Investing In What You Know: Maximizing Returns Through Familiarity With Michael Nicks, Deputy Chief Investment Officer, Pepperdine University

 

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Michael Nicks is the Deputy Chief Investment Officer at Pepperdine University and a member of the Investment Steering Committee for the Alternative Investment Management Association.

In this episode, Zack and Michael discuss:

1. The Failure of Self-Regulation in Digital Asset Markets
2. You Don’t Have to Do It All
3. How to Build a Resilient Investment Plan
4. Why Results Matter More Than Public Opinion in Investing

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Investing In What You Know: Maximizing Returns Through Familiarity With Michael Nicks, Deputy Chief Investment Officer, Pepperdine University

We have with us Michael Nicks, the Deputy CIO at Pepperdine University. Michael is one of the most outside-the-box innovative thinkers that I have met in the endowment space. I’m happy to have you here, Michael. The one thing I always think about when I think of you is that you are thinking about where the puck is going rather than where it’s been, as Wayne Gretzky would say. It’s always free to talk to you because I come away with new ideas every time. Before we dig in, tell everybody a little bit about your background and how you got there.

I probably have a fairly unusual background for an investment manager. I started as a college dropout who didn’t find anything in school that I wanted to do. I left to take some of my retirement upfront and spent a lot of time on the beach. I worked for Bob Dylan, the musician, for a long time as a security guard at his house in Malibu.

I enjoyed my life and became a scuba instructor. When I decided to go back to school, I studied Marine Technology because I knew it would be something that I would be motivated to do and be driven behind. By the time I finished that, I decided I wanted a more traditional education, so I went on and finished my bachelor’s degree.

I went into database design and database management. That’s what I found my way into as I started working in the daytime and going to school at night. I ran into someone who took me under her wing and taught me enough to take over her job when she moved on. I got into technology, and then when my wife and I decided to start a family, I decided to go back to school. I wanted to learn something about finance because I had entrepreneurial ambitions.

I started studying Finance at Pepperdine in graduate school. As I approached graduation, I thought I wanted to do something in bankruptcy work out, which is like a recycling version of entrepreneurship. I was interviewing with companies and I went to the University’s Head of Finance and said, “I’d love to work anywhere you can use me. I’m happy to work for free.”

He sent me down to the endowment, and I started doing what I could to support the team there. I fell in love with that stuff. I was talking to a distressed manager who I knew socially. She said, “You ought to consider taking a job and the endowment if they hire you instead of going into bankruptcy work out. They created a job for me. I started in the endowment. I have spent my whole career at Pepperdine in the endowment space.

One of the things that makes you an exceptional investor is that you have a very diverse background and, therefore, a diverse perspective, which opens up your mind to innovative opportunities that others missed. You see things that others don’t. This makes me wonder what’s something you are thinking about right now that you think the market is missing.

Institutional Vulnerability And Societal Respect For Institutions

What market or maybe other investors aren’t thinking about that is very important. I think a lot about the vulnerability of our institutions and how successful Western society is in general. American society. A lot of it has to do with these robust institutions specifically around our economics but also around our political life. There’s been a real change in tone at least within my life experience. I don’t know. I can’t speak for the whole of history.

In my lifetime, this seems to have been a real decline in the respect for institutions. The reverence. It’s weird because when I was young, I was irreverent because of my youth. I didn’t hold that point of view, but as I aged and started to appreciate the world more and more nuanced. I started to recognize the value of things like our governmental and economic Institutions. I think there’s a lot less respect among people now my age for those institutions. There’s a lot more of a focus on a short-term mindset. How do I win the day? There’s a willingness to sacrifice the institutions. I’m thinking of things like the Fed, the presidency, the Supreme Court, all very dangerous. Talk about modern society, but that’s part of it. A lot of this intensity has led to, “I don’t care about that institution, but what happens when the shoes are on the other foot? That’s something I think about a lot.

Today, there is a greater focus on a short-term mindset: How do I win today? This often comes with a willingness to sacrifice institutions. Share on X

One of the key themes in the market is what we are seeing with digital assets and a big driving force behind that is this intention to disintermediate existing financial and governmental institutions. What’s ironic is now that space has gotten itself and quite a bit of trouble and it’s clear that it can’t be self-regulated because many of the folks that were running exchanges and funds are now going to jail and their outright criminal in many cases.

It’s clear that now we need the institutions to step in to protect society, essentially. That’s ironic, and what drove the demand for these strategies was the idea that our institutions weren’t good enough but could be better. Ultimately, we have seen in the digital assets space that they are trying to recreate institutions by doing it in a way that doesn’t make any sense, and now they have to rely on the existing institution.

You are spot on there and I see a lot of folks that tend not to support the institutions that got us here, and I think that’s a mistake because, ultimately, one of the reasons why America, in my opinion, is the best place to live in the world is because of the strength of our institutions. We have had a lot of trial and error through centuries, so we have learned a lot from our mistakes. We are not perfect. We are far from perfect, but ultimately, we have a track record of being pretty successful relative to everything else that’s out there.

I would add stability. Stability allows you to plan because you have more solid expectations. If you can do better maybe that necessarily needs to. Turning to investing, what are some characteristics that you admire in the world’s best investors and how do you apply what you have learned from them?

Fundamental Principles Of Investing

There’s a single word for it, but thinking classically rather than in the moment, perhaps. Relying on foundational, fundamental ideas rather than analysis of the short-term environment. Thematically related to my desire to see institutions. This is institutional thinking, right? I think of people like Jeremy Grantham, who says, “What goes up must come down.” He’s known for mean reversion. That’s a classic point of view that never goes out of style but frequently gets thrown out.

When you are in a bubble, no one thinks it means a reversion of things. It’s all going to go on forever. Grantham is a guy that will keep you grounded from that point of view. Warren Buffett. Don’t invest in stuff you don’t understand. He famously talks about not buying Microsoft at the beginning because he didn’t understand it.

From Howard Marks, I garnered that purchase price matters a lot and I would say that the thing I probably run around talking about the most is that you can’t be saving money on the purchase because it’s baked in returns no matter what happens, it’s there. The old-fashioned ideas but also independence of mind because I sound like I might be going, “This dude thinks everybody thinks that, but these are all so people who are very independent-minded too,” so I think that’s cute.

The theme you hit on there was this fundamental approach to investing, which never goes out of style. When markets get hot, a lot of people tend to disregard fundamentals and they begin trading on momentum and, therefore, begin speculating in many cases. I like to think of speculating as very different from investing and a lot of the themes we saw in 2021, in my opinion, were speculation and a lot of those investments will lose a ton of their value and that’s playing out now and it will continue.

Those who do well through all types of cycles, whether good or bad, are those who adhere to the fundamental principles of investing based on value and thinking about the price-value relationship that you talked about. Howard Marks has been mentioned many times as being fundamental. I mentioned in a previous episode how I think it’s something that investors miss all the time. They think about the quality of the company or they think about price but they don’t always put the two together and think about how price relates to the value.

You can oftentimes buy mediocre assets, but if you get them at the right price, there’s substantial value there. It’s not price that matters. It’s the value that you are getting for that price. The other thing I think about a lot that both Warren Buffett and Howard Marks talked about quite a bit is the margin of safety. We know we are going to get things right some of the time, but we are oftentimes going to get things wrong and when things go wrong, are you protected on the downside and how are you mitigating risks?

Nobody gets anything right 100% of the time. I would cuff it that maybe 60% of the time, we get it right as professional investors. If you get it right 60% of the time, you are doing quite well, which means you are getting it wrong 40% of the time, so what do you do in that case? In cases where you got it wrong, you have to make sure that you have a margin of safety on the downside. I 100% agree with some of those fundamental principles that you brought up.

The last thing I will mention too is that the market is moving back towards a fundamental back-to-basic approach. In my opinion, we got very excited and irrationally exuberant over the last couple of years, and now people are saying, “I’m looking for value. I’m looking for companies that can survive a downturn and, ultimately, that always boils back to value investing and the financials of the company, which are the underlying business model.” It’s a lot less about psychology and more about fundamental value. With that, I wanted to ask if there is any investment advice that you have received that you think every investor should know.

There’s one thing that makes the rounds in our office on a regular basis. Somebody will mention it once a month. The quote itself is you don’t have to be in Europe. It comes from a phone call we had with the hedge fund manager. He was sharing an anecdote himself and he was talking about speaking to his mom and he was all upset about these companies that he had invested in and how hard it was to try and get on and she said, “You don’t have to be in Europe.”

He uses it and we use it as a reminder that you don’t have to do every good idea. You don’t have to be everywhere all the time, and if you are, you are probably overplaying your weak thing or your weak idea. It’s your weaker skills and your weaker opportunities. If you try to stay focused on the things you do well, that’s been a theme around here for the last couple of years, in particular, where we have tried to pare down what we are doing.

This manager, I can’t figure out how to categorize him. What somebody will invariably say is, “You don’t have to be.” That’s our local inside joke, but the advice is you don’t have to do it all, and it helps you be more efficient with your risk-taking and realize you can focus on things. As Buffett says, understand that you are comfortable with things that have a margin of safety. You can build the characteristics into your portfolio you want by not always pursuing things that maybe others would encourage you.

I think of it as conviction ideas. I used to be a bond trader in my previous life, so to speak, and it was all about high-conviction ideas and diversification is great, and that needs to be a part of every portfolio. If you are too diversified, it means you are putting some mediocre ideas into your portfolio. It also means you are going to have average performance.

If you are fully diversified by definition, you are going to have the market average return, which might be exciting to some. It’s not very exciting to you or me, I imagine, and I’m thinking about how to generate alpha consistently. To do that, you can’t do what everybody else is doing. You have to be a bit of a contrarian all the time and you have to put more risk capital to work on your highest conviction ideas and sizing them is a big part of that as well. You might have two good ideas, but if one is a lot better in your view, you have to make sure you size that appropriately and also consider the downside.

Sizing is super underappreciated. Good point. This applies to that as well.

We could get into a lot of stuff about sizing, entry, and exit points. Those are two areas that people miss in liquidity. Fundamentally, most investors mismanage their liquidity and have too much of it. Most of the time, investors don’t need all the liquidity in their portfolio, which brings us to the next question, which relates to how you manage an endowment portfolio because you have been doing this for close to twenty years and endowments are very different in terms of how they are managed versus retail money for instance. What key principles do you think about when managing Pepperdine’s endowment?

Managing Endowment Portfolios

I will start with what you mentioned about liquidity. For us, liquidity demands are typically pretty mild. We are paying a 5% annual payout of a moving average historical map, allowing for better planning. We do have some concerns but 5%. If you have an endowment with 15% of liquid assets, that’s not an issue. One of the things I remember earlier in my career talking about along the lines. The illiquidity premium you demand should be dynamic for your first dollar. The bar should be pretty low because you are never going to touch your last dollar or your endowments gone.

As you get more and more you should be more and more picky. What makes endowments a unique timeline, we are, in theory, perpetual. It’s like having a high net worth client who’s a mortal, which may happen someday. In theory, we should have the highest risk tolerance, but we are also an institution that’s public-facing.

If you had high volatility in your endowment, you would probably get a lot of bad press. You’d probably be accused of mismanaging the endowment and there would probably be a lot of pressure to call him down. With endowments, the biggest hazard you probably have to navigate is the whole issue around peers because you have multiple issues.

For one, my initial reaction as a young person was that I didn’t care what anyone else was doing. We need to do what’s right for us, which is a great way to think, except that the university competes with other universities. I was told a cautionary tale about a school I won’t name that got out of the equity market in the late ‘80s and didn’t get back in until the early 2000s.

Don't care what anyone else is doing. You need to do what's right for you. Share on X

Their endowment didn’t grow during that period, and their peers’ endowment stitched. They now have a much smaller endowment than the rivals they were tied with in the ‘80s. I don’t know the details, so I’m not going to name them, but that’s always at the back of my mind if you are out of step wrong alone. The classic idea of being wrong alone. It’s embarrassing for the school, but it’s also a competitive disadvantage.

Having to think about what your peers are doing is something that we have begrudgingly absorbed. I don’t think any of us want to be like that. We are all very independent-minded, but we are all growing up, so we recognize that we are constrained a little bit with our options. That’s another thing that we have to manage and there are some things that are similar to, say, being an RIA where we have clients who are human beings and who are not investment professionals and we have to make sure we are communicating to them well.

We need to get ideas across but also prepare their minds for eventualities, understand what the strategy is, and make sure we have buy-in every step of the way, and we constantly maintain that because there’s always turnover at an institution as well. There’s turnover in the staff and turnover on the governance side as well.

A lot of people forget that you have a lot of very diverse stakeholders because you have students, faculty, and alumni, and a lot of them have very different views and might not be the ones you want to invest in certain areas of the market. We see that a lot of universities where students or alumni might say, “We are opposed to something for reasons that aren’t necessarily economic.” It could be related to other factors, so you have to manage quite a lot of competing interests and divergent views. It’s tough. What keeps you up at night in terms of investment risks?

To some degree, we have a good relationship even with the students. We speak with the students. We can sleep at night in terms of our preparedness there. The thing that keeps me up at night is being right and losing the idea. The analogy I would use is climbing Everest, where after a certain point, a lot of it’s out of your control, no matter how good a climber you are or how prepared you are. You are up in the death zone.

Maybe that’s not a great analogy, but the idea is that we don’t control everything. It’s more poker than chess, or maybe, in my case, roulette and checkers are better analogies. I think poker is probably a better analogy. You have the randomness of the cards you get, but you also have how you played and I think that investing. The same. You have an element of randomness and reaction preparation.

I would be lying, but I didn’t say that sometimes I get a little sad about all the risks that I have defended against. It ended up being costly because they didn’t happen, especially in careers that span this century. When it looks like things are going to fall apart, we have had a massive intervention that rallies the market.

Those who were defensive didn’t win that much, even when things went badly. There’s a little bit of a temptation to abandon risk management and chase returns. That’s not something we are going to do. It’s in none of our nature here, but I do worry that “Oregon returns are losses in a way, too.” I worry that I may not deliver enough to the institution out of an abundance of caution. It tries to balance those things up.

Investing In Alternative Assets

That makes me think about investing in innovation and how that brings opportunity but also risks because if you are too early, sometimes that means you are wrong. I often think that the idea of being too early means you are wrong. To outperform over the longer-term, you are going to have to take risks on the margin in terms of your thinking and not just your thinking but where you are putting money to work, which brings me to the next question, which is how do you think about alternative assets particularly assets that are relatively new to some investors whether that’s your venture capital, venture debt, or other strategies that are emerging. How do you think about those in the portfolio context in terms of optimizing your upside and having that margin of safety?

First of all, I agree with you that we need those things. We need to seek out opportunities. It’s no risk, no reward. You have to take chances in this business. We are not in a risk-minimizing business. We are in a risk trade-off business. A lot of that is having a broad perspective and being a decent futurist on some level, but the truth is that we try to defend against our own perspective as well.

We genuinely believe that we will make forecasting mistakes, which is not our route to success. We look for good ideas and good partners in those ideas, and sometimes they are new. I believe you have talked with one of your guests before about the best returns from a manager, typically when they are new. Those are all the managers that planned out and don’t stick around long enough to be old.

We have had both of those things. We have had benefits from being with new managers and we have had things that fell apart and we try to debrief our team on what went right and what went wrong so that we can get better at it. I would say, for example, with one manager that we had that went out of business. It was a great portfolio construction choice. It’s a huge win on portfolio construction, but it was a bad manager choice or bad partner choice.

That was informative because I believe that those are the two big jobs I have right now: finding great partners and putting them together in a way that they are struggling in different times of my dream, which is a steady return of a very aggressive manager. Getting back to risk. We try to be aggressive and then diversify away a lot of that risk.

New managers tend to be in more concentrated positions, which means more idiosyncratic risk, which we like, especially if it’s something that we understand and can evaluate. If it’s a private equity co-invest in a space that we are familiar with. Those things are exciting because it’s this project’s success or failure that matters, not everyone else’s opinion about this product’s success or project, which the public markets tend to reflect public opinion rather than actual results. We can get closer to actual results, which means more specifications.

When we were talking offline, you mentioned how you have very little corporate bond exposure. I don’t know if you are allowed to talk about that, but if you are, I’d love to hear your thoughts about why you are underway corporates and all so looking at private credit or other income-generating strategies. It’s not a tactical decision. It evolved in the very fullness of my career. It’s not been an area of responsibility for me other than very early when I was reporting on everything.

We simply don’t feel we have a ton of expertise there, and so we have had plenty of other things to pursue, and we have chosen to do that and remove that factor from consideration. It’s something we don’t have to worry about. We are at a point now where we want to reverse that and turn our focus to corporate more private debt, to be honest. That’s something that suits us better. It’s a factor that we felt we didn’t need to build into our portfolio, and if we didn’t have any special ways to try and triangulate on it. Why be in Europe? Now I do that.

I traded corporate bonds and managed large bond portfolios for years over the next part of the cycle. I think of bonds as return-free risk. Corporate bonds. In my base case, you have risk in both interest rate risk and credit spread risk, and the likely returns will be below zero over the next couple of years. That’s the running joke. Return free risk. Noth risk-free return. We are almost out of time. I wanted to get your parting thoughts on any key themes over the next part of the cycle that you want to leave investors with.

It’s connected to your idea of return-free risk and one of my favorite guys to read who’s got a reputation as a permabear, but I think he’s a bright independent. The banker’s name is John Hussman. He gets mocked a lot because he seems to always be bearish, and he talks about return-free risk and equity markets. One of the things I have learned in time is that even if I think markets are overvalued that doesn’t mean anything has to happen at any time soon and I could drive myself nuts trying to play that as if it were about to happen.

Through that growing process, one of the things we have developed as a tactic here is to have real plans for if things happen. Instead of saying, “This is going to happen and we are going to position ourselves for it.” Say, “Look, we think there’s a big risk here that markets are priced to return nothing for a decade.” If that’s real, how do we handle that? What is our plan?

There are different ways that can play out. It could be mediocrity for a decade, but it could also be the crash and a rebound and things like that. We have formal playbooks for those scenarios. We have spelled the steps out to do it. We had good fortune with that in 2020. We moved much money into the equity markets when they pulled back in 2020 and we almost bought them tickets, which was luck, not skill. That was drawing well in poker but playing the hands correctly, following the model, following our plan, and doing what we said we do. That would be the thing I would say going forward. Think about the things you think might happen, and it could be something completely different. What’s your plan for doing it? Have a plan.

Mike Tyson said, “Everybody’s got a plan until they get punched in the face,” and even if you get punched in the face.

Equity markets down 50% is very analogous to getting punched in the face by Mike Tyson.

Michael, it’s been great having you. I always learn something by talking to you. I appreciate you coming on, and thanks to everybody for reading the show.

 

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About Michael Nicks

Michael Nicks (’00, MBA ’02) joined the University in 2002. Prior to joining Pepperdine, he served in a variety of roles in the business world, including programming, database creation/management, technical support management, and marketing management in the technology sector. In 2004 Nicks became the director of Absolute Return Strategies, primarily overseeing the University’s hedge fund investments.

As director of investments, his primary areas of responsibility include the endowment’s marketable alternative investments (hedge funds), risk management, analysis of managers, asset classes, and quantitative analysis and modeling. This includes portfolio management responsibilities for both the Alpha Portfolio and Overlay, and the Diversifying Portfolio. Nicks is a CFA Charter holder (2006) and also a Chartered Alternative Investment Analyst (2006). He has served as a senior grader for the Level 2 CAIA exams, and as a member of the curriculum committee of the CAIA organization. Nicks is also a member of the Investment Steering Committee for the Alternative Investment Management Association.

Nicks has a bachelor of science in management and an MBA with an emphasis in finance from Pepperdine’s Graziadio Business School.