Active Investing: Seeking the Elusive Edge!

In my last post, I pointed to the shift towards passive investing that has accelerated over the last decade and argued that much of that shift can be explained by the sub-par performance of active investors. I ended the post on a contradictory note by explaining why I remained an active investor, though the reasons I gave were more personal than professional. I was taken to task on two fronts. The first was that I should have spent less time describing the problem (poor performance of active investors) and more time diagnosing the problem (the reasons for that poor performance). The second was that my rationale for being an active investor, i.e., that I enjoyed investing enough that I would be okay not earning excess returns, could never be used if I sought to manage other people's money and that a defense of active investing would have to be based on something more substantial. Both are fair critiques and I hope to address them in this post.

The Roots of the Active Investing Malaise

There is no denying the facts. Active investing has a problem not only because it collectively under performs passive investing (which is a mathematical given) but also because the drag on returns (from transactions costs costs and management fees) seems to be getting worse over time.  Even those few strands of active investing that historically have outperformed the market have come under siege in the last decade. While there are many reasons that you can point to for this phenomenon, here are some that I would highlight:

1. A "Flatter" Investment Word: The investment world is getting flatter, as the differences across active investors rapidly dissipate. From information to processing models to trading platforms, professionals at the active investing game (including mutual funds and hedge funds) and individual investors are on a much more even playing field than ever before. As an individual investor, I have access to much of the information that an analyst working at Merrill Lynch or Fidelity has, whether it be financial statements or market rumors. I am not naive enough to believe that, SEC rules against selective information disclosure notwithstanding,  there are no channels for analysts to get "inside" information but much of that information is either too biased or too noisy to be useful. I have almost as much processing power on my personal computer as these analysts do on theirs and can perhaps even put it to better use. In fact, the only area where institutions (or at least some of them) may have an advantage over me is in being able to access information on trading data in real time and investing instantaneously and in large quantities on that information, leading to breast beating about the unfairness of it all. If history is any guide, the returns to these strategies fade quickly, as other large players with just as much trading power are drawn into the game. In fact, while much ink was spilt on flash trading and how it has put those who cannot partake at a disadvantage, it is worth noting that the returns to flash trading, while lucrative at first, have faded, while attracting smaller players into the game. In summary, if the edge that institutional active investors have had over individual active investors was rooted in information and processing power, it has almost disappeared in the United States and has eroded in much of the rest of the world.
2. No Core Philosophy: There is an old saying that if you don't stand for something, you will fall for anything, and it applies to much of active investing. Successful investing starts with an investment philosophy, a set of core beliefs about market behavior that give birth to investment strategies. Too many active investors, when asked to characterize their investment philosophies, will describe themselves as "value investors" (the most mushy of all investment descriptions, since it can mean almost anything you want it to mean), "just like Warren Buffett" (a give away of lack of authenticity) or "investors in low PE stocks" (confusing an investment strategy with a philosophy). The absence of a core philosophy has two predictable consequences: (a) a lack of consistency, where active investors veer from one strategy to another, often drawn to whatever strategy worked best during the last time period and (b) me-tooism, as they chase momentum stocks to keep up with the rest. The evidence for both can be seen in the graph below, which looks at the percentages of funds in each style group who remain in that group three and five years later and finds that about half of all US funds change styles within the next five years.

   

   Source: SPIVA

3. Bloated Cost Structures: If there is a core lesson that comes from looking at the performance of active investors, it is that the larger the drag on returns from the costs of being active, the more difficult it is to beat passive counterparts. One component of these costs is trading costs, and the absence of a core investment philosophy, referenced above, leads to more trading/turnover, as fund managers undo entire portfolios and redo them to match their latest active investing avatars. Another is the overhead cost of maintaining an active investing infrastructure that was built for a different market in a different era. The third cost is that of active management fees, set at levels that are not justified by either the services provided or by the returns delivered by that management team. Active money managers are feeling the pressure to cut costs, as can be seen in expense ratios declining over time, and the fund flows away from active money managers has been greatest at highest cost funds. I can only speak for myself but there is not one active investor (nope, not even him, and not even if he was forty years younger) in the world that I have enough reverence for that I would pay 2% (or even .5%) of my portfolio and 20% (or 5%) of my excess returns every year, no matter what his or her track record may be. To those who would counter that this is the price you have to pay for smart money, my response is that the smart money does not stay smart for very long, as evidenced by how quickly hedge fund returns have come back to earth. 
   
4. Career Protection: Active money managers are human and it should come as no surprise  that they act in ways that increase their compensation and reduce their chances of losing their jobs. First, to the extent that their income is a function of assets under management (AUM), it is very difficult, if not impossible, to fight the urge to scale up a strategy to accommodate new inflows, even if it is not scaleable. Second, if you are a money manager running an established fund, it is far less risky (from a career perspective) to adopt a strategy of sustained, low-level mediocrity than one that tries to beat the market by substantial amounts, with the always present chance that you could end up failing badly. In institutional investing, this has led some of the largest funds to quasi-index, where their holdings deviate only mildly from the index, with predictable results: these funds deliver returns that match the index, prior to transactions costs, and systematically under perform true index funds, after transactions costs, but not by enough for managers to be fired. Third, at the other end of the spectrum, if you are a small, active money manager trying to make a name for yourself, you will naturally be drawn to high-risk, high-payoff strategies, even if they are bad bets on an expected value basis. In effect, you are treating investing as a lottery, where if you win, more money will flow into your funds and if you do not, it is other people's money anyway.

There are macroeconomic factors that may also explain why active investing has had more trouble  in the last decade, but it is not low interest rates or central banks that are the culprits. It is that the global economy is going through a structural shift, where the old order (with a clear line of demarcation between developed & emerging markets) is being replaced with a new one (with new power centers and shifting risks), upending historical relationships and patterns. Given how much of active money management is built on mean reversion and lessons learned by poring over US market data from the last century, it should come as no surprise that the payoff to screening stocks (for low PE ratios or high dividend yield) or following rigid investing rules (whether they be centered on CAPE or interest rates) has declined.  In all of this discussion, I have focused on the faults of active institutional investors, be they hedge funds or mutual funds, but I believe that their clients bear just as much responsibility for the state of affairs. They (clients) let greed override good sense (knowing that those past returns are too good to be true, but not asking questions), claim to be long term (while demanding to see positive performance every three months), complain about quasi indexing (while using tracking error to make sure that deviations from the index get punished) and refuse to take responsibility for their own financial affairs (blaming their financial advisors for all that goes bad). In effect, clients get the active money managers they deserve.

A Pathway to Active Investing Success

If you accept even some of my explanation of why active investing is failing, at least collectively, there is a kernel of good news in that description. Specifically, the pathway to being a successful active investor lies in exploiting the weakness of the active investment community, especially large institutional investors. Here are my ingredients for active investing success, though I will add the necessary caveat that having all these ingredients will not guarantee an investment payoff.

1. Have a core investment philosophy: In my book on investment philosophies, I argued that there is no best investment philosophy that fits all investors. The best investment philosophy for you is the one that best fits you as an investor, in sync not only with your views about markets but with your personal makeup (in terms of patience, liquidity needs and skill sets). Thus, if you have a long time horizon, believe that value is grounded in fundamentals and  that markets under estimate the value of assets in place, old-time value investing may very well be your best choice. In contrast, if your time horizon is short, believe that momentum, not value, drives stock prices, your investment philosophy may be built around technical analysis, centered on gauging price momentum and shifts in it.
2. Balance faith with feedback: In a post on Valeant, I argued that investing requires balancing faith with feedback, faith in your core market beliefs with enough of an acceptance that you can be wrong on the details, to allow for feedback that can modify your investing decisions. In practice, walking this tightrope is exceedingly difficult to do, as many investors sacrifice one at the expense of the other. At one extreme, you have investors whose faith is so absolute that there is no room for feedback and positions once taken can never be reversed. At the other extreme, you have investors who  have no faith and whose decisions change constantly, as they observe market prices.   
3. Find your investing edge: It has always been my contention that you have to bring something uncommon to the investment table to be able to take something away. Drawing on the language of competitive advantages and moats, what sets you apart does not have to be unique but it does have to be scarce and not easily replicable. That is why I am unmoved by talk of big data in investing and the coming onslaught of successful quant strategies, unless that big data comes with exclusivity (you and only you can exploit it). Here are four potential edges (and I am sure that there others that I might be missing): (a) In sync with client(s): I was not being facetious when I argued that one of my big advantages as an investor is that I invest my own money and hence have a freedom that most active institutional investors cannot have. If you are managing other peoples money, this suggests that your most consequential decision will be the screening your clients, turning money away from those who are not suited to your investment philosophy (b) Sell Liquidity: To be able to sell liquidity to investors seeking it, especially in the midst of a crisis, is perhaps one of investing's few remaining solid bets. That is possible, though, only if you, as an investor, value liquidity less than the rest of the market, a function of both your financial security.  (c) Tax Play: Investor price assets to generate after-tax returns and that effectively implies that assets that generate high-tax income (dividends, for instance) will be priced lower than assets that generate low-tax or no-tax income. If you are an investor with a different tax profile, paying either no or low taxes, you will be able to capture some of the return differential. Before you dismiss this as impossible or illegal, recognize that there is a portion of each of our portfolios, perhaps in IRAs or pension funds, where we are taxed differently and may be able to use it to our advantage. (d) Big Picture Perspective: As we become a world of specialists, each engrossed in his or her corner of the investment universe, there is an opening for "big picture" investors, those who can see the forest for the trees and retain perspective by looking across markets and across time. 

If you are considering actively investing your money, you should be clear about what your own investment philosophy is, and why you hold on to it, and identify the scarce resource that you are bringing to the investment table. If you are considering paying someone else to actively manage your money, my suggestion is that while you should consider that person's track record, it is even more critical that you examine whether that track record is grounded in a consistent investment philosophy and backed up by a sustainable edge. 

Conclusion

There is much that I still do not know about investing but here are the lessons that I learn, unlearn and relearn every day. First, an investment cannot be a sure-bet and risky at the same time, and you can count me among the skeptical when presented with the next easy way of beating the market. Second, when I believe that I own the high ground in any investment debate, it is a sure sign that I have let hubris get the better of me and that my arguments are far weaker than I think they are. Third, much as I hate to be wrong on my investment choices,  I learn more when I concede that "I am wrong" than when I contend that "I am right".  For now, I will continue to invest actively, holding true to my investment philosophy centered on intrinsic value, while nurturing the small edges that I have over institutional investors. 

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Active Investing: Rest in Peace or Resurgent Force?

I was a doctoral student at UCLA, in 1983 and 1984, when I was assigned to be research assistant to  Professor Eugene Fama, who wisely abandoned the University of Chicago during the cold winters for the beaches and tennis courts of Southern California. Professor Fama won the Nobel Prize for Economics in 2013, primarily for laying the foundations for efficient markets in this paper and refining them in his work in the decades after. The debate between passive and active investing that he and others at the University of Chicago initiated has been part of the landscape for more than four decades, with passionate advocates on both sides, but even the most ardent promoters of active investing have to admit that passive investing is winning the battle. In fact, the mutual fund industry seems to have realized that they face an existential threat not just to their growth but to their very existence and many of them are responding by cutting fees and offering passive investment choices.

Passive Investing is winning!
When Jack Bogle started the Vanguard 500 Index fund in 1975, I am sure that even he could not have foreseen how successful it would become in changing the way we invest. Not only have index funds become an increasing part of the landscape, but exchange traded funds have also added to the passive investing mix and index-based investing has expanded well beyond the S&P 500 to cover almost every traded asset market in the world. Today, you can put together a portfolio composed of index funds and ETFs to create any market exposure that you want in stocks, bonds or commodities. The growth of passive investing can be seen in the graph below, where I plot the proportion of the US equity market held by passive investors (in the form of ETFs and index funds) and active investors from 2005 to 2016:

Source: Morningstar

In 2016, passive investing accounted for approximately 40% of all institutional money in the equity market, more than doubling its share since 2005. Since 2008, the flight away from active investing has accelerated and the fund flows to active and passive investing during the last decade tell the story.

The question is no longer whether passive investing is growing but how quickly and at what expense to active investing. The answer will have profound consequences not only for our investment choices going forward, but also for the many employed, from portfolio managers to sales people to financial advisors, in the active investing business. 

Aided and Abetted by Active Investing
To understand the shift to passive investing and why it has accelerated in recent years, we have to look no further than the investment reports that millions of investors get each year from their brokerage houses or financial advisors, chronicling the damage done to their portfolios during the course of the year by frenetic activity. Put bluntly, investors are more aware than ever before that they are often paying active money managers to lose money for them and that they now have the option to do something about this disservice.

1. Collectively, active investing cannot beat passive investing (ever)!
Before you attack me for being a dyed-in-the-wool efficient marketer, there is a simple mathematical reason why this statement has to be true. During 2015, for instance, about 40% of institutional money in equities was invested in index funds and ETFs and about 60% in active investing of all types. The money invested in index funds and ETFs will track the index, with a very small percentage (about 0.11%) going to cover the minimal transactions costs. Thus, active money managers have to start off with the recognition that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns. Not surprisingly, therefore, active investors will collectively generate less than the index during every period and more than half of them will usually underperform the index.  To back up the first statement, here are the median returns for all actively managed funds, relative to passive index funds for various time periods ending in 2015:

Source: S&P (SPIVA)

The median active equity fund manager underperformed the index by about 1.21% a year between 2006 and 2015 and by far larger amounts over one-year (-2.92%), three year (-2.78%) and five year (-2.90%). Thus, it should come as no surprise that well over half of all active fund managers have been outperformed by the index over different time periods:

Note that in this graph, active fund managers in equity, bond and real estate all under perform their passive counterparts, suggesting that poor performance is not restricted just to equity markets.

If active money managers cannot beat the market, by construct, how do you explain the few studies  that claims to find that they do? There are three possibilities. The first is that they look at subsets of active investors (perhaps hedge funds or professional money managers) rather than all active investors and find that these subsets win, at the expense of other subsets of active investors. The second is that they compare the returns generated by mutual funds to the return on a stock index during the period, a comparison that will yield the not-surprising result that active money managers, who tend to hold some of their portfolios in cash, earn higher returns than the index in down markets, entirely because of their cash holdings. You can perhaps use this as evidence that mutual fund managers are good at market timing, but only if they can generate excess returns over long periods. The third is that these studies are comparing returns earned by active investors to a market index that might not reflect the investment choices made by the investors. Thus, comparing small cap active investors to the S&P 500 or global investors to the MSCI may reveal more about the limitations of the index than it does about active investing. 

2. No sub-group of active investors seems to be able to beat the market
The standard defense that most active investors would offer to the critique that they collectively underperform the market is that the collective includes a lot of sub-standard active investors. I have spent a lifetime talking to active investors who contend that the group (hedge funds, value investors, Buffett followers) that they belong to is not part of the collective and that it is the other, less enlightened groups that are responsible for the sorry state of active investing. In fact, they are quick to point to evidence often unearthed by academics looking at past data that stocks with specific characteristics (low PE, low Price to book, high dividend yield or price/earnings momentum) have beaten the market (by generating returns higher than what you would expect on a risk-adjusted basis). Even if you conclude that these findings are right, and they are debatable, you cannot use them to defend active investing, since you can create passive investing vehicles (index funds of just low PE stocks or PBV stocks) that will deliver those excess returns at minimal costs. The question then becomes whether active investing with any investment style beats a passive counterpart with the same style. SPIVA, S&P’s excellent data service for chronicling the successes and failures of active investing, looks at the excess returns and the percent of active investors who fail to beat the index, broken down by style sub-group. 

Source: S&P (SPIVA)

Note that not only is there not a single sub-group that has been able to beat the index for that group but also that the magnitude of under performance is staggering. It is true that these are the results for US equity fund managers, but just in case you are holding out hope that active money management is better at delivering results in other markets, the following table that looks at the percent of active managers who fail to beat indices in their markets should cast doubt on that claim:

Source: S&P (SPIVA)

There are glimmers of hope in the one-year returns in Europe and Japan and in the emerging markets, but there is not a single geography where active money managers have beaten the index over the last five years.

3. Consistent winners are rare
The third and final line of defense for active investors is that while they collectively underperform and that underperformance stretches across sub-groups, there is a subset of consistent winners who have found the magic ingredient for investment success. That last hope is dashed, though, when you look at the numbers. If there is consistent performance, you should see continuity in performance, with highly ranked funds staying highly ranked and poor performers staying poor. To see if that is the case, I looked at how portfolio managers ranked by quartile in one period did in the following three years:

Note that the numbers in the table, when you look at all US equity funds, suggest very little continuity in the process. In fact, the only number that is different from 25% (albeit only marginally significant on a statistical basis) is that transition from the first to the fourth quartile, with a higher incidence of movement across these two quartiles than any other two. That should not be surprising since managers who adopt the riskiest strategies will spend their time bouncing between the top and the bottom quartiles.

As your final defense of active investing, you may roll out a few legendary names, with Warren Buffett, Peter Lynch and the latest superstar manager in the news leading the list, but recognize that this is more an admission of the weakness of your argument than of its strength. In fact, successful though these investors have been, it becomes impossible to separate how much of their success has come from their investment philosophies, the periods of time when they operated and perhaps even luck. Again, drawing on the data, here is what Morningstar reports on the returns generated by their top mutual fund performer each year in the subsequent two years:

While the numbers in 2000 and 2001 look good, the years since have not been kind to super performers who return to earth quickly in the subsequent years. We could try to explain the failure of active investing to deliver consistent returns over time with lots of reasons, starting with the investment world getting flatter, as more investors have access to data and models but I will leave that for another post. Suffice to say, no matter what the reasons, active investing, as structured today, is an awful business, with little to show for all the resources that are poured into it. In fact, given how much value is destroyed in this business, the surprise is not that passive investing has encroached on its territory but that active investing stays standing as a viable business. 

The What next?
Since it is no longer debatable that passive investing is winning the battle for investor money, and for good reasons, the question then becomes what the consequences will be. The immediate effects are predictable and painful for active money managers. 

1. The active investing business will shrink: The fees charged for active money management will continue to decline, as they try to hold on to their remaining customers, generally older and more set in their ways. Notwithstanding these fee cuts, active money managers will continue to lose market share to ETFs and index funds as it becomes easier and easier to trade these options. The business will collectively be less profitable and hire fewer people as analysts, portfolio managers and support staff. If the last few decades are any indication, there will be periods where active money management will look like it is mounting a comeback but those will be intermittent. 
2. More disruption is coming: In a post on disruption, I noted that the businesses that are most ripe for disruption are ones where the business is big (in terms of dollars spent), the value added is small relative to the costs of running the business and where everyone involved (businesses and customers) is unhappy with the status quo. That description fits the active money management like a glove and it should come as no surprise that the next wave of disruption is coming from fintech companies that see opportunity in almost every facet of active money management, from financial advisory services to trading to portfolio management.

While active investing has contributed to its own downfall, there is a dark side to the growth of passive investing and many in the active money management community have been quick to point to some of these. 

1. Corporate Governance: As ETFs and index funds increasing dominate the investment landscape, the question of who will bear the burden of corporate governance at companies has risen to the surface. After all, passive investors have no incentive to challenge incumbent management at individual companies nor the capacity to do so, given their vast number of holdings. As evidence, the critics of passive investors point to the fact that Vanguard and Blackrock vote with management more than 90% of the time. I would be more sympathetic to this argument if the big active mutual fund families had been shareholder advocates in the first place, but their track record of voting with management has historically been just as bad as that of the passive investors. 
2. Information Efficiency: To the extent that active investors collect and process information, trying to find market mistakes, they play a role in keeping prices informative. This is the point that was being made, perhaps not artfully, by the Bernstein piece on how passive investing is worse than Marxism and will lead us to serfdom. I wish that they had fully digested the Grossman and Stiglitz paper that they quote, because the paper plays out this process to its logical limit. In summary, it concludes that if everyone believes that markets are efficient and invests accordingly (in index funds), markets would cease to be efficient because no one would be collecting information. Depressing, right? But Grossman and Stiglitz also used the key word (Impossibility) in the title, since as they noted, the process is self-correcting. If passive investing does grow to the point where prices are not informationally efficient, the payoff to active investing will rise to attract more of it. Rather than the Bataan death march to an arid information-free market monopolized by passive investing, what I see is a market where  active investing will ebb and flow over time.
3. Product Markets: There are some who argue that the growth of passive investing is reducing product market competition, increasing prices for customers, and they give two reasons. The first is that passive investors steer their money to the largest market cap companies and as a consequence, these companies can only get bigger. The second is that when two or more large companies in a sector are owned mostly by the same passive investors (say Blackrock and Vanguard), it is suggested that they are more likely to collude to maximize the collective profits to the owners. As evidence, they point to studies of the banking and airline businesses, which seem to find a correlation between passive investing and higher prices for consumers. I am not persuaded or even convinced about either of these effects, since having a lot of passive investors does not seem to provide protection against the rapid meltdown of value that you still sometimes observe at large market cap companies and most management teams that I interact with are blissfully unaware of which institutional investors hold their shares.

The rise of passive investing is an existential threat to active investing but it is also an opportunity for the profession to look inward and think about the practices that have brought it into crisis. I think that a long over-due shakeup is coming to the active investing business but that there will be a subset of active investors who will come out of this shakeup as winners. As to what will make them winners, I have to hold off until another post.

Making it personal
Should you be an active investor or are you better off putting your money in index funds? The answer will depend on not only what you bring to the investment table in the resources but also on your personal make-up. I have long argued that there is no one investment philosophy that works for all investors but there is one that is just right for you, as an investor. In keeping with this philosophy of personalized investing, I think it behooves each of us, no matter how limited our investment experience, to try to address this question. To start this process, I will make the case for why I am an active investor, though I don’t think any you will or should care. I will begin by listing all the reasons that I will not give for investing actively. Since I use public information in financial statements and databases, my information is no better than anyone else’s. While my ego would like to push me towards believing that I can value companies better than others, that is a delusion that I gave up on a long time ago and it is one reason that I have always shared my valuation models with anyone who wants to use them. There is no secret ingredient or special sauce in them and anyone with a minimal modeling capacity, basic valuation knowledge and common sense can build similar models. 

So, why do I invest actively? First, I am lucky enough to be investing my own money, giving me a client who I understand and know. It is one of the strongest advantages that I have over a portfolio manager who manages other people’s money. Second, I have often described investing as an act of faith, faith in my capacity to value companies and faith that market prices will adjust to that value. I would like to believe that I have that faith, though it is constantly tested by adverse market movements. That said, I am not righteous, expecting to be rewarded for doing my homework or trusting in value. In fact, I have made peace with the possibility that at the end of my investing life, I could look back at the returns that I have made over my active investing lifetime and conclude that I could have done as well or better, investing in index funds. If that happens, I will not view the time that I spend analyzing and picking stocks as wasted since I have gained so much joy from the process. In short, if you don’t like markets and don’t enjoy the process of investing, my advice is that you put your money in index funds and spend your time on things that you truly enjoy doing!

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Brighton and Hove Albion - Knockin' On Heaven's Door

It was another case of “so near, yet so far” for Brighton and Hove Albion last season, as the Seagulls missed out on automatic promotion to the Premier League only on goal difference, while a spate of untimely injuries led to defeat in the play-off semi-finals by Sheffield Wednesday, who had finished a full 15 points behind them in the league table.

Chairman Tony Bloom captured the feelings of the Albion fans: “The 2015/16 season was one of the most remarkable and exciting in my 40 years as a Brighton and Hove Albion supporter. The team, under Chris Hughton’s astute leadership, gave us a season to savour – and although we twice missed out on taking that final step to the Premier League, it has laid the foundation for our current season.”

This is the third time in the last four seasons that Brighton have reached the Championship play-offs, only to fall in the semis. This consistency on the pitch is all the more impressive, as it has been achieved under different managers: Guy Poyet in 2013; Oscar Garcia in 2014; and Hughton last year. The only blip came in 2015, when the club slipped back under the far-from-flying Finn Sami Hyypia.

"Many Happy Returns"

Of course, for those with longer memories it is great news that Brighton are still around to mount a challenge, given that they only avoided dropping out of the Football League to the Conference by the skin of their teeth in 1997 with a final day 1-1 draw at Hereford United.

There then followed years of struggle, exacerbated by the problems of finding a suitable ground after the Goldstone was sold to property developers, leading to exile in Kent and a ground share with Gillingham. The club returned to Brighton two years later to the Withdean, an old council-owned athletics stadium where the facilities were far from ideal.

It took 12 years, but finally Brighton moved to the magnificent new Amex stadium in 2011, coinciding with promotion to the Championship. The major investment required to build the stadium (and indeed a superb new training centre) was funded by Bloom, a lifelong fan who became chairman.

He has continued to finance the club, as can be seen by the 2015/16 accounts, which revealed a massive £25.9 million loss, £15.4 million worse than the previous season’s £10.4 million loss. To put that into perspective, that means that Brighton lost more than £2 million a month or around £500,000 every week.

The club said that this underlined Bloom’s commitment and in particular the ambition to reach the Premier League, while the chairman himself explained the strategy: “Our increased losses result directly from an ongoing and growing investment in our playing squad.”

This explains the main reasons for the higher loss, as wages shot up £6.7 million (33%) from £20.6 million to £27.4 million, while player amortisation (the annual cost of transfer fees) also rose £1.4 million (60%) from £2.4 million to £3.8 million. Moreover, the desire to retain players meant that profit from player sales fell £7.5 million from £8.7 million to just £1.2 million.

In addition, other expenses also increased by £1.1 million (7%) from £15.0 million to £16.0 million, largely due to higher costs associated with running the stadium.

The sizeable cost growth more than offset the £1.0 million (4%) increase in revenue from £23.7 million to £24.6 million, mainly due to broadcasting income rising £0.9 million (18%) to £5.9 million, though commercial income was also up £0.5 million (8%) to £9.4 million, driven by catering and events. On the other hand, gate receipts fell £0.4 million (4%) to £9.4 million, primarily due to no home cup ties.

Other operating income was up £0.4 million, thanks to other grants received.

In fairness to Brighton, almost all clubs in the Championship lose money and are reliant on owners’ funding. In 2014/15, the last season where all clubs have published their accounts, losses were reported by 18 of the 24 clubs – in stark contrast to the Premier League where the new TV deal, allied with wage controls, has led to a surge in profitability.

The club that made most money in the Championship that season were Blackpool – and their model is not one to be recommended, as it culminated in relegation to League One. As Bloom noted, “Any Championship club without parachute payments wishing to compete for promotion will inevitably make significant losses.”

That said, Brighton’s loss of £26 million in 2015/16 is likely to be one of the highest in the division. Only two clubs reported higher deficits in 2014/15: Bournemouth £39 million, though their loss was inflated by £9 million promotion payments and an £8 million fine for failing Financial Fair Play (FFP); and Fulham £27 million, but this was impacted by £11 million of exceptional impairment charges.

Brighton could have reduced their loss by accepting some of the lucrative offers received for their top talents, but Bloom noted that the club made a conscious decision “to retain our key players” and “not to cash in on our key assets”.

Consequently, there were no significant player disposals in the 2015/16 season, leading to only £1.2 million profits, probably driven by additional clauses from earlier player sales, as the contingent receivables on transfers have fallen from £2.1 million to £0.8 million in the latest accounts. In comparison, £8.7 million was booked in the previous season, mainly from the sales of Leo Ulloa to Leicester City and Will Buckley to Sunderland.

Although Championship clubs rarely sell players for big bucks, at least compared to the Premier League, this was a useful money-spinner for Brighton in 2014/15 with only four clubs generating more money from this activity. In contrast, the 2015/16 profit of just over £1 million is likely to be one of the smallest in the division.

Of course, losses are nothing new for Brighton. In fact, the last time that they made a profit was back in 2007/08 – and that was less than £1 million and only arose because of a £3.6 million exceptional credit, due to a change in the accounting for the Falmer stadium expenses. Since then, the club has made cumulative losses of £88 million.

Moreover, the losses have been growing. Since promotion to the Championship, Brighton’s total losses have amounted to £71 million, averaging £14 million a season. As finance and operations director David Jones confirmed, “We’ve lost money every year we’ve been (at the Amex).”

Jones added, “While we’re getting a competitive team on the pitch, we’re going to continue to lose money with the revenue streams that we’ve got.” The difference with the top flight is colossal. Jones again, “If we were in the Premier League, we would be able to be a sustainable business that makes an annual profit.”

If they are not promoted, it will be interesting to see what the board decides regarding player sales. Traditionally Brighton have made very little from the transfer market , though there was a change in stance in 2013/14 when the club sold Liam Bridcutt to Sunderland and Ashley Barnes to Burnley, followed by the even more profitable sales in 2014/15.

This summer Brighton could have made a lot of money if they had accepted all the offers they received, e.g. Dale Stephens (Burnley), Lewis Dunk (Fulham) and Anthony Knockaert (Newcastle United). That could have brought in £15-20 million, though obviously would have damaged Brighton’s prospects of promotion.

The current strategy is to “speculate to accumulate”, but as Bloom has admitted, “It would be ridiculous for me or any owner to say that a player is never for sale. There’s always a price for any player.”

Brighton’s strategy is more clearly seen by the club’s alternative presentation of the profit and loss account, which highlights the 29% (£7 million) increase in the football budget in 2015/16.

Chief executive Paul Barber, who has overseen a “pretty radical and dramatic programme of reducing our costs” explained the approach as follows “It gives us more opportunity to put more into the football budget, which should improve our chances of promotion.”

In this way, administrative and operational costs have been cut by 22% since 2012, which has meant that Brighton’s different managers have benefited from a significant increase in the football budget over this period of around 134%, as it has grown from £13 million to £31 million.

Bloom praised his team for “ensuring we remain operationally efficient”, but the reality is that Brighton’s underlying profitability has still been getting worse, as seen by the reduction in EBITDA (Earnings Before Interest, Depreciation and Amortisation).

This metric is considered to be an indicator of financial health, as it strips out once-off profits from player trading and non-cash items. It has been consistently negative at Brighton, but has declined in the last eight years from minus £3 million in 2008 to minus £18 million in 2016.

Unsurprisingly, a negative EBITDA is far from uncommon in the Championship with 21 clubs generating cash losses, though only Nottingham Forest have worse underlying figures than Brighton. In stark contrast, in the Premier League only one club reported a negative EBITDA, which is again testament to the earning power in the top flight.

Brighton’s revenue surged from £7.5 million in 2011 to £24.6 million in 2016 following promotion from League One to the Championship, exacerbated by what can be described as the "Amex effect" with gate receipts being more than four  times as much as Withdean, increasing from £2.3 million to £9.4 million.

In addition, the new stadium has brought more commercial opportunities, leading to income climbing from £3.1 million to £9.4 million. The club could negotiate better deals with sponsors in the higher division (up from £0.8 million to £5.5 million), increase retail sales, e.g. from the stadium megastore (up from £0.5 million to £1.3 million) and make more from catering, i.e. pies and the famous Harveys beer (up from £35k to £1.3 million).

However, the growth since the first season back in the Championship in 2012 is less impressive, amounting to just 11% (£2.5 million) in four years. The fact is that it is difficult to substantially grow revenue streams without another promotion to the top flight.

Brighton’s revenue of £25 million places them around 7th highest in the Championship, but the clubs with the three highest revenues in 2014/15 (Norwich City, Fulham and Cardiff City ) were more than 60% higher with £40-52 million.

Bloom is acutely aware of the challenge this poses: “Our player budget is the highest it has ever been, so we have certainly invested, but we absolutely can't compete financially with relegated clubs like QPR, Burnley and Hull with their parachute payments.”

He’s not wrong, as two of the three clubs he named were promoted back to the Premier League last season, once again proving that money talks in football. Jones reiterated his chairman’s message, noting that this factor “presents difficulties when trying to assemble a playing staff that can compete with clubs coming down from the Premier League, whose TV parachute payments can inflate their revenue to around £40 million.”

Excluding the impact of the parachute payments made to those clubs relegated from the Premier League (£26 million in first year after relegation) Brighton’s revenue would be one of the highest in the Championship. This season the disparity between “the haves and the have nots” will be even larger, as the relegated clubs include Newcastle United and Aston Villa.

Even Chris Hughton has commented on this hurdle, when discussing Newcastle: “They’ve come down with parachute payments, they are a massive club and they are doing their very best to make sure they go straight back up again.”

The majority of Brighton’s revenue comes from the stadium with gate receipts contributing 38%, up from 30% at Withdean, though this is only just ahead of commercial income 38%, following the relatively higher growth rate in the last few seasons. Broadcasting is up to 24%, though this is much lower than the Premier League, where TV money accounts for 70-85% of total revenue at half the clubs.

Clearly, Brighton are more reliant on match day income than most. In fact, in 2014/15 only two clubs were more dependent on this revenue stream: Nottingham Forest and Charlton Athletic.

Despite improved results on the pitch, gate receipts fell for a second consecutive season, decreasing 4% (£0.4 million) from £9.8 million to £9.4 million, largely due to a lack of home cup ties.

Nevertheless, this is still likely to be the highest match day revenue in the Championship in 2015/16, as the only team ahead of them in 2014/15 was Norwich City, who were promoted to the Premier League last season. It will be another story this year, due to the arrival in the second tier of Newcastle and Villa with their large crowds.

Average attendance slipped slightly from 25,640 to 25,583, partly due to the knock-on impact of the disappointing 2014/15 season, but this was still the second highest in the Championship, only surpassed by Derby County 29,663, though ahead of all three promoted clubs: Middlesbrough 24,627, Hull City 17,199 and Burnley 16,709.

Since the move to the Amex, attendances had been steadily rising from the 7,352 at Withdean, as the new stadium finally met latent local demand for tickets. Brighton’s potential has been highlighted this season by three games selling out (Norwich, Villa and Fulham). In fact, the club has in excess of 22,000 season ticket holders and 1901 Club members.

Ticket prices are among the highest in the Championship. According to the BBC’s Price of Football survey, Brighton has the second highest cheapest season ticket (only below Norwich) and the third highest most expensive season ticket (behind Ipswich and Fulham). However, the survey did note that tickets include a travel subsidy to and from the ground for fans by public transport or use of the park-and-ride option, valued at £4 per game for adults.

It is also worth mentioning that Brighton supporters are happier with their match day experience than any others according to a Football League study, partly due to the magnificent facilities that are second to none, including free wi-fi and VIP padded seats. The club is also good to away fans, lighting the concourse in their colours and having their local beer on tap. The only fly in the ointment is the appalling “service” from the dreaded Southern Rail.

The good news is that the club froze most ticket prices in 2015/16 and have restricted price rises in 2016/17 to no more than a couple of pounds per match. Barber said this was to reward fans for “the ongoing loyalty and support they’ve shown to the club.”

Brighton’s broadcasting revenue rose 19% (£0.9 million) from £4.9 million to £5.9 million in 2015/16, which was attributed to an increase in the Football League basic distribution plus the club being shown more times on live TV.

In the Championship most clubs receive the same annual sum for TV, regardless of where they finish in the league, amounting to around £4 million of central distributions: £2.1 million from the Football League pool and a £2.3 million solidarity payment from the Premier League. There are also payments for each live TV game: £100,000 home; £10,000 away.

This might not sound much, but Barber argued, “TV income is extremely important for all clubs, including ours”, adding, “without revenue from Sky TV, ticket prices would go up.”

However, the clear importance of parachute payments is once again highlighted in this revenue stream, greatly influencing the top nine earners in 2014/15. Nevertheless, it should be noted that these payments are not necessarily a panacea, e.g. Middlesbrough secured promotion last season, even though their broadcasting income of £6 million was less than half the size of those clubs boosted by parachutes.

Looking at the television distributions in the top flight, the massive financial chasm between England’s top two leagues becomes evident with Premier League clubs receiving between £67 million and £101 million in 2015/16, compared to the £4 million in the Championship. In other words, it would take a Championship club more than 15 years to earn the same amount as the bottom placed club in the Premier League.

The size of the prize goes a long way towards explaining the loss-making behaviour of many Championship clubs. This is even more the case with the new TV deal that started in 2016/17, which Barber described as “astonishing”. This will be worth an additional £35-60 million a year to each club depending on where they finish in the table.

Even if a club were to finish last in their first season in the top flight and go straight back down, their TV revenue would increase by an amazing £95 million. They would also receive a further £71 million in parachute payments, giving additional funds of around £166 million. If they survived another season, you could throw in another £120 million.

Of course, if they did go up, Brighton would also have to spend more to strengthen their playing squad, but the net impact on the club’s finances would undoubtedly be positive, as evidenced by the improvement in the bottom line for those clubs promoted in the past few seasons.

As we have seen, parachute payments make a significant difference to a club’s revenue and therefore its spending power in the Championship. From this season, these will be even higher, though clubs will only receive parachute payments for three seasons after relegation. My estimate is £83 million, based on the percentages advised by the Premier League: year 1 – 55%, year 2 – 45% and year 3 – 20%.

The other point worth emphasising is that if a club is relegated after only one season in the Premier League, it will only benefit from parachute payments for two years.

There are some arguments in favour of these payments, namely that it encourages clubs promoted to the Premier League to invest to compete, safe in the knowledge that if the worst happens and they do end up relegated at the end of the season, then there is a safety net. However, they do undoubtedly create a significant revenue disadvantage in the Championship for clubs like Brighton.

Commercial income grew by 5% (£0.5 million) from £8.9 million to £9.4 million, comprising commercial sponsorship and advertising £5.5 million, catering and events £1.3 million, retail £1.3 million, academy grant £0.9 million, other income £0.3 million and women and girls £0.1 million. The main driver for the growth was a £0.4 million increase in catering and events, primarily as a result of the Rugby World Cup matches hosted at the Amex.

In the new world of FFP, Bloom has said that the club “had to adapt and move quickly to establish a sharper commercial focus. We had to focus on the inherent value of our brand.” The club’s success in this area is reflected by Brighton having one of the highest commercial revenues in the Championship, only behind Norwich City and Leeds United in 2014/15.

This is despite the fact that Brighton now only report the net catering commission in revenue, whereas in previous seasons all the gross revenue was included in revenue with the expenses shown in costs.

"Back on the Shane gang"

What has been particularly impressive in recent years is the increase in sponsorship, though it remained static in 2015/16, largely due to the contractual cycles. American Express are not only shirt sponsors, but also naming rights partner for the stadium and the training ground. This multi-year agreement, signed in March 2013, was described by Barber as “the biggest in the club’s history.”

Similarly, Barber said that the 2014/15 Nike deal, replacing Errea after 15 years as the club’s kit supplier, represented “a significant increase on our existing commercial arrangement.”

Interestingly, the club has applied for planning permission for a 150 room hotel alongside the stadium, though the City Council has to date rejected the application. Barber said that this “would have been a valuable addition to our non-matchday revenue.” They remain “hopeful of a successful outcome”, which is just as well as they have to date spent over £2 million on this development.

Brighton’s wage bill shot up by 33% (£6.7 million) from £20.6 million to £27.4 million in 2015/16, “in order to be as competitive possible and give ourselves the best possible chance of success on the pitch.” This would have included high wages for the returning Bobby Zamora, even though he arrived on a free transfer.

It is worth noting that since 2012, the first year back in the Championship, the wage bill has grown by £12.7 million (87%), while revenue has only increased by £2.5 million (11%).

This is all seen on the pitch, given the significant reduction in administrative and operational expenses. For example, in 2015/16 the number of players rose from 61 to 73, while other staff were flat at 197.

Despite this growth, Brighton’s £27 million wage bill is still only the eighth highest in the Championship, so promotion would indeed be a fine achievement. As a comparative, the top three in the Championship in 2014/15 were Norwich City £51 million, Cardiff City £42 million and Fulham £37 million.

Barber understands this challenge: “We haven’t got anywhere near the biggest budget in the division. We’re probably 10th or 11th. So we’ve had to spend wisely, and eke out every ounce of value from every deal.”

That said, it would be no surprise if Brighton’s wage bill further rose this season, as they have been extending contracts for a number of important individuals, including Hughton, Beram Kayel, Solly March and Conor Goldson, though this will ensure a decent price if they are sold.

The remuneration for the highest paid director, who is not named, but is surely Paul Barber, has increased from £558k to £578k. This is a lot of money, but  Barber is really a Premier League level chief executive, who has been pretty successful in cutting operational expenses and renegotiating many of the sponsorships.

Brighton’s wages to turnover ratio increased (worsened) from 87% to 111%, the highest since 2009 when the club was in League One. This is not exactly great, but it is by no means one of the highest in the Championship. In 2014/15 no fewer than 11 clubs “boasted” a wages to turnover ratio above 100% with the worst offenders being Bournemouth 237%, Brentford 178% and Nottingham Forest 170%.

The (relatively) prudent approach is evidently the one that Brighton want to follow, especially in a FFP world, as noted by Bloom: “While we do want to play at the highest level, we cannot simply open our cheque book and start spending without care or attention.”

Other expenses rose by 7% (£1.1 million) from £15.0 million to £16.0 million, which is by far the highest in the Championship, ahead of Fulham £13.4 million and Leeds United £12.6 million.

This is the other side of the coin of moving to the Amex, as this year’s increase was largely due to stadium expenses: maintenance, running costs and security. There are also some costs that are exclusive to Brighton, as Barber note, “The contribution that the club makes to the cost of travel has grown, meaning that we have a large seven-figure transport bill that other clubs don’t have.”

Non-cash expenses have also been on the rise with depreciation and player amortisation increasing from just £237k in 2009 to £8.7 million in 2016, reflecting the club’s investment in infrastructure and the playing squad.

In 2015/16 depreciation was unchanged at £4.9 million, which is more than twice as much as any other club in the Championship, the next highest being Derby County £2.1 million. This represents the annual charge of writing-off the cost of the stadium and the training ground. These are depreciated over 50 years, i.e. 2% of cost per annum.

Player amortisation was 60% (£1.4 million) higher at £3.8 million, following the strengthening of the squad, but this not out of the norm in the Championship. The highest player amortisation in 2014/15 was found at clubs recently relegated from the Premier League, namely Norwich £13 million, Cardiff £11 million and Fulham £11 million.

However, to place this into perspective, even these clubs are miles behind the really big spenders in the top tier like Manchester City (£94 million) and Manchester United (£88 million). This is partly because there is no amortisation required for those players who have been developed at the Academy, e.g. Dunk and March in Albion’s case.

The accounting for player trading is fairly technical, but it is important to grasp how it works to really understand a football club’s accounts. The fundamental point is that when a club purchases a player the transfer fee is not fully expensed in the year of purchase, but the cost is written-off evenly over the length of the player’s contract, e.g. Irish international defender Shane Duffy was bought from Blackburn Rovers for a reported £4 million on a four-year deal, so the annual amortisation in the accounts for him is £1 million.

Over the years, Brighton have not been a big player in the transfer market, often registering net sales, though they have increased their gross spend recently, averaging £5.6 million in the last two seasons, compared to just £0.9 million over the previous nine seasons.

It is striking that there have been no meaningful sales in this period, as Barber explained, “Our key objective this summer was to retain our best players which, despite a lot interest and a number of offers for different players in our squad, we have managed to do.”

They also wanted to strengthen the squad in key areas this summer, so recruited Shane Duffy and Oliver Norwood, who made a good impression at the Euros with the Republic of Ireland and Northern Ireland, and the returning Steve Sidwell. They have also made good use of the loan market, bringing in prolific goal scorer Glenn Murray from Bournemouth and full-back Sebastien Pocognoli from West Brom.

"A French Kiss in the Chaos"

Last season they also bought well with Anthony Knockaert, Tomer Hemed, Jiri Skalak, Conor Goldson, Liam Rosenior, Jamie Murphy, Gaetan Bong and Uwe Hünemeier all making decent contributions.

However, it is apparent that Brighton have not gone overboard in terms of spending, especially compared to some of their principal rivals who are really “going for it”. To illustrate this, in the last two seasons Brighton had net spend of 11 million, while they were comfortably outspent by Derby County £26 million, Norwich City £23 million and Sheffield Wednesday £21 million.

Not to mention Aston Villa and Newcastle United who have somehow found themselves in the Championship despite substantial net spend of £47 million and £43 million respectively. As Hughton said, “There are big spenders in this division. We can’t compete with what Newcastle and Aston Villa are doing. What we have done has been sensible.”

Therefore, Brighton have to box clever, as Bloom explained: “There are other clubs in the division who have spent significantly more than us. So we just have to make sure we recruit smarter and that the team dynamic overcomes the financial disadvantage we've got against certain other clubs.”

Although holding onto players was clearly the strategy for this season, Bloom recently indicated at a fans’ forum that things might be different next season, so this may well be Brighton’s best opportunity to get promotion.

Brighton’s net debt rose by £25.6 million from £140.5 million to £166.1 million with the £23.0 million increase in gross debt to £170.6 million compounded by cash falling by £2.6 million to £4.5 million.

Debt has been rising over the past few years, so much so that Brighton now have the largest debt in the Championship, substantially more than other clubs, e.g. Cardiff City £116 million, Blackburn Rovers £104 million and Ipswich Town £88 million. However, it is entirely owed to Bloom, is interest-free and can be regarded as the friendliest of debt.

The cash flow statement reveals that Bloom has also converted £22 million of loans into share capital, including £11 million in 2015/16, which means that Bloom actually stumped up £34 million last season. Furthermore, since the accounts were published, he converted an additional £8 million of loans into shares, i.e. a running total of £30 million.

Adding the £80 million that Bloom has funded via share capital (including the debt conversions) to the £171 million of debt means that Bloom has put in a total of £251 million – that’s a cool quarter of a billion.

Just pause to let that sink in for a moment. One. Quarter. Of. A. Billion. Pounds.

As David Jones commented, “That’s a massive amount of money for an owner to have to subsidise a club for. And when you consider we’ve got one of the highest two or three attendances in the Championship, some of the best sponsorship deals, we’re still needing the owner to help us with that kind of subsidy. It’s substantial.”

Looking at how Brighton have used these funds since Bloom took charge, the majority (£155 million) has gone on investment into infrastructure (including £103 million on the stadium and £32 million on the training centre), while £83 million has been used to bankroll operating losses. Hardly any money was spent on new players in this period with a net outlay of less than £5 million.

There were a couple of interesting corporate actions after the accounts closed. Authorised share capital was doubled from £100 million to £200 million – potentially paving the way for a significant debt conversion? In addition, the club created £40 million of Convertible Unsecured Loan Notes.

Being so dependent on one individual can be a concern, but Bloom comes from a family of Brighton supporters: “I have absolutely no intention of selling. I think I will be here for many years to come.”

"Hands Held High"

He continued: “Our ambition remains for the club’s teams, both men and women, to play at the highest level possible – and as chairman (and a lifelong supporter of the club) I will do everything I possibly can to achieve that and I remain fully committed to that goal.”

Bloom is seriously wealthy from his property and investment portfolio (plus money earned from poker and other forms of gambling), but Brighton are very fortunate to have such a generous benefactor.

As Jones said, “If you’re an ambitious Championship club and you don’t have the benefit of parachute payments, then you’re going to need an owner that’s prepared to subsidise you substantially.”

"Sound Czech"

However, Bloom would not be able to simply buy success, even if he wanted to, as Brighton need to follow the Football League’s FFP regulations. Under the new rules, losses will be calculated over a rolling three-year period up to a maximum of £39 million, i.e. an annual average of £13 million, assuming that any losses in excess of £5 million are covered by owners injecting equity (hence the £8 million debt conversion in July 2016).

These limits are much higher than the previous £6 million a season, so are likely to encourage clubs to spend even more, making the division even more competitive.

Brighton have confirmed that they will comply with these rules in 2015/16 (“as we have done each season”), which might seem strange, given that the reported £26 million loss was twice the £13 million limit.

"Another Dale in my heart"

This is because FFP losses are not the same as the published accounts, as clubs are permitted to exclude some costs, such as depreciation, youth development, community schemes and any promotion-related bonuses.

Brighton’s depreciation was £5 million, which implies that they have spent £8 million on their academy and the community in order that the FFP loss was lower than the £13 million limit in 2015/16. Even though these activities represent a major investment for the Albion, it seems unlikely that the expenditure would be that high, but it is difficult to see how else the club could have complied.

Going forward, the assessment is calculated over a three-year period, which means that a higher loss one year can be compensated in later years, e.g. via player sales, or might even become irrelevant (if the club is promoted).

Either way, Bloom was right when he said it is “a delicate balancing act for the board, as we strive to achieve our ultimate aim.”

"Spanish Steps"

The last time Brighton were in the top flight was way back in 1983, but this club is clearly ready for the Premier League. As Bloom said, “That’s what we built the stadium for, that’s what we built our magnificent training ground for.”

Bloom appears just as happy with the situation on the pitch: “To compete at the top end of the Championship, it’s important to have a manager who knows how to win at this level and to possess a strong group of quality players. We have both, and while this doe not guarantee promotion, it gives us an excellent chance.”

Given what happened last season, nobody at the Amex is taking anything for granted. Barber spoke for everyone: “We’ve made a really strong start. But we also know that this is the toughest division in the world and that nothing has been achieved at this point.”

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