June 2016 10 Questions

Kevin O'Leary on the Biggest Lessons He's Learned as an Investor and Advice for Entreprenuers

Journal of Financial Planning: June 2016



WHO: Kevin O’Leary

WHAT: Chairman of O’Shares
Investments, author, entrepreneur, “shark” on ABC’s Shark Tank

WHAT'S ON HIS MIND: “I will never own a security that doesn’t pay a dividend, never. Because 71 percent of the time, that’s where your return comes from.”

You know him from the popular entrepreneur reality TV show, Shark Tank, as a no-nonsense, disciplined investor who fights hard for the deals he wants and is quick to offer his strong opinions. Kevin O’Leary is that, indeed, but he’s much more, too—a true renaissance man.

He brings that investing discipline to the helm of ETF provider, O’Shares Investments. But he also is a winemaker (he mixes his own varietals that you can now find on the shelves at Costco), an accomplished photographer (profits from his photography shows around the country go to aspiring teenage entrepreneurs), and a hobby guitarist who once dreamed of being a rock star.

The Journal sat down with O’Leary in March to learn more about his latest ETF products, where his passion for financial literacy stems from, and how his mother has been the biggest influence on his investing philosophy.

1. I’ve heard you say that one of your investing rules is to never own a stock that doesn’t pay a dividend? Why not?

Because I learned through experiences in my life that really profoundly changed the way I invest.

When I was young, my mother worked at a factory that made winter clothing for children. She was always concerned about having money to raise her family; she was a breadwinner. She used to tell my brother and me, “Never spend the principal, only the interest.” I had no idea what she was talking about because I was only seven years old, but she would grind it into our heads all the time.

What happened was, 50 years later I became executor of her estate when she passed, because I was the older brother. I called my brother up and I said, you’re not going to believe this. Our mother had an account that she kept separate from both of her husbands. She kept it a secret. It had telco five-year bonds in it. It had dividend-paying stocks. And the performance of that thing over 50 years was stunning. I always wondered where she got all the money to pay for our education, to buy me a car in college, and take care of her sisters and her brother.

She’s not a portfolio manager, but she had that philosophy of getting paid something. So I started to do some research (this was about 10 years ago). And if you go back 40 years, during the period that she had run this portfolio, 71 percent of the market’s returns came from dividends, not capital appreciation. That’s been the case in all markets. It turns out that dividends are the backbone of returns. And so, from that experience, I’ve just made it a personal philosophy. I will never own a security that doesn’t pay a dividend, never. Because 71 percent of the time, that’s where your return comes from.

It’s proven to me to be a very powerful ally in my own investment philosophy across all the things I do today. That’s the basis upon which I invest our family trust and how I personally invest. And that is what O’Shares is all about. It’s a way to find the very best way to own the very best companies in all of the markets around the world that are dividend payers and have extremely strong balance sheets. Because at the end of the day, that is where the returns come from.

2. What has been the biggest lesson you’ve learned as an investor?

Diversification is the key. In my own personal portfolios, and certainly in our family trust, we have some basic rules. No. 1 is we can never own more than a 5 percent weighting in any security. No. 2, never [own] more than 20 percent in any one sector, ever. And so we keep a balance mandate. We’re 50 percent in equities and we’re 50 percent in fixed income, because we pay out 5 percent of the family trust every year. And it used to be very easy to make 5 percent. It’s not so easy today. The covenant of 5 percent forces diversification.

It’s saved my heinie so many times in market cycles, to be capped out at 5 percent, which is why I could never use ETFs. I was so frustrated, because the first generation of ETFs were all market-cap weighted, which means stock like Apple ends up being double-digit weighting. It could be 15 percent of the index. I can’t own it because I’m limited to only 5 [percent]. So, it was after multiple years of frustration of not being able to look at this asset class of ETFs that I finally sat down with the people at FTSE Russell and said, guys, you’re the biggest investors in the world. Why is it you don’t have something I can buy?

Their initial reaction was, wait a minute, we don’t just build indexes for some guy complaining about market-cap weighting. And I said no, listen, I just don’t want something that’s capped at 5 percent. And I have other rules I’d like you to consider: I’d like you to think about sales accruals—I don’t want to own companies that accrue sales like WorldCom. I don’t want to own companies that use debt to increase or maintain their dividends. I want to test the asset turnover on the balance sheet so that I can really test for quality. And I’d like to own companies that have 20 percent less volatility on the index.

I think that over time, in the dialogue my team had with them, they started to think, wait a minute, this is an interesting investment philosophy—maybe there is a demand for something like this. And that was the birth of O’Shares.

Not only do we do it for OUSA [ETF], which is domestic, we take a universe of 650 stocks and apply all these stringent rules to them, and we come up with about 140 that make the cut. And that index has outperformed the market since January 1 by over 500 basis points, and provides a dividend yield as a symptom of these rules that’s 50 percent higher than the S&P.

It’s become a very popular discussion point, because not only is it outperforming, it’s providing what I really care about. I want to make that 5 percent a year, and I’m getting more than half of it from the dividend distribution, because we only own dividend-paying stocks.

So, that was the beginning. And then we said, if it’s working for the U.S., why wouldn’t we do it for Europe? And that was how OEUR was born. We applied the same rules to Europe and then we applied the same rules to Asia. As a result, we have five products now, because when we built the European index, we also built a fully hedged one, so you could buy it in U.S. dollars and not take currency risk.

For each market, we’ve put the same rules in place, and I think that’s really what investors are looking at. We give you the distribution. We’re tapped out at 5 percent. We’re tapped out at 20 percent on the sectors. We trim back the 5 percent every quarter, and we rebalance the book every year based on balance sheet tests. And I think it’s a new way. This is a new innovation in ETFs. I think you’ll see a lot more of this innovation coming. We’re working with FTSE Russell on some new ideas using the same kind of quality rules.

3. Let’s talk specifically about “smart beta,” because this phrase could have different definitions for different people. What does “smart beta” mean to you?

“Smart beta” means nothing to me. I don’t even understand what that means. I look at it as—what we’re doing is we’re creating rule-based investing.

Imagine if you could create the perfect portfolio manager that had no style drift, that never, ever got emotionally involved in a stock, that only used the most hardcore rules on balance sheet testing, and never, ever strayed from that. That’s what rule-based investing is. It takes out one of the challenges I’ve found as an investor over the decades. I’ve worked with so many great portfolio managers [and] every seven years they blow up. It’s not that they’re bad people, it’s because they’re human beings. They fall in love with a sector. They fall in love with a stock. They get committed to an idea that isn’t working, but they believe they’ll be right eventually. All of those mistakes have happened. Why do I know this? Because I’ve had dozens of them work for me over the years.

What I find so interesting about this new innovation of what I call rule-based investing is you set some disciplines and you never, ever vary from them. The discipline forced on that is incredibly interesting.

Think about OUSA last September. I’m a huge Apple fan. I’ve got Apple computers all over the house. I’m wearing an Apple watch as I’m speaking to you. Our rules kicked Apple out in September. I called up and said, what? Apple is one of the biggest tech companies that pays a dividend in the world; in fact, it is the biggest. How is it possible that OUSA doesn’t have Apple? And the answer was, there’s no emotion to this; [Apple] broke the rules. They’re adding debt to the balance sheet to repay trade capital. Their asset turnover is slow. Their margins are compressing. And look at what happened to Apple.

Instead of owning Apple, we added Microsoft, because the rules tested that balance sheet and said it was a better one than Apple. And if you look at the divergence to performance on those two stocks in September, it’s stunning. And that’s when I realized you have to take the emotion out of it. When you list the rules and you live by that discipline, you’re a much better investor. That’s why this innovation is so exciting.

4. Wouldn’t that strict discipline ultimately cost the investor more money in fees?

No, because what it does is it says if you are making sure that you’re living by the rule of balance sheet quality, if you believe in the long run—and certainly, history teaches you over the last 40 years that 71 percent of the returns came from dividends—the only way you can maintain dividends and grow them is [by] having a rock solid balance sheet. So one is hand-in-hand with the other. Quality of balance sheets in the long run is pretty well the only thing that matters in business.

5. O’Shares currently offers five rule-based ETFs. What’s next?

There’s no question we’re going to look at this concept of quality in other sectors of the economy. Right now, O’Shares in Europe and Asia are the mega caps. Our average market cap is over $120 billion, so it’s bigger than the average of the S&P; this is the most conservative index there is. Many people have called me up and said, why aren’t you doing the same thing in other sectors of equities? And I said, well, I don’t know if I want to own other sectors of equities. And so that’s the dialogue we’re having right now.

Most companies are not $128 billion market cap; they’re obviously smaller, so that’s an area of innovation. No one’s done it there yet. I’m certainly looking at it with our team.

There are a lot of different places to go when you really mine by quality. But mostly, if you think about it, 90 percent plus of ETFs are all market-cap weighted. Over the next 20 years, there’s going to be all kinds of innovation in this space, because I think fund flows are going to move from the mutual fund industry into the ETF market by the billions. It’s so transparent; it’s so tax efficient; it’s so low cost. And I think O’Shares is going to own that space where quality balance sheets matter.

I don’t really want to own micro-cap stocks that don’t pay dividends; that’s not something that’s for me. I’m not saying it isn’t for others. But we’re for conservative investors who want preservation of capital and are looking to get paid while they wait. That’s basically what’s happening here. So, I guess I’m going to innovate more products.

6. Where are your new dollar allocations going today? What sectors are you excited about, here at the end of March?

That’s a good question, because I put some money to work yesterday and it went to Europe. What I find so interesting about Europe right now is if you look at the market’s P/E, it’s not cheap, it’s not expensive; it’s sort of in the middle. It’s the Goldilocks just-right kind of thing. But given all of the turmoil and the sadness that’s occurred [because of] the tragedy in Europe, it has compressed market multiples to incredible lows. So you can buy into giant market-cap companies in all the sectors of Europe that have remarkable multiples 20, 25 percent cheaper than North America, with dividend yields 30, 40 percent higher.

Look at LVMH, for example. They sell fashion goods. When they sell products in the United States, which is a huge part of their business, they have the wind at their backs because the euro is significantly cheaper than it was just a few years ago. So they have a currency advantage. All of those pharma companies, all of the British companies, the German companies, and those that are trading in the eurozone have an advantage, so all of those sectors look very attractive to me. The largest, highest-quality companies in Europe are extremely attractive.

So, in new dollars going into the same strategy, I’m building up a portfolio to about a 25 percent weighting in Europe. So, 50 percent domestically, 25 percent in Europe, and 25 percent in Asia. The same thing has happened in Asia. Stocks bottomed out in Q4 of last year and they’re coming back in Japan, in Malaysia, in Singapore, in Hong Kong. Generally, we don’t think of those markets, but the truth is that the global economy in many places is growing faster than it is stateside, and most of us should have some exposure to the best companies in those markets.

7. What impact do you think the election cycle will have—or perhaps is already having—on the market?

I think it’s adding volatility. I don’t think we’re going to know the policies of whoever [the next president] ends up being. I’m going to make the assumption that Bernie Sanders is not going to be the [Democratic nominee]. If that happens, that’s going to be pretty strange because he’s a socialist. I think it’ll end up being a Hillary [Clinton] contest with Donald Trump. We know Trump is at a 15 percent tax rate corporately, which would get us competitive again with our European counterparts.

While the debate goes on—and I have no idea who’s going to win—it’s going to be volatility. But again, if you own the best balance sheets, you get 20 percent less of that volatility. So I think, for the rest of this year, quality will matter and stability, because I think we’re going to get some real rock and roll.

Hillary is attacking health care and biotech, and it’s had its effect on those markets, which in some cases have made the multiples very attractive. You know, her whole shtick about repricing drugs and everything else has put a lot of pressure on the pharma, which makes it an interesting asset class, particularly if she doesn’t win.

8. You have written three popular consumer finance books through your Cold Hard Truth series, and you clearly have a passion for financial literacy. Where does this passion stem from?

My mother. That is basically her pounding into my brother’s and my head about getting responsible about money. Much of [Cold Hard Truth: On Business, Money, and Life] is my experience being a parent. I think what we don’t teach enough of, either in high school or college, is financial literacy. We don’t tell people what debt is and how it can be damaging. We don’t explain to them the difference between a stock and a bond, dividend and interest, and all of that. To me, that’s remarkable. We give them education about math and reading and sex education and geography, but we don’t talk about money; it seems ridiculous.

That’s one of my pet peeves and one of my missions is to get out there and basically teach this at an early age. I believe when you’re the age of 5 to 7, the concept of money and debt should be introduced into the family, because money is a family member. You can’t live without it. And so that’s what I did in my household. Now I’m proud to say that my children—one’s a teenager and one’s in her 20s—are investors now. My daughter owns OUSA; it was her very first investment. And she definitely gets what a dividend is.

9. Through your work on Shark Tank, you clearly also have a passion for start-ups. You are a successful entrepreneur yourself, and many financial planners are entrepreneurs, starting and running their own planning firms. What advice do you have for entrepreneurs?

When I’m asked that, I like to take examples from the last seven years of Shark Tank. I’ve seen so many different entrepreneurs come through the Tank and I’ve looked at the ones that have been successful in getting funded, and they all have three common attributes, which I think are a great lesson.

So there are three things that occur when you watch Shark Tank that are very useful, no matter what business you’re running or how you’re communicating with people.

No. 1, you’ll always notice that successful entrepreneurs are able to articulate the opportunity in 90 seconds or less. They’re able to explain what their business is and their vision very quickly. They are articulate about it, and they make it clear. All of the deals that get funded on Shark Tank are teams that are able to come out and say, this is what my business is. And in most cases, they do it in less than a minute. So communication skills are very important. Given all the noise in the world today, being able to explain the opportunity quickly is No. 1.

No. 2 is to explain why you’re the right person to execute on the business plan. That becomes very important. You’ll see on Shark Tank how things really get interesting once the investors or the sharks see the opportunity and understand it and then start to realize that the people talking to them clearly have the track record, or at least have explained why they have the attributes to be able to execute the business plan.

Lastly, and this is the most important one for people in our industry, you have to know your numbers. You can’t have a vision and be leader in financial services without understanding the numbers. I mean, that is the whole deal.

I’ve seen many people come to Shark Tank, get the first two right and it looks like they’re going to get a check from somebody, and then when they’re asked about market share or return on investment or break-even margins or number of competitors or size of the market or how fast it’s growing, they don’t have the answers. They’re slaughtered. It’s over.

10. I hear you are a guitarist. Electric or acoustic?

I always wanted to be a rock star but I got distracted. So yes, I do play guitar. And I have both; I play both. I have a huge collection of guitars.

I was a shareholder once in Fender guitar, and I have some unique guitars that were built by Fender for me. I have a Shark Tank guitar we built. I have a Mr. Wonderful guitar made of olive wood, which has some of the original Fender pickups in it. They’re remarkable and rare, but I just like to play.

I think if you’re involved in financial services, it’s extremely disciplined. It’s black and white. Either you make money or you lose it. So you need to have the yin and the yang. You need to have something in the arts that you like. I pursue guitar playing. I like to play blues and jazz. I’m also a photographer. I’ve got a series of [photography] shows across America, and I sell my work for charity. I’m also a winemaker. O’Leary Wines has been quite successful this year. It’s the No. 1 selling wine on QVC today and it’s in Costco now. I blend my own varietals.

Those things keep me busy; they keep me balanced. But my real work is as an investor, because all of this flows from my ability to get returns on my portfolios, and that’s what I spend most of my time doing. I think it’s really interesting work, there’s no question about it. 

Carly Schulaka is editor of the Journal. Contact her HERE.

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