” deadline. A framework for this planning is contained in the chart below.

PLANNING FOR GIFTS AHEAD OF THE 12/31/2025 “SUNSET”

Depending on the size of the estate, families may want to consider a variety of strategies for maximizing the value of current estate tax exemptions—which are at historically high levels today but may revert to lower levels when certain tax laws expire.

Source: Brown Advisory

Of course, other factors besides the size of one’s estate can be equally or more important when evaluating estate planning steps. In addition, the increasing geographic dispersion of our clients’ family members and their assets across multiple jurisdictions is an important planning factor, as residency and domicile typically have a profound impact on taxation, requiring a holistic economic and tax lens, factoring in all relevant jurisdictions' economic outlooks, taxing rights and rates. This is why we place so much emphasis on the ongoing “discovery” phase of our work with clients—the value of our advice is directly proportional to how well we know them.

Business Transition Planning: Millions of private U.S. businesses will likely transition leadership, ownership, and control to new blood over the next decade or so, representing a potential aggregate value of multiple trillions of dollars. As business owners prepare for these important transitions, they should consider a planning process that incorporates both desired business and financial outcomes and personal outcomes for them and their families. Accordingly, we encourage such business owners to spend time on their personal, family and legacy goals and try to clarify what they are really looking for after the transaction. This step is often ignored, and the result can be a financially rewarding transaction that nonetheless leaves the seller in a situation that doesn’t align with their broader personal goals beyond the business.

It may seem like every year in the recent past has brought with it additional complexity, uncertainty and chaos, but this only serves to reinforce the importance of strategic planning. The better we understand a risk—whether that risk is rising interest rates, political instability or a family wealth transition—the more likely it is that we can turn it into an opportunity, and the easier it is to identify wise methods to navigate and even thrive under those challenging conditions.

As in prior years, we have provided a high-level checklist that covers many of the most common questions and issues that we plan to tackle with clients this year; this list is always supplemented by the distinct and specific challenges that each of our clients brings to the table from their often-complicated lives. We look forward to discussing these matters with you—as well as any other topics you deem important—in the weeks ahead.

To download a copy of the checklist, please click here.

¹Coldwell Banker. (2019). A Look at Wealth 2019: Millennial Millionaires.

The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Irrational Behaviour, Rational Investing: How We Overcome Our Biases

bgregorio — Wed, 15 Nov 2023 17:42:29 +0000

Irrational Behaviour, Rational Investing: How We Overcome Our Biases bgregorio Wed, 11/15/2023 - 12:42

Download the Report

“We have spent a considerable amount of time thinking about how human behaviour can damage our clients’ capital – indeed it is why we work with a team of behavioural coaches – so that we can short-circuit our own potentially harmful biases.”

We focus on delivering attractive long-term performance by investing in a concentrated portfolio of companies that uniquely solve problems for their customers and generate attractive economics for shareholders. As active managers in a highly competitive market, we believe we have two sources of alpha in our approach to investing: our long-term investment horizon and our disciplined focus on capital allocation. We believe that our long-term investment horizon is a powerful competitive advantage, as many market participants are more focused on the short term, leaving compelling investment opportunities for patient investors. Our rigorous capital allocation includes implementation of behavioural analysis into the investment process to overcome these heuristics and biases. In this note, we want to focus on our capital allocation approach and behavioural analysis specifically.

The Pillars of Our Process: Payoffs, Psychology and Portfolio Risk

We employ two distinct processes when investing: investment selection and capital allocation. Most investment managers focus on the investment side, or the “treasure hunt,” but we have seen that spending equal time on determining how much capital to put behind each investment can be even more impactful from a return perspective.

Our capital allocation process includes three parts: (1) a payoff versus probability assessment, (2) the integration of our behavioural rules and (3) a portfolio risk analysis. The goal of capital allocation is to improve the risk-adjusted returns of our portfolio.

With the launch of the Brown Advisory Global Leaders Strategy in 2015, we embraced the opportunity to create processes around our strengths and weaknesses as investors and to combine our individual skills with a set of guidelines appropriate for the strategies we manage. To do so, we started working with a team of behavioural investing coaches who provide reflection and insights into our investment process to this day.

Outsmarting Evolution: Managing Our Stone Age Brains

We are firm believers that human beings are uniquely disadvantaged in the activity of investing. Many of our behaviours have been shaped by evolution – we are hardwired to survive and reproduce – behaviours that can be frighteningly detrimental to allocating capital. We rely on pre-programmed biases and heuristics to achieve these aims. In many ways, we are doing a 400-year-old activity with a 2-million-year-old brain. The accepted wisdom of social proof embeds the heuristic of focusing on near-term multiples into most investors’ minds as they succumb to myopia and forget about the net present value of an investment. Acceptance is the first step toward improvement, and we have spent a considerable amount of time thinking about how human behaviour can damage our clients’ capital (and ours!) and how we can create a repeatable process to increase investment skills by minimising the negative impact of behavioural biases.

Clients rightly look at the inputs of an investment strategy (the process) rather than simply the outcome (performance) to disentangle a fund manager’s skill from luck and get a better understanding of predictability around success. We aim to partner with investors for the long term and be very transparent about what we are looking for in an investment as well as our process for capital allocation. For us, embracing the behavioural side of investing is a key ingredient of our capital allocation approach. We believe we can improve our decision-making by addressing unconscious, emotionally-driven choices. Self-awareness of our own biases is the first step to improving skills; the systematic implementation of a decision-making framework and the measurement of its outcomes further help us minimise potentially capital-destructive biases.

Examples of biases we have identified and created processes around are loss aversion, regret aversion and the endowment effect. In this note, we analyse the loss aversion bias and our approach to overcoming it in more detail. Over the years, we have spent significant time with a multi-disciplinary team of coaches examining our strategy’s data. Portfolio managers’ digital decision-making diaries are combined with trading data and review sessions for analysis. This leads to implementation of decision-making processes to overcome our potentially harmful biases.

How Human Biases Undermine Returns

It is our hard-wired evolutionary focus on survival and pain avoidance that can be incredibly damaging to long-term returns during a crisis. Loss aversion is best described as a mental state where we aim to avoid risks when gains are at stake but seek risk when already in a losing position. It is the idea that human beings feel pain more than pleasure. In investing, this manifests itself in losing positions where we do not want to face up to the painful loss – in moments of crisis, loss aversion can short circuit rational long-term thought. Additionally, humans do not like thinking about selling a loser, as we will be crystallising a loss forever and will expose ourselves to another source of pain – the pain of regret should that loser rebound after the sale.

Loss aversion manifests itself in another way that can undermine our long-term thinking. When faced with stress, our natural reaction is to avoid pain and focus on the immediate source of that pain. This natural instinct dramatically shortens our time horizon, and in times of market turmoil, it makes it much harder for investors to think long-term. Nobel prize winner Richard Thaler coined this myopic loss aversion. In his 1995 seminal paper, “Myopic Loss Aversion and the Equity Premium Puzzle,” he leverages Daniel Kahneman and Amos Tversky’s groundbreaking work on prospect theory to explain the existence of the equity risk premium. Myopic loss aversion is particularly acute in moments of market stress when the temptation is to frequently check falling stock prices – the sources of pain – despite intentions of being long-term investors. In a self-destructive cycle of evolutionary bias, the more we check falling security prices, the more we succumb to loss aversion, the shorter our time horizons become and the more our long-term time horizon advantage is undermined. The outcome can be disastrous, as the probability of recovering from a loss quickly diminishes.

Drawdown Review: Our Secret Weapon Against Knee-Jerk Reactions

Within the Brown Advisory global strategies, we have sought to overcome loss aversion bias through our “Drawdown Review.” When one of our companies’ share prices either declines 20% since purchase or underperforms by 20% over a rolling 12-month period, this process is triggered. This results in a review of the investment case. Our process for dealing with “losers” creates repeatability, metrics for measurement and also takes the emotion out of a stressful situation, particularly as it relates to the analyst team. Instead of blaming the immediate source of pain on the analyst who recommended a specific investment, as a team, we focus on this moment of opportunity. It allows us to identify if we are facing market inefficiency, which, if acted on successfully, should help us protect and grow our investors’ capital. Our focus in a Drawdown Review is on the reason driving share price performance, whether it is temporary (demand side) or permanent (supply side or regulation). It is the permanent impairments of a company’s business model that concern us most. If, at the end of a Drawdown Review, we conclude the investment thesis is intact, then it is seen as a “bargain moment,” and we buy more. If not, we exit. This process has evolved over time as we have collected more strategy-specific data to learn from.

Adapting to Thrive: Making Our Process Even Stronger

As investors, we firmly believe in the importance of self-improvement, which means we need to be open to adapting a process when new information presents itself. This is in line with the Edisonian approach of trial and error and, therefore, the idea that small improvements can yield big benefits over time. The best things in life come from compounding – in relationships and in learning but also at the company level from a compounding cash flow perspective. Small incremental improvements can compound over time into what look like large quantum leaps – these are what we aim to harness for our investors.

Triggers for a process improvement can be manifold, such as new learnings from our data, suggestions from our coach or observations and ideas from our colleagues in the investment team. We do not undertake changes to our process lightly, but we must avoid slavish adherence to a process that no longer serves the goal of sustainable alpha generation. As such, we have an annual offsite where the entire global equity investment working group comes together to scrutinize the investment process and reflect on areas for improvement. We think back on challenges faced throughout the year and often over many years, including inputs from our behavioural coach. In 2023, we further introduced Think Week, a week of uninterrupted time to build lasting knowledge that can help us become better investors. By placing Think Week ahead of our annual offsite, we can gather and discuss impactful ideas and compounding knowledge with the aim of further process improvements in the future.

A Capital Preservation Mindset: Why Our Behavioural Focus Will Keep Us Ahead

The goal of integrating behavioural analysis is to systematically improve skills by avoiding bias pitfalls and explicitly avoiding losers. It is typically the “wrong” investments in a portfolio that destroy capital, not what you don’t own. While self-awareness is indispensable, it alone is not enough. Our institutionalised decision-making framework and continuous measurement enable ongoing optimisation, anchoring us in insights that provide a durable edge. By instilling behavioural analysis into our DNA, we believe our sharpened process will keep us ahead, but no shortcuts exist – we must keep observing, learning and enhancing. After all, the process is there to drive performance. We strongly believe that Brown Advisory’s independent ownership structure, which is flat in nature and aligned to our investors’ success, is a vital ingredient for investment excellence. This structure also helps attract the type of self-motivated and curious investors that, when working in a collaborative and psychologically safe environment, can continuously drive success for our clients.

Triggers for a process improvement can be manifold, such as new learnings from our data, suggestions from our coach or observations and ideas from our colleagues in the investment team. We do not undertake changes to our process lightly, but we must avoid slavish adherence to a process that no longer serves the goal of sustainable alpha generation. As such, we have an annual offsite where the entire global equity investment working group comes together to scrutinize the investment process and reflect on areas for improvement. We think back on challenges faced throughout the year and often over many years, including inputs from our behavioural coach. In 2023, we further introduced Think Week, a week of uninterrupted time to build lasting knowledge that can help us become better investors. By placing Think Week ahead of our annual offsite, we can gather and discuss impactful ideas and compounding knowledge with the aim of further process improvements in the future.

Mick Dillon, CFA
Portfolio Manager

Bertie Thomson, CFA
Portfolio Manager

*Brown Advisory entities included are: Brown Advisory LLC, The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.

All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.

Brown Advisory is the marketing name for Brown Advisory LLC, Brown Investment Advisory & Trust Company, Brown Advisory Ltd., Brown Advisory Trust Company of Delaware LLC and Brown Advisory Investment Solutions Group, LLC.

Sustainable investment considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. Sustainable investment analysis may not be performed for every holding in the strategy. Sustainable investment considerations that are material will vary by investment style, sector/industry, market trends and client objectives. The (Insert name) Strategy (“Strategy”) seeks to identify companies that it believes may be desirable based on our analysis of sustainable investment related risks and opportunities, but investors may differ in their views. As a result, the Strategy may invest in companies that do not reflect the beliefs and values of any particular investor. The Strategy may also invest in companies that would otherwise be excluded from other funds that focus on sustainable investment risks. Security selection will be impacted by the combined focus on sustainable investment research assessments and fundamental research assessments including the return forecasts. The Strategy incorporates data from third parties in its research process but does not make investment decisions based on third-party data alone.

The Equity Beat: JUST a Bit Outside!

bgregorio — Wed, 15 Nov 2023 16:41:52 +0000

The Equity Beat: JUST a Bit Outside! bgregorio Wed, 11/15/2023 - 11:41

With the World Series barely in our rearview mirror and my brain reaching the familiar point of fatigue towards the end of a very busy corporate earnings season, I’ve amused myself by reminiscing about the 1989 movie classic Major League. Former catcher and broadcaster (in real life) Bob Uecker plays the Cleveland Indians’ (now Guardians) broadcaster in the movie, a total underdog of a team whose management wants to lose so they can relocate the team to a warmer climate. Bob’s character, Harry Doyle is hilarious and wears his emotions on his sleeve (the formality of his attire is in direct correlation to the success of the team as shown below).

Doyle’s most famous quote from the movie is when Charlie Sheen’s character (a.k.a. ‘Wild Thing’) throws his first career pitch a good five feet wide of the plate and the cheerful broadcaster sarcastically exclaims, “JUST a bit outside”. If you want a good laugh, Google it.

What does any of this have to do with the topic of investing? Well, if I were broadcasting the third quarter earnings season, I’d probably need to borrow Doyle’s line a few times. In terms of outlooks for the December quarter, it’s been a rough go. It’s becoming painfully clear that the early-year expectation of meaningful EPS growth by the fourth quarter is not likely to occur. Not quite through 3q earnings season in full, we’ve seen the S&P 500® Index 4q year-over-year EPS growth expectations drop to only 3%, versus double-digits at the beginning of the year.

Despite comments from several companies that have their fingers on the pulse of the consumer (large banks, Visa, Mastercard) who have stated the U.S. consumer remains resilient and even healthy, we are starting to see some cracks in that narrative. META commented that it’s observed softer ad spend in the beginning of 4q, correlating to the start of the conflict in the Middle East. UPS offered that while spending has been resilient in 2023, headwinds are mounting for the consumer in 4q. Harley-Davidson shared that it is seeing a more stressed customer base. Align Technologies (Invisalign) stated that demand (particularly among adult customers) didn’t recover in September and didn’t improve in October. Spirit Airlines said it hasn’t seen the anticipated return to normal demand and pricing for the peak holiday periods. Life science tools companies are broadly taking down forecasts on more conservative spending by pharma companies.¹

To be balanced, there have been some patches of optimism among the fields of negative earnings revisions. Microsoft saw an acceleration of Azure revenue growth and strength across its platform, with guidance for the December quarter ahead of consensus. Amazon guided to strong operating profit in the December quarter, on the heels of signing several new cloud related deals in September. ServiceNow delivered a solid quarter and outlook through its innovative approach to enterprise workflow automation. Lastly, DexCom showed why the death of continuous glucose monitoring (CGM) at the hands of GLP-1 use has been greatly exaggerated (at least for now), with a strong 3q beat and 4q raise (see our October Equity Beat for further context on this last point).

However, According to FactSet as of November 3, 2023, fewer than one in three S&P 500 Index companies have seen an increase in 4q EPS estimates since the beginning of the quarter (among those who have reported). In addition, fewer than 40% of reporting companies have seen their 2024 consensus EPS estimates climb quarter-to-date. While S&P 500 2024 consensus estimates continue to call for a sharp acceleration of growth next year (11.5%) it seems like a very high bar to achieve given the current macro environment.

Not unexpectedly, stocks of companies that have seen their EPS estimates rise for either 4q or 2024 have on average been rewarded with positive stock moves thus far this quarter, while those with declining estimates are largely in the red.

Given the large number of disappointing corporate outlooks we’ve experienced so far this earnings season, the crystal ball predicting 2024 S&P 500 Index earnings growth is getting cloudier by the moment. Instead of over-analyzing the near-term, our analysts are attempting to evaluate the medium to long-term competitive landscape of companies in our portfolios and coverage lists, determine whether we can make a good return over the next few years (not months), and have that process dictate our investment decisions.

It's easy to feel like Major League announcer Harry Doyle in mid-season form as companies broadly disappoint while providing their quarterly outlooks. It’s our job to continue to evaluate companies through a longer-term investment lens and make investment decisions that will reward our clients over the long run.

Thanks for reading, and remember to never skip a Beat - Eric

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

_{Terms and Definitions:}

_The_{S&P 500® Index}_{, an unmanaged index, consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value.}

_{Standard & Poor’s, S&P®, and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc.}

_{All financial statistics and ratios are calculated using information from FactSet as of the report date unless otherwise noted. FactSet® is a registered trademark of FactSet Research Systems, Inc}_.

Earnings per share (EPS) is a measure of a company's profitability, calculated by dividing quarterly or annual income (minus dividends) by the number of outstanding stock shares. The higher a company's EPS, the greater the profit and value perceived by investors.

The importance of evaluating social factors in mortgage bond analysis

bgregorio — Mon, 13 Nov 2023 14:02:13 +0000

The importance of evaluating social factors in mortgage bond analysis bgregorio Mon, 11/13/2023 - 09:02

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Social factors such as housing affordability and demographic data have never been more relevant in the mortgage markets. Over the past few years, rapidly rising home prices coincided with one of the sharpest increases in mortgage financing rates in recent history, resulting in one of the most unaffordable housing markets in the nation’s history. The brunt of this impact has been felt by lower-income homebuyers, many of whom were left out of the home equity gains amassed during this period and have found themselves increasingly disadvantaged by unattainable mortgages. From an investment standpoint, rising and increasingly unpredictable rates have made mortgage securities much more difficult to model and analyze, making every incremental piece of insight all the more important.

Integrating measures of affordability and demographic data into our investment process not only enhances our understanding of the factors affecting the performance of our underlying mortgage investments, but it also allows us to specifically target which communities we support through our capital allocation.

The New Normal

It is difficult for investors and individuals alike not to have been directly impacted by the rapid rise in inflation in 2021 and 2022, the succeeding interest rate hikes by global central banks and the ensuing effects these economic events have had on financial markets, including the mortgage market. The 30-year fixed mortgage rate in the U.S. more than doubled in 2022, climbing from 3.27% on 12/30/21 to 6.66% on 12/29/22 according to the Freddie Mac Primary Mortgage Market Survey (PMMS). This rate environment has led to a drastic decline in affordability for homebuyers. The chart below illustrates this predicament, with home affordability for a typical buyer hitting its lowest point since the start of the index in 1989.

^{Source: Bloomberg Data as of 4/30/2023 and is the most recent data available.}

The problem goes beyond higher mortgage borrowing rates, however. New construction costs have become significantly more expensive due to rising financing and material costs – a direct result of higher rates and inflation, respectively. Additionally, underbuilding in the years following the subprime mortgage and global financial crisis of 2007-2010 resulted in a systemic shortage of housing that has driven rapid appreciation in home prices and rental costs alike. Rising household formations as the millennial generation enters homeownership age only exacerbated these pressures, resulting in fierce demand for a limited supply of affordable homes. Lower income buyers have found themselves priced out of a highly competitive market and unable to amass the ballooning requirement for a down payment for a home. Unfortunately, this has made these potential homebuyers even more exposed to rapidly rising rental costs in recent years, as shown in the chart below.

^{Source: Bloomberg Data as of 4/30/2023 and is the most recent data available.}

A core tenet of our sustainable investment philosophy is that we firmly believe that the most attractive opportunities reside at the intersection where both investors and borrowers mutually benefit from the relationship. We have consistently been drawn to a variety of mortgage securities that support lower-income borrowers and residents, discovering several instances over time that align with our return objectives while also increasing housing access and affordability.

For example, within the Residential Mortgage-Backed Securities (RMBS) sector, Fannie Mae’s and Freddie Mac's labeled social and sustainability programs proactively cater to underserved borrowers, including first-time homebuyers and those who may be cost-burdened, income-challenged, disabled or from minority communities. Fannie Mae’s HomeReady program and Freddie Mac’s Home Possible program both further address cost barriers through lower down payment requirements and increased flexibility for borrowers. These programs provide the most appealing financing relative to borrowers’ credit profiles. As a result, cashflows backed by these pools are generally much more predictable and may make them more enticing for investors given the increased certainty of repayment timing. While mortgages typically have higher prepayment rates when rates are falling, periods where investors least prefer to receive their capital back sooner, the appeal of RMBS backed by these programs to investors is they are less likely to seek alternative financing in these periods. This typically results in more stable prepayment profiles over the life of these securities.

In the Commercial MBS (CMBS) sector, Freddie Mac's Workforce Housing program helps provide multifamily housing opportunities to residents in the "missing middle," i.e., those who do not qualify as low-income but still face affordability challenges in their local housing market. These individuals often hold essential community roles such as firefighters, police officers, teachers and healthcare workers. The impact of these programs is particularly acute as multifamily housing stock has been shrinking in recent years due to underbuilding. According to the National Multifamily Housing Council’s report published in May 2022, over half of all renters in America spend more than 30% of their income on housing, and the U.S. will require 4.3 million additional apartments by 2035 to meet current rental demand. Given this backdrop, well-managed and affordable multifamily developments not only support local communities but are likely to maintain high occupancy and generate consistent cash flow for the foreseeable future.

While investing in traditional or labeled social bond programs can be more straightforward, an investment process that relied entirely on these programs would likely miss many attractive and high-impact opportunities that are available to investors willing to put in the work to find them. Given that, we use a holistic process that drills into the loan-level data, anonymized and aggregated to protect borrowers’ privacy, to understand the underlying communities we are financing through our investments in mortgage-backed securities. Specifically, we augment our process with a third-party data provider, ICE Sustainable Finance, that provides geospatial data analysis which can help us identify these opportunities. This provider links anonymized borrower data provided by the securities we invest in with publicly available datasets, helping us to characterize the demographics of residents within each census tract by cross-referencing location data with other community-specific details such as physical climate risk exposure, income levels, property values and social vulnerability. Characteristics are summarized into both a physical climate risk score and a social impact score.

The social impact score is especially helpful for analyzing and sourcing MBS outside of the growing, but still limited, labeled bond universe, allowing us to build a more diversified portfolio.

A Better Lens into Borrower Behavior

Investing in mortgages is challenging due to the unique feature of mortgages in that they typically can be paid off (prepaid) at any time by the borrower without penalty. This subjects investors like us to reinvestment risk if rates fall and we are required to reinvest at the now lower market rates. Unfortunately, but not unsurprisingly, borrowers tend to refinance their homes and prepay their mortgages more often when interest rates fall, creating a dynamic that investors get their principal returned at exactly the inopportune moment, when prevailing rates are low. Lower-income borrowers typically have lower mortgage balances as a result of less expensive homes and stricter debt-to-income restrictions put in place by lenders. These smaller-balance mortgages can be attractive during periods when rates change significantly, as prepayment activity doesn't fluctuate as drastically for these mortgages at inopportune moments for investors. This is a simple math issue—refinancing a $100,000 mortgage will lower the monthly payment by a much smaller amount than refinancing a $1,000,000 jumbo mortgage, while the fixed costs of refinancing will be relatively much more burdensome for the $100,000 mortgage than for the $1,000,000 mortgage. As a result, performance for pools of small balance mortgages such as these can tend to have more consistent investment performance over time.

Since the timing of repayment on mortgage-backed securities relies in part on the behavior of the underlying borrowers, our understanding of these borrowers allows us to better predict and model their behavior into our analysis of the securities and the portfolios that hold these securities. As an example, if a large number of borrowers unexpectedly repay their mortgages early, a portfolio is likely to shorten in duration when interest rates are decreasing. We believe understanding social factors, such as housing affordability and demographic factors can be highly informative for understanding how borrowers may respond to swiftly changing economic conditions, and an analysis that includes these factors helps us to better manage the duration and risk of our portfolios and avoid surprises.

We believe that by identifying mortgages related to underserved and high-need communities, both investors and borrowers’ benefit. For the same reason that a smaller mortgage tends to have more stable performance than a jumbo mortgage, lower-income borrowers can tend to have more consistent repayment behavior when it comes to refinancing. Meanwhile, low-income borrowers have been particularly affected by higher rates, and as sustainable investors, we seek to invest in mortgages that will support these borrowers and be held long term. In recent years, rapid appreciation in real estate has intensified wealth inequality, making this issue even more pressing. According to the National Association of Realtors, low-income homeowners comprised just 27% of all homeowners in 2020, down from 38% in 2010. High-income homeowners reaped more than 70% of the $8.2 trillion increase in the value of U.S. owner-occupied housing from 2010 to 2020, while low-income owners benefited from just 3% of that increase—a situation that is not only unfair to that demographic but potentially detrimental to the mortgage market in the long run.

In short, integrating housing affordability and demographic factors into our analysis gives us a deeper understanding of the borrowers backing the mortgages we are investing in, which enables us to better forecast the prepayment behavior of our loan portfolio and invest in well-established programs backed by the government that do not have credit risk corresponding to the underlying borrowers.

Geospatial Loan Level Approach

While mortgage-backed securities provide substantial loan level information to investors, that information has remained relatively stable over the years while the availability of outside data sets continuously improves. We believe we can refine our investment analysis and further distinguish our approach by going beyond the details provided in deal documents, and complementing them with geographic, climate and demographic data sourced from the communities where borrowers live. This process allows us to more comprehensively evaluate not only specific investment opportunities, but also the overall environmental and social outcomes of the investment portfolios we manage.

Using all of the tools at our disposal, we are able to target our mortgage investments toward communities likely to have the highest social need. As an example, the map below shows the city of Baltimore's various census tracts, with the yellow and purple shading indicating areas with higher social impact scores where investment may have the greatest positive outcomes on the community. At a high level, our analysis is based around the goal of identifying and evaluating investable mortgage pools for their overlap with similar neighborhood characteristics to those highlighted in the map. While personal privacy concerns prevent us from conducting our analysis below the census tract level, the work done by ICE Sustainable Finance provides significant information around the broader community that does give us a unique perspective into the communities and borrowers we are supporting through our investments.

^{Source: ICE Sustainable Finance data as of 06/2023.}

In conclusion, we believe integrating housing affordability and demographic factors into our evaluation of mortgage-backed securities allows us to gain clearer insight into the communities in which underlying borrowers live, better manage risk, and provide much needed financing to underserved communities. We believe our data-driven and differentiated process based on loan level data and external data sets puts us in a unique position to navigate the uncertain markets.

Disclosures

^{The information provided in this material is not intended to be and should not be considered a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only and is not individually tailored for or directed to any particular client or prospective client.}

^{Bloomberg is a trademark/service mark of Bloomberg Finance L.P., a Delaware limited partnership.}

^{The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index}^{is a composite of single-family home price indices for the nine U.S. Census divisions and is calculated monthly. It is included in the S&P CoreLogic Case-Shiller Home Price Index Series, which seeks to measure changes in the total value of all existing single-family housing stock.}

^{US Zillow Rent Index (ZORI):}^{A smoothed measure of the typical observed market rate rent across a given region. ZORI is a repeat rent index that is weighted to the rental housing stock to ensure representativeness across the entire market, not just those homes currently listed for rent. The index is dollar-denominated by computing the mean of listed rents that fall into the 40th to 60th percentile range for all homes and apartments in a given region, which is once again weighted to reflect the rental housing stock.}

^{Freddie Mac Primary Mortgage Survey Rate:}^{Each week, since April 1971, Freddie Mac surveys lenders on the rates and points for their most popular 30-year fixed-rate, 15-year fixed-rate and 5/1 hybrid amortizing adjustable-rate mortgage products. The survey is based on first-lien prime conventional conforming home purchase mortgages with a loan-to-value of 80%. In addition, the adjustable-rate mortgage (ARM) products are indexed to U.S. Treasury yields, and lenders are asked for both the initial coupon rate and points as well as the margin on the ARM products. There is a mix of lender types surveyed each week—credit unions, commercial banks and mortgage lending companies—that is roughly proportional to the level of mortgage business that each type commands nationwide.}

^{The National Association of Realtors (NAR) Housing Affordability Fixed Mortgage Index}^{measures whether a typical family earns enough income to qualify for a mortgage loan on a typical home at the national and regional levels based on the most recent price and income data.}

Sustainable Small-Cap Core Strategy: Reporting on the impact of our investment decisions 2022

bgregorio — Fri, 10 Nov 2023 18:26:24 +0000

Sustainable Small-Cap Core Strategy: Reporting on the impact of our investment decisions 2022 bgregorio Fri, 11/10/2023 - 13:26

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A Letter of Introduction From The Portfolio Managers

Brown Advisory has made a deep commitment to sustainable investing across a wide range of its equity and fixed income strategies. We firmly believe that there does not have to be a trade-off between strong performance and investments that seek to address society’s environmental and social challenges.

This report for our Sustainable Small-Cap Core Strategy includes a review of our sustainable investment research and integration approach and examines how we use this to identify compelling long-term investments. We also discuss the positive environmental and social outcomes being created by our portfolio companies, and report on our engagement and proxy voting activity during the year.

We are pleased to report continued progress and advancement of our sustainable investment initiatives at the firm, particularly our work to develop new investment strategies for our clients. Most recently, we have brought together Brown Advisory’s expertise in large-cap, value and sustainable investing to launch the Brown Advisory Large-Cap Sustainable Value strategy.

Further, we have continued to build our team and expertise internally, further integrating fundamental and sustainable investment analysis by adding several new research analysts across our equity and fixed income research teams that act as industry-sector specialists.

We thank our research team for its contribution to this report and our work in general. The team works tirelessly to ensure that our investment decisions are informed by solid data and clear insights about how that data may affect a company’s prospects. We also thank our fundamental equity research colleagues and all of our colleagues across the firm for embracing sustainable investing principles so enthusiastically. Most importantly, we are deeply grateful to our clients, who trust us as stewards of their capital and serve as our partners as we learn, innovate and improve over time.

The year in review was filled with both sustainability hurdles and progress forward. Natural disasters that occurred in 2022 were among the costliest on record. Global conflict has impacted energy and commodity access and affordability. Mixed progress was made at COP27. Despite these events, we are encouraged by the passage of the historic Inflation Reduction Act, which we believe could provide opportunities for many companies of interest to the Sustainable Small-Cap Core Strategy.

We hope you find this report informative, and we welcome an ongoing conversation with you about our work and continuing evolution as investors.

Sincerely,

Emily Dwyer
Portfolio Manager

Tim Hathaway, CFA
Portfolio Manager; CIO and Co-Head of U.S. Institutional Business

^{*Brown Advisory entities included are: Brown Advisory LLC, Brown Investment Advisory & Trust Company, Brown Advisory Ltd., and Brown Advisory Trust Company of Delaware, LLC.}

Long-Term Planning for Founders & Builders: A “Phase-Gate” Process

ajackson — Tue, 07 Nov 2023 16:13:15 +0000

Long-Term Planning for Founders & Builders: A “Phase-Gate” Process ajackson Tue, 11/07/2023 - 11:13

The evolution of a business—from initial concept, to thriving enterprise and finally an eventual exit for the founder—is a long-term process and involves a meaningful investment today in pursuit of large rewards tomorrow.

Likewise, the evolution of an entrepreneur’s financial strategy requires serious attention today, in order to achieve results tomorrow. Of course, time is the most precious of resources for most entrepreneurs, and many simply do not have the bandwidth to focus on anything other than their current venture. Thus, we build our relationships with entrepreneurs on a simple principle: We seek to deliver results without requiring them to shift focus from their business. We are committed to investing in each individual founder and builder, and consequently, devoting our time to help them on their entrepreneurial journey.

Managing Assets, Preserving Time

Business founders may find it odd—or even superstitiously dangerous!—to focus heavily on personal planning for a liquidity event that may not come to fruition (and won’t occur for several years if it does). However, early attention to these matters can pay off tremendously down the road when an entrepreneur is ready to exit.

Business transition planning is art as much as it is science. It is designed to let entrepreneurs accomplish their business and personal goals by resolving known and unknown problems unique to their situations. This type of planning often encompasses many planning disciplines, such as financial, estate, investment, business, contingency, succession and tax. Brown Advisory has a great deal of experience helping entrepreneurs develop long-term investment strategies. These often intersect and complement their plans for their businesses.

As noted, a core aspect of our approach is respect for the entrepreneur’s time. Throughout the business growth cycle, from startup to exit, we concentrate our engagement on a limited set of focused activity periods, each one targeting key moments in the evolution of the clients’ business. During these activity periods, we lay out options and choices clearly for our clients, so they can quickly make important decisions—and get back to work.

This process is similar to the “phase-gate” process used in many product development cycles. It is fairly straightforward:

Discovery. We do a deep (but efficient) dive into the founder’s financial circumstances and business dynamics, so we can craft an appropriate long-term approach to the relationship.
Phase-gate planning. We craft a process that involves a finite number of concise meetings over the projected growth cycle of the founder’s business. Each phase or meeting is designed to identify, analyze and resolve known and unknown problems that entrepreneurs may encounter during a business transition. These meetings are roughly planned out in advance, to coincide with the key decision moments that the founder will likely face based on the initial business plan— projected funding rounds, the projected transition point from “cash burn” to “cash flow,” etc.
- We meet with the founder for conversations at these identified milestone moments. We prepare carefully for these meetings, so we can lay out essential information and make it as clear as possible to the founder what decisions are needed to move forward.
- In between these meetings, the client can focus on the business, and we take care of driving all of the investment and planning work.
Preparation for exit and beyond. As we get closer to a liquidity event, meetings are likely to be more frequent as we prepare for the coordination of wealth generated by that liquidity event. For example, if the founder anticipates a liquidity event in three-to-five years, we could build a process that involved only four or five meetings in total, to coincide with one or two funding rounds, and then a string of meetings in the months before a planned exit.

THE PLANNING J-CURVE: EARLY DEDICATION TO PLANNING PAYS OFF

A great financial strategy for entrepreneurs requires an investment of time and energy today, in order to achieve results tomorrow.

SOURCE: Brown Advisory

The “Planning J-Curve”

Entrepreneurs and private investors often refer to the “J-curve” of young businesses, where time and money are sunk into a venture upfront (the bottom of the “J”), in order to reap payoff years later (the top of the “J”). Our aim is to provide tailored advice to clients that is highly relevant at each phase of the business’ development, and to help them focus on the key planning decisions required at each phase.

Startup. At the onset, we focus attention on business structure and governance, reserve planning, insurance and asset protection. Concurrently, we can help build an advisory ecosystem to assist founders with a wide range of services. We find increasingly that entrepreneurs can benefit by starting their exit planning even before they form their business entity. The choice of business structure can have a lasting impact on the tax treatment of a liquidity event, issues regarding succession, and many other important factors.
Build / Grow. At this stage, we work to enhance cash management and risk diversification of a client’s assets. Tax and estate planning considerations are important during this stage; for example, we work with many clients to create trusts to hold business interests in a manner that will serve them well down the road. We also work with clients on best practices to support an eventual exit valuation of the enterprise.
Exit. Deal execution marks this stage. At this juncture, a good deal of attention is focused on stakeholder care—namely support of employees, family, etc. Concurrently, we work on tax matters, coordination with bankers and other parties connected to the liquidity event, and tax and estate plan implementation.
Post-Liquidity. The post-liquidity stage of our work with founders looks more like our traditional private client relationships, with a focus on ongoing investment management and pursuit of family and legacy goals, such as generational transfer of assets, philanthropy and potentially the start of a new business venture and a new planning cycle. We find this is also an optimal time to restructure insurance and asset protection needs.

How We Can Help

Investment and financial strategy are critical for those who choose to create their own businesses. We understand that it can take a few years for the trajectory of a new business to become clear. Until that point, it can be very challenging for entrepreneurs to construct, maintain and monitor a plan to meet their financial and personal goals, given that they are fully absorbed in building their new enterprise. We have developed a philosophy, process and practice at Brown Advisory to help entrepreneurs translate business success into attainment of personal financial goals, while preserving their most precious resource—time.

This Present is Accounted For: An Overview of Low-Basis Gifting Strategies

achen — Wed, 01 Nov 2023 15:20:00 +0000

This Present is Accounted For: An Overview of Low-Basis Gifting Strategies achen Wed, 11/01/2023 - 11:20

After spending a career helping clients with tax and estate advice, I often see reminders and lessons about my job in the unlikeliest places. In fact, I received an excellent reminder about low-basis gifting strategies (the topic we are addressing today), from a story about one Jimmy McDonald—aka MrBeast, the reigning king of the world’s biggest social media empire.

Mr. McDonald was criticized recently for the practice of…. giving large, life changing gifts to his fans. He has gifted tens of millions of dollars in prizes to his Youtube and TikTok followers (as well as complete strangers), sometimes in the form of cars and other big-ticket items. The criticism he has received for these acts—it’s lonely at the top! —include comments to the effect that the recipients often are not prepared and/or cannot afford to maintain these gifts, or to pay the taxes on them.

That was not the most interesting angle of the story for many readers. But it was the angle that caught my tax-obsessed eye; my colleagues and I are keenly aware that large gifts, however well-intentioned, may not end up working out as envisioned if they are given away without a proper plan in place to manage taxes.

We work with families every day, developing strategies to help them reduce their estate tax burden and position themselves to transfer their assets to heirs or beneficiaries efficiently. The planning options available to families are numerous. Clients can gift a certain amount of assets to family members without triggering gift taxes, thereby reducing their taxable estate; gifts to so-called “dynasty trusts” may insulate gifted assets from estate tax for multiple generations; the list of options goes on.

A fairly common “dilemma” we face with families is the matter of legacy, low-basis assets and how to manage the potentially large tax burden associated with them. Lifetime gifts of these assets offer the benefit of “estate freezing,” and when trust structures like GRATs are used, we can work with clients to move these low-basis assets outside of the client’s estate and ensure that future appreciation and gains will be taxed outside the estate.

There is a fundamental tradeoff between managing one’s estate tax burden and the capital gains tax burden that heirs may face; ultimately, both of these tax mechanisms combine to determine the efficiency of your estate plan. When you gift assets out of your estate, you generally seek to reduce your future estate tax burden, but your low-basis gift may generate a large future capital gain for the recipient if and when they sell those assets. The opposite is true if you keep those assets in your estate—the estate will bear the tax burden of that appreciation, but your heirs will have a lower capital gains liability. The question is always whether one can benefit more from reducing estate tax or capital gains tax liability.

Logically, these strategies generally make sense when the tax burden inside the estate is much higher than outside. And for many years, that was the case for most clients in the U.S., as estate tax rates historically were much higher than capital gains rates. But that “spread” has narrowed in a meaningful way. Federal estate tax rates have fallen, from 55% in the 1980s to 40% today. Further, estate taxes in many states have been outright eliminated in the 21st century; before 2001, all 50 states had an estate tax, but today, there are only 12 (plus an additional six with various forms of inheritance taxes). Moreover, the estate tax rate is effectively zero if an estate is under the exemption amount, which is at an historically high level - $12.92 million for an individual, and $25.84 million for a married couple. Meanwhile, capital gains taxes have risen at the federal level (now at nearly 24% for most of our clients when the additional 3.8% net investment income tax from the Affordable Care Act is considered), and many states impose their own tax on gains, so the marginal tax rate for capital gains often approaches 30%. As a result, gifting low-basis assets during a client’s lifetime has become relatively tax-inefficient in a growing number of scenarios, when compared to retaining those assets within one’s estate.

But don’t look a gift strategy in the mouth! Transfers of low-basis assets in the form of lifetime gifts may still be advisable in some cases. While not an exhaustive list, here are several scenarios in which gifts of low-basis assets may make sense.

When you can retain the income tax liability of the gifted asset. In some situations, you can retain the income tax burden inherent in the gifted asset (both ordinary income tax and capital gains tax upon a sale), even while the economic value of the asset is passed to a beneficiary. A primary mechanism for achieving this result is a so-called intentionally defective grantor trust (IDGT). If you create an IDGT, you are deemed the owner of the trust for income tax purposes, but the trust beneficiary receives the economic benefit of the trust’s assets. If you contribute a low-basis asset to an IDGT and the asset is sold, you will still pay the tax on that sale even though you no longer legally own it. Functionally, this serves as an additional gift to the trust but is not treated as a gift for gift-tax purposes. Essentially, your beneficiary receives a greater net return on the gifted asset than you would because his or her return is not subject to income tax. What’s more, the tax payment reduces your remaining assets and thus lowers your eventual estate tax bill.

When you can discount the fair-market value of the gift for gift-tax purposes. You may be able to discount the value of a gifted asset if the beneficiary will not have administrative control over a received asset and/or they cannot easily sell the asset. Tax law allows discounting in these situations to reflect the lack of control and lack of marketability of the asset. For example, if you hold minority interest in, or nonvoting shares of, a closely held business, you may be able to discount the value of that asset for gift-tax purposes. There are other ways to generate valuation discounts through indirect gifting strategies. For example, publicly traded securities wouldn’t normally be eligible for a discounted valuation, but if you place them in a family limited partnership and gift interests in that partnership to your beneficiaries, you may be able to apply a discounted valuation to the partnership units. Such discounting enhances estate tax savings because the amount of the discount is the functional equivalent of additional post-gift appreciation in the value of the asset. Please don’t try this at home! You need an experienced tax adviser to guide you on whether such discounts are available and how to establish them.

When it is unlikely the transferred asset will ever be sold. If your beneficiary is highly likely to retain the asset, concerns about capital gains taxes become irrelevant—if those gains are never realized they will never be taxed. Accordingly, any asset viewed as a “family legacy,” such as a family vacation home, could be a good candidate for low-basis gifting. Remember, of course, that “never” is a long time, so such plans should only be put in place after ensuring that the recipients truly want to retain the asset, intend to do so, and can afford to do so!

So, as we stated earlier, the gap between estate and capital gains tax rates has narrowed somewhat in recent years; this has made low-basis gifting strategies far less attractive in many cases when compared to simply keeping those assets inside one’s estate and achieving a stepped-up basis at death. But there are also some clear exceptions where it may make sense to consider these lifetime gifts, even when the gifted assets are highly appreciated.

As is always the case in matters of estate planning, your decisions depend greatly on your unique circumstances. Whether you are considering giving a family home to your children or a fleet of cars to one of your Youtube followers, we consider it our responsibility to help you devise a plan that helps you and your family achieve its long-term goals.

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Mission Possible: Charting your Course with a Family Mission Statement

jharrison — Wed, 01 Nov 2023 14:31:00 +0000

Mission Possible: Charting your Course with a Family Mission Statement jharrison Wed, 11/01/2023 - 10:31

The “Mission: Impossible” movie franchise has taken on a near-mythical status, due to its leader Tom Cruise and his single-minded focus with each new film: add more risk, take more chances, generate more excitement and danger. Whether it involves scaling the outside of the Burj Khalifa, or hanging from a plane in mid-flight, the team behind the franchise all operate from a clear and unmistakable mission statement: Risk it all to entertain the world.

Of course, the hidden truth in these movies is that the team surrounding Ethan Hunt is just as important as he is, managing all the risk and coordinating all the details, so that the impossible mission becomes…possible.

At Brown Advisory, we have a similarly single-minded mission—to help clients chart their long-term path of progress—and we want to help them develop clear and unmistakable mission statements of their own.

Of course, our work with families approaches risk from a very different angle than Ethan Hunt! Rather than leaping into risk in the face of impossible odds, we seek to account for and manage the various risks and challenges a family may face in pursuing its objectives. In order to do this effectively, we try to help families build consensus about those objectives, so everyone is rowing in the same direction.

We believe a family mission statement allows a family to filter out the “background noise” of day-to-day challenges and focus on long-term goals and objectives. Developing these documents provides a process for reaching agreement on the family’s core values and creates a shared vision amongst all family members.

Many of our clients tell us it’s helpful to think of the family as a type of “business” with a broad set of constituencies extending beyond the immediate family members, and whose success depends on a common purpose and culture. With that in mind, the process of crafting that statement over multiple discussions and meetings is often more important than the statement itself, and that process requires time and commitment.

As with many projects, the first step--starting the conversation—is often the hardest. To maintain long-term perspectives, we believe it is important to have a multi-generational engagement and allow for all voices to be heard. While financial matters will ultimately be a critical part of the conversation, we believe other issues like leadership, stewardship and character must also be included; without building these broader issues into the family’s mission and plans, it can become more difficult over time to ensure that everyone is rowing in the same direction.

A family mission statement is a succinct statement of the family’s purpose and core values, addressing personal, financial and philanthropic matters. When drafting a mission statement, we believe that some questions to consider are:

Personal

What is our family’s purpose and identity?
What kind of relationships do we want to have with one another?
How do we want to resolve our differences?
Which traditions do we want to carry forward and preserve?
How will our family’s story be re-told?
What issues and values are most important to the family?
What are our responsibilities as family members?

Financial

How will our family’s wealth be preserved, grown and deployed?
If there is a family business should it be extended to the next generation? How should ownership and management be handled in the future?
How should we fund things like education? Buying a home? Starting a business?
How should our family’s values impact our approach to investing?

Philanthropic

How do we want to be remembered as a family?
What philanthropic missions do we care about?
Where can we have an impact by devoting our time?
What should be our financial goal for giving?
What talents do we have that can be put to use in our communities?

An important complement to a family’s mission statement is the strategic plan put in place to communicate its goals and implementation steps to the family. Such a plan should address:

Empowerment: How will family members be empowered to advance the family mission?
Family governance and connectedness: How will the family communicate about their shared mission while maintaining personal relationships and individual responsibility?
Legacy preservation: How will the family pass on their values, preserve “legacy assets”, and safeguard the family history, stories, and overall ethos?
Management and oversight of family financial capital: How will the family work with outside partners to ensure their financial capital is managed properly?
Accountability: How will family members be held accountable to each other, their overall mission and strategic plan?

In short, a family mission statement, simple or complex, helps ensure that your family’s big picture goals and objectives are articulated, and your family’s strategic plan helps ensure that your capital is deployed in a way that is meaningful to you. A challenging task, to be sure, but certainly not…..impossible.

For a list of tools to help execute your strategic plan, and a more comprehensive look at how to create a family mission statement and strategic plan, don’t hesitate to contact us >

Sustainable Investing at Brown Advisory

When constructing your family’s mission statement and strategic plan it is also important to determine if your family wants to incorporate their values into their investment philosophy. Between the “traditional” poles of investing and philanthropy lies a spectrum of options that may allow the family to pursue investment goals and express values – which is known as “Sustainable Investing.”
Learn more >

The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.

The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

529 Plans And The New Tax Code

ajackson — Tue, 31 Oct 2023 15:30:07 +0000

529 Plans And The New Tax Code ajackson Tue, 10/31/2023 - 11:30

You Can Now Use 529s for K-12 Costs—But Should You?

The cost of college is growing at an astronomical rate, and Section 529 plans have long helped individuals and families grow assets earmarked for education in a tax-efficient manner.

The 2018 tax overhaul expanded the reach of 529 plans beyond college. As of this year, Federal law lets you distribute up to $10,000 each year from your 529 plan to fund primary (K-12) education tuition. But should you? Here are a few wrinkles to consider.

Your state may see things differently than the IRS.

The first thing to consider is that 529 plans are governed at the state level. States vary widely in how they conform to federal tax law governing 529s—in other words, the IRS may not tax a distribution for K-12 tuition, but your state might.

As it stands today, 31 states¹ conform to the federal tax code on 529 plans (see graphic). These states either exempt K-12 distributions from state taxes up to the $10,000 limit, or do not impose any state income tax (in which case the issue is not relevant).

If you reside in one of the other 19 states, you should review the current rules in your state AND look at whether your state is considering a change. Some states impose state taxes and/or penalties on any withdrawals for K-12 tuition. In some cases, states allows current-year deductions for contributions into the 529, but a subset of those states are looking at rolling back those deductions if assets are ultimately used to fund K-12 education. The situation may be further complicated if you live in one state but invest in a 529 plan in another state.

529 Plans and K-12 Expenses: A State-By-State Breakdown

Source: Brown Advisory. ¹https://www.savingforcollege.com/article/529-savings-plans-and-private-school-tuition#sfc-page-anchor-2

K-12 expenses will likely occur much sooner for you than college expenses. That impacts your investment equation.

Remember that 529 plans and other tax-deferred growth vehicles are most effective over longer periods of time, so that you can (potentially) benefit from the compounding effect of tax-free growth over many years. Over shorter periods, there is less of a compounding effect to compensate you for the sacrifice of liquidity that comes with a tax-deferred vehicle.

One specific point to consider: If you built your 529 asset allocation with a long-term target in mind (for example, 18 years from your child’s birth), it may be invested for long-term growth with a relatively heavy allocation to equities. If you decide now to use the plan to fund elementary education, those expenses may kick in for you just a few years after you’ve opened your 529. In that case, your initial long-term allocation may no longer be appropriate for your adjusted short-term time horizon. So if you are interesting in using 529 assets for K-12 education, it is worth reviewing your investment selections to ensure the account’s allocation is in alignment with your new goals.

Participation in a 529 plan impacts financial aid eligibility.

Lastly, 529s can impact financial aid eligibility, so whether you are deciding how much to contribute, when to withdraw, or even whether to have a 529 in your name, it is important to consider the impacts on the financial aid calculation.

The FAFSA application (Free Application for Federal Student Aid) combines several factors to calculate your Expected Financial Contribution (“EFC”), or the amount your family is deemed financially able to pay toward education. One key factor is who “owns” financial assets—up to 5.64% of non-retirement parent assets are deemed “available” for college costs, compared with up to 20% of student assets. Parent-owned 529 plans are typically counted as investment assets of the parents for the EFC calculation, so they are actually more favorable in this regard than student-owned assets such as UTMAs. The EFC calculation can also influence whether a grandparent should create their own 529 plan, or make contributions to a parent-owned plan instead.

Even if you have substantial wealth and financial aid is not a consideration for you, many states provide additional benefits for 529 assets, including scholarship provisions and creditor protection. Depending on your circumstances, there may be many reasons to keep 529 assets in place until college.

As is often the case when tax law changes, just because a new option is available does not mean it is always advisable. The new flexibility for using 529 plans to fund K-12 expenses is certainly worth considering, but as always you should consult with qualified advisors to ensure you are looking at the bigger picture.

The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities or asset classes mentioned. It should not be assumed that investments in such securities or asset classes have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client. Any business or tax discussion contained in this communication is not intended as a thorough, in-depth analysis of specific issues.

The Equity Beat: Obesity Drugs Weighing Down Healthcare Sector

bgregorio — Tue, 17 Oct 2023 08:53:24 +0000

The Equity Beat: Obesity Drugs Weighing Down Healthcare Sector bgregorio Tue, 10/17/2023 - 04:53

Folks, time has not been kind to my mid-section. Whether due to slowing metabolism, a weakness for office snacks or my genetic makeup, I’m currently among the 40+% of American adults who are considered obese. Despite attempting low-carb diets, intermittent fasting and increased exercise I have struggled to maintain a healthy weight.

I’m well-read enough to know that the health complications associated with obesity, particularly as one ages are not good. More than 80% of Type 2 diabetes cases can be attributed to obesity. There are heightened cardiovascular and cancer-related risks as well. Thus, consider my excitement at the prospect of a wonder drug that could help me lose 25% of my body weight!

I’m referring to the latest class of glucagon-like peptide drugs (GLP-1s) that were designed to allow diabetics to absorb glucose after a meal. However, more recently, these drugs – specifically Wegovy/Ozempic (Novo Nordisk - NVO) and Mounjaro (Eli Lilly - LLY) have demonstrated other substantial and favorable benefits, including material weight loss and a reduction in major adverse cardiovascular events.

While these drugs are rarely covered by insurance for weight loss today – and some, like Mounjaro are not yet FDA approved for weight loss (they are used off-label) - the advantages of lowering the risk of heart attack and stroke suggest it may only be a matter of time before payers are unable to deny coverage. That would bring the $1,000/month cost today down to a more palatable level for potentially the 70% of American adults who are either obese or overweight. Peak industry revenue projections for GLP-1s have climbed upwards of $100 billion; in 2022, GLP-1 revenue was just a fraction of that amount.

This explains why LLY and NVO have nearly doubled over the past year in a sector that’s seen muted performance over the same time horizon. The perceived winners of the proliferation of GLP-1s have been few and far between relative to the perceived losers. On July 18, robotic surgery leader Intuitive Surgical (ISRG) sent a warning shot to investors that it was starting to see a slowing rate of growth for bariatric surgeries due to increased use of GLP-1s. While bariatric surgery only accounts for 4% of company procedures, ISRG is down more than 15% since its earnings call. LLY is up more than 25% since then; NVO is up 15%.

^{Source: FactSet. Data as 10/9/2023. Please see the end of this report for company names and important disclosures.}

ISRG isn’t alone in being perceived as a victim of LLY and NVO’s success. Dexcom (DXCM) – a leader in continuous glucose monitoring (CGM) systems has seen 40% of its market value evaporate in less than three months on concerns that a thinner future population would be less at risk for Type 2 diabetes, and thus its total addressable market (TAM) will shrink. Similarly, Insulet (PODD), a leader in insulin pump therapy, is down nearly 50% on heightened concerns of a smaller TAM. ResMed (RMD), which makes CPAP machines for sleep apnea, has lost more than a third of its value in recent months. Edwards Lifesciences (EW), a leader in aortic, mitral and tricuspid heart valve replacement has declined more than 20% – despite stating that valve stenosis is an age-related disease, not obesity-related.

Many companies have in fact tried to defend themselves; Dexcom recently presented a study by United Healthcare showing that CGM systems have been complementary to GLP-1s to date, with CGM attachment rates in the GLP-1 patient base increasing – even for those patients not on insulin. PODD stated that while GLP-1s are effective at glucose control, they haven’t demonstrated the ability to reverse the natural progression of diabetes itself for Type 2 patients – a population that has been completely written off as a potential growth opportunity for PODD according to our team’s analysis. Our conversations with endocrinologists support the view that Type 2 patients should not be uniformly removed from PODD’s TAM. Like so many aspects of this phenomenon, it is much more nuanced than the market’s knee-jerk interpretation.

Our equity strategies have been closely evaluating some of the perceived losers in recent weeks and months, given the market’s extreme extrapolation of early data points. It will likely take time for any of these companies to disprove the current sentiment of a shrinking TAM, while according to our health care analysts, most investors remain very short-term oriented. We can use this temporal differentiation to our advantage, although considerable uncertainty remains surrounding the eventual use and impact of these drugs not just on the health care sector, but the broader economy. Here are just a few creative second or third derivative factors to consider:

Medical device/hospitals: a less obese population may experience fewer joint replacements. That said, the population may become more active, which in turn may counterintuitively increase the TAM for sports-related surgeries.
Clothing/retail: a GLP-1 saturated population may need to purchase an entire new wardrobe of clothing, reaccelerating growth for some apparel companies.
Online dating: single people may be more likely to take their new wardrobes and waistlines to sites like Tinder or Hinge (as MTCH shareholders, this would be a welcome benefit).
Airlines: fuel accounts for nearly a quarter of airline operating expenses. Imagine what a 25% reduction in average body weight for 40+% of the customer base would do for profit margins?
Restaurants: With muted appetites, will this portion of the population meaningfully cut back on dining experiences? Even Pepsi was asked about the impact of GLPs on its earnings call on October 10th (impact thus far is negligible).

In conclusion, our take on this breakthrough pharmaceutical innovation is that it is way too early to draw conclusions on the direct and indirect consequences of the proliferation of GLP-1s. Where the market seemingly draws definitive conclusions from very early-stage information, we will attempt to invest opportunistically in the other direction, doing so with a tremendous amount of humility for what is still to be learned.

Thanks for reading, and remember to never skip a Beat - Eric

_{Factset® is a registered trademark of Factset Research Systems, Inc

Global Industry Classification Standard (GICS) and “GICS” are service makers/trademarks of MSCI and Standard & Poor’s.

Figures shown on sector diversification and quarterly attribution by detail slides may not total due to rounding.}

Terms and Definitions:

Listed stocks:

Novo Nordisk (NVO), Eli Lilly (LLY), Intuitive Surgical, Inc. (ISRG), Edwards Lifesciences Corp. (EW), DexCom, Inc. (DXCM), Insulet Corporation (PODD), ResMed, Inc. (RMD). Match Group Inc. (MTCH), PepsiCo, Inc., (Pep)

Protecting the Family Legacy—How to Plan with Prenuptial Agreements

ajackson — Thu, 12 Oct 2023 20:36:38 +0000

Protecting the Family Legacy—How to Plan with Prenuptial Agreements ajackson Thu, 10/12/2023 - 16:36

Few moments in life can compare to the moment you look at the person you love and say, “I do.” A lifelong commitment, an ultimate expression of love and devotion—for many people, it is the moment in life when they are happiest and most hopeful about the future.

All of us enter marriage with powerful faith in our love for our spouse; we believe that divorce just isn’t going to happen to us. And yet half of us still get divorced, somehow. To assume you are “immune” to divorce may feel romantic (and to be clear – it may be true!), but it is also unwise. For families of means, who have substantial estates to safeguard, divorces can be incredibly costly—whether the wealth was created by the couple themselves or inherited from a parent or family member.

The “prenuptial planning” process is made more difficult by the fact that—well, it’s likely that you had a visceral reaction to the word “prenuptial” just now. Obviously, none of us relish the prospect of developing a financial strategy to protect ourselves from a loved one, but it remains an extremely important step in many prudent multigenerational plans. Here, we’ll offer a few introductory thoughts on this awkward, unromantic and very important topic.

Prenuptial Agreements

Defining Property: A well-written prenuptial agreement defines what property is deemed each spouse’s “separate property” (i.e., property they held when entering the marriage) and may also identify gifts, inheritances or property from family trusts as separate property that cannot be subject to division in a divorce.
Setting Terms of Spousal Support: A prenuptial agreement may waive alimony entirely (i.e., establish that a spouse is not entitled to any support in the event of a divorce) or may set forth the terms of that support based on the length of the marriage.
Addressing Debt: Typically, prenuptial agreements make each spouse individually liable for debt (if any) prior to the marriage, and then outline who is liable for any joint marital debts.
Updating the Estate Plan: The prenuptial agreement also addresses each spouse’s disposition of assets on death and sets the “floor” of what each spouse must leave the other. For example, the estate planning portion of the agreement may include a requirement that spouses buy life insurance to protect the other spouse in the event of an untimely death.
Carving out Family Assets: Prenuptial agreements often aim to keep family assets out of the marriage. Meaning, if a spouse is a beneficiary of a family trust, his/her spouse will not be entitled to distributions from that trust.
Determining Jurisdiction: Prenuptial agreements address which state law will govern in the event of the couple’s divorce. In an increasingly global society, prenuptial agreements help eliminate a great deal of uncertainty with respect to the applicable law at the time of divorce.

Clarity and shared understanding are the two key principles that we seek to resolve when helping clients create a prenuptial agreement—and this is especially important in the case of a child getting married when their parents are seeking to protect that child’s inheritance. If parents have the ability to leave their child a substantial legacy, it is understandable that they want both the tangible and intangible value of that legacy to stay with their child through a divorce or other adverse life events. Of course, these conversations have the potential to become emotionally fraught, but this is often the result of a lack of clarity. If conducted in a reasonable manner where everyone feels like they are being treated fairly, they can lead to reduced financial stress overall.

As with many financial strategies, one of our greatest allies in prenuptial planning is time: the process generally proceeds much more smoothly when the groundwork has been laid with repeated discussions about the topic as a family’s younger generation grows into adulthood. This is, of course, beneficial in providing attorneys and other advisors with ample time to develop and establish trust vehicles and the like, but perhaps more importantly, it sets the stage for a prenup as a simple matter of precedent and not an indictment of any potential bride or groom. (When such topics are broached for the first time AFTER someone is in love, it can be exceedingly difficult for that person to not view the topic as a personal attack.)

Additional Thoughts for the Parents

Beyond any prenuptial agreements, there are additional steps that parents can take to protect a child’s inheritance from a future divorce. Reviewing estate plans thoroughly can ensure that they are drafted in a manner that contemplates a child’s marriage and potential divorce; such topics are often left unaddressed if estate plans were drafted when children were hypothetical or very young.

In most states, trusts established by third parties (i.e., a trust established by a parent for a child) are less likely to be subject to division in a divorce, but parents can take additional protective steps—for example, such trusts can avoid mandatory distributions when the child hits a specific age, and/or prohibit withdrawals by the child’s spouse. We also advise that trusts set up for children should be wholly discretionary and should have an independent trustee; this can help mitigate the potential for personal conflicts of interest entering into decisions about the trust.

Non-trust entities, such as an LLC, can be another effective vehicle for holding and protecting family assets. These entities can be sheltered in a variety of ways from a child’s divorce, and typically prohibit non-family members from owning any interest in the entity. Family entities are a preferred planning technique for many cross-border families, as they can eliminate the complexity of estate and trust planning across multiple jurisdictions with different legal frameworks.

We have barely scratched the surface of this complex and delicate topic; it is off-putting, but the conversations about it should never be put off. Plan early, plan wisely, and prenuptial planning can help contribute to a happy marriage as well as a better outcome should that marriage come to an end. For a more comprehensive conversation, don’t hesitate to contact us

Audio Updates: Flexible Equity Strategy

mhannan — Sat, 30 Sep 2023 15:12:40 +0000

Audio Updates: Flexible Equity Strategy mhannan Sat, 09/30/2023 - 11:12

The Brown Advisory U.S. Flexible Equity strategy aims to achieve capital growth. The investment team searches across a broad investment universe to find attractive or improving businesses trading at prices that the manager believes do not reflect their favorable fundamentals. We do not limit our investment universe by exclusively investing in fast growing companies or by focusing only on companies that trade on cheap multiples and are represented in a value index. In our view, “value” can be found even in growthy companies as long as the stock is trading below its intrinsic value. We like to refer to our investment approach as having a “value philosophy”, which is distinct from a “value style” of investing. Simply put, we are looking to invest in good businesses at bargain prices. The resulting portfolio consists of a moderately concentrated group of mid- and large-cap companies.

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Audio Updates: Large-Cap Growth Strategy

mhannan — Sat, 30 Sep 2023 15:00:51 +0000

Audio Updates: Large-Cap Growth Strategy mhannan Sat, 09/30/2023 - 11:00

We believe that a concentrated portfolio of companies with sound, sustainable business models has the potential to deliver attractive risk-adjusted returns over time. We are also disciplined, and invest where we believe outcomes are skewed heavily in our favor and can support high absolute growth rates.

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Audio Updates: Large-Cap Sustainable Growth Strategy

mhannan — Sat, 30 Sep 2023 13:58:52 +0000

Audio Updates: Large-Cap Sustainable Growth Strategy mhannan Sat, 09/30/2023 - 09:58

The strategy seeks to deliver competitive risk-adjusted returns over a full market cycle through a concentrated portfolio of companies that we believe offer durable fundamental strengths, sustainable competitive advantages and compelling valuations. We seek out companies with particular sustainability drivers we refer to as Sustainable Business Advantages (SBA), that directly benefit financial performance by specifically driving revenue growth, cost improvements and enhanced franchise value.

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Audio Updates: Global Leaders Strategy

mhannan — Sat, 30 Sep 2023 13:19:57 +0000

Audio Updates: Global Leaders Strategy mhannan Sat, 09/30/2023 - 09:19

The Brown Advisory Global Leaders Strategy invests in the top 30-40 leading companies that we believe deliver exceptional customer outcomes. We use franchise quality, management quality, quantitative measures and investability to identify a global leader. We believe that companies that combine exceptional outcomes for their customers with strong leadership can generate high and sustainable returns on invested capital (ROIC), which can lead to outstanding shareholder returns.

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Six Considerations When Inheriting Wealth

ajackson — Mon, 25 Sep 2023 16:15:05 +0000

Six Considerations When Inheriting Wealth ajackson Mon, 09/25/2023 - 12:15

During our Women’s Listening Tour we heard from clients that they wanted to better understand what questions they should be asking during specific financial milestones, one of which could be inheriting wealth. The following document is meant to be an easily digestible and high-level perspective on how to approach both the composition and timing of an inheritance.

We recognize that receiving an inheritance is not as simple as it seems and that there may be emotional, legal and financial implications that can feel overwhelming. We hope the following guide can serve as a navigation tool as you plan ahead and build your team.

Click Here to Download the Six Considerations

It's the Little Things: Why US Small-Cap Stocks Deserve More Attention

bgregorio — Mon, 25 Sep 2023 12:42:38 +0000

It's the Little Things: Why US Small-Cap Stocks Deserve More Attention bgregorio Mon, 09/25/2023 - 08:42

For most investors, a primary objective is creating an optimal portfolio allocation that maximizes returns for a given level of risk. When designing portfolios, investors might consider various things such as allocating to mixed asset classes, different types of securities or geographies. Key considerations will likely include historical performance, correlation of returns, and volatility.

Key Benefits of Small-Cap Investing:

Inefficiency – the small-cap universe is typically far less thoroughly researched than large-caps as illustrated in the charts below. The relative lack of analyst coverage can contribute to mispricing that creates potential opportunities – that is, without experts actively evaluating a stock, shares can diverge from their fair value.
The power of stock-picking – with over 2,000 companies to choose from in the US alone, active managers can dig deep to identify promising growth stories or undervalued opportunities that may be overlooked by the broader market.
Specialization – managers and research analysts who focus on this area develop the expertise needed to uncover specific sectors, industries or geographic niches that may be under-represented in small-cap indexes. For example, an analyst might specialize in software companies or emerging biotechs. This can help identify promising opportunities that others may overlook or misunderstand.

Demystifying Small-Caps

Small-cap investing has a rich history that spans decades and reflects the evolution of financial markets and investment strategies. In the US, small-cap stocks typically represent companies with a total market capitalization ranging between $300 million and several billion dollars.

The history of small-cap investing is blurry, but a significant moment came in the post-World War II era with the rise of mutual funds and the advent of portfolio diversification theories, such as Harry Markowitz’s Modern Portfolio Theory in the 1950s. This led to a greater appreciation for the role of small-cap stocks in achieving benefits derived from a diversified portfolio.

The introduction of the Russell 2000® Index in the 1980s marked a big step forward for small-cap companies and made it easier for investors to gain exposure. Since then, the increased availability of data and advancements in technology has made it possible for investors to conduct more thorough research and analysis.

The Small-Cap Opportunity

Put simply, the universe of small-cap companies covers a wide breadth of sectors, industries and factors compared to the relatively narrow large-cap market which is dwarfed by a few enormous organisations. Exploring these smaller companies could provide early access to the successful businesses that will likely make up the future mid and large-cap universe.

The host of opportunities in this space opens a range of complementary dimensions for investors. The advantages of carving out space for small-cap companies in a portfolio start to become obvious. For example:

1) The diversification boost – this seems straightforward. Why restrict a portfolio to large-cap stocks when the opportunities are far wider? It could even be argued that the lower correlation between small-and large-cap stocks improves overall portfolio efficiency. Put simply, small-cap companies behave differently (for example, they are often nimbler and can react faster to change), providing diversification.

2) Small-caps, big growth – smaller companies tend to grow revenues and earnings faster than their larger counterparts. Investing in these companies early in their life cycle could therefore provide more upside. In other words, the expansion opportunity is greater.

3) Spanning the economic landscape – we have already acknowledged the much larger number of companies available to invest in versus the large-cap space. Add to that fact that the breadth of sectors that small-cap companies span is wider than their large-cap counterparts who are typically concentrated in sectors like technology as the chart below demonstrates.

Source: Factset as of 08/31/2023. Sectors are based on the Global Industry Classification Standard (GICS) classification system.

Balancing the Risks and Rewards

Of course, with opportunity, comes risk and balancing the two takes expertise.

In this case, the smaller size of these firms compared to their large-cap counterparts introduces higher idiosyncratic risk, or the risk associated with the individual investment in a company. Examples might include the impact of a management team’s decisions, the culture of an organisation, new competitors, or a change in a legal framework.

Liquidity risk is another key area to consider. Low trading volumes can lead to wider bid-ask spreads and difficulties exiting positions. Other issues like crowded trades can exacerbate liquidity challenges and result in higher share price volatility.

Finally, due to a lack of analyst lack coverage, there is generally less availability of information than might typically be seen in larger cap companies.

All of this can result in higher volatility and requires a higher appetite for risk. But for patient investors, the results could be worth waiting for as the charts highlight below. To achieve this, active managers, supported by specialist research teams are key to mitigating the risks, selecting the best opportunities and taking advantage of any volatility for an attractive entry point. Implementation requires diligent security selection and risk management – an important reason for a rigorous investment philosophy and process.

The Active Advantage

Skilled active small-cap managers can add alpha by exploiting their experience, their deep research and sticking to their investment process in different market environments. There are various opportunities that investors can exploit to generate alpha in this space:

Inefficiency – the small-cap universe is typically far less thoroughly researched than large-caps as illustrated in the charts below. The relative lack of analyst coverage can contribute to mispricing that creates potential opportunities – that is, without experts actively evaluating a stock, shares can diverge from their fair value.
The power of stock-picking – with over 2,000 companies to choose from in the US alone, active managers can dig deep to identify promising growth stories or undervalued opportunities that may be overlooked by the broader market.
Specialization – managers and research analysts who focus on this area develop the expertise needed to uncover specific sectors, industries or geographic niches that may be under-represented in small-cap indexes. For example, an analyst might specialize in software companies or emerging biotechs. This can help identify promising opportunities that others may overlook or misunderstand.

America’s Small-Cap Advantage

A dedicated US small-cap mandate with high active share, focused on high-quality companies and mitigating downside risks, may enable investors to capitalize on the long-term potential found in US small-cap equities.

US-based smaller companies include an exciting and dynamic group of growing businesses that typically demonstrate high innovation and strong entrepreneurial cultures.
Over half of global smaller companies – more than 2,000 companies – are listed in the US, creating a huge opportunity.
US smaller companies offer a deep and liquid market but are typically not as well covered by sell-side research analysts as their larger counterparts, creating inefficiencies and missed opportunities that can be exploited.
A US stock market listing means there are high governance hurdles relative to their global peers, considerably reducing the risk profile of US smaller companies.

Levering Experience and Expertise

Brown Advisory has been investing in small, medium and large-sized companies in the US for over 25 years. Across its range of small-cap strategies, it manages approximately $9bn on behalf of institutional and intermediary clients as well as high net worth individuals. Clients benefit from Brown Advisory’s extensive research capabilities with a large team who cover the entire US market – analysing different sized companies (as they grow) and how they interact with one another across the spectrum. Alongside this, the firm benefits from an extensive network of venture capital, private equity and corporate relationships . Understanding the full spectrum of private and public companies is of fundamental importance to not only have a full picture of the competitive landscape but also to have access to the companies that might be likely to float in the future.

Brown Advisory believes that disciplined, bottom-up research, coupled with collaborative teamwork and the free exchange of ideas amongst colleagues, are the keys to achieving long-term outperformance. The combination of its investment philosophy and its client-first culture helps to make Brown Advisory a compelling portfolio manager.

In Summary

Offering diversification, growth potential, and a breadth of opportunities, in our view, small-caps deserve serious portfolio consideration - while individually small, collectively they account for nearly 3/4 of all U.S. listed companies across a diverse mix of sectors . Though sometimes neglected, this niche allows skilled active managers to unlock overlooked value. Despite higher risks, a modest small-cap allocation can enhance portfolio efficiency for patient, long-term investors aiming to boost returns.

Learn more about our US Small-Cap Growth Strategy

View Strategy

^{The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.}

^{1 Source: Factset. Data as of 08/31/2023.

2Data as of 08/31/2023. Client assets are held in the following entities: Brown Advisory LLC, Brown Investment Advisory & Trust Company, Brown Advisory Ltd., Brown Advisory Trust Company of Delaware, LLC Brown Advisory Investment Solutions Group LLC, NextGen Venture Partners LLC and Signature Financial Management, Inc.

3Alternative investments may be available for Qualified Purchasers and Accredited Investors only.

4Source: Factset. Data as of 08/31/2023.}

^{Factset® is a registered trademark of Factset Research Systems, Inc}

^{The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.}

^{The Russell 2000® Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 companies with higher price-to-value ratios and higher forecasted growth values.}

^{The Russell MidCap Growth Index is an unmanaged index that measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. It is not possible to invest directly in an index.}

^{Russell® and other service marks and trademarks related to the Russell indexes are trademarks of the London Stock Exchange Group Companies.}

^{The S&P 500 Index, an unmanaged index, consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value.}

^{Standard & Poor’s, S&P®, and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc}

^{Global Industry Classification Standard (GICS) and “GICS” are service makers/trademarks of MSCI and Standard & Poor’s.}

Uniting Around a Legacy: Generational Wealth Transfer

achen — Wed, 20 Sep 2023 13:30:21 +0000

Uniting Around a Legacy: Generational Wealth Transfer achen Wed, 09/20/2023 - 09:30

One of our primary responsibilities as strategic advisors is helping our family clients manage the gradual transition of financial responsibility and accountability from one generation to the next. This has always been a complex process for any family, but it has grown more complex in recent years. The current rising generation in many families faces very different circumstances than their parents did; they learned very different lessons from the formative events of their lives, and thus they often make different decisions and have different priorities than their parents.

We need to understand these differences so we can effectively advise all members of a family, young(er) and old(er) alike. We often work with multiple generations within a family and can see firsthand the similarities and differences between parents and children, and the circumstances they respectively faced when starting out. In most cases, the families who successfully manage generational transitions are the ones who can effectively bridge differences between generation and unite around a common set of principles or beliefs that can tie the family’s various goals together.

Kids These Days

There are some obvious differences between generations that crop up fairly often—for example, younger clients are generally more comfortable with technology and with the concept of operating in the digital world—but it is the more nuanced differences that stand out to us, and that offer us a particular opportunity to help create value across generations:

Comfort with nontraditional income streams. Clients that are relatively early in their careers are generally working to build wealth and save for the future. Today, many of them find themselves in sectors shifting toward non-traditional corporate structures or work settings. Their compensation may take the form of consulting income, business distributions or equity ownership. Some of these structures enhance long-term security for the client, while others increase uncertainty.
Nontraditional income influences the way we as advisors think about risk and liquidity for the client when we construct their portfolio. It also impacts matters outside of pure investment decisions; for example, it can pose challenges for those seeking loans or financing from traditional banks—some clients may find themselves frustrated by the challenge of demonstrating income from a collection of non-traditional sources.

Comfort with entrepreneurial ventures. Technology and other factors are making it easier and less costly to start new business ventures, or to build a career on a set of ideas and projects. Career trajectories now take many different forms than the traditional path of a long-term career commitment to an employer.
This approach offers many benefits—flexibility, opportunity, intellectual stimulation—but it also may carry individual and family risks. We work with all of our clients to help them manage these risks—such as health insurance or ensuring a safety net if income is interrupted—on both a short- and long-term basis. This kind of risk planning is critical for anyone on an entrepreneurial path that offers both risk and reward.

Comfort with newer investment ideas. Generally, younger clients are more comfortable with change than older ones—it is a natural part of life to desire change when younger, and stability when older. (This rule has plenty of exceptions, of course!) For example, sustainable investing has gained an immense amount of traction in the past decade, especially with younger investors. Many of our clients were raised in homes focused on charity, philanthropy and giving back to their communities. They also grew up in an era of global connection and have friends and contacts around the world. All of this has led many of them to want to invest sustainably. We have helped many of our clients as they gradually bring newer ideas like sustainable investing (or cryptocurrency, for example) into their strategic financial plans.

In working with clients that face these emerging circumstances, we find that family collaboration and unity can be a powerful tool to help older and younger generations accomplish their goals together. Here, we offer a number of case studies and examples of situations where we worked with our family clients to enact a planning strategy that offered specific tangible benefits to both the parents and children.

Risk Management for the Young Entrepreneur

Our client “Sharon” has both a young family and an entrepreneurial spirit. She wanted to start a new venture but did not want to expose her family to undue burden or risk in the process. With a well-vetted business plan, she came to us for guidance on how to proceed.

We started by reviewing Sharon’s cash flows and understanding her basic financial needs. As we do for many of our clients, we ran a capital sufficiency simulation to determine whether her current spending rate was in line with her long-term goals. This helped us assess the level of risk that she could afford to take when committing capital to a new venture.

Our next priority was to ensure Sharon’s estate plan was in place and up to date. In addition to reviewing basic trust, will, and power of attorney documents, we advised her on the best entity to use for setting up her business, and on how to keep her business cash flows separate from her personal accounts. Additionally, as part of the review, we implemented a thoughtful succession plan and updated her personal and liability insurance.

Finally, we had a unique opportunity to assist Sharon, because we advised both her and her parents. We were able to strategize with the entire family about the most effective way for Sharon’s parents to help with her venture. By engaging in upfront asset transfers to Sharon, rather than waiting to transfer wealth as an inheritance at the time of her parents’ deaths, we helped her parents reduce transfer taxes while also enabling Sharon to utilize those funds at the time when she needed them most.

It was a highly rewarding outcome for all parties. Sharon gained a better appreciation of her parents’ careful planning and went into her venture with peace of mind that her family was protected. Her parents were impressed with her conservative approach to entrepreneurship and were confident that she would be an effective steward of their hard-earned capital.

Sustainable Investing in a Family Foundation

“Helen” is another younger client of ours whose family has a long history of charitable giving. In the 1980s her parents set up a family foundation, and about five years ago, they asked Helen to assume leadership. We had worked with Helen’s parents to educate her on the functions of the foundation and the values on which it was based. Because of this, Helen felt empowered to take on this role when the time came and immediately wanted to bring her own perspective to the foundation. Helen broadened the mission of the foundation to address a wider range of sustainability topics, such as the environment, education and health care in developing countries.

She also wanted to develop a stronger link between the foundation’s portfolio decisions and its mission, with specific ideas about investing more of the foundation’s assets with companies, managers and ventures that provided both a financial return and positive global impact.

In helping her implement her ideas, we advised a patient approach, in which we worked with her to gradually adjust the portfolio overtime. We find that in most cases, when a client is transitioning assets toward sustainable investments—especially when a portfolio is already fully invested—it is important to move deliberately. When taxes are a factor, it is essential to consider the consequences of exiting holdings that may be held at a lower cost basis, and in non-taxable situations (such as Helen’s family foundation), it is still important to carefully evaluate potential new managers on both a financial basis and on the basis of potential impact of their investments on society.

The family greatly appreciated this approach. Helen was pleased to have a team focused on the full range of investment factors she considered important, and Helen’s parents were also confident in the portfolio changes, as each manager that we recommended was approved through our firm’s strict manager due diligence process. The parents had put a great deal of time into their foundation, and they were thrilled to see their daughter leading it to strong financial results and an expanded mission.

The cases of Sharon, Helen, and many others give us new opportunities to learn about the needs of our clients. These cases also highlight the fact that there are more similarities than differences between generations. Like her parents, Sharon is risk averse. Before heading down the entrepreneurial path, she wanted to have a safety net in place and make sure her family was protected. Helen shares her parents’ love of charitable work and is focused on reinvesting her family’s wealth into her community through high-quality investments. Despite the differing experiences of younger and older family members, we find that a unified approach to planning that spans generations is often the best way to achieve everyone’s individual goals.

These examples also highlight for us the fact that a relationship with both the older and younger generations of a family puts us in a position to be most effective during transitional moments. Bridging that gap and finding common ground is perhaps the most rewarding outcome we can help families and younger investors achieve.

Steps Toward Sustainability

Many investors have deeply held beliefs and values that shape their life choices, yet three out of four investors are still hesitant about discussing sustainable investing with their advisors, according to a 2013 study by Calvert Investments. We have found that an incremental approach, with an emphasis on comfortable starting points, is an excellent way for families to begin building a sustainable investment plan that addresses their full range of goals.

Identify the values you prioritize.
Families often have a wide range of beliefs; you and your family may struggle with how to tackle all of your values within your portfolio. It can be helpful to target one or two priority issues to begin making concrete progress.

Consider and learn about all your options.
There are many tools at your disposal, from simple screening to innovative impact strategies. After learning about your options, you can select the ones that best match your specific goals.

Stay true to your plan; be comfortable with gradual change.
Sustainable investing is a worthy endeavor, but changes to your portfolio should progress at a deliberate pace. By proceeding gradually, you can avoid disruption and leave time to adopt new ideas you learn from experience.

1. http://www.fa-mag.com/news/millennial-interest-in-values-investing-rising-with-performance-27349.html

Private investments mentioned in this article may only be available for qualified purchasers and/or accredited investors.

Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, indepth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.

The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Family Matters: New Considerations for Structuring Family Offices

ajackson — Wed, 20 Sep 2023 12:48:37 +0000

Family Matters: New Considerations for Structuring Family Offices ajackson Wed, 09/20/2023 - 08:48

Families that have created or inherited considerable wealth are incredibly blessed, but such blessings can come with a wide range of challenges and responsibilities. Overseeing the often-complex lifestyle of the current generation involves can involve responsibility for homes, boats, planes, large support staffs, curated art and other substantial fixed assets, not to mention stewardship of ongoing corporate or other entities. Additionally, these families are seeking to preserve both their wealth and their beliefs and principles to benefit future generations and, in many cases, fund broader community and philanthropic aims.

These “family affairs” can become enormously complicated, and many multigenerational families have created family offices to manage these complex financial and investment matters. Recent years have brought some changes to the rules governing such offices, and how they are taxed, leading many families to reconsider (or consider for the first time) questions about whether to start a family office, or whether to restructure an office already in place.

If your family is thinking about these questions, this white paper may help. In it, we provide some background on recent relevant changes in tax law, and we offer a framework that your family can use to evaluate any restructuring decision in a comprehensive manner.

BACKGROUND

Decisions about whether to start a family office, and how to structure such offices, are multilayered. The thought process should be driven primarily by the goals and desired outcomes of the family: What do they want to achieve? What skills and competencies are most important given their priorities? Can an existing firm provide what they need, or will a dedicated team do a better job? Do they have the resources to support a high-quality operation?

Of course, it can be expensive to run a family office. Expenses typically include salaries and other costs for staff, fees for legal/accounting services, direct and indirect investment expenses, technology and infrastructure, and a variety of other requirements specific to a family’s needs.

Historically, tax treatment—specifically, the ability to deduct various expenses of a family office for tax purposes—was often the critical factor that determined whether a captive family office made financial sense. Recent developments in tax law have raised the stakes for families weighing family office structure decisions and helped to clarify the income tax landscape for those already operating a family office.

Prior to 2017, families could deduct investment management fees (typically the largest cost for a family office) from their income taxes, but the 2017 Tax Act eliminated that deduction along with all miscellaneous itemized deductions. However, deductions for trade and business activities are still available to these families.
Two recent court cases (between the Internal Revenue Service (IRS) and the Lender and Hellman families, respectively) have provided a template for structuring a family office so that it may qualify as a trade or business in the eyes of the IRS.

Because the tax savings from deducting family office expenses can be meaningful, many family offices are now tempted to restructure in a manner that seems to have been blessed by the courts. To be clear, one of the primary motivators for families in recent years—the provision that eliminated deduction of investment management fees in the 2017 Tax Act—is due to sunset in 2025. Should that come to pass, the financial case for restructuring one’s family office will become less compelling for many families.

However, tax treatment of expenses is only one part of a complete analysis needed to make the right family office choices for a given client. In this article, we seek to provide some background on the recent tax law developments, and then walk through a three-step framework that families can use to think through their options for structuring a family office—focused on the financial impact and feasibility of a new structure, and the family’s appetite for that new structure. Ultimately, each family and its trusted advisors need to make its own determination. No two families are the same, and even with a clearer tax environment, two families may examine the same quantitative scenario and make very different decisions about it.

RELEVANT LEGAL ISSUES—A BRIEF REVIEW

The 2017 Tax Act. Prior to 2017, investment management expenses were deductible (with some limits) as miscellaneous itemized deductions. Investment expenses usually represent a large proportion of family office costs, and their deductibility generally mitigated the net costs of running such an office by a meaningful amount.

The 2017 Tax Act eliminated miscellaneous itemized deductions entirely, and as a result, families are no longer able to deduct investment management fees from their taxable income. This immediately made the deductibility of business expenses an area of focus for families. If a family can structure its family office so that it qualifies as a trade or business, the costs of that office would still be deductible. (Such a step would also benefit families that could not deduct investment fees before 2017, because of the Alternative Minimum Tax (AMT).)

As might be expected, when families began seeking to deduct family office costs as business expenses, they ran into objections from the IRS, and matters began escalating to the U.S. Tax Court for resolution. Two recent cases involving the Lender and Hellmann families (whose wealth stems from the well-known Lender’s Bagels and Hellmann’s grocery brands, respectively) are now serving as early precedent.

The Lender Case: The Lender family office has been in operation for more than 25 years. After the family sought to deduct the costs of the office as business expenses, its case vs. the IRS ended up in court. In its decision (Lender Management v. Commissioner, TC Memo2017-246), the U.S. Tax Court concluded that the costs are in fact deductible, because the family office was:

Structured like a professional advisory firm. The family office is a separate entity, a fact reinforced by the ownership structure of two investment LLCs that held private equity and hedge fund investments, respectively. The family office was an advisor, not a parent, of these LLCs. Its ownership interest in the LLCs was less than 10%, while family members individually owned more than 90% of the LLCs. (Note: LLC structures such as these are generally available to qualified purchasers or accredited investors only.)
Staffed like a professional advisory firm. Keith Lender, the CIO, holds an MBA and works 50 hours per week for the family office, alongside a non-family member who is the CFO. Other staff include an office manager and several part-time employees. The office manages outside vendors and holds formal meetings with various members of the Lender family—in short, it is run like a real business.
Compensated like a professional advisory firm. The family office receives payment for investment advice, as well as a share of the carried interest or “profits interest” of the two LLCs (contingent on the performance of the underlying investments held in the LLCs).

Notably, the Lender case did not rule on several matters pertaining to the family office’s status as a business—for example, whether it might be subject to additional business taxes, subject to mark-to-market rules, or if the carried interest it collects from the LLCs might be recharacterized as ordinary income vs. long-term capital gain. It also did not resolve potential estate tax implications (i.e., if trusts that benefit a younger generation are allowed to be owners of the management entity, it could allow for additional wealth transfer).

The Hellmann Case: A group of Hellmann family members own and operate GF Family Management LLC. They took the position that the Lender decision cleared the way for their family to deduct its family office expenses as well. The IRS objected.

There are four Hellmann family members related to the court case; they all reside in Atlanta, have a good relationship and the family office made investment decisions for the group as a whole. The Lender family members are geographically dispersed, in some cases do not get along or do not know each other at all, and the family office makes decisions for each family member separately.

The Hellman family members owned 99% of the relevant investment partnerships, and each of the four held a 25% interest in the family office. In contrast, the Lender family office owned a meaningful portion of the LLCs it managed, and most of the family members who invested in the LLCs did not have an ownership stake in the family office.

From these two cases, a new understanding is beginning to emerge about the criteria that the Tax Court may use in the future to determine whether a family office qualifies as a trade or business.

A FRAMEWORK FOR EVALUATING FAMILY OFFICE OPTIONS

Given these tax considerations, many family offices will seek to structure themselves in a manner that qualifies as a trade or business under IRS rules. Again, we want to remind our clients: Many family offices have pursued a new structure because the 2017 Tax Act eliminated deductions for investment management fees. That provision of the code is due to sunset at the end of 2025. If families are once again allowed to deduct that expense, it may change their financial calculus as they consider potential changes to their family office.

Furthermore, restructuring one’s family offices may create new problems while solving old ones. If their family office qualifies as a business, it may also be required to register with the SEC as a registered investment advisor (RIA), as outlined in the Investment Advisors Act of 1940 (the “Advisors Act”). SEC registration creates an entirely different set of costs, burdens and risks. So, the theoretical ideal for families is to thread the needle, so to speak, and structure the family office so the IRS recognizes it as a business and the SEC recognizes it as exempt from registration.

Establishing or restructuring a family office to fit the Lender template is much more challenging in reality than on paper. These structural decisions generally have impacts that extend far beyond the tax benefits being pursued.

Families who are considering their options may follow this three-step process to help ensure a more comprehensive evaluation:

Step 1: Evaluate current expenses (Financial benefit of new structure)

Families should quantify and evaluate their current costs, including staff, retained legal/accounting services, direct and indirect investment expenses, technology, infrastructure and any others. They should further review their current effective tax rate, and then look at how the effective rate could change under a Lender-like structure. State taxes are important to examine as well—for example, many states tax realized capital gains no differently than ordinary income.

This first step should help a number of families make a quick determination. Every family is different, but when aggregate expenses are less than $1million, often it may not make financial sense to form or restructure a family office—and for such families, the option of outsourcing may now be more attractive than it was a few years ago. Additionally, families that already have operating businesses may find that the incremental deductions are not enough to justify a change.

Step 2: Evaluate family’s fact pattern (Feasibility of new structure)

If the tax savings under a Lender-like structure would be compelling, the next step is to determine if such a structure is practical or even feasible. There are several hurdles to clear.

First, does the family’s situation serve as a logical basis for the structure? A “Lender-like” model makes sense for a family of multiple branches containing multiple generations, with independent advice for different family members, and outside investors in the family office. However, for a family of two generations within the same branch, served collaboratively, it would be difficult to defi ne the family office as an actual business in the eyes of the IRS—not to mention or to justify the many added costs of an intricate family office structure.

There are additional hurdles to qualification as a “trade or business.” For example, it is not always feasible to compensate staff based on a profits interest in the family office. Further, the ideal structure may come at a cost. Many families look to create a C-Corp, for example, but in such an instance it is desirable to keep the business at breakeven to avoid the potential for double taxation of profits that a C-corp creates (i.e., first at the corporate level, and again at the shareholder level once distributed). Finally, the structure may require new or different management skills, and it is important for families to know whether that talent is available at reasonable cost.

Step 3 – Evaluate likelihood of success (Durability of new structure)

Finally, if a Lender-like structure appears both financially attractive and achievable in practical terms, the family members still need to take an honest look at its likely impact on their day-to-day lives and determine whether they would be comfortable adhering to a new set of rules over time. A new family office structure, as mentioned, will likely require new costs and may require new staff and leadership to operate properly, and family members may not be unified in their desire to take on these additional burdens. Managing and calculating the profits interest in a family office is complicated and may very well create tension among family members. Any changes in how the family members meet and interact with the family office and each other may require adjustments as well.

No two families are identical, and every family will respond differently to a potential change in how its investment assets are managed, and to any downstream adjustments that are required to adapt to a new management structure. In all cases, a complete understanding of the anticipated changes is critical to the long-term success of the office.

CONCLUSION

Families should keep in mind that much of the law discussed in this article is fairly new, and precedent is still emerging. The Lender case, for example, represents the ruling of one Tax Court judge; it may serve to guide future decisions but that is not guaranteed. The risk of being wrong—or even of being right but having to pay the legal expense of proving it in court—is a meaningful one.

The issues involved with operating a family office have always been complex, and the recent changes in tax law have only added to that complexity. We expect it to be challenging for families to find the right solution that satisfies the demands of the IRS, the SEC and their own family, and the topic is worthy of extended and comprehensive consideration by families and their advisors. While maximizing the financial efficiency of the family office (by capturing allowable tax deductions) is important, it has become more challenging to achieve. For families with family office expenses over $1 million and a business that serves multiple family branches (and even some outside investors), an initial review through our suggested three-step process with their advisors is the prudent first step. The financial considerations are just one part of a complex analysis to determine whether a family should form a family office or how best to structure it.

¹Investment management expenses are sometimes referred to as “Sec. 212 expenses,” and business expenses as “Sec. 162 expenses,” based on the relevant sections of the Internal Revenue Code that cover the tax treatment of these expense categories.

Any business or tax discussion contained in this communication is not intended as a thorough, in-depth analysis of specific issues. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Business Resilience in Portfolio Construction

bgregorio — Tue, 19 Sep 2023 09:12:47 +0000

Business Resilience in Portfolio Construction bgregorio Tue, 09/19/2023 - 05:12

Only Time Will Tell

While the old adage “only time will tell” generally refers to a future outcome, it reflects our belief that a truly enduring investment must have proven to be resilient under a variety of macroeconomic circumstances. The Sustainable International Leaders (SIL) strategy views resilience as a crucial lens through which to analyze businesses and seeks to invest in companies that have withstood the test of time. Consequently, the median age of the portfolio is 69 years. The youngest company we own, Dutch semiconductor company NXP, is only 17 years old, while French luxury goods firm LVMH is by far the oldest, having incorporated at the end of the 16th Century (Figure 1).

Figure 1. Time is the ultimate measure of resilience: Over 95% of Sustainable International Leaders’ holdings have been in business for at least 25 years.

Source: FactSet as of 08/31/2023. ¹Chateau d’Yquem is part of LVMH and was founded in 1593. Portfolio information is based on a representative Sustainable International Leaders account. Please see the end for important disclosures.

A fundamental premise of any business is that the company in question will be operational well into the future. But just how far into the future is where we pay close attention. Portfolio holdings such as Swiss pharma and diagnostic giant Roche Holding, Finnish elevator engineering company Kone, French luxury conglomerate LVMH, and Swedish industrial compressor company Atlas Copco are businesses where the founding families are still involved in the business, and that operate on a multi-generational timeframe, far beyond the investment horizon of most investors. We believe this is what allows them to create enduring businesses with sustainable competitive advantages and attractive capital deployment opportunities. All but one of Sustainable International Leaders’ holdings have been around for at least 25 years. This means that an overwhelming majority have withstood the early 2000s recession in developed markets, the 2008 to 2009 Global Financial Crisis, and the Covid-19 global pandemic. Indeed, these businesses have not only survived such events, but in most cases have emerged stronger and thrived in the period that followed, all while building and improving their competitive position.

The concept of gauging a business’ resilience largely by how long it has already been in existence might seem odd in an era when newer companies with more contemporary business models and product ideas often garner more investor attention than the overgrown dinosaur companies of yesteryear. However, in our view, it is the companies that have persevered through a multitude of cycles —market, business, geopolitical to name a few — that are more likely to exist in the years and decades ahead. This concept has been formalized through what is known as The Lindy Effect.¹ In short, the theory holds that the future life expectancy of certain non-perishable phenomenon like a technology or an idea is proportional to their current age. Thus, every additional period of survival implies a longer remaining life expectancy.

Identifying Resilience

Our portfolio holdings’ resilience comes from several sources: the durability of their competitive advantages, structural growth tailwinds, and a history of strong execution. Additionally, we have found these businesses to face low risk of permanent loss of capital caused by excessive leverage, obsolescence, or exposure to significant risks and hidden liabilities. Our investments are not immune to macroeconomic fluctuations; we nonetheless think they have unique qualities that should help them outperform their peers over time.

Even when the best company fundamentals are combined with the most capable management teams, the success of such companies can be highly dependent upon industry structure. Thus, we place a strong emphasis on competitive positioning of companies within their sector.

In financial services, for example, we have steered clear of large, commoditized banks and instead sought to invest in companies that we believe have a differentiated positioning that is hard to replicate and which also benefit from secular tailwinds toward new financial market penetration, such as Hong Kong-based general insurance services company AIA Group, Ltd, Indonesian microlender Bank Rakyat, and India’s HDFC Bank.

In the industrials space, we have refrained from investing in deeply cyclical commoditized businesses and see resilience in companies that typically benefit from a meaningful after-market component or subscription-like revenues from maintenance or service contracts, e.g. Atlas, French Aerospace manufacturer Safran Group, and Kone (Figure 2.) Others such as U.S. waste services company Waste Connections and British pest-control firm Rentokil Initial are traditionally defensive businesses that benefit from local economies of scale in distribution, which can be incredibly hard for smaller players to compete with.

With resilience as a key principle guiding Sustainable International Leaders’ portfolio construction, our focus inherently points toward high quality, free-cash-flow generative companies that we believe have strong potential to generate attractive throughout the cycle risk-adjusted returns.

Figure 2. Selling past the sale: cash flows from equipment servicing contracts
Original equipment revenues vs aftermarket revenues

Source: Company reports. Data as of 2021 and is most recent data available.

In the technology sector — which is a double-edged sword of huge capacity for innovation along with huge potential for disruption — our areas of focus are competitively advantaged businesses within consolidated, rational industries. While the semiconductor business has seen violent cycles in the past, the industry is more consolidated today and benefits from strong cyclical upturn with digitalization of the economy. We are able to gain exposure to companies with strong competitive positions in this sector via holdings such as Dutch semiconductor supplier ASML Holdings, and Dutch semiconductor manufacturer NXP Semiconductors. Other stocks we own in this space include providers of mission-critical solutions such as Wolters Kluwer, a Dutch provider of information solutions for professionals such as health care practitioners, lawyers and accountants that they would typically be loath to cut down on even in a downturn and Indian IT services provider Tata Consultancy Services, which derives a significant proportion of revenues from less discretionary maintenance spend by its customers.

Finally, our holdings in the consumer discretionary sector include businesses that have a history of not only rebounding quickly, such as the luxury conglomerate LVMH, online travel agent Booking.com, and Compass, Inc. While these businesses can be impacted by short-term cyclical headwinds from time to time, we think their long-term prospects remain attractive.

Navigating Macro Uncertainty via a Bottom-Up Approach

Looking beyond sector dynamics, another key source of resilience across our holdings is their ability to withstand the prevailing macro environment, especially the ongoing inflationary cycle and supply chain challenges. Indeed, while some portfolio holdings are managing well, others are able to capitalize and even benefit in the current environment.

Due to a combination of strong structural growth tailwinds in their sectors and supply chain shortages, our semiconductor holdings such as ASML and NXP are benefitting from strong pricing power, versus the price deflation that we have historically seen in this sector. Meanwhile, Deutsche Boerse has benefitted from strong cyclical growth across their asset classes and the impact from inflation has been limited: revenues grew 18% in H1 23 vs operating costs up 10%. Despite inflation, they continue to manage the cost base well on the back of strong cyclical and secular top line growth.² Others that have been able to pass on inflation or have even benefitted from it include luxury conglomerate LVMH, outsourced food services provider Compass, pest control business Rentokil, and information solutions company Wolters Kluwer, which have all been able to fully offset the impact of inflation. At the same time, we believe it is reassuring to see that pricing actions have been taken with integrity and none of these companies mentioned here are looking to exploit what is no doubt a tough operating environment for their customers.

Others have been able to largely absorb the immediate impact of inflation and have only seen modest margin compression, such as British consumer goods producer Unilever, Atlas Copco and Kone. Over time, we think these companies should be able to more than offset inflation through mix-driven innovation in the case of Unilever and Atlas or improved pricing in the aftermarket for Kone.

Today’s Environment is an Attractive Entry Point for Long- Term Investors

The soundness of our investment strategy is not predicated on a narrow range of projections of the future. We believe that these businesses represent good long-term sustainable investments, but the current market environment of global uncertainty offers an attractive entry point. Going forward, we see meaningful long-term potential and attractive portfolio characteristics that are reflected in 20.0% ROIC, 7.11% three-year sales growth and a 4.2% free-cash-flow yield as of August 31, 2023.³

^{1 article in The New Republic. The idea has since been refined more quantitatively, first by Benoit Mandelbrot in his 1982 book, The Fractal Geometry, and more recently by Nassim Nicolas Taleb in his 2007 book, The Black Swan: The Impact of the Highly Improbable, and then again in his 2012 book, Antifragile: Things That Gain from Disorder.

2 Source: Deutsche Boerse’s second quarter of 2023 company earnings call.

3 Source: FactSet® and Brown Advisory calculations. Portfolio information is based on a representative Sustainable International Leaders account. Portfolio attributes and performance characteristics exclude cash and cash equivalents which is 2.9% as of 08/31/2023 and are subject to change. Financial measures for the representative portfolio were calculated as the median values, in order to reduce the effect of significant outliers and provide a representative view of the average returns of the portfolio. ROIC is a measure of determining a company’s financial performance. It is calculated as NOPAT/IC; where NOPAT (net operating profit after tax) is (EBIT + Operating Leases Due 1-Yr)* (1-Cash Tax Rate) and IC (invested capital) is Total Debt + Total Equity + Total Unfunded Pension + (Operating Leases Due 1-Yr * 8) – Excess Cash. ROIC calculations presented use LFY (last fiscal year) and exclude financial services. Free Cash Flow

(FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF yield is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF yield calculations presented use NTM and exclude financial services. Sales growth rate is based on reported company revenue for the past three years at the end of the current quarter, provided as a historical average.

Portfolio level information is based on a representative account as of 8/31/2023.}

The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timelines s o r accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Multiple informational inputs are considered as part of the investment process, alongside data on traditional financial factors. The strategy intends to invest in companies with measurable sustainable outcomes, as determined by Brown Advisory, and seeks to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions. The strategy intends to invest in companies with measurable sustainable outcomes, as determined by Brown Advisory, and seeks to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions.

Sectors are based on the Global Industry Classification Standard (GICS) classification system. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and Standard & Poor’s. “Global Industry Classification Standard (GICS), and “GICS” are service marks of Standard & Poor’s and MSCI. “GICS” is a trademark of MSCI and Standard & Poor’s.

FactSet® is a registered trademark of FactSet Research Systems, Inc.

All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.

The Equity Beat: Can the Swift Economy Remain on Stage?

bgregorio — Wed, 13 Sep 2023 08:16:37 +0000

The Equity Beat: Can the Swift Economy Remain on Stage? bgregorio Wed, 09/13/2023 - 04:16

In August, superstar singer and entertainer Taylor Swift completed the first leg of her Eras tour in Los Angeles, performing 52 dates through 20 U.S. cities over the past few months. Despite causing Ticketmaster’s (owned by Live Nation Entertainment) website to crash last November due to overwhelming traffic, ticket revenue from Ms. Swift’s tour – which now continues outside the U.S. - is expected to reach roughly $1.5 billion. No prior tour has even approached $1 billion in ticket revenue. What’s more, while the average ticket price (not resale) is around $200-$250, the average Eras “experience” – inclusive of outfit, food and beverage, travel and merchandise – has cost more than $1,300 per person. One research company estimates the potential U.S. economic impact of the Eras tour at close to $5 billion. No less an authority on the economy than the Federal Reserve stated, “May was the strongest month for hotel revenue in Philadelphia since the onset of the pandemic, in large part due to an influx of guests for the Taylor Swift concerts in the city.” Travel, experiences and Taylor Swift have kept the U.S. economy afloat this summer!

In 1998, co-authors and economists B. Joseph Pine II and James H. Gilmore published an article in the Harvard Business Review titled, “Welcome to the Experience Economy”. The authors claimed that the next generation of consumers would prefer compelling experiences over products, and proclaimed the arrival of the fourth economic frontier, following the agrarian, industrial and service economies.

Surely, they couldn't have envisioned quite this magnitude of success for Taylor Swift, Beyonce’s Renaissance World Tour (which was the likely cause of rising inflation in Sweden this spring) or the Barbie movie (raking in close to $1.4 billion at the box office) in 2023. Girl Power, indeed!

Other forms of "experiences" have seen a material pick-up in demand as well. Take Major League Baseball. The sport experienced waning popularity in the years leading up to and following the pandemic. With a few rule changes to shorten the length of the game – and perhaps due to the rebound of the "Experience Economy" – this year’s average attendance is its highest since 2017. Fun fact – compared to 2019 levels, my adopted hometown Orioles have seen the second largest percentage increase in home attendance per game in 2023, up more than 40%. Winning doesn’t hurt!

^{Source: ESPN}

The list continues with restaurants, hotels, casinos, airlines and cruise lines. I’ve consumed 2q earnings transcripts from companies across all of these industries. Nary a one is expecting or seeing the consumer slowing down. Here are just a few examples worth sharing:

LYV (Live Nation): “We’re seeing strong growth in theaters and clubs. Our amphitheaters are doing great, substantially up in number of fans attending per show, and the high-end stadiums are doing very well. And how is the low end? Demand across ALL (demographics) continues to be very strong.”

BKNG (Booking Holdings): “We saw an acceleration in total growth of nights booked from 1q to 2q in North America…and we’re forecasting further acceleration of night growth from 2q to 3q.”

RCL (Royal Caribbean): “I want to share what we are seeing for millions of daily interactions with our customers. Sentiment remains strong and is bolstered by strong labor markets, high wages and excess savings.”

CZR (Caesars Entertainment): “We’re not really seeing anything I can speak to that’s material in terms of softness at any level of property.”

DAL (Delta Air Lines): “Consumers want to travel. It’s their number one big ticket purchase priority and they desire premium experiences.”

HLT (Hilton): “I know there are a lot of questions on the leisure business. What I would say to you is we’re having a WILDLY strong summer in leisure.”

DRI (Darden Restaurants): “Within the restaurant industry, there appears to be only minimal switching between lower-priced occasions at this point. Overall, we’re not seeing anything concerning.”

Pretty straightforward, right? There’s a longer-term trend benefiting experiences over things – there are literally dozens of recent articles on the Internet that emphasize that happiness comes more from experiences than material goods. During the pandemic, consumers went overboard on accumulating goods and people are now making up for lost time. Thus, not only is the trend towards experiences a secular phenomenon, but cyclically in vogue today.

Surely however, the party cannot last forever - although I’m certainly not qualified to tell Swiftie Nation to stop singing and dancing! Still, recent economic data reveals a consumer who may need to take a breather. The Fed recently stated that U.S. credit card debt had eclipsed $1 trillion for the first time, rising $45 billion in 2q. Additionally, delinquencies on credit card debt are on the rise, while savings rates are historically low and average interest rates on credit cards are north of 20%! Although bank deposit levels were elevated in recent years, consumers are suddenly at risk of taking on very high-cost debt to maintain their experience-based lifestyles.

^{Source: US Federal Reserve}

I can see the multitude of Swifties shaking their heads at this data, saying “Eric, you just don’t get it. Seeing Taylor Swift on stage is an other-worldly experience…and I’d do it again.” In fact, I do get it – if I could go back in time, I would have refinanced my home in 2017 to watch Roger Federer win his final Wimbledon trophy. However, that’s back when mortgage rates were sub-4%!

Thanks for reading, and remember to never skip a Beat - Eric

CIO Perspectives: Goldilocks Economy and Opportunities Outside the Magnificent Seven

mhannan — Thu, 24 Aug 2023 13:15:25 +0000

CIO Perspectives: Goldilocks Economy and Opportunities Outside the Magnificent Seven mhannan Thu, 08/24/2023 - 09:15

In our latest episode, Sid and Erika are joined by Mick Dillon, who co-manages Brown Advisory’s Global Leaders and Global Focus strategies and has played a critical role in developing the firm’s global equity investment platform since joining Brown Advisory in 2014.

Mick joins the podcast at an especially timely moment. Many investors and pundits continue to focus their attention on the “Magnificent Seven” tech stocks that have dominated the U.S. market for several years, but there are a large number of significant geopolitical and regional matters that are impacting investments all over the globe. In this discussion, he offers his perspective to help Sid and Erika dive deep into what is going on in Europe, Japan, China and elsewhere.

Highlights:

Mick’s investment philosophy is heavily focused on “bottom-up” investing in companies with strong fundamentals. But such philosophies can be challenged during periods when markets become overwhelmed by macroeconomic issues. The team discusses this and Mick talks about the tools he, and his global equity team, use to assess various macro risks and determine which factors are legitimate threats to the cash flows of their portfolio companies.
Mick offers some extended thinking about the Japanese market, and he stated that he is more excited about that market now than he has ever been in his career, due to the big-picture changes sweeping through that market recently.
After living in China for nearly a decade earlier in his career, Mick always has excellent insights about that country and where he sees investment potential. He used case studies of portfolio holdings Taiwan Semiconductor and AIAA in a discussion of opportunities and risks.
Building from the discussion about Taiwan Semi, the team dives deeper into the discussion of technology and supporting infrastructure. Asked if he is seeing a lot of activity driven by economic stimulus like the Inflation Reduction Act, Mick said he is really seeing the impact of the new U.S. and European programs to support domestic semiconductor development. Here is where bottom-up investors can get creative in their search for exposure to macro trends; Mick discusses three companies that he thinks stand to benefit from a revived Western chip manufacturing industry—none of whom are actual chipmakers

Mick, Sid and Erika covered a number of other topics in a freewheeling conversation including Mick’s Summer reading recommendations. Sid and Erika offered their periodic roundup of key issues impacting the markets and how they are positioning portfolios for their clients.

We hope you enjoy the episode and welcome your questions and feedback.

Global Leaders Strategy: Reporting on the impact of our investment decisions

We believe our investments generate a wide variety of positive impacts. In this impact report for our Global Leaders Strategy, Portfolio Managers Mick Dillon and Berite Thomson reflect on the past year. Read the report >

CIO Perspectives: A New Bull Market?

In this episode, Erika Pagel and Sid Ahl are joined by Brown Advisory’s David Schuster, portfolio manager of the firm’s Small Cap Fundamental Value strategy, for a discussion about the surprising resilience of capital markets in the face of a challenging economic environment. Listen now >

The views and opinions expressed in this podcast are those of the speaker(s) and do not necessarily reflect those of Brown Advisory. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this podcast is not intended to be and should not be considered a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.

Alternative Investments may be available for Qualified Purchasers and/or Accredited Investors only.

ESG considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. ESG analysis may not be performed for every holding in every strategy.

ESG considerations that are material will vary by investment style, sector/industry, market trends and client objectives. Certain strategies seek to identify companies that Brown Advisory believes may have desirable ESG outcomes, but investors may differ in their views of what constitutes positive or negative ESG outcomes. As a result, certain strategies may invest in companies that do not reflect the beliefs and values of any particular investor. These strategies may also invest in companies that would otherwise be screened out of other ESG oriented funds. Security selection will be impacted by the combined focus on ESG assessments and forecasts of return and risk.

Certain Strategies intend to invest in companies with measurable ESG outcomes, as determined by Brown Advisory, and seek to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions.

Sectors are based on the Global Industry Classification Standard (GICS) sector classification system. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and Standard & Poor’s. “Global Industry Classification Standard (GICS), “GICS” and “GICS Direct” are service marks of Standard & Poor’s and MSCI. “GICS” is a trademark of MSCI and Standard & Poor’s.

An investor cannot invest directly into an index.

Global Leaders Strategy Investment Letter: August 2023

bgregorio — Mon, 14 Aug 2023 09:34:00 +0000

Global Leaders Strategy Investment Letter: August 2023 bgregorio Mon, 08/14/2023 - 05:34

Just want the PDF? Download it here >

The Hidden Trouble Within

Dear Fellow Investors,

We have fielded a number of questions over the past six months from clients and prospects about how we think about and control factor risks within the Global Leaders strategy. We discuss factor risk, some views on artificial intelligence, and our upcoming offsite in this letter. Factor risk is best described as any exposure that can explain the portfolio returns other than the individual investments, such as a “theme” or a sector. An obvious example is if one has over half their portfolio invested in consumer staples companies then the biggest driver of relative performance will likely not be the individual investments but whether or not the consumer staples sector outperforms the benchmark. In this example, the stock picking hardly matters anymore – the portfolio is predominantly a sector bet and hence has a large factor risk. This is the antithesis of what we are trying to do but nonetheless an easy trap into which we could fall as bottom-up, concentrated, stock-picking fund managers if we don’t think about our factor risk properly. We need to view the complete portfolio; it is not just a collection of 30-40 great companies. This is “The Hidden Trouble Within” – when the collection doesn’t work as a portfolio and the outcome can be attributed to – and easily replicated by – factors such as interest rates, country or industry exposures.

We have seen these factor risks play out many times. Over just the past three years we have witnessed unintended factor risks and opportunities manifest across the market due to COVID-19, meme-stocks, inflation, interest rates, the ongoing war in Ukraine, the European energy crisis, the “value-rally” in 2022, the U.S. banking crisis in 1Q23 and this is undoubtedly not an exhaustive list. As bottom-up investors, maximising idiosyncratic stock-specific risk is one of the core reasons for our weekly capital allocation meeting. We want to ensure that we are managing these opportunities and risks in balance. When we think of risk it is about losing money: supply-side from competitors stealing our precious customers, or regulators changing the rules, or overpaying for the prospect of future cash flow which does not eventuate. Our challenge is to find differentiated investments which combine at the portfolio level to limit individual factors but still produce double-digit annualised absolute returns over the long-term.

We believe that 30-40 investments give Global Leaders enough diversification to ensure that stock specific risk (i.e, risk associated with each individual investment case) is driving our outcomes – not factors. Our investment selection process follows a bottom-up, fundamental approach so we are wary of “sleepwalking into factor risk”. At the margin, the factors can be a tailwind as experienced in 2017 and 2018 or a headwind as seen in 2016 and 2022, but when we look at attribution over the past three years in the chart below it shows over 100% of the strategy’s alpha came from individual investment selection or stock-picking as the factors combined were a net negative drag. For us, the factors are basically a wash over a long horizon.

^{Source: Bloomberg. Total effect figures provided above reflect the combination of the factor return from country, currency, market, style, and industry exposures and the selection effect, and are based on the Brown Advisory Global Leaders Representative Account, and includes cash. Numbers may not total due to rounding. Performance figures may vary from actual portfolio performance, as calculations are based on end-of-day security prices and do not incorporate the actual cost basis or sale price of individual securities. The portfolio information provided is based on a Brown Advisory Global Leaders Representative Account and is provided as Supplemental Information. Please see the end of this letter for a GIPS Report, important disclosures and a complete list of terms and definitions.}

For as much as we are cognisant of factor risks, the backward-looking nature of these models – and unpredictable embedded covariance matrices – means we are careful to not over-interpret the results. The future is rarely the same as the past. We have twice seen British Sterling spike up as a factor risk on one-off non-repeatable issues: Brexit in 2016 and the mini-budget fiasco in 2022. Both “risks” faded in the models quickly; the events had already happened. By necessity these models are somewhat looking in the rear-view mirror. A key risk for any fundamental, bottom-up, low turnover, long holding period, “stock picking” investor is that all their hard work is overwhelmed by unmanaged or unintended macroeconomic factors. Ultimately our guide is to always aim for idiosyncratic stock-specific risk to be driving portfolio outcomes. As noted above, we use these models as a sense check to stop us sleep-walking into unwanted exposures and we do not see large factor risks in the portfolio today.

Quantitatively, factor risk manifests in high tracking error. The higher the tracking error then more likely the higher the embedded factor risk as that portfolio is significantly (often overwhelmingly) divergent from its benchmark in a way that can easily be replicated with relatively inexpensive factor ETFs. The stock picking no longer matters – what matters is whether the consumer staples sector outperforms or energy underperforms etc. In Global Leaders, we aim for high active share – typically approximately 90% divergence from our benchmark – but only moderate tracking error. This magnifies our stock picking. Our tracking error, since inception, has typically been in the 4-5% range which is not high for a diversified manager, let alone a concentrated one. This is due to our managing of the factors at an aggregate portfolio level and focus on idiosyncratic stock-specific risk as the primary driver of our risk and returns. We check our idiosyncratic risk every week in our capital allocation reports. We don’t like factor risk as we have no idea what these factors will do, nor when. Most importantly for us is that the horse always leads the cart. We are concentrated investors first and foremost so we are never going to buy something just to fill a “factor risk” bucket. The real risk is that the investment starts performing poorly and we get shaken out at a loss on a low conviction “risk reduction” position within a concentrated portfolio.

What About Factor Risk Within Financials?

Another interesting query has been “is our current bias to the financials and technology sectors in the strategy structural?” We don’t think so. In March we saw Visa and Mastercard moved in the GICS sector classification from technology to financials. This means we currently have close to one-third of the portfolio classified by GICS as financials. On the surface this could be a factor risk. However, we have found some completely differentiated investments and business models within our financials with investment drivers ranging from emerging market credit and insurance penetration to irreplaceable financial market infrastructure. Consequently, the correlations between our financial investments are low (aside from Mastercard and Visa) and this sector doesn’t show up as an outlier risk – notably it is well below our 5% “watch closely” level. Our technology investments range from semiconductor design and manufacturing to vertical market software and we believe these have very different long-term economic drivers and ways of capturing value which is precisely what we seek.

We are an all-sector, all-country investment strategy. That is how we think and how we measure ourselves. We don’t believe the current shape is permanent but rather an outcome of the opportunity set in the past few years. To be clear, we would love to have more investments in any diversifying business or sector but every investment must first pass all our tests, particularly valuation. We tend to think more about business models and how companies make money than sectors or countries; we believe sectors such as industrials, technology and financials are quite heterogeneous. In contrast, some consumer staples companies might have 100-year old brands but unless that brings loyalty or a price premium then the brand is irrelevant economically and the business models are startlingly similar. Consequently, the cross correlations are high as is factor risk; sectors are a blunt instrument.

As we have noted many times, our strict valuation framework using a minimum 10% weighted average cost of capital (WACC) and double-digit base case internal rate of return (IRR) hurdle-rate means we have passed over many otherwise attractive potential investments. This is especially true in the health care and consumer staples sectors over the past five years. Our ‘Ready-to-Buy’ list has a healthy set of potential investments across all sectors but investing all comes down to price. The price you pay drives so much of the final return that we remain super disciplined and happy to be patient. More recently, our view on valuations in health care has become more constructive as share prices have come down. In 2022, we invested in Coloplast, our first new health care company for three years. It is an illuminating case study.

Our weekly capital allocation process includes three parts: (1) a payoff versus probability assessment for every individual holding, (2) the integration of our behavioural rules, such as buying and selling rules, and (3) a portfolio risk analysis which includes a risk factor analysis and a focus on deferrable vs. non-deferrable revenue in the portfolio. Before making any new investment, we analyse that potential new idea’s contribution to total portfolio risk with the aim of lifting stock-specific risk. We funded our investment into Coloplast in September 2022 by trimming Microsoft. This de-risked the portfolio by lowering our sector factor risk whilst lifting our recurring revenue with the addition of Coloplast. Importantly both investments had double-digit five-year expected IRRs and high base case probability so this was not a performance trade-off. By increasing stock specific risk without trading off long-term portfolio performance we actively managed factor risk down. Interestingly we have added more to both Microsoft and Coloplast already in 2023 as the IRRs improved. We believe that our style of investing in high-quality companies in Global Leaders is permanent but the make-up of underlying sectors will likely continue to change over time.

A Few Thoughts on Artificial Intelligence

One area that we are watching closely is the emerging use cases for artificial intelligence (AI) applications and Generative AI. We think about the impact of AI by categorising into four broad groups stepping from those closest to end-users to the underlying infrastructure:

End-user Applications: This group includes companies like Adobe, Wolters Kluwer, and Intuit, which offer applications directly to consumers or businesses that could benefit enormously from embedded AI.
AI Models, including Large Language Models (LLMs): This includes the development and deployment of advanced AI models, including large language models such as ChatGPT as well as propriety or use-specific datasets such as those owned by London Stock Exchange Group.
Cloud Compute: Major cloud service providers like Microsoft Azure, Amazon Web Services(AWS), and Google Cloud play a significant role in AI infrastructure. We own Microsoft and Alphabet (who also operate multiple LLMs, but the moats appear bigger in cloud computing infrastructure).
Technical Infrastructure: This encompasses GPUs, Networking, Memory and related value chains including semiconductor equipment, which is represented by Marvell Technology, Taiwan Semiconductor and ASML in our portfolio.

It is still too early to make a clear assessment of the impact AI will have on the competitive positioning for our companies. The opportunities and risks vary wildly depending upon which group a company is in. Currently we believe the highest probabilities are in the Technical Infrastructure and semiconductor companies which typically have dominant market positions for leading node semi design, production and equipment (Marvell, Taiwan Semiconductor (TSMC) and ASML in the Global Leaders portfolio). Following closely are the Cloud data-centre companies (e.g. Microsoft's and Alphabet's data centre business within Global Leaders) which have no emergent competition and strengthened relative positions.

We expect competition to intensify as we move up the stack into AI models. LLMs have proven significantly easier to create and scale due to mastery of the Transformer technology so it is not clear who wins here nor even if these LLMs become a commodity. Those with proprietary data sets will need to harness the power of AI to deliver improved customer outcomes, without falling prey to new entrants. The Applications group has significant productivity benefits yet runs the risk of numerous new companies trying to compete or enter so has the widest distribution of potential outcomes.

We have undertaken a number of capital allocation decisions in 2023 when opportunities arose on the back of short-term volatility in share prices due to concerns around AI. The most obvious was in March when Alphabet was under pressure due to fears about the combination of Bing and ChatGPT/OpenAI into its core search profit driver. We did a full drawdown review and added. We have recently started trimming Alphabet again following a rapid approximately 50% share price rise. We also added to our investment in Microsoft in February after share price weakness. At the time, Microsoft had one of the best IRRs and higher base case probabilities in the strategy. It is our biggest investment. Lastly, we added to Marvell Technology in early January on the back of another drawdown review. All three are long-term holdings that benefit from expanding AI opportunities.

We have engaged our investigative research analyst team to better understand this emerging technology and end use cases, as well as the potential impact on the companies in our portfolio. For now, we are closely watching progress in our investments, relating to product offerings, infrastructure capex, monetisation opportunities, and most importantly new market entrants. A number of our long-term investments are clearly beneficiaries from advances in AI but some may be more exposed to risk. Global Leaders has benefitted so far from the long-term AI related investments into technology research and development (R&D) that management teams have made such as Microsoft, Marvell and Alphabet noted above, but we remain highly attentive to the developments in this dynamic landscape.

Favourite Day of the Year

Our children would no doubt disagree but our favourite day of the year is fast approaching – our annual offsite! The whole team gathers to dissect and analyse our investment processes with the aim of marginal improvements. We have found a way to get better every year. One exciting opportunity this year has come from Annie Duke’s latest book Quit.¹ Annie, a former professional poker player, discusses “quit triggers” or when to walk away; for us this could be a quantitative numerical sign we are wrong (market share loss, falling margins etc.) and thus should just exit an investment. We have trialled quit triggers in our drawdown reviews so far this year and it’s been very powerful when we buy more…but fear we could be wrong.

Quitting is part of decision-making efficiency – which for us in particular is saying no to ideas quicker. Every time we say no is an opportunity to reprioritise our time and potentially say yes to something else. Process efficiency and taming personal curiosity is amplified by reducing distractions and focusing time spent on the most likely investment candidates. Does the idea have all the moats we are looking for? If not stop now, no matter how intriguing. Is there a question over persistence of barriers to entry? If so then why take the risk – better to move on. Fail fast is a mantra from venture capital which has a corollary here. Every time we decide to persist with an activity or research it is taking up time we could have used to investigate something more promising. This opportunity cost of time is rarely tallied. In many parts of life quitting is equivalent to failure but not so when investing. Naturally curious individuals (life-learners) are often so intrigued by the possibility that an investment might work that we don’t stop to think at the outset about the probability of it working. “How might this work?” or “could this work?” dominate thinking over what is the likelihood of this working (and does it fit within our portfolio)?

Ultimately this is all part of maximising our return on time spent. Not taking the decision to quit and forging ahead with more research is a decision in itself. There are a number of intertwined behavioural biases at play which favour persistence over quitting. The first is that we value consistency highly - both in others and we like to display it ourselves – quitting looks inconsistent and potentially lacking in persistence; neither appear good. This is much discussed in Robert Cialdini’s book Influence2 and we have addressed it in prior letters. Another is the “status quo bias” whereby we tend to pursue behaviour that reaffirms prior decisions rather than switch course (and appear inconsistent). A third is the sunk cost fallacy whereby having spent so much time and effort already it implies we should continue even though there might be a better use of research time. Having started the research shouldn’t we finish it? Often the correct answer is no – it is better to fold and deal a new hand. Not being ready to make a decision on one investment idea doesn’t mean that we shouldn’t reprioritise to something more promising. A great categorisation tool here is the “too hard bucket” – sometimes it will just take too much time to work out if something fits – and even then the payoff may not be worth it. Better to get onto a clearer path – we can always come back to something if we change our minds later when new information presents itself.

There is a critical step when learning in relation to how our brains reward system works when taking in new information. Irrespective of the value of the information, every time we learn something new our brains get a dopamine kick. Dopamine is released in the brain when it is expecting a reward and this can become addictive. This is nefariously exploited by social media.3 One trigger for our brains to release dopamine (one of the four pleasure hormones) is learning.4 Learning is a new experience and dopamine plays a part in helping us retain the new information through the creation of new connections. For life-learners, understanding new things is effectively an adventure and learning can be rewarding in itself. For social media types selling advertising, the algorithms need to be tuned to keep serving up “new” information to keep our attention – with scant regard to the quality of the information presented. Our brains struggle to differentiate quality from quantity. Unfortunately, we reward all new information. Hence, we can get tricked into consuming “empty brain calories” where the information has little value. For investors endless curiosity is a distraction when attempting controlled learning and to get to decision points – our learning must be productive not a goal in itself. Learning prioritisation is difficult, but a good process can help direct both what we need to understand and when in order to make effective decisions.

^{1 Quit: The Power of Knowing When to Walk Away by Annie Duke

2 Influence: The Psychology of Persuasion by Robert Cialdini

3 The Attention Merchants: The Epic Scramble to Get Inside Our Heads by Tim Wu

4 The other “feel-good” hormones are serotonin, endorphins and oxytocin.}

Ultimately the vast majority of our investment decisions end in a “no”. We decide to not invest – or at least “not yet”. Getting to no faster will likely increase our return on time spent. Over the past five years we have invested on average in four new companies each year whilst rejecting up to ten times that amount. Getting to one more high quality yes could amplify our results. Ray Dalio has a good schematic in his book Principles5 on how to think effectively. It is OK to delve into proverbial rabbit holes along the way (we certainly go down plenty of these!) so long as we get back to complete all steps of the process and finalise a decision – and that decision might well be to quit!

Favourite Week of the Year

We are going to undertake what may well become our favourite week of the year – our inaugural Think Week this August. Think Week is our chance to find uninterrupted time to read, think and gather compounding (versus expiring) knowledge. We were inspired by Microsoft co-founder Bill Gates and our aim is to unplug and think about how we, as individuals and as a team, can be better investors. Everyone will share their thoughts with the team to be fed into our annual offsite; we are excited by what may come out of this! There are an enormous variety of books and many more research topics on participants’ reading agendas. One book Mick is reading is called A Guide to the Professional Interview⁶ which despite its prosaic title is a wealth of information for those of us whose job is to gather information by asking good questions. We meet with management teams most days and a well-constructed interview can elicit a wealth of valuable insight. The book uncovers the common pitfalls and cognitive bias we fall into when interviewing and offers techniques such as how to structure questions in order to get more accurate and reliable information. On the surface it appears to be essential reading for any investor – with any luck it will feed some ideas into our offsite as well.

As ever we are grateful for readers who stick with us to the end of our letters. We have also recently published our annual report on the impact of our investment decisions. This year we highlight the carbon intensity of the companies in the portfolio and focus in on the adoption of Science Based Targets. We shine a spotlight on impact within the financials sector and have enhanced our reporting on voting and engagement. We hope it makes for interesting reading.

Mick, Bertie and the Global Leaders Team

Download the full letter >

The Global Leaders Strategy invests in a concentrated portfolio of market-leading companies from across the globe. We believe that companies that combine exceptional outcomes for their customers with strong leadership can generate high and sustainable returns on invested capital (ROIC) which can lead to outstanding shareholder returns.

Disclosures

Past performance may not be a reliable guide to future performance and investors may not get back the amount invested. All investments involve risk. The value of the investment and the income from it will vary. There is no guarantee that the initial investment will be returned.

^{The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.}

^{ESG considerations are one of multiple informational inputs into the investment process, alongside data on traditional financial factors, and so are not the sole driver of decision-making. ESG analysis may not be performed for every holding in the strategy. ESG considerations that are material will vary by investment style, sector/industry, market trends and client objectives. The strategy seeks to identify companies that it believes may have desirable ESG outcomes, but investors may differ in their views of what constitutes positive or negative ESG outcomes. As a result, the strategy may invest in companies that do not reflect the beliefs and values of any particular investor. The strategy may also invest in companies that would otherwise be screened out of other ESG oriented funds. Security selection will be impacted by the combined focus on ESG assessments and forecasts of return and risk. The strategy intends to invest in companies with measurable ESG outcomes, as determined by Brown Advisory, and seeks to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.}

^{Bloomberg is a trademark and service mark of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. Any other trademarks or service marks are property of their respective owners. The MSCI ACWI® Index (All Country World Index), MSCI’s flagship global equity index, is designed to represent performance of the full opportunity set of large- and mid-cap stocks across developed and emerging markets. As of May 2022, it covers more than 2,933 constituents across 11 sectors and approximately 85% of the free float-adjusted market capitalization in each market. All MSCI indexes and products are trademarks and service marks of MSCI or its subsidiaries.}

^{RoIC is a measure of determining a company’s financial performance. It is calculated as NOPAT/IC; where NOPAT (net operating profit after tax) is (EBIT + Operating Leases Due 1-Yr)*(1-Cash Tax Rate) and IC (invested capital) is Total Debt + Total Equity + Total Unfunded Pension + (Operating Leases Due 1-Yr * 8) – Excess Cash. ROIC calculations presented use LFY (last fiscal year) and exclude financial services.}

^{The internal rate of return (IRR) is a measure of an investment’s rate of return. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. It is also called the discounted cash flow rate of return.}

^{Tracking Error is the standard deviation of the difference in the portfolio and benchmark returns Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a portfolio and compares its risk-adjusted performance to a benchmark index.}

^{Annualized Return is the geometric average amount of money earned by an investment each year over a given time period. It is calculated as a geometric average to show what an investor would earn over a period of time if the annual return was compounded.}

^{Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a portfolio and compares its risk-adjusted performance to a benchmark index.}

^{Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index.}

^{Weighted Average Cost of Capital (WACC) presents a firm's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. WACC is the average rate a company expects to pay to finance its assets.}

^{Factor Return is the return attributable to a particular common factor. We decompose asset returns into common factor components, based on the asset's exposures to common factors times the factor returns, and a specific return.}

^{Selection Effect measures the effect of choosing securities that may or may not outperform those of the benchmark.}

^{Active Share indicates how different the portfolio is from its benchmark. Calculated as the sum of each security's absolute weight difference.}^{**Return is for period May 1, 2015 through December 31, 2015}

^{Brown Advisory Institutional claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Brown Advisory Institutional has been independently verified for the periods from January 1, 1993 through December 31, 2022. The Verification reports are available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance on the accuracy of any specific performance report. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.}

^{1. *For the purpose of complying with the GIPS standards, the firm is defined as Brown Advisory Institutional, the Institutional and Balanced Institutional asset management divisions of Brown Advisory. As of July 1, 2016, the firm was redefined to exclude the Brown Advisory Private Client division, due to an evolution of the three distinct business lines.}

^{2. The Global Leaders Composite (the Composite) aims to achieve capital appreciation by investing primarily in global equities. The strategy will invest in equity securities of companies that the portfolio manager believes are leaders within their industry or country, as demonstrated by an ability to deliver high relative return on invested capital over time. The minimum account market value required for Composite inclusion is $1.5 million.}

^{3. The Composite creation date is August 26, 2015. The Composite inception date is May 1, 2015.}

^{4. The benchmark is the MSCI ACWI Net Index. The MSCI ACWI Net Index captures large and mid cap representation across Developed Markets (DM) and Emerging Markets (EM) countries. The Index covers approximately 85% of the global investable equity opportunity set. All MSCI indexes and products are trademarks and service marks of MSCI or its subsidiaries. An investor cannot invest directly into an index. Benchmark returns are not covered by the report of the independent verifiers.

5. As of September 1, 2022, the Composite benchmark was changed from the FTSE All-World Net Index to the MSCI ACWI Net Index. The change was applied retroactively from the Composite inception date. The Advisor determined that MSCI indices are more widely used for global products, and thereby provide more relevant data to shareholders and prospects as well as comparisons to competitors.

6. Composite dispersion is an equal-weighted standard deviation of portfolio gross returns calculated for the accounts in the Composite for the entire calendar year period. The composite dispersion is not applicable (N/A) for periods where there were five or fewer accounts in the Composite for the entire period.

7. Gross-of-fees performance returns are presented before management fees but after all trading commissions, and gross of foreign withholding taxes (if applicable). Net-of-fees performance returns are calculated by adjusting the gross-of-fees performance return by the highest fee for the institutional strategy as outlined in Part 2A of the firm’s Form ADV, applied on a monthly basis. Certain accounts in the Composite may pay asset-based custody fees that include commissions. For these accounts, gross returns are also net of custody fees. Other expenses can reduce returns to investors. The standard management fee schedule is as follows: 0.80% on the first $50 million; 0.55% on the next $50 million; 0.45% on the next $50 million; and 0.40% on the balance over $150 million. Further information regarding investment advisory fees is described in Part 2A of the firm’s Form ADV. Actual fees paid by accounts in the Composite may differ from the current fee schedule.

8. Effective July 1, 2023, the firm transitioned from using actual account fees in the calculation of net performance returns to applying the highest fee for the institutional strategy as outlined in Part 2A of the firm’s Form ADV. The net performance track record was revised back to Composite inception.}

^{9. The investment management fee for the Investor Shares of the Brown Advisory Global Leaders Fund (the Fund), which is included in the Composite, is 0.65%, and represents the highest fee charged excluding Advisor Shares. The total expense ratio for the Investor Shares of the Fund as of the most recent fiscal year end (June 30, 2022) was 0.90%. Further information regarding investment management fees and expenses is described in the fund prospectus and annual report.

10. The investment management fee for the Dollar Class B Acc Shares of the Brown Advisory Global Leaders Fund (the UCITS), which is included in the composite, is 0.75%. The total expense ratio for the Dollar Class B Acc Shares of the UCITS as of the most recent fiscal year end (October 31, 2022) was 0.87%. Further information regarding investment management fees and expenses is described in the fund prospectus and annual report.

11. The three-year annualized ex-post standard deviation measures the variability of the Composite (using gross returns) and the benchmark for the 36-month period ended on December 31. The 3 year annualized standard deviation is not presented as of December 31, 2015, December 31, 2016 and December 31, 2017 because the 36 month returns were not available for the Composite (N/A).

12. Valuations and performance returns are computed and stated in U.S. Dollars. All returns reflect the reinvestment of income and other earnings.

13. A complete list of composite descriptions and broad distribution and limited distribution pooled funds is available upon request.

14. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request.

15. Past performance is not indicative of future results.

16. This is not an offer to sell securities. That may only be accomplished by the issuance of a private offering memorandum/subscription documents.

17. This piece is provided for informational purposes only and should not be construed as a research report, a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell or hold any of the securities mentioned, including any mutual fund managed by Brown Advisory.}

The Equity Beat: Old Economy Stocks Aging Like Fine Wine

mhannan — Fri, 11 Aug 2023 21:10:27 +0000

The Equity Beat: Old Economy Stocks Aging Like Fine Wine mhannan Fri, 08/11/2023 - 17:10

Unlike my good friends who frequent Baltimore’s finest dining establishments about as often as the division-leading Orioles win (you know who you are), I would never be confused for a wine connoisseur. Yet through osmosis I’ve learned that aging affords some wines time to become smoother and mellower, developing a fuller flavor as the months and years pass.

While the majority of wine lovers would shudder at the comparison of a mature half bottle of sweet Sauternes and International Paper, I shall attempt to make the connection. Most investors have been laser focused on generative AI and the Sensational Seven this year. However, over the past two months it’s been the old economy stocks leading the market. Old economy refers to industries that have not changed significantly despite advances in technology – subsectors like steel, agriculture and manufacturing come to mind, but for inclusivity let’s broaden the definition out to the industrials and materials sectors.

Source: FactSet. Data as of July 30, 202. Sectors are based on the Global Industry Classification Standard (GICS) classification system.

If we go back 50 or so years, corporate giants like General Motors, Ford and General Electric were among the very largest in the world by market capitalization. Today, it is challenging to find an industrials or materials company among the top 35 constituents in the S&P 500® Index by weight – the largest today is Linde plc, a global industrial gas producer (held in some of our sustainable strategies) that is not a household name. Still, the combined weight of industrials and materials stocks in the S&P 500 Index remains formidable at 11% - nearly as large as the oft-discussed consumer discretionary sector.

As resilient as the US consumer has been during this rate hiking cycle that may have reached its climax, US manufacturing activity according to the Institute of Supply Mangers (Purchasing Managers Index) has continued to contract, with a reading below 50 since last October. June’s reading of 46 indicated the fastest rate of contraction in the manufacturing sector since May 2020, while July’s reading of 46.4 was only marginally better. Demand remains weak as the economy continues to shift away from goods and towards services, yet very low customer inventory levels indicate the period of destocking could be concluding, a potential positive for future production should demand start to percolate.

Historically, cyclical stocks will begin to climb a couple of months in advance of any significant rise in earnings expectations. As shown below, we haven’t seen much of an inflection yet in estimates for these two sectors (consistent with the ISM data). However, it’s worth pursuing what companies from the old economy are saying thus far this earnings season in order to gauge whether positive earnings revisions are on the horizon, perhaps supportive of a further broadening of stock market leadership.

Source: FactSet. Data as of July 30, 2023

Below, we highlight earnings call comments from a handful of old economy companies in recent weeks. You’ll note the tone of these excerpts run the gamut – some suggest the bottom is upon us or even behind us; others suggest a recovery is truly a world away. It’s challenging to generalize “old economy” with just one face and name, although the equity market tends to do just that. After all, while the Sensational Seven compete with each other in pockets, they are all different business models. Time will tell whether the perception of an improving backdrop for old economy sectors will persist, but for now, the stocks in these areas, much like an aged, rare Madeira are getting better with time.

Ticker	% Return (June-July)	Comment
ODFL	35%	“We’re at the end of a long, slow cycle.”
NUE	31%	“Positive trends continue in the automotive and energy sectors.”
FCX	30%	“…growing intensity in autos, renewables and data centers.”
IP	22%	“We believe that destocking is finally coming to a close.”
JBHT	22%	“We saw evidence from customers in June that destocking has moderated.”
CCK	22%	“Europe – the core consumer is exceptionally weak…stretched to make ends meet.”
SHW	21%	“Some positive signs in new residential construction indicate we may have reached bottom.”
UNP	21%	“Automotive – we expect growth to continue driven by strong OEM production.”
FTV	20%	“Healthcare – industry recovery is on track as labor and productivity challenges moderate.”
MMM	19%	“Ongoing weakness in electronics, soft discretionary retail spend patterns and mixed industrial.”
BA	16%	“Broadly (in aerospace), demand is strong and resilient.”
DOW	16%	“Third, fourth quarters are going to be the low point and then we start to ramp back.”
AVY	15%	“The period of challenging results will soon pass…inventory destocking (is) moderating.”
IEX	14%	“Key customers…are considering lower growth in China and overall macro pressures.”
GWW	14%	“Pockets of softness, including decelerating growth in manufacturing and commercial services.”
GE	13%	“Looking at the (aerospace) market, departures have almost returned to pre-COVID levels.”
LIN	11%	“We are seeing some economies (China, EMEA) stagnate or start to soften.”
PPG	10%	“We expect global industrial production to remain at lower levels in 3q.”
FAST	9%	“PMI has always been a good indicator…suggesting the back half is going to be weak.”
CSX	9%	“We look for destocking activity to wind down…though timing remains uncertain.”
SNI	8%	“We’re now assuming the economic recovery is pushed into 2024.”
WM	2%	“Customers seem to be taking a more cautious wait-and-see approach regarding large jobs.”
HON	1%	“Our aerospace business continues to perform at a very high level.”
RTX	-5%	“Global commercial air traffic remains on track…very robust summer travel season.”

Thanks for reading, and remember to never skip a Beat - Eric

Global Sustainable Total Return Bond Strategy: Reporting on the impact of our investment decisions 2022

bgregorio — Thu, 03 Aug 2023 13:16:42 +0000

Global Sustainable Total Return Bond Strategy: Reporting on the impact of our investment decisions 2022 bgregorio Thu, 08/03/2023 - 09:16

Download the Report

A Letter of Introduction From The Portfolio Managers

Our 2022 impact report builds on our commitment to measuring, documenting and communicating the outcomes that our strategy produces for our clients. We firmly believe that there does not have to be a trade-off between strong performance and smart investments that help address global sustainability challenges.

The report includes a review of how we conduct and use ESG research to drive returns, and how we think the investments in our portfolio are helping to create positive environmental and social outcomes. We also discuss how we engage with issuers—sometimes for ESG due diligence, sometimes for impact and other times in an advisory capacity with issuers seeking guidance or feedback on structuring labeled bond offerings. Further, we discuss our participation in the broader sustainable investing community; collaboration helps us enhance our knowledge, and provides us the opportunity to help maintain positive and credible momentum in this space alongside many other stakeholders.

While the availability of ESG data across various asset types in fixed income is improving over time, the quality and standardisation of data continues to be a challenge. Despite this, since the inception of this strategy in 2022, we have been dedicated to assessing material ESG risks and sustainable opportunities within every investment we consider. To help our clients better understand how we integrate ESG and how that manifests itself across all fixed income sectors, this year, we published a focused, fixed income supplement to our firm’s institutional sustainable investment policy.

This year, we also added additional sector expertise to our ESG and fundamental research teams, to support our growing global sustainable fixed income platform. As always, we thank our teammates for their continued collaboration and tireless efforts to ensure that our investment decisions are informed by trustworthy data and analysis.

It has been incredibly rewarding to see the evolution in sustainable fixed income, and much has changed in this space since Brown Advisory launched our first strategies nearly a decade ago. We have seen firsthand how global crises have shone a bright spotlight on sustainable investing, revealing both positives and negatives about how it is broadly practiced. Despite regional differences in its implementation and regulatory scrutiny that has accompanied the recent rise of sustainable investing, the demand for investments that are augmented with ESG research continues to grow. We think this is at least in part due to growing awareness that public-market capital needs to be aligned to address the massive sustainability challenges the world faces today.

Despite the rapid changes occurring within this space, we have not altered our investment process, and we remain committed to our focus on both performance and impact. We hope you find this report informative and we welcome a conversation with you about the work we are doing.

Sincerely,

Chris Diaz, CFA
Portfolio Manager

Ryan Myerberg
Portfolio Manager

Colby Stilson
Portfolio Manager

^{*Brown Advisory entities included are: Brown Advisory LLC, Brown Investment Advisory & Trust Company, Brown Advisory Ltd., and Brown Advisory Trust Company of Delaware, LLC.}

The Equity Beat: Would ‘AI’ By Any Other Name Smell As Sweet?

bgregorio — Wed, 19 Jul 2023 17:41:13 +0000

The Equity Beat: Would ‘AI’ By Any Other Name Smell As Sweet? bgregorio Wed, 07/19/2023 - 13:41

The famous adage from arguably Shakespeare’s most popular play is the backdrop of our journey this month. Juliet, of the House of Capulet, falls in love with Romeo, a member of the House of Montague, with which the Capulets have a blood feud. Juliet’s profound proclamation that Romeo’s name is just a label suggests the importance of a person or thing is the way it is; not because of what it is called.

As we transition naturally from classical poetry of the late 16th century to equity markets circa 2023, one might question the logic of the tragic heroine. After all, Artificial Intelligence (AI) has become this year’s most prominent catchphrase. While generative AI differs from traditional AI (the former is used to produce new content; the latter is used to simply detect patterns), this important distinction be damned! It’s the phrase ‘AI’ that seems to matter most to both companies and investors today.

Source: FactSet as of July 10, 2023

This is not the first time in which companies have been lured by a popular buzzword or catchphrase to capture the imagination of their investor base. In 2001, a group of authors affiliated with Purdue University’s Krannert School of Management published a study[1] that documented the striking positive stock price reaction to the announcement of corporate name changes during the “dot-com” boom of the late 1990s. The authors found that during a period from mid-1998 through mid-1999, companies that changed their name to a ‘dot-com’ moniker earned “significant abnormal returns on the order of 53% for the five days around the announcement date.” A rose by any other name? Not by a longshot.

They also determined that this price reaction was similar across all companies, regardless of their actual involvement with the Internet. A mere association with the term 'Internet' was enough to provide a firm with a large value increase. Of course, the dot-com bubble burst in the early 2000s... when stocks of companies that transitioned their names AWAY from the Internet began to benefit!

While the broad use of the term ‘AI’ has occurred across many sectors during recent earnings calls (including the industrials sector, according to FactSet, 17 S&P 500® Index companies uttered the phrase last quarter) we were able to closely analyze the largest dozen information technology companies. We broadened the catchphrase to also incorporate graphic processing units (‘GPUs’) and large language models (‘LLMs’), which are also key related buzzwords. In the chart below, you’ll see that the majority of these large-cap tech companies were generous in their use of these terms on their calls.

Source: FactSet as of July 10, 2023. Please see the end of this letter for company names.

With Purdue University's study in mind, we wanted to examine whether there was much if any correlation between year-to-date stock price performance and the frequency of these buzzwords in the most recent earnings transcripts of these large technology companies. The findings are statistically relevant – the more times AI was mentioned on a company earnings call, the higher the stock has risen this year. I should note that we left Apple (AAPL) out of the chart below as it continues to march to the beat of its own drum – AI-influenced or not. I’m sorry, dear Juliet, but on the surface 2023, much like the dot-com era, appears to be a period where mere association matters more than "truth and substance".

Note: Performance as of July 5
Source: FactSet

While the scatterplot displayed above presents compelling evidence, it doesn’t paint the whole picture. Perhaps the companies that frequently discuss AI in their earnings calls, and have experienced significant stock price appreciation, are also effectively convincing analysts that there will be a corresponding increase in demand for their products and services in the years ahead. Surely, NVIDIA (NVDA) is the big winner this year because of the remarkable upward revenue guidance it has provided for the next several quarters. However, very few companies have been explicit as to the magnitude of accelerated revenue they expect to generate as a function of generative AI.

The chart above confirms that a handful of large cap tech companies have seen an increase in 2024 consensus revenue estimates this year. However, just as many have seen their consensus revenue estimates for 2024 decline this year despite the excitement around generative AI. Advanced Micro Devices (AMD) – which we do not cover/own – has seen its forward revenue estimate decline by a sizeable 5% this year, yet the stock has climbed 75% YTD. While AMD will likely continue to attempt to compete with NVDA’s GPUs, AMD’s stock run rhymes with the “dot-com” effect - driven by mere association.

We are still in the very early innings of a technological advancement that has driven equity market returns this year, where early winners have seemingly already been crowned. Similar to prior periods of market hype, buzzwords and speculation should eventually give way to “truth and substance” – and in the end Juliet’s rose adage will likely prove accurate. Call NVDA by any other name, and it is still in the catbird seat to capture its fair share of data center infrastructure spend in the years to come as a result of ChatGPT’s success and the imaginations it has captured. Other companies – some within the technology sector and others outside – are parroting a catchphrase that may sputter in relevance. “Out, out brief candle!”

Thanks for reading, and remember to never skip a beat – Eric

Global Leaders Strategy: Reporting on the impact of our investment decisions 2022

bgregorio — Mon, 17 Jul 2023 10:59:08 +0000

Global Leaders Strategy: Reporting on the impact of our investment decisions 2022 bgregorio Mon, 07/17/2023 - 06:59

Download the Report

A Letter of Introduction From The Portfolio Managers

Welcome to our 2022 Impact report. We aim to improve the report every year and have added sections on our significant votes and most impactful ESG engagements. Given the priority we place on quality in the portfolio, there are very few items in either category but we believe that it is nonetheless useful to see. Almost all our companies are now working towards adoption of science-based targets, and we have engaged with the remaining ones on their pathway. The portfolio’s carbon intensity is quite low, as detailed in last year’s report and this one.

We are long-term investors with our capital invested alongside yours. Our average investment is held for approximately eight years. We have a long-term investment horizon that requires us to incorporate all risks and opportunities—both ESG and fundamental–into our holistic research in order to maximize long-term investment returns. The longer the timeframe, the more that ESG matters, in our view.

All our research starts with the customer – what problem the company is solving and why this will create value over the next five years. For us, it makes good business sense to do good and make a social statement. The best companies we see are using either environmental or social outcomes for customers to compound their competitive advantages and to drive business outcomes – we call these their Sustainable Business Advantage (SBA) drivers. In our view, the SBA drivers differentiate the companies we invest in from their rivals and their clients often pay more for their products as they are creating intangible value beyond the input costs. This is not virtue signalling – money talks! One of our favourite quotes from customer surveys is “it is not cheap but it’s good value.” This gets to the heart of how SBA drivers can lead to long-term returns and we can see it in the numbers. The corollary of ESG risks is obvious.

We remain enthusiastic about the increasing adoption, from the companies in our portfolio, of Science-based Targets (SBTs) and use of sustainability policies to work towards solutions to current environmental and climate challenges. Our strategy’s primary goal is first and foremost to deliver investment returns and this is our guiding fiduciary responsibility – but not at any cost to earth and our societies. We are deeply committed to sustainable investing. As described above, we seek companies that use sustainability in a positive way to drive business outcomes and identify them using our proprietary SBA framework. In our view, this results in a win for customers, a win for the environment and society and ultimately, a win for shareholders. We also consider ESG risk and any potential downside to our investments from negative actions.

We would like to take this opportunity to address any concerns about the recent “ESG backlash” we have witnessed in some geographies – this is an understandable concern. As global investors, we are very conscious of the range of views on many topics, including ESG, and how these differ across countries, regions and continents. We believe our common sense approach to investing, alongside thinking holistically about sustainable opportunities and ESG risks, sets us up for long-term investment performance. We have written in detail in the past about our thinking on this subject and very little has changed. As a concentrated global investment strategy we set very high standards for our investments – afterall, we have the widest possible universe to select from and can afford to be picky. While there is some “noise” on ESG in some markets, we don’t believe that lowering our standards as a result of this is a good idea.

We are very fortunate to benefit from Brown Advisory’s in-house Sustainable Investing team. They helped us define SBA and support us with primary ESG research. The good news is that this team continues to grow. Building this expertise internally gives us huge value add – just as we would never outsource investment selection to a sell-side broker, we don’t outsource ESG research or ratings to third party providers either. Afterall, a large part of what we do is subjective – alpha generation does not come from a template.

This team also challenges us to think through new developments in the world of sustainability – a constantly evolving space. We have worked with the team to integrate additional concepts into our work, such as Net Zero Asset Managers (NZAM) targets and introductory work on evaluating Scope 3 emissions. We thank them and the entire equity research team at Brown Advisory for their efforts!

Thanks for taking the time to read this report. We hope you enjoy it and look forward to any feedback that will help us improve it going forward.

Mick Dillon, CFA
Portfolio Manager

Bertie Thomson, CFA
Portfolio Manager

^{*Brown Advisory entities included are: Brown Advisory LLC, Brown Investment Advisory & Trust Company, Brown Advisory Ltd., and Brown Advisory Trust Company of Delaware, LLC.}

CIO Perspectives: A New Bull Market? Markets shaking off a long list of concerns

mhannan — Wed, 21 Jun 2023 17:34:56 +0000

CIO Perspectives: A New Bull Market? Markets shaking off a long list of concerns mhannan Wed, 06/21/2023 - 13:34

The economy shakes, but the market shrugs. The team discusses how the market is currently climbing an especially daunting wall of worry, and how investors are shrugging off multiple examples of geopolitical and financial concerns around the world.

When macro conditions are uncertain, a banker’s approach to valuation can help. David, a former investment banker, has always brought a banker’s mentality to valuing smaller companies by breaking down their assets and operations into components that can be more accurately assessed. He offers examples to show how this approach can be especially helpful when markets are behaving in surprising ways.

Other topics: The team also discusses how small caps are currently valued at historically low levels and what might cause their fortunes to turn; how bearish sentiment around the state of the U.S. consumer may open up investment opportunities; and how the work-at-home movement continues to impact the commercial real estate market.

As always, we welcome your thoughts, feedback and questions.

The Equity Beat: Yes, Virginia, This is a Bull Market

Is it time to pop open the champagne? Perhaps. We'll see, but you can hear what Eric Gordon thinks about this current trend in his latest Equity Beat blog post. Read more >

2023 Asset Allocation Perspectives and Outlook

We are pleased to share Brown Advisory’s 2023 Outlook. Each year, the Annual Outlook report assesses the current investment landscape and discusses some of the main themes being expressed in client portfolios. Read more >

Alternative Investments may be available for Qualified Purchasers and/or Accredited Investors only.

An investor cannot invest directly into an index.

The Equity Beat: Yes, Virginia, This Is A Bull Market

bgregorio — Wed, 14 Jun 2023 15:34:41 +0000

The Equity Beat: Yes, Virginia, This Is A Bull Market bgregorio Wed, 06/14/2023 - 11:34

It’s time to pop open the champagne! Despite a heavy dose of pessimism among industry experts throughout 2023, the S&P 500® Index is in fact in bull market territory. As of the end of last week (June 9^th), the broad Index has risen 20% since its most recent trough on October 12, 2022 in the face of several factors that on the surface might appear counterintuitive to a bull market. To borrow from the New York Sun’s famous 1897 editorial exclaiming the bona fide presence of Santa Claus, “Virginia, your little friends are wrong. They have been affected by the skepticism of a skeptical age.”

^{Source: Apple TV+}

We no doubt continue to live in a skeptical age (with the possible exception of the hype surrounding generative AI); but with good reason. Over the past few months the US has experienced three sizable regional bank failures, bi-partisan negotiations that extended to the 11^th hour in order to prevent a default on US government debt, mixed economic data pushing down earnings expectations and inflation levels that remain well above the Fed’s target. With this imbroglio of a backdrop, only 35% of the S&P 500’s constituents have outperformed the Index since the market trough last October.

This last point may not be terribly surprising, given the media’s rapt attention placed upon the Sensational Seven (AAPL, MSFT, AMZN, GOOG, NVDA, META and TSLA have combined to account for the entirety of the market’s positive return year-to-date). However, at least as measured since the market trough in October, the period of outperformance among these mega-cap tech-oriented companies was largely concentrated in the March through May timeframe. The combination of investor fear surrounding the uncertainty of the early March regional bank crisis and the late May debt ceiling negotiations, combined with NVDA’s impressive evidence of highly accelerated investment in generative AI, created an ocean-wide gap in performance among the haves and have nots. We’ve rarely seen a three-month stretch so heavily dominated by just a handful of companies, leading to the Russell 1000® Growth Index demolishing the Russell 2000® Value Index from March to May in similar fashion to Novak Djokovic’s drubbing of Carlos Alcaraz on his way to a record 23^rd Grand Slam victory at the French Open this month.

Source: FactSet Data as of 06/12/2023

During the pronounced March – May period, only 21% of S&P 500 constituents beat the Index – that’s about as narrow as market leadership gets. The breakdown of the average characteristics of Index outperformers and underperformers during this period are shown below, demonstrating how larger, higher multiple and higher growth entities were in vogue during these three months.

Source: FactSet Data as of 06/12/2023

Our own research analysts have taken these recent trends into consideration when adjusting their internal stock ratings thus far in 2Q. Since the beginning of April, our team has upgraded close to 15 names while downgrading nearly 20. Below, we present the difference in characteristics (on average) among the stocks that have been upgraded relative to those downgraded.

Source: FactSet Data as of 06/12/2023

Clearly, in recent weeks our team has been favoring the smaller, less expensive stocks that have been underperforming based on this set of data. That said, during a recent team research meeting, our analysts who cover the Sensational Seven stocks (excluding TSLA which we don’t own) were not inclined in an absolute sense to trim positions in those names given their favorable longer-term characteristics and return profiles.

It’s a tricky moment for investors as we approach the early summer lull (most companies are in a “quiet period” and the flow of earnings reports has declined to just a trickle). Earnings season for 1Q (March-quarter end) was generally better than expected, however commentary from April quarter-end companies across retail spoke of a deteriorating consumer spending environment in April and into May in many cases. At the same time, market leadership thus far in June (since the effective end of the debt ceiling drama) has shown a broader trend with the Russell 2000 Value Index substantially outperforming the Russell 1000 Growth Index.

Time will tell whether the next 5-10% move from roughly 4,300 on the S&P 500 Index will be up or down, but in the meantime, let’s celebrate a bull market that has surprised a large population of incredulous investors so far this year!

Thanks for reading, and remember to never skip a Beat - Eric

Factset® is a registered trademark of Factset Research Systems, Inc

Terms and Definitions:

Sensational Seven Stocks: Apple Inc. (AAPL), Microsoft Corp. (MSFT), Amazon.com, Inc. (AMZN), Alphabet Inc. (GOOG), Nvidia Corp. (NVDA), Meta Platforms Inc. (META) and Tesla Inc. (TSLA)

The S&P 500® Index is an unmanaged index consisting of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value.

Standard & Poor’s, S&P®, and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”), a subsidiary of S&P Global Inc.

The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.

The Russell 2000® Value Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.

Next Twelve Months P/E Ratio: The sum of a company's price-to-earnings, calculated by taking the current stock price and dividing it by the projected earnings per share for the next 12 months.

Long Term Earnings Per Share Compound Annual Growth Rate ( LT EPS CAGR), summarizes stock analysts' estimates for how quickly a company will grow its earnings per share. The mean annual growth rate of an investment over a specified period of time longer than one year. It represents one of the most accurate ways to calculate and determine returns for individual assets, investment portfolios, and anything that can rise or fall in value over time.

Free Cash Flow Yield is a measure of financial performance calculated as operating cash flow minus capital expenditures divided by its market value per share. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt

Market Capitalization is the value of the fund as determined by the market price of its issued and outstanding stock. The Weighted Average Market Capitalization of a portfolio equals the average of each holding's market cap, weighted by its relative position size in the portfolio (in such a weighting scheme, larger positions have a greater influence on the calculation).

Tax-Exempt Sustainable Fixed Income Strategy: Reporting on the impact of our investment decisions 2022

bgregorio — Mon, 05 Jun 2023 09:22:52 +0000

Tax-Exempt Sustainable Fixed Income Strategy: Reporting on the impact of our investment decisions 2022 bgregorio Mon, 06/05/2023 - 05:22

A Letter of Introduction From The Portfolio Managers

The report includes a review of how we conduct and use ESG research to drive returns and how the investments in our portfolio are helping to create positive environmental and social outcomes. We also discuss how we engage with issuers—sometimes for ESG due diligence, sometimes for impact and other times in an advisory capacity with issuers seeking guidance or feedback on structuring labeled bond offerings. Further, we discuss our participation in the broader sustainable investing community; collaboration helps us enhance our knowledge and provides us the opportunity to help maintain positive and credible momentum in this space alongside many other stakeholders.

While availability of ESG data across various asset types in fixed income is improving over time, quality and standardization of data continues to be a challenge. Despite this, since the inception of this strategy in 2014, we have been dedicated to assessing material ESG risks and sustainable opportunities within every investment we consider. To help our clients better understand how we integrate ESG and how that manifests itself across all fixed income sectors, we published a focused fixed income supplement to our firm’s institutional sustainable investment policy last year.

We have also added additional sector expertise to our ESG and fundamental research teams to support our growing global sustainable fixed income platform. As always, we thank our teammates for their continued collaboration and tireless efforts to ensure that our investment decisions are informed by trustworthy data and analysis.

It has been incredibly rewarding to see the evolution in sustainable fixed income, and a lot has changed in this space since we launched our first strategies nearly a decade ago. We have seen firsthand how global crises have shone a bright spotlight on sustainable investing, revealing both positives and negatives about how it is broadly practiced. Despite the political polarization and regulatory scrutiny that has accompanied SI’s recent rise, the demand for investments that are augmented with ESG and impact research continues to grow. We think this is at least in part due to growing awareness that public-market capital
needs to be aligned to address the massive sustainability challenges the world faces today.

Despite the rapid changes occurring within this space, we have not altered our investment process, and we remain committed to our focus on both performance and impact. We hope you find this report informative, and we welcome a conversation with you about the work
we are doing.

Sincerely,

Amy Hauter, CFA
Portfolio Manager

Stephen Shutz, CFA
Portfolio Manager

*Brown Advisory entities included are: Brown Advisory LLC, Brown Investment Advisory & Trust Company, Brown Advisory Ltd., and Brown Advisory Trust Company of Delaware, LLC.

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