How AI Transforms The Investment Industry With Stefan Whitwell, Founder & CIO, Whitwell & Co.

 

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Stefan Whitwell, founder and Chief Investment Officer of Whitwell & Co., enjoys helping business owners prepare for the sale of their businesses and be more strategic in how they fund their business in its early growth stages. Stefan shares his extensive experience in finance and discusses the intersection of AI, automation, and the investment industry.

In this episode, Zack and Stefan discuss:

1. The Wisdom of Following Market Trends
2. The Dangers of Stagnant Portfolio Strategies
3. Is AI Going to Hurt White Collar Workers the Most?

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How AI Transforms The Investment Industry With Stefan Whitwell, Founder & CIO, Whitwell & Co.

AI’s Impact On Investment

I’m here with Stefan Whitwell, founder and CEO of Whitwell & Co., based in Austin, Texas. Stefan has a ton of experience on Wall Street, worked at Goldman Sachs, Credit Suisse, is a CFA charterholder, has worked on the trading floor, he’s worked in M&A, and is a very smart investor. I’m really happy to have you on, Stefan. Tell us a little bit about yourself, how you got here, and what you’re working on.

I think my most important job is dad. I’ve got four kids, and I love being a dad, but I also love the world of finance, running Whitwell & Co. We’re in fourteen states, and all of our clients are just really different and accomplished, and it’s fun to learn from them. I think it’s also been especially fun the last three years, when the world has gone crazy, and we’ve had a very new set of problems to look at and figure out how to apply age-old principles to. I’d say two things I’m working on first, and we can talk about it more later, but I don’t think the banking crisis is over yet.

I think it’s going to create some challenges to the system that I’m interested in finding the right ways to take advantage of. The second thing that I’ve been spending a lot of time on is thinking about functional automation, marrying the superpowers of humans and computers, and understanding where one starts and the other stops. Even the use of advanced automation, ironically, requires, in my experience, a tremendous amount of humanity, which is ironic. I think the effective use of AI does, too. I’ve just been working on some projects related to that, and it’s been fun.

AI is certainly changing the nature of everything very quickly, and I’m thinking a lot about how it’s changing the investment industry in particular. Within the RIA space, how do you think it’s going to evolve, and what’s it going to mean for advisors and how they interact with clients?

I’m sure you do, too. Every day I get tons of junk mail, people trying to sell me a new app, a new tool. There’s a lot of people that are trying to automate. I think there’s the investing side and the financial planning side. They’re trying to automate both. I think it’s really hard to automate the financial planning side. A lot of people have tried, there have been some who have been very successful in the automated trading space, but that’s really hard. At least for us, I think that where we see the most opportunity is looking at your workflow and going, what can a computer do better than I can? Also, adding some discipline.

For example, thinking in a more disciplined way about data, making sure that you only enter data once, that you don’t have multiple duplicative databases, thinking about things like being able to automate intelligent double-checking of data or your systems and processes, I think can be really valuable. Same way on the investment side, short of having the resources of Renaissance, I think there are some things you can do to automate that first preliminary data sifting that we need to all constantly be doing. There’s so much data out there that it’s just impossible to try to keep up with it all as a human being in a manual sense.

I think there’s a real race to come up with the most intelligent tools to isolate the factors or the developments or the changes in the market or data that are of greatest interest to you. I think intelligent systems, instead of forcing you to then go to that database and say, what you got? The best ones are proactively reaching out to you and saying, knock, knock, guess what? Some interesting data that meets these criteria that you selected is happening, take a look. I think ideally, one of the most low-hanging fruit use cases is just that, helping us get through the mass of data, isolating it to the pieces that we need, then as humans be exercising our judgment and insight on to then make the tough calls on the investment side.

I agree, and I think about it a lot. One of the things I think about is comparative advantage. If you go back to Econ 101, when you were at Wharton and I was at Swarthmore, they teach you about comparative advantage. The reality is that AI and computers are going to do things that we can’t do. They’re going to do things better in some cases, but there’s a lot of things that we will do better as humans.

I’m thinking it’s going to evolve into almost like a very powerful tool that will enable us to take the low-touch, repetitive activities off our plates and give us more time to spend with clients, deepening the relationships with them, and spend more time thinking about big-picture strategic issues and less time on the day-to-day small issues that need to get done, but that, quite frankly, can be automated to a large extent. I’m thinking hard about what AI does better and what we can use it for, to take a lot of our work that we’re spending time on and push that to AI, and then take that free time and use it for higher-value activities.

When I think about wealth management, the highest-value activity, in my opinion, is really that relationship with a client. You know this well, I think you can not necessarily have the best financial performance. If you’ve got a great relationship with your clients, and they trust you, and they know that you’re always working hard for them and that you’re doing the right thing, they’ll give you a pass at times if your performance lags a little bit for periods. But if you don’t have that relationship, I don’t think they’re going to give you that pass. I think it’ll be a very powerful tool for folks that utilize it wisely because it’ll enable you to develop the relationship.

I think you nailed it. There’s this perception that it harms the workforce. I think it’s going to change the workforce in a few years fairly dramatically, but I think it will, to your point, create a better pathway. For example, on our ops team, I would much rather have somebody on our ops team not having to manually enter data multiple times, but have a computer do that, which could do it much more perfectly, consistently, but free them up to do some things that they can still do better than a computer today. An example of that would be listening. Another example would be empathy. There’s still an intimacy to the act of listening between two human beings.

It’s one reason we very rarely ever hear, and I’m going to generalize, but women complain about how great their husbands listen. “He listens too much.” You never hear that. “He listens too well.” Never hear that. In a client relationship, that’s just crucial. Sometimes there’s just that being present with that person and listening that creates that intimacy that a computer can’t do yet. I do think it’s going to enhance the quality of the time that we spend doing what we do, but I do think it’s going to be very disruptive. I think it’s going to end up creating a lot of job shifts that I think we in Corporate America need to proactively try to figure out how we can help people adjust.

If we see people on our team whose jobs are, you could imagine, very replaceable by technology pretty soon, I think it’s our responsibility to think 2 or 3 steps ahead and go, what is that person’s superpower? How can I deploy them if we had technology, which we will tomorrow, to do 80% of what they’re doing? Even from a client standpoint, I’ll give you another example. We have a very automated onboarding process, and it all starts with a very interactive type form where the questions are highly personal and dynamic to how you last answered it. It’s funny seeing the times of day or night that clients end up choosing to fill that out.

There’s great freedom for clients in being able to do that on their timeframe rather than having to do it at a scheduled meeting sometime between 9:00 and 5:00. I don’t know, like most of us, we’re just pulled in a thousand different directions, and our schedules can be very different. From a client experience too, I think it gives them the freedom to engage with us in sometimes more convenient ways as well. I’m much more excited. I think there’s a lot of promise there, but I do acknowledge there’s going to be some change, and we need to try to get ahead of that in a conscious way and help in our companies to create the smoothest transition for people as possible.

I’ve been reading some research coming out of some of the bigger consulting shops, and they basically say it’s going to hurt white-collar workers the most and senior white-collar workers, meaning AI is going to replace or take some of the jobs away from those folks. I actually disagree because I think where it’s going to really have the biggest impact is the mid-level or white-collar professions, but mid- and lower-level folks. Ultimately, using ChatGPT and similar generative AI, it’s basically able to do the work of, I would say, a first-year analyst, and just like a first-year analyst’s work needs to be checked thoroughly by more senior people, so does ChatGPT’s outputs. But it’s so much faster than a first-year analyst and has a much greater scope where it can suck data in instantaneously.

What I think will wind up happening is teams will get a lot leaner in the middle and lower ranks. I still think there’s going to be the need for senior people who are making the big-picture strategic decisions. I don’t think you’re going to outsource your CEO’s job to AI, but I do think you’re going to outsource your mid-level manager’s job to AI. Anybody who’s doing functions that are repetitive and, quite frankly, don’t really change day to day, that’s all going to be automated. Anything that changes is going to be difficult to automate. If it’s the same process, like in trading, for instance, there’s processes that are the same every single day. Why is a human doing that? That should be automated. I think that’s what will happen in my view. How do you think about how it’ll affect the workforce?

I think that’s right. I think what’s going to happen is, there’s this explosion of curiosity around the different AI programs that have gone public. Actually, if you look at the speed with which they’ve got their first million users, it’s faster than any other app in history by a long shot. It took it like six days to get its first million users or something crazy. There’s resistance to change, it’s slow until you realize you have to, and then it can be very quick. I’ll give you an example. I have a friend who was told for many years, “You need to eat better. You’ve got to watch your cholesterol.” He didn’t change, or if he did, it was very minute. Then he had a heart attack.

Resistance to change is slow until you realize you have to, and that could be very quick. Share on X

Overnight, he became vegan, a super clean eater, because he had to. I think what’s going to happen is we’re going to see a lot of larger corporations be slow to really fully harness the power of automation. They’re going to get hit by competitive pressures of firms that are able to just run circles around them at a fraction of the cost. They’re going to be forced to do that. What I fear is that there’s going to be a point where there’ll be an accelerated amount of change if we’re not proactive ahead of time. I’ll give you an example in the financial industry. Where is the innovation taking place?

It’s not happening at the large banks, at the large brokerage firms, in part because they’re saddled with decades of legacy IT systems that are just a mess. They’re also not known to be great centers of innovation to begin with. It’s the smaller firms that are saying, “I don’t have the resources to hire ten people. How can I get this done? I want to compete with that firm that’s ten times bigger than me. What tools do you have that can help us?” What’s that quote?

Necessity is the mother of invention.

That’s exactly right. I think that it’s going to creep up on medium and larger-sized firms faster than they expect, but not immediately. There’s a lot of resistance to wholesale change. It takes great courage to be able to identify. If you’re managing 50,000 people, between you and me, there’s probably 10,000 people’s jobs that could be completely reinvented. It’s really exceptionally rare when you have a leader who’s willing and able to take that on at scale on the front end.

I think it’s going to creep up on a lot of firms, but if you embrace it, I think it can create a more human experience, ironically. That’s what I want. I don’t have a great experience interacting with some of these crude chat box things. I’m the guy that’s like, “Get me on the phone with a human.” I don’t like these automated phone systems where it’s like, “Hit one for this, hit two for that.” I’m the guy hitting zero like 30 times. “Get me a human being.”

I’m on the same boat. It’s funny, people often ask how ARI got its name, Applied Real Intelligence. This started about five years ago when I was thinking about the company that I wanted to build. At that time, AI was certainly used. My view was that what was happening was inevitable. I knew this was coming. It was inevitable. My view is that back then, you would essentially have to say what was AI-driven, because only 3% to 5% of interactions were AI-driven. People didn’t necessarily know this, but news outlets like Bloomberg, for instance, as early as 2016, I was meeting with senior people at Bloomberg.

They let me know that approximately 10% of the articles were generated by machine. I thought, “That’s pretty interesting. What are you guys doing in the bond markets?” It was all for stocks. They were like, “Nothing. It’s all for equity products.” I thought, “Wow.” I went back to my firm, and I built my own. I generated a newsletter that I sent out every day. It was probably 80% or 90% automated. I would basically suck in data via API on Bloomberg, and I built an algorithm. Basically, the text would be generated based on the numbers. People were reading this every day. It was one of the most-read newsletters in the markets by professional traders.

They’re like, “How do you do this? How do you get this out?” That’s like 6:37 in the morning. “You start at 3:00 AM?” because it was like 10 pages, and they didn’t even know. This is the first time I’ve told this to anybody publicly. Little did they know that 80% of that was auto-generated. To go back to how ARI got its name, my thinking was that back then, you’d have to say, this is AI-generated. When you call Bank of America, and you get the prompts that don’t work, you’re like, this is AI. You’d be in a chat conversation with some software company, and it’s not answering your question. That was clearly not a human, and it wasn’t effective. It was pretty much garbage, and it was so frustrating.

I thought, fast forward ten years, probably 95% of everything we do is going to be related to AI in some way, commercially. We’re going to have to differentiate what’s not AI. We’re going to have to say, “This is a human you’re talking to. This is applied real intelligence. This is not AI,” and that was really how this name was born. It was the fact that I knew this was coming. I wanted to differentiate and say, there’s going to need to be a term that people use to differentiate what’s not AI.

I hadn’t thought of that distinction, but that’s a really great point. Because you’re right, it’s going to become the dominant majority. We’re going to be wanting to know, where’s the real intelligence? One thing just to add real quick on the automation front, the other thing that I think is going to temporarily slow it down before it then goes light speed in its acceleration is when I first started getting into automation, I ran into an initial brick wall that I wasn’t expecting. That brick wall was if you have automation in theory, it helps you scale and go quicker. That’s assuming that you have a very defined process. If you would have asked me prior to beginning that internal experiment, “Do you have a process?”

I would have been like, “Yes, I absolutely do.” It was only when I had to program things in black-and-white rules that I realized, in this scenario, we don’t actually have that defined in that instance. We haven’t actually defined that. It was a very humbling process, very healthy, very thought-provoking, very strengthening, but I think it will expose a lot of companies’ parts of processes that are just not defined at all yet, because without that being clearly defined, you have nothing to automate. It was very humbling to realize how much we thought we had a real process but didn’t actually have it completely defined, if that makes sense.

A hundred percent. I’m incredibly process-driven, and going through exercises like automating a newsletter seven years ago taught me that, and I’m not a coder by any means. I just taught myself. That’s how we think about investing too. There’s an art to it, but there’s also science, and really, you need to combine both.

On the quantitative side, you should be very process-driven, and then there’s going to be a lot of judgment calls you have to make. But if you can take the quantitative side and automate a lot of that and be very process-based and rule-based and consistent, that then, it was very additive to the qualitative judgments you’re going to make. It essentially takes a lot off your plate and can allow you to think about the most important things that are not necessarily black and white, but that are always some shade of gray.

It also forces you to confront important choices that otherwise can get swept away in the sea of time because we get so busy that things can just escape us. The other benefit of rules like that on the investment side is it forces you, price violated this or this, boundary got broken, forces us to then have a conversation and deal with that in a really healthy way. That’s something I think, again, is a plus of automation, a plus of what computers can do, they’re not emotional. They will tell you when that condition is met.

Key Investment Principles

This leads nicely into my next question, which is, what are the key investment principles that you live by, and maybe loop that into how you think about process-based investing to some extent.

I wrote a couple down here, and I’m going to share them with you. Many of them I think are ones you probably share or have heard of, but just in the spirit of sharing, there are some big lessons that I’ve learned over time, and ones they don’t always teach you at Wharton or in the CFA program. First, I’d say, it’s better to be rich than right. One of the things that I really admire about investing is it promotes humility. If you don’t embrace humility and get over being right or wrong, then it can be a very expensive profession. Two, I would say this also confronts my traditional fundamental education.

Price is the ultimate yardstick. For most of us, if you’re Buffett and have a 50-year time horizon, then that may not apply to you as much, but price is truth. I struggled to accept and understand that until I started trading futures, where risk management becomes the difference between life and death. What I learned was you’ve got to first pay attention to price and take action based on what’s going on. You can then get intellectual and analyze and study and understand and all that later as long as you’re still alive. But staying alive is almost like speed in a car. If you’re going around a corner, there are just certain boundaries that you need to learn to observe and pay attention to in how you manage risk.

The third one related to that would be cut your losers fast and let your winners run. We say that in the financial sector, but I hear CEOs say that about how to manage employees on teams all the time. If you ask a CEO of a Fortune 500 company or even a smaller company offline, “What’s some of your biggest lessons learned?” many of them will tell you, “You know what, it’s when you realize somebody’s not the right fit on a team, taking action fast.” There are so many stories that you hear from seasoned CEOs about how they just tried to help, took forever, and it just caused all these other issues. I think that’s something we’ve got to practice in the financial space as well.

Another thing I would say is observe before judging, which I think would be a great lesson for modern American adults in culture. Observe before judging. That goes back to price. I think it was Charlie Munger, Warren Buffett’s partner, who talked about scotoma, the fact that neurologically we look for evidence to support our views. I think one of the other disciplines of investing is, as best we can as humans, to try to discard our biases and really try to see what is there. Sometimes what’s helpful for that is to look for evidence contrary to your view.

In investing, we learn as best we can as humans. To discard our biases and try to see what is there, it is sometimes helpful to look for evidence contrary to our view. Share on X

For example, in my inbox, if I’m just getting flooded with articles and some of those articles are about a position that we own, I will often ignore the good articles, and I will read the ones talking about how that particular security is bad or going to fall or got a sell rating or something with it. I will read those first, as just a discipline to make sure that I’m not getting caught in my own biases. Another one that I think we can credit Warren Buffett for, I don’t know if he actually said this or it’s just street lore, is “Be greedy when others are fearful and be fearful when others are greedy.”

I’ve seen opportunities time and time again, some of which I’ve taken advantage of, others I look back on and think, “Dang it, I really should have listened to my gut and taken advantage of that market extremity, whatever that may have been.” Easier said than done, but there’s great value when you can remember that at points of extremity. In old sailor lore, we always used to say, “It’s always darkest before dawn.” I think that’s true in the markets. Another one would be, and this goes back to our AI discussion, create a plan and then work it, it helps manage the emotion. We’re not going to be perfect, and there are things that are going to require human input.

I think a good plan gives us the discipline to make sure that we’re asking the right questions at the right time and having those tough conversations. Another one that is just so simple, but so true, many of us who’ve traded futures have learned the hard way before really understanding this wisdom, is don’t fight the trend. The trend is your friend. That again goes back to “It’s better to be rich than right.” We get a point of view where we’re like, “Dollar-yen should be falling or it should be going up,” and it starts going the opposite direction. You start increasing your positions. Why?

Because you’re convicted in your point of view, rather than paying attention to what’s actually happening in the world and end up getting on the wrong side of the trend, which can be very dangerous. Inspired by my grandfather, my grandfather was born in 1899, grew up in the Great Depression, and he never bought anything on credit. I wish I could say the same. He bought everything, all cash, very conservative. I think they kept every nail and screw, piece of wire, and jars in their basement till the day they died. Leverage can be very positive when used judiciously, and leverage can work against you very quickly if you’re not careful. I think with leverage, you just need to be extra thoughtful.

I see in real estate all the time, I’ll see people go, “Here’s a great deal. It makes 9%.” It’s actually a 2.5% cap rate levered to the chin. I’d rather have a 6% return unleveraged, I can always add leverage later. Looking at things pre-leverage and then understanding when it’s super advantageous to add it, and when you want to maybe take a pass on it. The very last thing I’d say, we’re human. There’s always this inner fear of missing out, FOMO. We even have our own name in finance for it. I think that’s another emotion that, as a professional investor, we need to really guard against. I think AI is a great example of that. The market’s gone up a bunch, really on the back of seven stocks.

A lot of people did not participate in that and had bad years last year. There’s a sense of like, “How do I make up for it?” That can lead to really bad decisions. I think it’s just important for investors to recognize when you’re feeling that, just acknowledge it, put it to the side, and go back to your plan. Those are some ones that, for me, are some really profoundly powerful lessons that I’ve learned from others, and some I’ve learned the hard way and continue to be important to our thought process.

Those are such good points. There’s so much I want to dig into there. We could probably talk about it all day, but you nailed it. Those are just all great points. The idea of FOMO, I’ll touch on just because it answers a question I was going to ask you, which is one of the biggest mistakes, or what are the biggest mistakes is the question. In my view, FOMO and getting in at the wrong time and chasing the shiny object, chasing that hot trade, just blows people up, and they do it again and again and again. Why do people not figure this out? I’ll give you a quick little anecdote that I find amusing, but let’s see what others think.

When I was a kid, I used to collect baseball cards and other sports cards, basketball, football, and had a huge collection. It was my thing. When I was young, there was this magazine called Beckett’s, which would give you the price of all the cards. It would come out once a month, and I was ten years old, and I’d go read it. It would show you the price versus the previous month. It would have a little arrow if it went up or down. What I would see is that the hot players and the hot cards would have the little up arrow. I soon realized this is not an indication of where the price is going to go. This is where it already went.

I started, as a third grader, realizing that you shouldn’t buy things that have already appreciated in value. You need to look for the cards to buy before they have the up arrow next to them. I figured this out in third grade, and it was pretty obvious to a third grader how this works. Yet the market, including institutional investors, still hasn’t figured this out. They’re basically waiting until the up arrow has been printed in the magazine for six months, and then they’re like, “I want in.” Whenever I read prognosticators saying that people should buy into the market because it’s done really well, I want to call up their boss and say, “Can you just shut this person up and fire them?”

It’s just complete nonsense, and yet the market has really bought into this way of thinking. I do want to get into this because it’s been bothering me, the quality of investing out there has plummeted in recent years. It’s absolutely gone down the tubes. You’ve got meme stocks, you’ve got assets that aren’t even real. People think they’re investors because they can speculate on their Robinhood app. It bothers me because real investors have spent decades going to school, working at the top firms, working 60, 70, 80 hours a week to get better every single day. We’re true experts in our field.

Somebody comes along, and because they’ve got a LinkedIn account and can spew their opinion, all of a sudden, they think they’re an expert, and somehow others do as well. To me, the investment industry is at risk. One stat I’ll share that I think is very interesting, we’re both CFA charter holders. CFA is like the gold standard in the industry. There are many tens of thousands of charter holders worldwide. I think there’s almost 200,000. What’s interesting to me is that the number of people registering for CFA exams has plummeted in the last three years. It coincides with this boom in crappy assets and a boom in liquidity. It’s gone down immensely.

The three-year average number of enrollments for the CFA tests from 2017 to 2019 was a little bit under 250,000 annually. So, pre-COVID, about 250,000 people were registering every year. In 2022, it was down to less than 150,000, it dropped by like 2%. The year before that, in 2021, because of COVID, only 50,000 people took the exam. You would expect that the number would have gone up in 2022 because of the pent-up demand from 2021. Instead, it went down. This year, the year-over-year run rate is lower than 2022. What we’re seeing is a massive decline in the number of people trying to participate in the CFA exams and earn the charter.

It’s interesting to me because I think there’s certainly a correlation there between the easy money that’s been made and the amount of work people want to put in to actually become skilled investors. Who wants to put in 1,200 hours studying for the CFA and probably not pass every level on the first attempt when they can just go buy cryptocurrency or a meme stock or an AI speculative stock, and all of a sudden they’ve made five times their money? The markets have basically helped people develop very bad habits. I think we need a cleansing to wipe out those bad habits. That’s why I’m rooting for a reset.

You mentioned a couple of interesting things that I want to hit on. On the emotional side, I think one of the other key mistakes that investors make is they look backwards instead of looking forwards. This is one of the most fundamental mistakes, and we saw it happen at Silicon Valley Bank, for example. For 20 or 25 years, owning bonds was an incredibly great trade, and then the Fed decides to start raising interest rates. They did not anticipate that. Suddenly, they were on top of a mountaintop shouting, “We’re going to raise rates.”

One of the mistakes that investors make is they look back instead of looking forward. Share on X

It’s amazing to me how many people, portfolios, strategies, and models all have a huge amount of bonds in them, traditional bonds, for no other reason than that’s what we did yesterday. I think that really hurts people. I think you’ve got to be forward-looking, not backward-looking. To your point, in other areas of life, people are pretty good at this. They get that. If you’re out driving and it looks like the sky is just going to start pouring, that’s what’s going to matter to you, not the fact that yesterday it was bright and sunny.

You’re going to be forward-looking in terms of thinking about a super cold weather projection for the next week in the city you’re traveling to, you’re going to bring warm clothes because you’re looking forwards, not backwards, because last week you were in Maui on a beach, it was 80 degrees, and you were wearing a bathing suit. But yet, in the investment space, it stuns me how much of the herd is still focused on yesterday.

This touches on the point you made earlier about resistance to change. I think the investment management industry historically has done well because it didn’t change and was always that steady rock that never did anything differently. In the current world, things are changing so quickly. Folks that don’t adapt are going to get eliminated. It’s going to be Darwinian, in my opinion.

I think there’s going to be a huge culling of all the folks that are resistant to change because they’ll go out of business. I think we’re going to see a big wave of that over the next 5 to 10 years, when a lot of mediocrity is wiped out, and folks that aren’t skating to where the puck is going, as Wayne Gretzky would say, just aren’t going to have a seat at the table anymore.

As they are going to be at the center of that, there are a few things on that I want to share. One other thing I want to add on the topic of human capital, I had a breakfast, I don’t know, it was probably fifteen years ago. I was invited to a relatively small breakfast hosted by Michael Milken. At the time, it was again one of these periods where we had twin deficits, and everybody was freaking out, asking, “Is the sky falling? Is America going down the tubes?” Nobody had asked him about that yet, so I did. His answer was really instructive to me, very insightful, very deep, and it inspires me to this day. He said, “I don’t worry about the financial deficit, I worry about the human capital deficit.”

If you look at the history of the country, some of the great things we did were powered by extraordinary intellects that we recruited to America, who made America home. Immigration had a large part to do with that. We want to make sure we are, in a healthy way, inviting the right people to make this home. When I think about some of what we’re seeing in the marketplace, I think there’s a lot of thought being given to the financial capital side of the equation, but not enough being given to the human capital side of the equation. I think there’s going to be a lot of disruption, but an enormous amount of opportunity. I think banks are going to be absolutely at the center of that.

Alternative Investments

So much good stuff to talk about here, but we only have a few more minutes. I want to use this as a segue into talking about alternative investments, because that is where the world is going, and that is in the investment industry, certainly. I’m curious, why do you think alternative investments are gaining popularity, and why are they very beneficial to have in one’s portfolio, generally speaking?

I think two reasons. One is experiential, the other substantive. From an experiential standpoint, a lot of clients don’t like the stock market because multi-billion-dollar companies could be up or down 25% in a day. That roller coaster was cool when you were a kid in an amusement park, but it’s not cool when that’s your net worth experiencing such dramatic fluctuations. In the private markets and alternative markets, in general, I think the experience is one of less volatility. There’s still risks that you have to manage, and I think that’s a bit of a point of attraction.

Substantively, my CFA hat on, and this does relate to the banking crisis, there are opportunities to earn very healthy rates of return on a risk-adjusted basis in the private markets that are not available in the public markets. From an investment standpoint, it doesn’t make sense to limit yourself to just one half of the menu. The private markets have been steadily expanding over the last 20 or 30 years. They are substantial markets. This is no longer a niche playing field. A great simple example would be, you’ve got a lot of investors out there who are saying, “I want something that’s going to stay ahead of inflation. I want to make high single digits or low double digits, but I don’t want to bet the farm.”

A lot of people have tried to accomplish that using leverage and investing in high-yield publicly traded securities, but that can be really risky. On the other hand, in the private markets, there are very attractive opportunities to do that on what I would argue is a reduced-risk basis, created by imbalances in the supply and demand of capital. The banking crisis we’re seeing is a great example of that. Small and medium-sized banks are incentivized to be a lot more conservative because they’re worried about the prospect of a bank run. They don’t want to end up without a job.

As it is, their deposits are leaving them because people are waking up and saying, “I’m not okay with the national average of 0.4% that you’re paying us in our savings account. I should be able to get 4.7% without taking much risk, if any at all, in the right money market fund.” Their deposits are leaving, risk level, they’re less willing to embrace any risk. You have a lot of companies and people out there who need access to capital. In the absence of banks being your lending partner and providing that, niche lending opportunities have existed and are becoming, I think, even more dynamic. There’s an opportunity to earn healthy yields that, if you’re organizing that fund the right way, you’re not betting the farm.

I think there are some really attractive opportunities there. Going back to your very first question, that’s one of the things we’re spending a lot of time looking at: where are the best opportunities that are coming from this tremendous credit reduction and decreased willingness to provide credit, not just interest rate, but simply a willingness to lend, because banks are under extra scrutiny by regulators, fearing bank runs and worrying about their profitability, as they should be.

This is a great tie-in to venture debt, which is what ARI does, in the sense that, first, I want to go back to tying it in with Milken. Milken became famous and rich because he basically popularized loans to non-investment grade companies. Back in the early 80s, a lot of folks said, “Why would you ever lend money to a company that wasn’t investment grade? That’s junk.” It was known as the junk bond market. The reality was that there was this huge percentage of the universe that needed this capital and they weren’t being efficiently served by that ecosystem, by the banks at that time.

Michael Milken, Howard Marks, and some others basically said, “We’re going to help these non-investment-grade borrowers access the capital markets more efficiently.” It was called junk bonds back then. Now it’s called high yield, and almost everybody has it in their portfolio. That’s ultimately the opportunity that I saw and continue to see in venture debt. There’s this need for capital from startups that are growing very fast. They’ve got revenue, and they don’t want to sell more equity necessarily, but they need growth capital. They’d like to borrow some money to help them grow because it’s cheaper and less dilutive than equity capital.

There’s this huge growing pool of innovative companies. Thinking about all the startups in this world that are coming to market that are going to need capital and there’s two ways to fund them, equity, the VC model or debt, the venture debt model. On the venture debt side, it’s very underserved, and there are very few players in the space. That brings us to the next point that you just made, which is that banks are pulling back on lending and providing less credit. I think that’s going to continue, creating a huge market opportunity for non-bank lenders. Do you have a question or a thought?

It’s all kinds of markets. The venture debt market is going to need capital. It could also just mean, for example, that the traditional banking credit model is really based on this idea of a credit score. If you have a perfect credit score, then we’ll give you capital. The next level down is cash flow. If you have really great cash flow but a terrible credit score, think a wealthy doctor or dentist who’s in the middle of a divorce, and amid the complications, credit cards haven’t been paid, and all these things are part of that process, the guy’s making bank, cash flow is strong, but from a traditional credit standpoint, his credit might be terrible.

A lot of the traditional banks look at that and are like, “We don’t want to touch it.” That introduces cash flow-based lending, which some banks do, but a lot of them don’t, surprisingly. The third level down is collateral-based lending. You don’t have cash flow, but you’ve got collateral. I think there’s a rich opportunity based on different types of lending models. Banks are pulling back in all three. There’s also speed. Banks are traditionally incredibly, painfully slow to work with.

Michael Milken, for example, innovated the allocation of capital not just in the financial markets, but also in the medical research space. He wrote an amazingly inspiring book about that, where traditionally, if you were a young upstart researcher in the medical space, the applications for grants would all ask you to cite what books you’ve written, what articles have been published. Like, “I don’t have any gray hair, I’m 25 years old, I just graduated with a PhD, I’ve got some really great ideas, I need some money to test them in the labs. I don’t have fifteen citations.” Even if they did consider your ideas, the turnaround time would often be a year.

Milken came in and said, “We don’t care about the gray hair, we care about the quality of ideas, and we’ll fund you in a week.” Can you imagine that, being a 25-year-old researcher, being like, “What?” The speed and the qualification process, he had experts evaluating the merit of the ideas. In a portfolio of ideas, there may always be a couple that don’t perform, which is why you always want to put a fund together so that you’re diversified across those credits so that, invariably, when some of those don’t go according to plan A, you’re still okay at the portfolio level and doing well. I think there are a lot of people who’ll be happy to pay a higher premium for the convenience of a faster decision process.

It’s the certainty of getting an answer, yes or no, rather than this long, drawn-out process. The banks that can be agile and give that quickly, I think, will continue to thrive. I think many banks, a lot of the banking sector, that’s just not their forte, and it creates unique openings for firms like yours and other specialty lenders to take advantage of and opportunities for us to deploy client capital in ways that are far more profitable, I think, with that imbalance and with higher interest rates than they have been for years.

That’s great insight. I think a lot of people are still figuring this out, and it’ll take them a while. You’re well ahead of the curve, I think, in terms of how you’re thinking about it.

It’s looking versus forward-looking. It’s easier for a lot of people to just buy a twenty-year U.S. government bond ETF. That was down 32% last year. Bonds are safe. We’ve heard that for decades, but twenty-year bond ETFs down 32% last year, not safe.

To add to that stat, if someone was invested in an average-performing venture debt fund last year, they would have been up close to 20%, versus being down 32% in the government bond. Think about that. They would have picked up 52%, which is basically a decade of fixed income returns in one year.

All the people that have been waiting, “I don’t want to get into venture debt. I don’t want to get into private credit. I just want to own these treasuries because they’re, quote, low risk,” didn’t really contemplate interest rate risk and didn’t really know what they were doing. They’re going to be behind the curve for the next decade, and just to get back to break-even, it’s going to take them ten years because they missed it.

I think this is going to get even more accentuated by the real estate problems that are on banks’ balance sheets, not to mention their long, a bunch of long bonds as well. I don’t think real estate’s out of the woods yet. I think residential is probably in a better position because home is the new office. Even three years after COVID, the physical occupancy of our downtown office buildings in the top 10 U.S. metro areas hovers at slightly below 50%. Other office buildings, malls are going under. Retail, here’s an interesting stat, only 25% of our retail business is done online. In my house, it feels like 100%. My wife is like, if they gave out designations, she’d be like an Amazon ninja. It’s amazing what you get online, but just 25%.

That 25% means the logistics and the warehouse logistics behind that. Is 25% going to go to 100%? Probably not, but is it going to go from 25% to 50% to 75%? I would absolutely argue that it’s headed in that direction. There will be niche areas that continue to do well, but I think a lot of people are going to lose money in real estate. They’ve been raised on this idea that real estate always goes up, and they grew up in an environment where interest rates were inexpensive and near free for a number of years.

The after-tax cost of debt is 2% or 3%, and so you had a lot of people that were just buying stuff, leveraging it up and going, “It’s always going to go up. I’m going to make a lot of money,” and it did. Backward-looking, forward-looking, going forward, interest rates are much higher, behaviors have changed, and you’ve got to be smart about it. I think that’s also going to saddle banks, and it’s going to create, again, more opportunities in the middle.

You hit on an interesting point about the growth of the market potential going from 25% online, and it could easily be more than that. That’s what I think a lot about in terms of innovation finance in the sense that only about 1% of total capital in the startup ecosystem is debt. If you were to go from 1% to 2%, 2% is not a big number. You literally double the size of venture debt in the ecosystem. That’s why I think these markets are poised for huge growth, because if you look at the public markets, S&P 500 companies, for instance, 30% of their capital structure, a little bit more than 30% actually, is debt.

Obviously, startups are never going to have as much debt as a mature company, but I don’t think the difference is 100% versus 30%. In my mind, that 1%, 5 to 10 years from now could easily be 5%, which means you’ve got 500% market growth. That’s why I see this venture debt market exploding in growth just like high yield did, or junk bonds back in the 80s and 90s.

You may have the actual statistics on this, I don’t remember off the top of my head, but when I was looking at the Silicon Valley Bank debacle, although I was incredibly shocked at the fact that nobody on their board or senior management seemed to be managing even the most basics of balance sheet risk with respect to their fixed income holdings, I do have to give them credit. When you look at their venture debt portfolios, the credit losses were very low. From what I saw, they did seem to do an exceptionally good job on that side of the business.

It’s a shame that they didn’t know how to manage the rate risk in their treasury portfolio and mortgage-backed portfolio. The jewel in their crown has always been the venture lending. I always use that as a great comp when I’m talking to people about venture debt. I say, we can look at Silicon Valley Bank’s numbers, and there’s other public companies that specialize in venture debt, and the numbers are out there. 2009 was the worst year in history, essentially, for financial asset performance, at least in our history. In our lifetime, Silicon Valley Bank only had to write off 2.6% of their loan book.

2.6 means 97.4% of their loans were all performing and generating interest, and therefore they didn’t even lose money in 2009. I think their venture loans actually performed better than their non-venture loans because venture loans are backed by the top VCs in the country. There’s implicitly huge support and a lot of money behind these companies. It’s not the same as lending to a traditional small business or lending to a restaurant, a hairdresser, or a lawn care company. You’re lending to one of the fastest-growing tech companies in the world.

It’s backed by big VCs, there’s a lot of money that’s gone into it, a lot of reputational risk. There’s a massive amount of skin in the game that’s subordinate to you when you’re the senior lender. You basically control the cap structure as a senior lender, and everybody else that’s put in money is subordinate to you, and you’re going to get paid off first in it.

That’s another example of where I think there are niche lending sectors where there’s something about it, the exterior, that scares people. This being one of them, that if you structure it right on the inside, you’re doing a lot to reduce risk. It might be significantly more attractive on a risk-adjusted basis than people really realize. Another example of that would be like, we’ve invested in DIP financing strategies. A lot of people, they’d be like, “Why in the world would you ever lend to a company that’s in bankruptcy?”

On the surface of it, that sounds crazy and risky, but of course, if you dig into it and you see that you have no collateral risk because there’s total clear, absolute title, thanks to the power of the judge in that context, highly supervised process, user rates don’t apply, and you’re over-collateralized, suddenly you start to think, that’s pretty interesting. Also, the only place on earth, by the way, where you get paid before the IRS, I didn’t know that until we started doing due diligence on that. If the company owes money to the IRS, they don’t get paid until that DIP financing does first. Again, to the outside world, it might seem like a really crazy, scary thing.

When you get on the inside and you look at all the different precautions and things that are done to manage that risk, you start going, this is a lot better than some of those super volatile, high-yield funds on the stock market. I think that arbitrage of emotional perception of what it feels like to somebody who doesn’t know what they’re doing versus being on the inside.

A lot of people don’t realize this, but the history of value investing, if you look at Benjamin Graham, who Warren Buffett learned from, and really understand how it all began, they would invest in companies that they called cigar butt companies. Basically, you have a cigar butt on the street, but there’s still a little bit left to smoke, and you’re picking it up for free essentially, and there’s value there.

Very similar analogy to like DIP financing. Where the company might be going down, but there’s still value. If you can extract that value and you pay the right price for it, you can be a big winner. I think a lot of people don’t understand that, they get these concepts of price and value confused. I would tell people to go read up on Howard Marks and his views on price and value.

He has some great quotes on that, doesn’t he?

Yeah.

What a great mind.

Brilliant. Random thought here, but I think both Howard Marks and Michael Milken are also Wharton grads? I don’t know.

Yeah. That’s right.

Marks went to Chicago Booth or the GSB when he went there for business school. I always like him for that as well.

A funny story about Milken. I was friends with his son, Greg. We were in Japanese class together, and he had a big birthday party and invited a bunch of people and rented out a boat. On the second floor of this boat, there was a casino, and Michael would walk around, and he was mathematically one of the smartest guys, holistically smart, really out there making a difference in the world, but also just ridiculously sharp and smart. We’d be at the craps table or whatever table, and it was pretty funny because he’d have some guys who thought they knew what they were doing, chest out, trying to impress the girls or whatever. He’d walk up, and he’d coach whoever was the underdog at the table.

You’re like, I want him on my team. Such an amazing guy that you’re right, seeing that disconnect of capital back in the day. And to your point about value, with his miner light on, on the bus reading financials, he wasn’t speculating. He wasn’t saying, “I think this company might be successful in the future.” He was saying, if you look at the numbers, it’s got the cash flow to support it, it’s got the assets to support it. It’s just that the big sources of capital, they’re not serving these companies, and I will. In the process, he invented a whole genre of financing and I think did a lot of good for America because a lot of those companies grew and created a lot of jobs that wouldn’t have happened without that funding.

I’m actually part of the Milken Institute Young Leaders Circle and go to the Milken conference every year, and I agree with you. The stuff that they’re doing is just incredible.

I didn’t know that, actually. What a small world.

I’m in Santa Monica.

Round water from Cherokee.

It’s great, but it’s amazing the impact that they’re having. It’s special to be part of it in many ways, and it’s going to keep growing. Some of the things that they’re doing that I was looking at at the conference this year, it’s mind-boggling. We’re out of time, unfortunately. I feel like we could talk all day. This has been fantastic. I’ve loved it. I’ve learned a lot. I wanted to ask you, what’s the best way for folks to reach out to you, to learn about you? Is it on LinkedIn? Is it a website? What’s best?

Yeah, it could be LinkedIn, or you can look us up online at www.WhitwellAdvisors.com. Always open to having conversations and getting to know new people. Don’t be shy, reach out, and again, thank you for setting this up. I’ve really enjoyed our conversation and feel like we could extend it for another twelve hours.

We will offline. Everybody else will miss that. Maybe we’ll do another one later to talk about all the advances that are happening. There’s so much going on that we’re going to have to talk in 6 or 12 months, so we’ll get you back.

I think exciting times.

Thanks again for coming, and thanks, everybody, for listening to the 7in7 show with Zack Ellison. See you next time.

 

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About Stefan Whitwell

As Founder and Chief Investment Officer of Whitwell & Co., LLC Stefan leads the overall Firm and its investment practice. He is also a sought-after advisor who works closely with clients at the intersection of health, wealth and purpose.

Stefan has particular expertise in tax planning and alternative investing. In addition, given his mergers and acquisitions investment banking background, Stefan enjoys helping business owners prepare for the sale of their business and be more strategic in how they fund their business in its earlier growth stages. Last but not least, Stefan is passionate about venture philanthropy and legacy planning.

Stefan started his career learning from some of the most globally respected bankers at James D. Wolfensohn, Inc., Goldman Sachs and Credit Suisse First Boston. He has worked in New York City, London, Hong Kong and Tokyo and has a first-hand understanding of global markets and multicultural work environments.

Stefan graduated from the Wharton School of Business at the University of Pennsylvania and subsequently earned the Chartered Financial Analyst and CIPM designations from the CFA Institute, where he served for 5 years on their global Educational Advisory Committee. Stefan has also served on the Long Center Corporate Advisory Board, the Baylor Scott & White – Development Advisory Board and was previously a Social Venture Partner at Mission Capital.

Stefan lives in Austin, Texas. He is the proud father of 4 children with whom he enjoys playing and spending time outdoors, along with their German Shepherd Hallie. He is a purple-belt in Brazilian Jiu-Jitsu, a black-belt in Hakko-Ryu Jiu-Jitsu, a long-time patron of the arts and a violinist of over 40 years.