The accelerated pace of technology means disruptive innovation is affecting every sector of the economy. Kim Parlee talks with Bill Priest, CEO and Co-Chief Investment Officer, Epoch Investment Partners, with over $60 billion dollars in assets under management, about how they’re investing in companies that are using digital strategy to transform their businesses.
Tonight's show, we are taking a deep dive into innovation disruption and how it's affecting virtually all sectors of the economy, and how investors should be looking at disruption, not just from a technology and sector standpoint, but what it also means for the asset management industry.
But before that we're also talking about US President Donald Trump, who is looking to make good on a campaign promise for major tax cuts.
We are joined for the entire show by Bill Priest. He is co-CIO of EPOCH Investment Partners and CEO of EPOCH Investment Partners. It is great to have you back.
Pleasure to be here again.
And we're lucky to have you, as I said, for the whole show. So we don't have to rush through anything, which is really nice.
One thing, because we've had you on quite a bit in the past little while. Tell people the story fresh, if they haven't seen before, EPOCH's main principle I would say in terms of how you invest fundamentally. You're all about cash.
We are all about cash. You can't run a business unless you generate cash. And it's the ability to measure that generation of cash, and more importantly to allocate that cash. There are only five things you can do with a dollar of cash if you run a business. You can pay a dividend, buy back stock, pay down debt, make an acquisition, or reinvest in your business. So you want to find those companies who are good capital allocators, because they will grow value faster than ones who are poor.
Yeah. And if people want to hear more about that I will tell you, just go onto our website. We've got tons of interviews with Bill, who talks in a little more detail on that.
We're shifting, though, I'd say, a little more in terms of things that are a little more timely in terms of what's happening in the States right now. But also talk a great deal about innovation and what's coming.
There's three factors I understand you think that are having impact on where markets are headed. You've got interest rates, growth rates, and valuations, which we'll talk about. But also before that in a less fundamental basis we've got Mr. Trump-- President Trump, excuse me-- tax reform, also fiscal spending. Do you expect anything to actually happen out of this administration right now, or is it just all talk and it's not going to amount to anything?
Well, I think there will be an attempt to do something with respect to taxes. But a big move I think will be difficult. Partly because there's a principle of this revenue neutrality argument, that if we get a big tax cut today and we have a big deficit, but down the road you have to see that deficit is made up somehow, either through additional taxes or growth.
There's a group of people that think you can use something called dynamic scoring. I think it's highly suspect. But essentially what it means is if the government spends $1 on something, down the road it will generate $1.20 or $1.50, and it kind of pays for itself.
So you will hear more about this. I don't think it holds a lot of water, personally. But I think because of this particularly large bloc of Republicans that want revenue neutrality it's going to be hard to get anything big done.
But I do think you'll get some things done. I think it's highly likely that there'll be a way in which corporations can bring back the cash that's offshore.
Which that in itself is huge.
It's a big number. It's $2 and 1/2 trillion, or something of that nature.
There may be an attempt to tie that to you can bring it back if you build a plant. I think that's silly, that you shouldn't tie it that way. I don't think it will work because you only build a plant if there's demand for what you make or a service.
But I do think there will be something there. I think you also have a chance at getting the corporate tax rate down a little bit, somewhere between 100, maybe 300 basis points, which is significant.
It's significant, but a far cry from what was said, I think, when he won. And we saw the markets react.
Correct. But it's possible. I think the only way you can make that up is to close some loopholes.
So one of the things I think he'd like to do is get rid of carried interest. It affects hedge funds and some private equities.
You also have the proposal to do away with the deduction of state and local taxes when you calculate your federal return. If you did that, that's a fairly significant tax increase for the upper 20%.
So there are some loopholes that can be closed. And I think they'll get something. But I tend to think it will be of a modest nature. But it will be positive.
- Well, it's positive that it's positive again. But you're saying it's going to be not a big move.
Let's shift more into, I say, the more fundamental issues in terms of where the market's headed right now. Interest rates.
Well, interest rates, my own view is that it's going to be lower for longer. We've been saying that for a long time.
The Fed can really control short rates. They have a huge influence on short rates. Long rates kind of listen to their own drummer. And the outlook for long rates is really tied to inflation. And inflation is likely to be very, very modest. Unless inflation weaves its way into labor and to wages, it's really hard to see a lot of inflation.
And I don't think you're going to see much of that. First of all, real growth is going to be modest. Real growth is real GDP. It's just a function of two things. It's growth in a workforce and growth in productivity.
And productivity right now, what I call measured productivity, is running around zero in the United States. I think that's incorrect, because I think there's productivity that's tied to the internet. But the way it's measured it's close to zero.
We're growing our employment at 1 and 1/2%, or something like that. 2% real growth is, I think, we'll get something like that in the US, maybe even a little less. That's just not enough to get a concern about rising rates.
And you're not getting inflation into wages. And part of that is due to tech. This technology effect is actually quite deflationary when you look at its impact on wages.
So I think the outlook for the long rates is you might get a little bit of move, but not much. Short rates, yeah, you'll probably get another one or two increases over the next year or two. But I think the outlook for rates is lower for longer, with the short rates moving up a little bit, but very modestly.
What about valuations right now? And I had the benefit of-- we speak on a regular basis, and I was actually at a presentation when you showed what's driven stock valuations over the last few years. And it's a startling chart for people to see, because in one case earnings were negative, and yet stocks still went up I think it was something like 80% over the time frame because of QE and all that good stuff.
Right. Well, I think what drives valuation is, first and foremost, interest rates. And what drives interest rates is inflation. So if you have low inflation, you have low rates, and you tend to have high P/E ratios.
And one of the things that's happened in the last five years is that quantitative easing pulled down the discount rate enormously.
And you're alluding to the MSCI world index. Now, the MSCI world index from 2012 to 2016 rose 87%. The amazing thing is earnings were actually down. Of those 87% points, 74% came from multiple expansion.
So if the MSCI was a company they actually earned less money in 2016 than they did in 2012, but the value of that company was 74% higher, which is strange and very unusual.
But that period has ended. This QE period that artificially drove down discount rates is over. So what's going to drive stocks will largely be dividends and earnings.
But we're not going to see double-digit growth in earnings. But you're going to see meaningful growth and single digits in earnings.
And earnings will actually be helped by all this technology. So when you look at valuation, we have low rates, which is going to wind up with high PEs. Will PEs go higher? Who knows.
Well, my guess is you're in a world where interest rates are going to be flat to up a little. PEs will be flat to down a little. But I don't think there's big risk in multiples at this point, at least not from interest rates.
All right. You laid out a few things that I'll say traditional, fundamental things have been driving the markets.
You talk about tech as the new macro. What does that mean?
I think people are finally realizing that tech is going to influence virtually every single part of their lives. It's affecting their job, their job opportunities. It affects how they shop, what they buy, how they invest. It's an incredibly powerful force, arguably the most powerful force in a long time.
The way to see this is that we have entered what I would call the second machine age.
And what's that?
Well, the first machine age was when we kind of went from human muscle power and animal muscle power to the steam engine. And that's carried us into the combustion engine world. And that's lasted a long time.
But we have the digital world now. And the digital world started, really, back, I would say, around 1965 or so. There's something called Moore's law, named after Gordon Moore, who was at Fairchild Camera first and then Intel.
But Moore made a statement that the power of a computer chip would double every 18 months per dollar. And you've had a lot of doubles. In fact, you've had about 35 doubles since that.
That has brought you to the point where it's now highly visible what this meant. So Moore's law has enabled us to digitize just about everything imaginable-- music, any data you can think of. And it's all stored in the cloud. And because it's in the cloud you now have the ability to recombine that data in a myriad of shapes and forms.
So, for example, you and I have a glass of water in front of us. There's an old saying, you can't have your cake and eat it too. That would apply to that cup of water. But if that's a digit, if that's a bit, you can use that. Both of us can use that. And it's going to be here tomorrow. And it's in the cloud. We can use it again and again.
We are leaving a world of atoms, A-T-O-M-S. And we are going to enter a world of bits. This is strange. But you can see it particularly in a number of companies.
You can see what Amazon has done to retailing. Retailing has been a business of atoms. You had inventory. You had clerks. You had to have space that you rented and whatnot. And along comes Amazon. It's a bit company. And it's completely disintermediated the entire industry.
So what you have, you have this issue of why now? Why all of a sudden did this happen?
Well, the doubling finally got noticed by people around 2007, roughly halfway through what you think of as a chess board. With the doubling-- and it's really hard to imagine this-- but the idea that this doubling has taken place, it's not noticeable for years, and years, and years, until all of a sudden the seed that Moore sewn with this statement flowers. And you can see that on this slide that we have before us.
You had the Apple phone, it was 2007. You can see all the events that took place since then. Not only did you have the phone, but you had Google buying YouTube. You had new developments in the creation of chips alone. And it all happened in '07.
Now, this slide, What Happened in '07, is actually a chapter in a book by the author who wrote "Thank You for Being Late."
And Thomas Friedman's the author.
And that chapter walks you through, well, why now? It's when the seed finally flowered. And every day there's a doubling.
I was going to ask… because one thing I know you talked about today that I think is interesting is you talked about I think that parable of how you can have one piece of rice or two, and that idea that that chess board. And just tell us a bit about that, because that I think is a great illustration.
Well, this is a story that came right out of the book, "The Second Machine Age" by McAfee and Brynjolfsson. And it was a story. It's a myth about the emperor of India who in the 9th century said, I'd like a new game.
And up popped this subject with, hey, I've invented a game called chess. The emperor loved it and said, how do I reward you? And the subject said, well, look, I just want some rice to feed my family. But let's use the chess board to count. We'll put one grain on space one, two grains, two, four on three, a doubling of every square.
Well, after 32 squares you have about four billion grains of rice. That sounds like a lot, but it really isn't. But if you get to the 64th square you have more rice that is produced in the history of the world.
Which gets to that exponential growth you're talking about.
It is the exponential growth. So somewhere around 2007, 2010 we entered the back half of the chessboard. And suddenly this doubling effect is visible everywhere.
Now, Brynjolfsson and McAfee have another book out, which I would encourage watchers to read. And it's called "Machine, Platform, Crowd."
I think of it almost as a 3D lens. If you've ever gone to a movie when it's 3D and take off the glass they gave you, it's almost hard to see the movie. You can kind of see the figures. You've lost depth perception. The colors are odd. And frankly, it hurts your eyes.
This book is like putting on a pair of lenses, and suddenly you will see this will create order out of what appears to be chaos. It's a fantastic book. And it walks you through machine learning, the role of the platform.
We're going to talk about that. The one thing I wanted to say about when you spoke earlier I think which was kind of my personal aha moment is when you talk about the chessboard, I think people often think about because we're in the moment when it's happening it's like, oh, we're at the end of the cycle. We're so far advanced. And I think what you're alluding to a little bit with this, if I'm not mistaken, is that if you look at that chessboard, maybe we're only at the 32nd square right now. We haven't reached that 64th. And it's going to keep going.
It is going to keep going. And it has a lot of pluses and a lot of minuses to it.
What are they?
Well, the pluses. In finance what you're going to see, in finance there's going to be a substitution of technology for labor. Now, if that happens profit margins will actually go up, assuming sales are flat. You'll also see a substitution of technology for assets themselves. It's bits replacing atoms. Your sales per dollar of assets will go up. So return on assets will likely go up.
The other thing, though, is if you don't need assets, you don't need equity. And you will see a movement in companies to what I call a capital light model. You don't need as much equity as you used to have. That means that equity will come out in the form of dividends, stock buybacks, and debt pay downs. So the outlook for dividends is actually quite good.
There's a downside to all this stuff in terms of potentially employment. Robots don't buy anything.
No. They don't pay taxes, either.
So if robots aren't buying anything and they're not paying taxes, what's the offset to that? Well, we'll have to see how it plays out. But in the short run, the outlook for profits is actually pretty good.
I have a couple of things I want to get done in this five minutes. First off, we talked about how technology could essentially replace a lot of labor. Isn't that bad?
It's potentially bad. The question is, as labor gets replaced, where does this labor go?
Now, in the past, societies have always come up with someplace for them to go. We went from today, if you look at the United States, only 2% of our workforce is in farming. At one point it was 80% or 90%.
But it takes time to do that. And it's unclear how all that happens, and how quickly it happens.
A lot of it has to do with what's going on in the business models. Platform companies. Well, who are they?
Well, Amazon's a platform company. For various reasons we don't own that. They don't generate free cash flow sufficiently for us.
But another one would be Apple. It's Microsoft. It's Google. There are a number of companies that would meet that test.
What happens in a platform company is the business model, the revenue maximization model, changes dramatically. If you're in the atoms world you know that you usually own space. You probably have inventory. You employ clerks, all this. Your price points for what you sell have to be higher.
The minute you're in this bit world, the relationship of price and quantity changes dramatically. Price falls dramatically. And it's one of the reasons why technology is very deflationary in many ways.
Now, the other side of that is that you have an almost infinite ability to produce things, because you can use bits over, and over, and over again. So these platform companies wind up offering things at a very low price, but they will wind up owning the market.
So very often when you look at an industry, roughly 80% of the value the industry is going to wind up with 20% of the players.
I always worry whenever I hear deflation. I'm just like, oof.
Well, it's unclear. Some deflation is probably OK. But it's deflationary in the sense that there's a substitute of a factor cost.
Now, as time goes by if you can redeploy that human that's being displaced-- and there will be other jobs. The question is, is it going to take two years, or five years, or 10 years, or a generation? We don't know that.
And what happens in the social in the meantime?
The social thing is a subject for almost another session. It's a huge issue. And I think if you live in a democracy, you're going to have to figure out a way where you have some mechanism to train or help the people displaced. It's just going to be a very unpleasant place to live if you aren't able to do that.
But this change, it's going to come faster than people think just because of this doubling effect.
You've got a couple other names I want to mention as well in terms of names that EPOCH owns. You mentioned Google, Apple, Microsoft, Paypal as platform companies. Applied Materials.
PTC. Who's PTC?
PTC is basically a leader in what's called the Internet of Things, IoT. And these are essentially sensors that are placed on airplane engines, in factories.
Real-time data going back and forth.
Real-time data. And you don't have to have scheduled downtime. It actually increases the efficiency of industrial items quite effectively.
Bill, I've got about a minute left. So let me ask you, of all this, for someone who's watching it's kind of like they're either going to be really excited by this or utterly terrified by this. What should you be?
Well, I think the world goes on. Barring some crazy event out of North Korea or something of that nature, the world will adapt. We'll all adapt. That's how we got through these past millenniums. So I think it's about education. It's going to be lifetime learning. The idea that you finish school, you get a job, and you never go back to school, it's over. You have to pursue a lifetime learning project of some kind.
And I think the issue is to just continue to try to make yourself relevant. So how I would look at this, I would try and look at this as the glass is half full, not half empty.
It appears half empty when you look at it in the short run. But in the long run, hopefully society is better off. The standard of living will be higher. And society should, if you want to sustain a democracy, figure out a way to help the people who are displaced.
Tall order. Exciting times, though. But really interesting to have your overview on everything.
Bill, thanks so much.
Thank you very much again.
Bill Priest. He is the chief executive officer and co-chief investment officer of EPOCH Investment Partners.