Alex Warren: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, and Aristotle Atlantic Partners, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor registered under the Investment Advisors Act of 1940, as amended.

Catalina Llinás: Welcome to the Power of Patience, Aristotle’s podcast, where we cover different topics of interest. I’m Catalina Llinás, Co-Chief Investment Officer of Aristotle Capital, and I will be your host today. In today’s episode, we’re going to be learning about uranium. What is it used for? Why is it important for nuclear energy? We’re also going to talk about fear surrounding nuclear energy, and why we think this is an important source of clean energy for the world. So for this, I will be speaking with Alberto Jimenez Crespo. Alberto is a senior member of Aristotle Capital’s investment team. His experience includes being a portfolio manager, also a research analyst. Welcome to the episode. It’s great having you here, Alberto.

Alberto Jimenez Crespo: Thank you for having me, Catalina. It’s great to be here.

Catalina Llinás: Why don’t you tell us a little bit about yourself?

Alberto Jimenez Crespo: Well first, I’m from Spain, that’s where I grew up. My technical background relevant to what I think we’re going to talk about today is that I am a mining engineer, and I have a Master’s in Colorado School of Mines as well. For those of you who might not be familiar with natural resources, think of Colorado School of Mines as the Harvard of rocks.

Catalina Llinás: Oh, Harvard of rocks.

Alberto Jimenez Crespo: So, I’m very happy that you chose this topic, because uranium is actually a very different commodity. It’s a very differentiated industry.

Catalina Llinás: Well, great. So why don’t we start with that? What is uranium?

Alberto Jimenez Crespo: So, uranium is a … Think of a silvery white metal. If you imagine an element that is very dense, think of lead. I think we are all familiar with lead. Well, uranium would be 70% denser than that. So, the feature that is also very unique is that it is the only naturally occurring fissile element on Earth. So, what does that mean? It means that it’s a material capable of sustaining a chain reaction of nuclear fission. That is very important to what we’re going to talk about today. Even though it’s pretty much everywhere, think of that in your soil and water and your house and everywhere, typically it occurs in higher concentrations in the mineral, it’s called uraninite, and so the majority of the isotopes of uranium, what we call U-238, call it 99.3% of the world uranium, occurs in this isotope.

Catalina Llinás: So, there’s uranium everywhere, but the one we’re going to talk about is, what, 0.7% of that uranium is the one that is relevant for our discussion today?

Alberto Jimenez Crespo: Yeah, yeah. Good point. So much for rounding. If it wasn’t for that 0.7%, that is really what we called U-235, we wouldn’t be talking today. The life as we know it, it would just not exist. It would not be possible. So that is really the importance of that huge minority of the 0.7%.

Catalina Llinás: So, what is this U-235, we’re just going to call uranium, what is it used for?

Alberto Jimenez Crespo: The only significant commercial use of uranium is really to power nuclear plants, so the generation of electricity. There’re about 427 reactors globally today, and 56 or so are under construction. If you drive throughout California, you wouldn’t think that this is such a growing industry because you will not see any. In fact, in the U.S. we’ve been shutting down some of our reactors. But if you travel throughout Asia, the Middle East and some other parts of the world, you will see that there is a recognition which is growing, that nuclear role is really a must when it comes to providing safe, affordable, carbon-free, base load, reliable electricity. And that is a key word, reliable. So, despite all these massive investments that we’ve seen, including in the U.S., in clean energies renewables, in the last, call it 15 years, the reality is that about 85% of global electricity grid is run by carbon emitting sources of thermal power. We have a huge work to do in order to diversify away from that.

Catalina Llinás: So before we get too much into the discussion of nuclear, which we will, why don’t you tell us a little bit about where is this uranium found? Where can we find some of that uranium?

Alberto Jimenez Crespo: Yeah. For the purpose of commercial use, that’s what they call a mining ore grade uranium, there are only three countries that you can go to. That is Australia, Kazakhstan and Canada. If you think of high grade deposits, those will be deposits that will provide uranium with a very low cost. There’s only one country, which is Canada. If you’re looking for high-grade deposits, that’s where you have to go. Then the interesting thing about this industry is that it’s highly consolidated. There’re only eight companies that provide, call it 83% of the global supply. So, everybody’s familiar with, or many people are familiar with the OPEC in oil and gas. So, this is significantly more consolidated than that.

Catalina Llinás: So those operators will have mines that… The same operator may have mines in Kazakhstan, Australian and Canada, right? They diversify that way I guess, geographically?

Alberto Jimenez Crespo: Yeah. Yeah.

Catalina Llinás: Have you been to a uranium mine?

Alberto Jimenez Crespo: Yeah, I’ve been actually in the three countries. In Kazakhstan, I was being chased by a sandstorm, so as we landed in Almaty and we had to go to visit the engineers in the uranium field, that’s the first time I’ve been chased by a sandstorm. It was not fun, but it was exciting.

Catalina Llinás: Something to be able to tell a story about. Going back to the topic, I do remember in some of our investment meetings, you were once talking about that there was a mismatch between where the uranium that is produced and where the uranium is going to be consumed. Why don’t you tell us a little bit about that?

Alberto Jimenez Crespo: Yeah, that’s a good point because this is a very strategic commodity as you can imagine. You cannot just buy this in the futures market just like you would trade orange juice or copper or any other commodity. Yeah, believe me, there will not be delivery. So don’t go to Amazon and try to order uranium. It will not come. That I guarantee.

Catalina Llinás: No, hopefully not.

Alberto Jimenez Crespo: So, 80% or so of the production, it’s in the hands of state-owned enterprises. This is very strategic. You’re right, the mismatch in the planet is very significant in that 70% or so comes from countries that have very little consumption because they have no nuclear plants, while 90% of the consumption comes from countries with very little production, including the United States.

Catalina Llinás: Interesting. So how is uranium mined?

Alberto Jimenez Crespo: Yeah, so there are mainly three ways. Now, once the orebody is discovered by and defined by exploration, which takes a while, up until the ’80s, the 1980s, the main way was what we call open-pit mining, which is a hole in the ground. As geological properties change, underground mining is being used when the ore is too deep, so it doesn’t make sense economically to open-pit. But most recently, in the last two decades, the majority of the uranium more so is coming from what’s called in-situ recovery. What that is, is that you have a hole that is drilled into the ore, and then a solution is used to dissolve that uranium, then you pump it up to the surface. Think of this as a commodity that has to be processed. You cannot just bring it up to the surface and then ship it to the nuclear reactor. You have to go through three main processes. The first one would be, call it the mining, then you mill it. You crush it and you add some chemicals. That’s what you will probably hear in the movies when they talk about yellowcake, or in the media. It is really not scary, and it is not something that is dangerous. It’s just a yellow-colored powder, and there’s not much you can do with it. It sounds pretty scary when you think of, oh, it has yellowcake, it’s not really a big deal. But then in order for you to be able to start thinking of utilizing this powder, you have to transform it into a gas, what’s called uranium hexafluoride, or UF6. That will be brought to the enrichment facilities. This is a very key part of the value chain. It’s probably the highest buyers of entry business in the world. This is very secretive. You cannot just copy the blueprints or you go to YouTube. You know how everybody now goes to YouTube to get things done and say, “How do I build an enrichment machine?” No, you cannot do that. It’s very secretive. It is very strategic, and there are very few facilities around the world. So, if you really have an enrichment plant, it is a very hard business to replicate. Once you take it there, the reason why enrichment is needed is that the majority of the reactors around the world is what we call light-water reactors. Those are the majority that you’re going to see, certainly in the United States. They require, remember we talked about U-35 earlier, that 0.7%?

Catalina Llinás: Yep.

Alberto Jimenez Crespo: Okay, so you need about 3 to 5% concentration of U-235 in order to use that into a reactor. But then by nature, you only get 0.7% concentration. So, you have to spin it into these machines to bring up the concentration. That’s what enrichment is. Finally, the last part of the process is, you form these pellets of uranium that have massive energy density, put them in a tube made of zirconium, create like a tower, and that’s what you ship to the nuclear reactor. You probably fuel the reactor twice a year. So, this is a very efficient way of generating energy.

Catalina Llinás: When you were talking about the yellowcake, that didn’t sound so scary, but as you kept talking more and more about this enrichment, I do have to say that sounds a little bit scary. So maybe that’s a good segue. People have strong opinions about nuclear energy, nuclear plants. It sounds scary. People don’t want to have it next to their homes. Also, people have flashbacks of more recent images like what happened in Fukushima, but also back in the day with the Chernobyl nuclear disaster and accident. So, tell us what you think about that and whether those concerns, are those real concerns, should they be?

Alberto Jimenez Crespo: Yeah, you’re right. Nuclear radiation freaks people out. It’s just something you can’t see. We’ve been shaped, our opinions, into having a lot of fear about this. Yeah, if you talk to environmental groups and people that are drafting energy policy, you’ll see that they feed into people’s emotions. What that has created, in our opinion, is that there’s a big gap between perception and reality. We find that there’s a significant, embedded biases in the thinking of people, particularly when these debates occur in public about what you just mentioned, about the issue of radioactivity and whether nuclear energy is safe or not. So, we at Aristotle like to do our own research, our own independent analysis, and we try to stay away from psychological biases that might create what we call blind spots, and that can impair your judgment. So, that’s what we’ve done in this case as well. What we found is that the reality is that natural substances contain some form of radioactive material, whether you like it or not. Soil, rocks, rivers and oceans. Since we are in LA, think about Catalina, think about your backyard. Every time you’re going to go and do a barbecue or whatever, you can tell your friends there, next time try this, that they’re going to be on top of few hundred grams of uranium. So, you could think of your backyard being slightly radioactive, but that shouldn’t scare you because, call it 80% or so of all the ionizing radiation that people are exposed to, you and I, everybody are exposed to, occurs naturally.

Catalina Llinás: Really? No, no me lo puedo crear, radiación en el jardin [Translation: I can’t believe it, radiation in the garden]. We have radiation in the backyard? I’m not scared about that radiation. I’m scared about then the other 20%.

Alberto Jimenez Crespo: Yes, there’s this whole notion about artificial radiation, as you know, and that is radiation that we have created. But there’s huge benefits to humanity that we have to think about. How so? Well in medicine, if you think about diagnostics, treatment and research, agriculture, food preservation, manufacturing engines, think about radioactive tracers also help analyze pollutants. If you talk to archeologists, paleontologists, people running a museum, consumer products, for example, in smoke detectors, I’m sure you have smoke detection in your house, right? They will not insure your house if you don’t. So, you cannot exclude that from the system. You cannot have the lives that we have today and function without these forms of artificial radiation.

Catalina Llinás: I’m going to keep pushing back a little bit because I get that, and also if I have to get an x-ray, fine, I’ll get some radiation. But that’s different from radiation of a nuclear plant. I would guess that if I had a nuclear plant two miles from my house, I would probably be concerned about that radiation on my family and not so much about the x-ray or when I have to go to the dentist and get an x-ray.

Alberto Jimenez Crespo: Good point. Let’s say you include all the military testing and all the accidents that we have in the nuclear industry, it accounts for 1% of all the radiation people are routinely exposed to. In fact, if you were to think about the nuclear fuel cycle, which is what we’re talking about here, it only accounts for 0.01% of the total radiation. So, the main issue that every policymaker should be thinking as in a society, is that whether we like it or not today, call it 37%, almost 40% of the global electricity that we’re consuming is coming from coal. A lot of my friends think, oh, well, isn’t that coal something from the Middle Ages and something from the past, while there’s so much coal that we are consuming in today’s world. So why is that an issue? Well, first because it kills a lot of people. If we think about the WHO as a source, World Health Organization, they claim that pollution related sicknesses kill over 7 million people a year. Think about it. In the life of a nuclear reactor, call it a few decades, you’re just killing a whole country, a big country. It’s just huge. We cannot operate like that, killing so many people.

Catalina Llinás: A nuclear accident is very, very rare, is what you’re saying?

Alberto Jimenez Crespo: Very rare.

Catalina Llinás: Of course, we don’t want to diminish what those cause, but it’s extremely rare. The pollution generated by coal, it’s much more deadly. I guess that gets us to the climate change. When we talk about nuclear as being part of the solution, it has to be part of the solution in order to help with climate change.

Alberto Jimenez Crespo: Yes, you’re right. We don’t want to downplay any loss of life. What we want to do is we want to prevent massive losses of life with the technology that we do have today. So according to the IEA, the International Energy Agency, they know this. They’re projecting that we will need to double the world’s nuclear output by 2050 to reach the net zero energy targets that every government now is talking about. As much as we have invested massively into renewables, particularly in the last 15 years, it’s been very significant, and that’s all good, but that cannot be the only solution. The resources that are needed, the land, the unreliability, the investments in grid that we need to support that. Any way you analyze this issue, you’re going to come out with the conclusion that nuclear is a must. We have to have that into the power mix. One statistic that I think is interesting is that since I was born in the 1970s, is that if we were to replace all the coal fire plants, dirty plants we were talking about earlier, with nuclear, we will reduce the CO2 emissions back to the level when I was born. So that’s like going back to the world when I was a baby. I think that’s just wonderful. So, we should be embracing anything that has to do with lowering the carbon footprint in their climate.

Catalina Llinás: It’s interesting that you were saying, yes, a lot of countries have come out with their plans for net zero. So, you would think then that, and there is currently under construction, there are nuclear plants around the world that are being constructed. Why has the price of uranium then been so low for so long? For a while it was very low.

Alberto Jimenez Crespo: That is a good point. You would think that with all the stuff that we’ve talked about today, all the attributes and all the benefits and all these things, that in the last 14 years though it seems we’ve seen a massive amount of liquidity pumped into the financial markets. We would’ve seen massive investments into making sure that we have enough investment in the supply chain in nuclear. The opposite has been the case, unfortunately. If I gave you an energy option, think about, let’s just visualize this for a second, for the energy density of what we’re talking about here. Think about 0.24 ounces of pellet. Many people say, “What does that mean, 0.24 ounces?” So, think about the tip of your nail and the energy provided by that pellet from uranium will be equivalent to 2000 pounds of coal. So, with that sort of magic and energy transformation, you will think that we would’ve been all very excited, and to your point, uranium price would’ve gone to the moon and we would be talking about a booming industry in terms of investments. Let me give you this, a statistic that will convince you that the opposite has occurred. Over the last five years, the nuclear reactors around the world, they have consumed 800 million pounds. We know that because if you own a nuclear reactor, you’re a utility company, you don’t purchase this on a spot market. This is a very sensitive thing for your chain. You have to contract this from the miners. So, the book of business is transparent, and you can see the material. We know that. So, they have consumed 800 million pounds, and guess what? They only contracted 400. So going forward, there’s a gap between what they need, because you don’t shut down a nuclear plant, this is based on 24 hours, between what they need and what they have in their books. If you go to 2035, it’s 1.4 billion pounds of unsecure material that they need. Think of an industry of 160 million pounds. That’s what 800 divided by five is, 160 million pounds consumption per year. With a gap of 1.4 billion pounds, it’s huge. So why is this an issue? Because it cannot be solved short term. Normally if you talk to mining engineers, you’re going to see that the average life of a mine is about 16 years from discovery to production. For uranium, as you could imagine, being more difficult, more regulated, more strategic, it’s at least two decades. So, we should be investing, to your point, massively into this now, but we’re not. That, to me, is the big gap and the big opportunity.

Catalina Llinás: Alberto, I have one last question that would be. Does Aristotle invest in this industry that we’ve talked about today?

Alberto Jimenez Crespo: Yes, we do. In our portfolios, we have exposure to the uranium industry, and we specifically invested in a company that have what we believe to be a sustainable, long-term competitive advantage.

Catalina Llinás: Thank you, Alberto. This was very interesting. I think this concludes our episode for today. I’m sure we will have some follow-up questions as there’s so much to learn about the world of uranium, the world of nuclear, and at Aristotle, we’ll continue to understand these industries and all other sources of clean energy. We’ll do that with a long-term perspective as we always do. Thank you, Alberto. This has been very interesting. We appreciate you joining.

Alberto Jimenez Crespo: Thank you for having me.

Catalina Llinás: We appreciate your time. Thank you.

Alex Warren: We hope you’ve enjoyed this episode and learned more about Aristotle. Thank you for listening to the Power of Patience. To learn more about Aristotle, please visit  www.aristotlecap.com or follow the link in the show notes. If you enjoyed this episode, please rate and review us on Spotify and Apple Podcast. Come back next time for discussion on cybersecurity with Nick Daft, Director and Senior Research Analyst at Aristotle Atlantic Partners. Until then, on behalf of Aristotle, thank you for listening.

Carla Price: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, and Aristotle Atlantic Partners, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor registered under the Investment Advisors Act of 1940 as amended.

Welcome to The Power of Patience, Aristotle’s podcast, where we share our reviews on topics actively explored by our investment teams and across our organization. I’m Carla Price, Director of Risk Management at Aristotle Capital, and I will be your host today. I have over 20 years of experience in the investment management industry. In that time, I’ve worked with over 50 registered investment advisors assessing these organizations’ internal controls, including cybersecurity. Additionally, I’ve led due diligence and remediation efforts resulting from actual cyber breaches and near misses across the industry. Coming up on today’s episode, we’ll be speaking with John Quan, Managing Director and Chief Technology Officer here at Aristotle Capital. If you enjoy this podcast, please like and share it on LinkedIn to help us spread the word. Today on the show, we’ll discuss what is cybersecurity, what are the threats today, and where are they coming from? How do small and mid-size organizations address the spending needs for effective defense? And lastly, what are some of the technologies companies are using to keep their data and systems safe? John, thank you so much for speaking with me today. To lead off the discussion, can you please introduce yourself and describe your role as Chief Technology Officer here at Aristotle Capital?

John Quan: Hi, Carla. First of all, I really want to take the opportunity to stress how important this topic is because it affects every individual, be it your personal life, your professional life, as well as affecting every company out there. We’re all fighting the same adversaries. So I think this type of knowledge sharing is going to be very beneficial to our listeners here as well as to those practitioners who are designing and executing on their own cybersecurity strategy. I’m John Quan. I’m the Chief Technology Officer here at Aristotle. I oversee all aspects of technology as well as cybersecurity. And before coming here, I was also the Chief Information Security Officer for a global asset manager where we led the development, the design, and the implementation of a comprehensive cybersecurity program while also dealing with numerous threats, potential attacks and investigations of potential breaches there.

Carla Price: Thank you, John. That’s helpful. You mentioned the current environment on cyber breaches being in the news on a regular basis for U.S. companies. Can you talk a little bit more about that for the listeners? What does the current environment look like for businesses and individuals today?

John Quan: Yeah, Carla. I think it’s important to talk about the who and the how when we consider what’s going on in the current environment around cybersecurity. So when you think about who, these are the range of attackers that are out there trying to penetrate various systems, companies and people, home, email. And so, on one end of the spectrum, we have very comprehensive and complex and well-funded nation states such as North Korea, Russia, India, as examples, who are deploying very complex attacks such as the one that we saw in the colonial pipeline. And then moving down the spectrum there, we’ve got criminal organizations and it’s very much as simple as just saying it’s organized crime behind cyber attacks because they appreciate the potential financial gain from these attacks that they’re conducting. And then finally, and this might be the one that people are most familiar with, but we just have bad individuals that are out there or people who are being opportunistic, trying to take advantage of a market, trying to take advantage of vulnerabilities out there and committing financial crimes and really for their own financial gain. One of the reasons why cyber is such an important topic is because there’s such a low barrier to entry. It’s about 50 bucks that you need to spend really to buy a ransomware type of package. And that just shows you how easy it is for anyone to get into the business of exploiting individuals and companies for their own financial gain. And then secondly, when you think about the how, how are these attackers like nation states and criminal organizations and individuals, how are they getting into these companies? It’s not going to be a surprise, but it’s 90% of all attacks originate via phishing email. So, when we think of phishing, this is not the click here and win a free iPad, those days are gone. Today, these are very sophisticated phish attacks that are utilizing social engineering to go and create a profile of their target. Where do they like to eat? Where do they go on vacation? Where do they work? Who are their friends? Things like that, that will help them craft an attack that will resonate with that individual.

Carla Price: What do you think the cyber criminals are trying to target at investment firms like Aristotle?

John Quan: Carla, that’s a great question because what you’re hitting on there is that these criminals, they don’t take one attack and believe that one size fits all, because it doesn’t. Our industry is different from any other industry, but there are very specific things that resonate with us, very specific lingo, for example, that when we hear, we go, “Oh, we know what that means.” That’s what they’re trying to target when they think about certain industries. So, with respect to the investment management space, I think there’s really three motivators for these bad actors. It’s financial gain, it’s disruption of operations, and it’s acquiring usable information. Let me give you a quick example there. Back in 2016, the Bank of Bangladesh suffered a hack. Hackers out there were trying to extract $1 billion from them via 35 swift transactions. Fortunately, many of them got stopped, but the hackers were able to walk away with about a hundred million dollars from that hack. And so, you would think, okay, was it a smash and grab type of attack? Well, no, it really wasn’t. I mean, for something as meaningful as that, if you’re going to try to steal a billion dollars, you’re going to take your time. You’re going to do your research. The organization that conducted this crime planned and prepared for years. In fact, they actually got into the Bank of Bangladesh in January of 2015. And so, you think, okay, January 2015, so they’re going to start hacking around that time, January, February, March. The answer is no. They actually stayed in their network for a year, and they were there quietly and they were there hiding, and they were there learning, and they were there trying to understand what is normal behavior for this institution, because if they are going to try to steal money, last thing they want to do is to, for example, try to send a wire of a hundred million dollars out from an account that generally sends out wires in the range of 10 to $20,000. That would raise a red flag immediately. So that’s why they had to hide so they could learn and ultimately craft such a large attack. And one other thing I want to point out too, and this might seem straightforward to many of our listeners, but I think it also just shows you the type of thinking that our adversaries are going through. The attack that they committed, they actually committed it on a Thursday night. And the reason they did that was because Thursday night in Bangladesh would then translate to New York opening on a Friday morning of which time Bangladesh would be on weekend. What does that mean? That means it gives them essentially three days of time before anyone potentially could have spotted this, before anybody potentially could have reached out to someone at the Bank of Bangladesh just to verify that these swift messages were indeed true. So, when you think about all that combined, these organizations going after companies like ours, they’re sophisticated, they understand swift, they understand how to comprise a swift message. They know thresholds not to go over. Financial gain is most likely the number one motivator for these attackers. But when you think about other aspects like disruption, so we’ve all heard of ransomware, what ransomware does, it will encrypt all your files, and without a secure key to unlock them, you’re not going to get access to those files ever again. And so, think about that from an investment management standpoint and frankly from a business standpoint. If your Excel models, if your financial statement, if your client records are all inaccessible to you, how do we expect to run our business? So, from a disruption standpoint, this is extremely, extremely highly disruptive. And then lastly, because we sit on so much information within the IM space, we’re also another target for information and secrets. So that could mean the research information that we have that we’ve been building to make investment decisions, they likely will want to get their hands on that.

Carla Price: Current cybersecurity buzzword, John, that I know is going around, and I’ve heard it and I’m sure some of our listeners have heard it, is Zero Trust security architecture. Can you explain for the listeners what this is, and describe the purpose of a Zero Trust architecture?

John Quan: Yeah, I’m happy to, and really glad that you brought that up too, because I think it really shows the maturing and the maturity of the cybersecurity industry. So, Zero Trust, it’s really a recent phenomenon maybe in the last five to seven years that has gotten a lot of traction out there. And so, what Zero Trust is, is a challenge to an outdated premise that everything within our network can be trusted. That is, if we have a sound perimeter, think of it as a circle. If we have a sound circle surrounding our building here and we keep all the bad guys out, that means everything in the building can be trusted. So, what Zero Trust is saying is we can no longer rely on that notion that if we have a sound circle out there that everything inside is safe. Because take the Bank of Bangladesh example again. They hid in there for a year. They hid in there for a year, so they could have been on a server watching activity and no one would be any smarter to it. So, can we trust that? No, that’s what Zero Trust is talking about. We can’t trust that. It’s really challenging, this premise of does a perimeter even exist as well? And so, in the past, before work from home, before the COVID situation occurred, we might all be in the same building, we might have a sound perimeter around us, but fast forward to where we are today and where we’re going to be going, you really have to challenge, do we have a perimeter anymore?

Carla Price: Thanks John. How would you say organizations can empower employees and create a culture where employees aren’t afraid to raise their hand or raise potential issues out to the cyber team or senior managers, which ultimately helped prevent cyber threats and identify them?

John Quan: That’s a great question because I think that building a culture of cyber awareness is critical to every organization. And when I say that, I’m not saying that cyber is the only priority within that organization. No, what I’m saying is it’s part of our culture, where you think about cyber, cyber first. You see somebody within your building and they don’t have a badge on, for example, that should make you suspicious. That should make you want to either report it or tell someone about it so that we can make sure that that’s not a person who’s unauthorized to be in that room. So, when we think about how do we empower our people, how do we put them in these positions to be our eyes and ears on the ground on a day-to-day basis, well, it’s very simple. Transparency about what’s happening in our industry. We also know that education and awareness and frequent testing, like testing our own employees when it comes to phishing emails is a good practice to give our employees a couple of at bats so that when the real phishing email comes, that they’ll be ready to identify it and to do something about it.

Carla Price: Yeah. Thank you, John, and thanks for all you do for our organization and the clients. Well, that brings us to the end of the episode. Thanks, John, for joining us today. We hope you enjoyed this podcast and learned more about Aristotle and cybersecurity. Thank you for listening to The Power of Patience.

Alex Warren: To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed this episode, please rate and review us on Spotify and Apple Podcasts. Be sure to come back next time for discussion on uranium with Aristotle Capital’s Alberto Jimenez Crespo, Portfolio Manager and Senior Global Research Analyst. Until then, on behalf of Aristotle, thank you for listening.

Alex Warren: The term Aristotle is used to represent a family of affiliates, which is comprised of Aristotle Capital Management, Aristotle Capital Boston, Aristotle Credit Partners, and Aristotle Atlantic Partners, which collectively operate under a unified platform known as Aristotle. Each firm is an independent investment advisor, registered under the Investment Advisors Act of 1940 as amended. Welcome to the Power of Patience, Aristotle’s podcast, where we share our views on topics actively explored by the investment teams and across the organization. I’m Alex Warren, product specialist at Aristotle Capital, and I’ll be your host. Coming up on today’s episode, we’ll be speaking with Aylon Ben-Shlomo, Managing Director and Client Portfolio Manager at Aristotle Capital. Aylon is responsible for some of Aristotle’s largest client relationships. If you enjoy the podcast, please like and share it on LinkedIn to help us spread the word. Today on the show, we’ll discuss what is quality, how Aristotle Capital thinks about quality from an investment standpoint, how Aristotle identifies quality companies, and why Aristotle believes investing in a diversified global portfolio of quality companies can provide inflation protection. Without further ado, let’s get started. Aylon, thank you so much for your time today. To lead off the discussion, can you introduce yourself and provide us a brief history of your role at Aristotle Capital?

Aylon Ben-Shlomo: Hi, Alex, and hi everyone listening to the podcast. This is my first time joining the Power of Patience, and hopefully the first of many. My name is Aylon Ben-Shlomo. I’m a member of the investment team here at Aristotle Capital Management in our Los Angeles office. I’m now in my sixth year with the firm, which is hard to believe. Time flies. And I’m one of 18 members on our investment team. And I was looking at it before I came in today. Collectively, we have nearly 400 years of industry experience, which is a staggering number, but when you average it out, it’s a little over 20. And so, we’ve been doing this for a long time. We’ve seen a lot of things, but there’s a lot of new to learn about, and hopefully we can share some of that knowledge today on the podcast. So, thank you for having me, Alex.

Alex Warren: Wonderful, thank you, Aylon. I’d love to dive right in. Can you talk a little bit about what quality means and how you think about it from an investment perspective?

Aylon Ben-Shlomo: Quality is an important term. It’s one that’s used a lot in our industry. Unfortunately, or perhaps fortunately for us, is that quality can mean different things and can be looked at in different ways by different people. In fact, it reminds me of a quote that’s often attributed to Albert Einstein, and it goes, not everything that can be counted counts, and not everything that counts can be counted. So, what does that mean? With respect to investing, it means that when we’re looking at quality, there are certain numbers that absolutely matter, but then there are certain items that don’t have numbers, but absolutely matter as well. What are some examples? Well, if you’re an index provider or a quantitative manager, you might define quality purely by return on equity, financial leverage or some type of measure of profitability. There are other factors or attributes that are not captured by those data points, things like, how have management teams behaved? How have industry participants reacted to changing environments? Those type of qualitative assessments can be just as, if not more important than data points that can be found in financial statements or on your Bloomberg terminal. So, quality is absolutely something that needs to be assessed from both the quantitative lens, and for lack of a better term, qualitative lens as well.

Alex Warren: Absolutely. No, that makes sense. Now, it sounds like quality in your opinion then is something that’s kind of in the eye of the beholder, given that, like you said, not all the attributes are fully quantifiable. How important is quality to your investment process? And how does Aristotle differentiate itself as a manager when investing in quality companies?

Aylon Ben-Shlomo: Quality is critical. Our process is rooted in three elements, quality, valuation and catalyst. You can think of it as a three-legged stool. We intentionally start with the quality of a business rather than the price that it’s being offered at. That’s one way to differentiate. We’re not running screens in the hopes that a backward looking, or if it’s forward looking, consensus-based metric will lead us to what is “statistically or optically” cheap. Instead, we operate with the mindset of a business owner and try and understand, what does this company do? What makes it unique? Why do customers choose to do business with them? Why are they able to earn a return over and above their cost of capital? And perhaps most importantly, why will that sustain going forward? Those are the things that we’re focused on when we’re trying to identify a quality business. Now, your point on it, being within the eye of the beholder is absolutely true. As a bottom-up fundamental research focus firm, we look at investment opportunities on a case by case, company by company basis. We do the same when assessing quality. For example, there are some businesses where high margins, gross margins, for example, are critically important when trying to assess quality. Pharmaceuticals come to mind, software companies come to mind. Their high margins translate to high free cash flow and high returns on invested capital, elements that we would all agree on as being signs of high quality. On the other side of the margin spectrum, though, our companies like food distributors or grocery stores, they operate at razor thin margins, but their high asset turnover allows them to earn very attractive returns on invested capital in the mid double digits, sometimes even high double digits. That is an important example that we’d like to share here to show that quality can’t be just one formula. It must be understood on a case by case or company by company basis.

Alex Warren: Let’s talk a little bit about the macro picture with inflation in the developed markets at the highest level in roughly 40 years, it’s top of mind for many investors. How do you think about inflation within your fundamental investment framework?

Aylon Ben-Shlomo: Inflation, macro, two of my less favorite topics, but nonetheless important items to discuss, especially as we sit here today recording on December 8th. Like you said, Alex, inflation is running at 40-year highs nearly. For us, we are a bottom-up fundamental manager. We’re focused on companies one by one, piece by piece, but we can’t ignore the macro, and we have to consider inflation. When we look across the developed world, areas like the U.S. and Europe have seen inflation moderate slightly recently, but places like Japan are seeing inflation really much lower than other places like the U.S. I believe Japan’s running at around 3%. The U.S. and Europe are running, let’s call it around 8%, pick your metric. So, a pretty big difference, and I will come back to that in a moment. On inflation, it’s important to recognize that not all inflation is created equal. And when we assess companies, not all cost structures are created equal. So, what matters for one business in terms of input costs might not matter as much for another. Those of us who are paying attention to markets these days will recognize that there has been a bit of a shift. Inflation was running very high because goods were more expensive. There were supply demand imbalances throughout 2020, 2021. Now, things are shifting back more towards services. We’re able to fly places, we’re able to see our family, experience “normal life” more, and so services are becoming more expensive. That shift is an important thing to consider, and I’ll come back to my company examples. So, when we analyze businesses, if we’re looking at a manufacturing company, let’s say a farm equipment manufacturing company, they make tractors, things like steel and aluminum will be very important items to consider in the cost structure. Labor too, but steel and aluminum much more. So, when we analyze that business, we’re going to try and understand that piece of the cost structure much more than say a global consulting business. If we’re analyzing a global consulting business, the price of steel and aluminum won’t matter as much. However, the price of labor, the availability of labor will. And so, a point I’d like to make on inflation is that one thing we’re seeing and we expect to continue is that historically, raw materials, things like steel and aluminum, their inflation has been more cyclical and mean reverting. However, things like labor, wages, that inflation is much stickier.

Alex Warren: Aylon, you made a great point about how Japan has been an outlier when it comes to inflation. Can you dig in a little more into how you think about Japan within a global portfolio?

Aylon Ben–Shlomo: We believe Japan is a rather attractive area to invest today. We’ve believed that for a long time, but in the current environment, the inflationary divergence between Japan and places like Europe and the U.S. is rather stark. We’re talking five 6% differences in inflation rates, and that matters when one is focused on a real earnings yield. When we take a step back and look at how Japan, relative to other places, has responded to the COVID environment, it’s really rather stark. Japan is effectively just now opening up. They’ve been closed for about two years. Things like tourism have really not gone on. That’s about to start. In fact, it is starting. They’re obviously a bit more reliant on Chinese travelers, and as we know, that has not happened. So, Japan has experienced lower inflation than the rest of the world, and they’ve been locked up a little bit longer than the rest of the world. And so, when we look at the investing landscape at Japan, it’s underperformed much of the rest of the world over the trailing decade or so, and it’s gotten to a point where the waiting of Japan in the MSCI World or ACWI indicies, I believe is at or near its all-time low.

Alex Warren: Wow. Wow.

Aylon Ben–Shlomo: That’s typically a good time to invest in an area. We can think back to energy in global markets or here in the U.S. Energy reached an all-time low of the S&P 500. I believe it was in late 2019. We know what’s happened since then. Just like Howard Marx has a great quote, “Trees don’t grow to the sky,” and the waiting that we’ve seen, the overreactions that we’ve seen perhaps in some industries on the upside and the downside, Japan stands out as something similar. And in our portfolios, we believe we’re able to access just as high a quality, if not higher quality, in Japanese headquartered companies that are global leaders in their industry. So, you can think of a few, and our compliance team would hit me on the head here if I started naming them all, but they’re oftentimes Japanese companies that are trading at maybe 50% of the valuation of their U.S. peers, yet their fundamentals, their data would suggest that they’re just as good of quality. So, to us, that’s an attractive opportunity.

Alex Warren: Absolutely. No, that makes sense. Now, I know you don’t enjoy macro, so let’s move away from that and let’s go back to your bottom-up focus. Can you discuss any attributes you believe believer important in identifying high-quality companies that may be better protected in an inflationary environment like the current one?

Aylon Ben–Shlomo: Pricing power immediately comes to mind. It’s kind of the holy grail. I’m sure a lot of listeners have heard about it and know what it is. When you can find a company that does something that its customers want, whether it be a good or service, they’re typically able to pass on cost increases, pass on those cost increases over and above what they receive from their suppliers, and therefore create a virtuous cycle of increasing free cash flows and increasing return. So, pricing power immediately comes to mind. One of the ways that you can test for that… Because unfortunately, it’s not a data point that is in annual reports. People don’t publish their pricing power each year, but you can look at things like gross margin. That can oftentimes be a sign of pricing power. And one of the things that we like to do is, if we can find two companies that do the exact same thing, maybe it’s selling diapers or selling beer, if they do the exact same thing but they earn different returns, they earn different gross margins and they can sustain those through different economic times, that’s often a sign of pricing power. So, that’s an area that we look. There is of course a plethora of other items that we’re assessing and can be signs of quality, whether it’s scale brands and tangible assets, things like network effects, switching costs, recurring revenue, barriers to entry. It could go on and on. There really is a litany of items. And like I mentioned before, there’s no one formula. There’s no magic equation that we follow, and it’s very much a mosaic approach, if you will, to understanding what makes a business unique, what makes their competitive advantages sustainable, and what therefore makes it a quality company in our eyes.

Alex Warren: Aylon, this has been an interesting conversation. We have time for one more question though. Taking a step back, how do you think about quality from the portfolio level?

Aylon Ben-Shlomo: Yeah. There’s two lines of defense in our eyes. There’s at the company level and at the portfolio level. And so of course it’d be great if we could always find the best business at the most attractive price with lots of compelling catalysts that can not only survive but thrive in difficult environments of high inflation or something else, but the reality is it just doesn’t work that way, and so we need to diversify at the portfolio level. And that’s why, in our portfolios, we try and own companies, again, not only that can stand on their own two feet, but offer a balance and can diversify things like inflation shape of the yield curve, geopolitical risks, or other factors. Hopefully we can diversify that out when we’re constructing the portfolio. Different industries have different exposures to inflation, like I mentioned. And so some might be vulnerable to raw materials, some might benefit from raw material increases, and that’s where, at the portfolio level, we’re adding in individual companies that interact well with each other, and again, can diversify away. We believe that constructing a diversified portfolio of high-quality companies can help insulate the portfolio from inflation or other factors. We start with quality at the company level, and we finish with quality at the portfolio level. It’s a recipe that has served our clients well, and it’s a recipe we’ll continue to follow for the years and decades ahead.

Alex Warren: Beginning and ending with quality. I think that’s also a great way to end the episode. Aylon, thank you so much for joining us today. We hope you enjoyed it and you learned more about Aristotle. Thank you for listening to the Power of Patience. To learn more about Aristotle, please visit www.aristotlecap.com or follow the link in the show notes. If you enjoyed the episode, please rate and review us on Spotify and Apple Podcasts and come back next time for discussion on cybersecurity with Aristotle Capital’s John Quan, Managing Director and Chief Technology Officer. Until then, this is Alex Warren, and thank you for listening.