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Atmos Energy’s (ATO) CEO Kim Cocklin on Q1 2016 Results – Earnings Call Transcript

Operator Greetings, and welcome to the Atmos Energy First Quarter 2016 Earnings Conference Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now turn the conference over to Ms. Susan Giles, Vice President, Investor Relations. Thank you Ms. Giles, you may now begin. Susan Giles Thank you, Manny, and good morning, everyone. Thank you all for joining us. This call is being webcast live on the Internet. Our earnings release and conference call slide presentation and Form 10-Q are all available on our website at AtmosEnergy.com. As we review these financial results and discuss future expectations, please keep in mind that some of our discussion might contain forward-looking statements within the meaning of the Securities Act and the Securities Exchange Act. Our forward-looking statements and projections could differ materially from actual results. The factors that could cause such material differences are outlined on Slide 17, and more fully described in our SEC filings. Our first speaker this morning is Mr. Bret Eckert, Senior Vice President and CFO of Atmos Energy. Bret Eckert Thank you, Susan, and good morning, everyone. We appreciate you joining us and your interest in Atmos Energy. Reported net income for the quarter was $103 million, or $1.00 per diluted share, compared with $98 million or $0.96 one year ago. Excluding unrealized margins in both periods net income was $96 million or $0.93 per diluted share compared to $93 million or $0.91 last year. Slides 3 and 4 provide financial highlights for our regulated operations for the three month period. The continued pursuit of our infrastructure investment strategy drove our quarter-over-quarter growth. Rate released through our regulated distribution and pipeline operations combined generated about $24 million of incremental margin in the first quarter of fiscal 2016. About $14 million of this amount came from our regulated distribution segment with about $7 million in our Mid-Tex division and the remainder from our Mississippi and West Texas divisions. The remaining $10 million came from the regulated pipeline segment primarily as the result of new rates from the approved 2015 GRIP filing. Additionally our weather normalization mechanisms, which over about 97% of utility margins, [worked its design] insulating both the company and our customers during atypical weather. We experienced a 21% quarter-over-quarter decrease in regulated distribution sales volumes due to the weather that was 29% warmer than last year’s quarter. However, gross profit decreased just $1.1 million. Focusing now on our spending as expected consolidated O&M increased by about $6 million quarter-over-quarter mainly due to incremental pipeline maintenance spending, as well as increased administrative expense in our regulated operations. Capital expenditures increased by $30 million in the first quarter compared to one year ago, despite the particularly challenging weather conditions in Texas during the quarter, which slowed several regulated distribution projects during the period. However, spending in our regulated pipeline segment increased as we continued to enhance and fortify our Bethel and Tri-City storage fields. These efforts will improve our ability to reliably deliver gas to our North Texas customers and serve the peak day requirement of the Mid-Tex division and ATT’s other LDC customers. We remain on track to achieve our capital budget target of $1 billion to $1.1 billion for fiscal 2016 as detailed on Slide 15. Moving now to our earnings guidance for fiscal 2016, we still expect fiscal 2016 earnings per share to be in the previously announced range of $3.20 to $3.40 per diluted share, excluding unrealized margins at September 30, 2016 and that is shown on Slide 12. The expected contribution from our regulated and non-regulated operation as well as estimates for selected expenses for the year remain unchanged since we announced fiscal 2016 projections last November, and we expect the continued execution of our infrastructure investment strategy coupled with constructive regulation to be the primary driver for this year’s results. Looking at slide 13, we anticipate annual operating income increases of between $100 million to $125 million from implemented rate outcomes this year. Thank you for your time and now I will hand the call to our CEO, Kim Cocklin, for closing remarks. Kim? Kim Cocklin Thank you, Bret. Excellent report. We have reported a very solid start to this fiscal 2016 and are very encouraged with the expectations for the full year. Without question the weather event this past quarter presented a number of challenges. Our West Texas division endured a record blizzard, while our Mid-Tex division encountered a series of deadly tornadoes and record rainfall in the Dallas-Fort Worth Metroplex. The devastating weather in Texas tested the reliability of our system and the good news is that the capital improvements we have made to our distribution system and the extensive training of our field employees proved to be both valuable and effective while operating safely and reliably during these challenging conditions. We also achieved very solid progress in the [rates] this first quarter. In Kansas, a settlement was reached and supported by all parties that will benefit our customers over the long term and there is now pending action before the Kansas Corporation Commission. In Colorado, we received approval for a Systems Safety and Integrity Rider, which is a forward-looking infrastructure investment mechanism effective January 1 of this year for a three year term. And in Mississippi we have a system integrity rider, which is also a forward-looking infrastructure mechanism. These important changes continued to demonstrate that fair and balanced regulation will continue to support our journey to becoming the nation’s safest utility with an annual capital investment of over $1 billion. Rate outcomes have provided annual operating increases of about $12 million and we have filed cases now pending which seek about $33 million of annual operating income increases. We expect to make between 12 to 15 more filings this fiscal year, which will request between $90 million to $100 million of additional operating income increases. Slide 14 provides a summary of our expected fiscal ’16 rate filings. We are off to a solid start and our performance continues the track record of meeting our commitments to invest in our regulated assets, growing our rate base and earnings and maintaining an unwavering attitude to strive to become the nation’s safest utility. Year-over-year our weighted average cost of gas has decreased, which will continue to help and alleviate any upward rate pressure associated with our increased capital spending. Our balance sheet remains very healthy and our credit ratings are strong. Our debt capital ratio at December 31 was essentially flat year-over-year at 49.6%. We remain focused on spending between $1 billion to $1.4 billion of capital annually through fiscal 2020. We believe our internal capital investment opportunities will enable rate based growth, which would generate earnings per share growth of 6% to 8% through fiscal 2020. Yesterday our board declared our 129th consecutive quarterly cash dividend of $0.42. The indicated annual dividend rate for fiscal ’16 is $1.68, which is a 7.7% increase over last year. With projected earnings per share growth of 6% to 8% coupled with our dividend yield we are committing to delivering total shareholder return in the 9% to 11% range through fiscal ’20. Thank you for your time and now we will open the call up for questions. Manny? Question-and-Answer Session Operator [Operator Instructions] Our first question is from Brian Russo of Ladenburg Thalmann. Please go ahead. Brian Russo Hi, good morning. Bret Eckert Good morning Brian. Kim Cocklin Good morning. Brian Russo I noticed that the rate base slide and the financing need slide is, as you mentioned, consistent with the assumptions laid out at your analyst conference in November, and I am just curious was there any impact to bonus depreciation since the assumptions in November or did November capture your outlook for bonus depreciation? Bret Eckert Brian, this is Bret Eckert. The impact of the extension of bonus at the 50% level really doesn’t have any significant impact on us in ’16 or really over the five-year plan. Brian Russo And why is that exactly? Bret Eckert It has a small impact from a cash basis percentage. But outside of that the impact on rate base is very small. Brian Russo Okay, and then also just on the rate base slide, if you just take your rate base plus CapEx minus depreciation it seems like that calculation is higher than the illustrated assumptions in your annual rate base growth through 2020 and I was just wondering what other adjustments are included in that adjusted for taxes? Bret Eckert Yes, I think that it is mainly just timing Brian, you take it at a period end or you are taking on cases that are in progress or approved rate base that is already approved. I think you’re just seeing the timing of annual rate making when you have got fiscal year-end at September 30, and you have rate filings throughout the year. Brian Russo Got it, understood. And the debt-to-cap ratio at 49.6% that seems lower than maybe what the assumption is for the full year or the trend in the debt-to-cap ratio and I’m just curious is it just the seasonality of the retained earnings? Bret Eckert Yes, it is really just the seasonality as your short-term debt balances are higher at the end of December than they are at the end of September. That really is just the timing and then as collections come in as you go through the winter heating season that balance comes back down. So really it is driven by timing. Everything that we discussed with regard to our financing plan is consistent with what we have laid out in November. Brian Russo Okay, great. And then lastly I noticed in the non-reg segment unit margins increased to $0.12 per Mcf versus $0.10, is that sustainable? Bret Eckert I think when you look at the guidance of the $14 million to $19 million we reaffirmed, the same guidance that we provided in November and so, I would still expect the earnings to come in at that range. Some of it is timing as you go throughout the year, but nothing has changed from our previous income projections for them. Brian Russo Okay, great. Thank you very much. Operator Thank you. The next question is from Spencer Joyce of Hilliard Lyons. Please go ahead. Spencer Joyce Hi, good morning guys and Susan as well. Congrats on a nice quarter. Bret Eckert Good morning Spencer. Kim Cocklin It is good to hear your voice. Thank you. Spencer Joyce Yes. Merry Christmas. Happy New Year. It has been a while. Just a couple of quick ones here from me, first I know Kim you mentioned a couple of special or not special weather items from the first quarter here. Would it be safe to assume there was a bit of additional O&M expense housed in the first quarter and maybe for projecting kind of 2Q ’17 maybe we will see a little bit of a give back or perhaps a pullback in the growth rate there? Bret Eckert I think, Spencer it is Bret, a little of that is just timing. We did have an increase as expected in O&M in the quarter. The O&M projected range that we provided back in November still holds today. So a lot of that is just going to be timing of spend. We did have some wet weather in some of our jurisdictions that impacted capital and O&M a little bit but on a full year basis we expect it to come in at the levels that we previously provided. Spencer Joyce Okay, perfect. And then more broadly, I know you all had been fairly steadfast in relaying that you are fairly insulated from a lot of the malaise that we have seen in the oil and gas markets and even in Texas I know the direct exposure of the economy to energy is fairly small, but can you just hold our hand a little bit more there and let us know kind of how you are doing in the context of what it feels like it could be a tougher economic environment there in Texas? Kim Cocklin Hi Spencer this is Kim. No, we really don’t expect – we haven’t noticed any changes particularly in Texas and the other major metropolitan areas that we are servicing and Louisiana and Mississippi, let us say Kentucky, Tennessee, Colorado, Kansas, even around the Blacksburg area, I mean everything continues to be better than what is being reported. I think there is a whole lot of information coming out of the financial channels right now that everybody expecting kind of a rocky ’16 for the stock market, and that a lot of that is driven by what is happening according to them in China and then some of the energy prices bouncing around, but we continue to be a significant beneficiary of lower energy prices and a strong dollar. We are controlling everything that we can control and so I think the other thing is the Fed probably is going to push back any kind of increase on the rate as well. So, I think that is going to bode well for utilities. So I think you are certainly in the right space and you are certainly right on target having Atmos as your top pick in 2016. Spencer Joyce So far, so good. Kim Cocklin Damn right. I mean, yes, you are all about it. You have been right for a good while now for the last three years. Spencer Joyce It is a good thing I’m on a call now. I’m blushing a bit. But all right, again nice quarter and we will talk soon. Kim Cocklin Thank you. Bret Eckert Thank you, Spencer. Operator Thank you. The next question is from Charles Fishman of Morningstar. Please go ahead. Charles Fishman Thank you. Just as a follow-up to that last question, I realized the insulation you have from commodity prices, but does the volatility help your non-regulated segment at all? Bret Eckert Go ahead Mike. Mike Haefner This is Mike Charles. Our non-reg segment really – primarily is focused on our delivered gas business, where they are really managing the aggregation of supply in the pipeline and storage contracts to get gas to municipalities, other LDCs and small industrial. So it is really not – we are really not affected by that and we run a flat book. We don’t take any risk. In the market we get a little bit of lift out of our facility, but it is just – it is miniscule. Charles Fishman Okay. So maybe the lower earnings from non-regulated quarter-to-quarter which I realize is just one quarter is really more volume driven than anything else, correct? Mike Haefner It is just timing. Bret Eckert Yes, it is just timing. Charles Fishman Okay. Kim Cocklin Charles, that business is all about managing risk and we are not about to try to take advantage of any volatility, we are going to run a flat book and as Bret said, and we continue to emphasize at every meeting we have with analysts, they are plugged in at about $14 million to $19 million of net income this year and every year till 2020. We are not encouraging them to grow, but we are encouraging them to be a value added service provider to the smaller municipalities, commercial industrial customers that need energy management expertise, which is what they bring to the table and have done so each and every year, demonstrated by their performance in the Masteo customer survey where they have came in at number one or number two the last five years. So we are very proud of that fact. But they do provide an extremely valuable service to the smaller customers that are situated behind our, the distribution utilities that we serve in eight states. And again it is energy management expertise for those people that don’t have it on staff. Charles Fishman And then Kim, just as a macro view of the industry, we saw a similar company in Salt Lake did acquire an announced acquisition earlier this week, at a price that was somewhat lower than some of the other premiums we have seen. Do you have any thoughts as far as the industry that we have reached the peak of maybe some of the multiples already? Kim Cocklin No, I don’t think so. I think you guys are better versed at looking at some of the parts than some of us, but if you – you got to factor in the business model that is being pursued in some of the parts of any that resides in the portfolio. So there is a difference I think between a peer regulated natural gas utility where 95% of the earnings are coming from distribution and intrastate pipeline in Texas versus other folks that may have a little bit more spread out with the non-regulated or they may have some MLP eligible assets in the form of an interstate pipeline or some midstream operations or even regulated production. Charles Fishman Okay. That is all I have. Thank you. That was quite helpful. Bret Eckert Great. Thank you. Operator Thank you. The next question is from Stephen Byrd of Morgan Stanley. Please go ahead. Stephen Byrd Hi, good morning. Susan Giles Good morning. Kim Cocklin Good morning Stephen. Stephen Byrd Most of my questions have been addressed. I just have one or two I wanted to follow-up on , over time you all have done a great job of reducing the regulatory lag quite a bit and just looking at your regulatory calendar coming up, how should we think about your further efforts to limit that lag, I know I guess it is less than 5% of your CapEx at this point and it has more than a 12 month lag, which is phenomenal, but just curious where should we be thinking about in terms of if things go well in terms of your upcoming filings, how should we think about further reducing that regulatory lag? Bret Eckert Hi Stephen, it is Bret Eckert, as we reaffirm, we still expect that regulatory outcomes on an annualized basis will be $100 million to $125 million in fiscal ’16, we continue to really focus on the execution of our capital spend and continuing to partner with our regulators in our annual filing. A lot of what we have got now is just continued execution. Kim highlighted the new mechanisms last year that we got in Tennessee, in Mississippi. We had a new mechanism in Colorado for infrastructure that went into effect on 1st January and then he commented on what we are doing in Kansas. And so, it is just the continued effort of what you have seen in previous years to be able to always focus on finding ways to continue to reduce regulatory lag, but things are continuing to progress as we expected. Kim Cocklin I mean, we are measuring this in baby steps and very incremental byte-sized pieces Stephen and I think, the resolution that we achieved with our customers and the staff and now that is being reviewed before the KCC in Kansas is something that we think is a very positive step in the right direction and then as Bret said, we pointed out the forward-looking infrastructure mechanism in Colorado and Mississippi both identified for capital. So I mean we feel very good and I mean every filing that we make we are trying to educate the staff and the regulators that we are talking to about the continued need to reduce lag in order to facilitate the investment in this journey to safety that we are on right now. I think we are spending about three times – the depreciation rate is only – can only be done as long as you have a manageable lag process that we are continuing to focus on. So we feel good and we are going to continue to try to do better. Stephen Byrd That makes perfect sense. My last question, I think I have got a good sense for the answer, but I feel compelled to ask it anyway just following up on the M&A environment that we are seeing, it is clear that there is still a lot of capital available, there is still likely to be strong valuations for really high quality, high growth companies, I am just curious in terms of your reaction to the continued pace of M&A activity, how do you think about that in the context of your own company versus your own standalone growth plans? Bret Eckert Well, I mean, we have been in the camp that we thought the M&A activity would not slow down and it started to heat up at the end of ’15 and it has just continued through ’16 and I think you are going to see a continuation of that activity in this pace. I mean I think that the companies that remain on the board have to be extremely attractive and have some very good business models and bring to the table some platforms that don’t exist for some of these – for some of the folks that are going up and down the shopping isles at the present time. So, we have got a great plan. We have got a great strategy. I mean I think there is a lot of good companies out there like us as well. You have got to have a better handle on it than we do, I mean, you’ve got to think please don’t grow to the sky and the multiples that where the companies are trading seem to be extremely rich, but we continue to represent that we are an attractive opportunity for prudent investors with just the metrics that we are throwing out and that we are committed to deliver and that the results that we are putting forth justify putting this in your portfolio. Stephen Byrd Well said, very much understood. Thank you. Bret Eckert Thank you, Stephen. Operator Thank you. Our next question is from Mark Levin of BB&T. Please go ahead. Mark Levin Hi guys. Very solid quarter and a very difficult market environment. Just a quick question and it maybe just entirely too early to answer it, but I will throw it out there anyway. The $3.20 to $3.40 guidance that you reaffirmed, maybe you can, having gone through at least one quarter give us some idea of how you feel about that range, it is reasonably wide, maybe there are two or three factors that you think are critical towards getting to the upper end and the two or three factors that could lead you to the lower end of the range? Bret Eckert Hi Mark it is Bret. I mean, you heard earlier yes, we did reaffirm that guidance of $3.20 to $3.40, we would look potentially to look totighten that guidance later in the year, butwe absolutely remain on track. As you said, the first quarter was a solid first quarter. It came in right in line with our expectation and we still remain very well positioned to achieve that $3.20 to $3.40 guidance range. Kim Cocklin This is a difficult market environment and we are up a bit above 10% year-to-date, we will take it. Mark Levin I know you guys are doing everything you can. Great… Kim Cocklin We are [battling] fast and furious, [Indiscernible]. Mark Levin Absolutely. All right, well thank you guys and congratulations on a good quarter. Bret Eckert Thank you Mark. Operator Thank you. We have no further questions at this time. I would like to turn the conference back over to management for any closing comments. Susan Giles I just want to say that a recording of the call is available for replay on our website through May 4. And again we appreciate your interest and thank you for joining us. Bye-bye. Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. 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Exited Gencor For 57.33% Return

On December 2, 2015, we exited our position in Gencor ( GENC ) for a total return of 57.33%. This position was first established on October 5, 2011. We held this stock for 4 years to wait for the catalyst of increased funding for Federal highway projects (transportation bill), which finally seems to be taking shape. Our average cost was $7.1/share and selling price was $11.25/share. Today, the company sports a $116 million market capitalization, carries no debt and has $96 million in cash. If you buy the stock today, you are looking at $20 million to buy the whole business (net of cash), with a great prospect of increased revenues and profits, as the Federal dollars start flowing in the infrastructure projects (which are sorely needed in the U.S.). Whether this is worthwhile investment now or not is your decision; for us, we felt that the capital can be reused elsewhere in this environment. A value trap is a value trap, until it isn’t. It took us close to 4 years to get a 57% return. Was it worth it? Maybe not. I remember when we first invested in Gencor, the large amount of cash on the balance sheet was very attractive to me, and so it was for many other value investors. Over time though, many of these investors have quit the investment. It has been a frustrating experience, for sure, to watch the management do almost nothing with the cash – neither invest in new projects, nor return it back to the shareholders. I suspect a calculation of significant increase in working capital requirements, when the highway funding finally comes through, played a big role in the management’s decision to hold on to cash. Looking at the opportunity cost of this wait, it was probably not worth it. However, one cannot fault the management of being more optimistic of the U.S. Congress’ ability to pass genuinely needed infrastructure funding. If I were running the company, I would have done the same, and then roundly vilified in the investment community. This is where the interests of the investors and the managers diverge a little, which is unfortunate, as we investors need to consider the long-term strategy for the business as the primary driver of the management actions. Why would the management not return the cash to the shareholders and then when needed raise the funds in the debt markets, is a question I cannot answer. Coming back to the Value Trap question – For the first 3 years of the holding, it indeed looked like one. This year the stock has risen 35%, so for a value investor who decided to get in towards the end of last year would definitely not consider this stock as a value trap. It is all in your perspective.

What ‘Smart Beta’ Means To Us

Summary The absence of a generally accepted definition of “smart beta” has given people license to describe a wide range of products as smart beta strategies. In equity investing, we use smart beta to refer to valuation-indifferent strategies that break the link between the price of an asset and its weight in the portfolio while retaining. By sharing our thoughts about the term, we hope to guide the discussion towards the real issue: how best to manage investor assets. As with most new expressions, “smart beta” is in the process of seeking an established meaning. It is fast becoming one of the most overused, ill-defined, and controversial terms in the modern financial lexicon. Unfortunately, the success of so-called smart beta products has attracted a host of new entrants purporting to be smart beta products when, frankly, they aren’t! They stretch the definition of smart beta to encompass their products, a natural business strategy. Without a simple, generally accepted meaning, the term “smart beta” risks becoming meaningless. Is that a bad thing? Probably not to the critics of the term smart beta. These are mainly the definitional purists. Bill Sharpe, who coined and defined “alpha” and “beta” in his seminal work (1964), famously remarked that the term makes him “definitionally sick.” His objection is completely legitimate: Bill defined beta as merely a measure of the non-diversifiable risk of a portfolio, measured against the capitalization-weighted market, and defined alpha as the residual return that’s not attributable to the beta. Some providers of traditional cap-weighted indices similarly object, either because they believed that there is only one “true” beta or because they infer from the smart beta label that its advocates believe that cap weighting is “stupid beta.” C’mon folks, is the beta relative to the S&P 500 Index-an actively selected broad-market core portfolio- really the one true beta?! Also, the practitioner community has increasingly embraced the notion of seeking beta (which has already morphed in meaning to refer to exposure to chosen markets, not the total market portfolio of investable assets, as CAPM originally defined it) for free, and paying for alpha. Viewed in this context, smart beta actually can mean something useful: a smarter way for investors to buy beta with alpha . After all, if one can find a more reliable alpha, and pay less for it, that would be pretty smart. The early critics of our Fundamental Index™ work were quick to point out that it was just a backtest and was merely clever repackaging of value investing. Well, it was a backtest, and it has a value tilt against the cap-weighted market. (Or, just to be provocative, does the cap-weighted market have a growth tilt against the broad macroeconomy, providing investors with outsized exposure to companies that are expected to grow handily, and skinny exposure to troubled companies?) It’s not a backtest anymore, as we approach our 10th anniversary of live results; and it has outperformed the cap-weighted market in most of the world, during a time when value generally underperformed growth . Critics have become more muted, as the efficacy of the Fundamental Index method (and other so-called smart beta strategies) is better understood. Defining Smart Beta for Equity The term smart beta grew out of attempts by people in the industry to explain the Fundamental Index approach vis-à-vis existing passive and active management strategies. When Towers Watson, a leading global investment consulting firm, coined the expression smart beta, it was not their intent to label cap-weight as “dumb beta.” Indeed, they referred to it as “bulk beta,” because it could be purchased for next-to-nothing. There is nothing “dumb” about cap-weighted indexing. If an investor wants to own the broad market, wants to pay next to nothing for market exposure, and doesn’t want to play in the performance-seeking game, cap-weighted indexing is the smartest choice, by far. People are beginning to understand that the dumb beta is the fad-chasing investor who buys whatever is newly beloved and sells whatever is newly loathed, trading like a banshee. Fortunately or unfortunately, these folks are legion, as is well documented in Russ Kinnel’s important “Mind the Gap” white papers (2005, 2014). As the debate over the smart beta label grew, Towers Watson (2013) sought to clarify the meaning of their expression with the following definition: Smart beta is simply about trying to identify good investment ideas that can be structured better… smart beta strategies should be simple, low cost, transparent and systematic. This straightforward definition indicates what investors ought to expect of a smart beta product. Our research suggests, however, that many alternative beta strategies fall short of this definition. Some are overly complex or opaque in the source of value added. Others will incur unnecessary implementation costs. Many so-called alternative beta strategies don’t seem so smart, by Towers Watson’s definition. The problem may be that even this definition is not clear enough. The absence of a rigorous, generally accepted definition gives me-too firms enough latitude to stamp smart beta on anything that’s not cap-weighted indexing. The way the term is bandied about, without much regard for meaning, is a disservice to investors. We don’t presume to define smart beta for the industry, but we would like to see more consistency in how the label is applied. Our definition builds on the Towers Watson definition, adding more specificity as it relates to equity strategies, where the smart beta revolution began almost a decade ago: A category of valuation-indifferent strategies that consciously and deliberately break the link between the price of an asset and its weight in the portfolio, seeking to earn excess returns over the cap-weighted benchmark by no longer weighting assets proportional to their popularity, while retaining most of the positive attributes of passive indexing. Earning Excess Returns The shortcomings of cap-weighted indices are by now well understood and widely acknowledged. Cap-weighted indices are “the market,” and they afford investors the market return. That’s indisputable. Nonetheless, because constituent weights are linked to price, they automatically increase the allocation to companies whose stock prices have risen, and reduce the weight for companies whose stock prices have fallen. If the market is not efficient, and prices some companies too high and some too low, then cap-weighted indices naturally have disproportionately large concentrations in companies that are likely to be overvalued and light allocations in companies that are disproportionately undervalued. This structure creates a return drag that is overcome by breaking the link between price and weight in a portfolio. 1 In fact, our research indicates that any structure that breaks the link between price and weight outperforms cap weighting in the long run. 2 In this sense, our work on the Fundamental Index concept is not special! 3 Equal weight, minimum variance, Shiller’s new CAPE index, and many others, all sever this link, and empirically add roughly the same alpha. This can be done simply, inexpensively, and mechanistically; these ideas show good historical efficacy all over the world; and some have live experience that roughly matches the backtests. Accordingly, this way to pursue a particular beta might rightly be considered “smart.” In periodically rebalancing to target weights that are unrelated to price, smart beta strategies engage in value investing: They buy low and sell high (we have demonstrated this result elsewhere 4 and will return to it in a moment). It will surprise many readers to learn that the value tilt is empirically a far smaller source of return than is the rebalancing process itself. 5 After all, what could be more uncomfortable than systematically trimming our holdings in the most extravagantly newly beloved companies, while topping up our holdings in the most newly feared and loathed companies? These portfolios look perfectly reasonable; their trading does not. That’s where the alpha is sourced: contratrading against the legions of investors who chase fads and shun recent disappointments . Accordingly, breaking the link with price is, in our view, the most important component to any useful definition of smart beta. Strategies that use market capitalization in selecting or weighting securities, such as cap-weighted value indices, are not smart beta using our definition: they leave money on the table due to the same return drag that afflicts any cap-weighted strategy. 6 Best Attributes of Passive Investing Compelling as it might be to define smart beta simply as those equity strategies that break the link with price, 7 we believe that tapping a reliable source of excess return is not sufficient to merit the label smart beta. As our general definition for equity market smart beta indicates, we also think smart beta solutions should retain some of the key benefits of passive investing, including: Smart beta strategies are transparent. The principles of portfolio construction and the intended sources of excess return are clearly stated and easy to understand. Investors know what they are getting. Smart beta strategies are rules-based. Their methodology is systematic and mechanically executed. Investors know that the process is disciplined. These strategies can be independently tested, including in out-of-sample tests covering new time spans or new markets. Smart beta strategies are low cost relative to active management . 8 In addition to lower fees, they have lower due diligence and monitoring costs. As a result, they offer investors affordable access to potential excess returns. Smart beta strategies have large capacity and the liquidity to accommodate easy entrance and exit. Smart beta strategies are well-diversified and/or span the macro economy. Because stock weights are uncoupled from prices, smart beta strategies do not expose investors to sector and industry concentrations arising from misvaluations. We think of these traits as family traits. Few will have every one of these traits; we’d be inclined to apply the smart beta label to a strategy that displays most or all of them. To us, the trait in our primary definition is sacrosanct: Any strategy that is not valuation-indifferent, that does not break the link between the weight in the portfolio and price (or market cap), is not smart beta. Performance Record We’ve described what smart beta means to us, and, in the process, indicated what we think investors should expect of products that are marketed as smart beta strategies. Is it also reasonable to expect long-term outperformance relative to cap-weighted indices? We cannot know the future. Perhaps, in the years ahead, investors will be rewarded by owning more of whatever is most expensive and less of whatever is least expensive. Personally, I doubt it. We can know the past. So-called smart beta strategies have produced value-added returns in long-term historical testing, all over the world, and on many 9 live-asset portfolios. And this outperformance has been driven, in large part, by the inherently value-based trading that takes place when smart beta portfolios are rebalanced to non-price-related weights. In long-term simulations, smart beta strategies have generated excess returns relative to cap-weighted indices. For instance, Figure 1 traces the hypothetical cumulative returns of a fundamentally weighted U.S. index and the comparable returns of two cap-weighted indices-a broad market index and a traditional value style index-over the 35-year period from 1979 through 2013. The fundamentally weighted index outperformed both of the indices whose weighting methods incorporate market prices. 10 A cautionary note is in order. As with any strategies, smart beta investing is a long-term strategy. Only a charlatan would encourage customers to expect 100% probability of future outperformance. There have been prolonged periods of underperformance, especially in secular bull markets. Smart beta strategies are contrarian, and they make sense only for investors with long-term planning horizons and a willingness to tolerate uncomfortable (even profoundly uncomfortable) portfolio rebalancing trades. In Closing Smart beta has been roundly dismissed as a marketing buzzword, rather than a significant development in finance theory and investment practice. We like the name, partly because it is jarring and controversial, but we don’t for a moment deny that it has been misused to flog me-too products. We hope that, by sharing our thoughts about the nomenclature, we can nudge the discussion in the direction of the real issue: how to best manage investor assets. Endnotes 1 To be sure, the cap-weighted index of the market cannot have a performance drag relative to itself. Here, we refer to a performance drag relative to the opportunity set. 2 Brightman (2013); Arnott, Hsu, Kalesnik, and Tindall (2013). 3 How many investment managers will say this about their own best products?! 4 Arnott, Hsu, Kalesnik, and Tindall (2013). 5 Chaves and Arnott (2012). 6 Hsu (2014). Note also that cap-weighted value strategies have a powerful, statistically significant negative Fama-French alpha. They derive value-added from their value tilt and then lose much of it due to cap weighting. 7 For bonds and other asset classes, our core definition can still apply. But, it’s a bit more nuanced. Do we want to weight a bond portfolio by the debt appetite of a borrower, and then be forced to buy more of the issuer’s debt as they seek to borrow more? That’s what cap weighting will do in bonds. Alternatively, do we want to weight a bond portfolio by the debt service capacity of the borrower, which is loosely related to the aggregate economic scale of the borrower? That’s one of many ways to construct a smart beta strategy in bonds. Historically, it works. 8 It should go without saying, but these strategies cannot price-compete with conventional cap weighting, nor should they. Did Vanguard charge 7 bps for their first S&P 500 fund? No, they did not. Should product innovation be rewarded? Of course. Reciprocally, these strategies must charge much less than the active strategies that purport to offer similar incremental returns, in order to justify their relevance. 9 We can’t say “most” because we don’t have access to the track record of all practitioners in this space. But, I personally am confident that the word “most” would be accurate… even though value has underperformed growth in most of the past decade! 10 Kalesnik (2014). References Arnott, Robert D., Jason Hsu, Vitali Kalesnik, and Phil Tindall. 2013. ” The Surprising Alpha from Malkiel’s Monkey and Upside Down Strategies .” Journal of Portfolio Management , vol. 39, no. 4 (Summer):91-105. Brightman, Chris. 2013. ” What Makes Alternative Beta Smart? ” Research Affiliates (September). Chaves, Denis B., and Robert D. Arnott. 2012. ” Rebalancing and the Value Effect. ” Journal of Portfolio Management , vol. 38, no. 4 (Summer):59-74. Hsu, Jason. 2014. ” Value Investing: Smart Beta vs. Style Indexes. ” Journal of Index Investing , vol. 5, no. 1 (Summer):121-126. Kalesnik, Vitali. 2014. “Smart Beta: The Second Generation of Index Investing.” IMCA Investments & Wealth Monitor (July/August): 25-29, 47. Kinnel, Russ. 2005. “Mind the Gap: How Good Funds Can Yield Bad Results.” Morningstar FundInvestor (July). —. 2014. “Mind the Gap 2014.” Morningstar Fund Spy (February 27). Sharpe, William F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk.” Journal of Finance , vol. 19, no. 3 (September):425-442. Towers Watson. 2013. “Understanding Smart Beta.” Insights (July 23). This article was originally published on researchaffiliates.com by Rob Arnott and Engin Kose . Disclaimer: The statements, views and opinions expressed herein are those of the author and not necessarily those of Research Affiliates, LLC. Any such statements, views or opinions are subject to change without notice. Nothing contained herein is an offer or sale of securities or derivatives and is not investment advice. Any specific reference or link to securities or derivatives on this website are not those of the author.