William Priest, CEO and co-CIO of Epoch Investment Partners, a proponent of active investing, makes his case for active investing in his new book, “Winning at Active Management.”

On one side of the investment management debate stage: Proponents of actively managed portfolios. On the other side: Advocates of passive indexes and ETFs. Who’s winning? Who’s whining? Indeed, for the last few years, passive investing has bested active management.

But wait. Passive is actually creating opportunities for active, and the outlook for actively managed strategies is upbeat. So says William Priest, CEO and co-CIO of Epoch Investment Partners, in an interview with ThinkAdvisor.

Before co-founding Epoch in 2004, Priest spent 30 years at Credit Suisse Asset Management Americas as chair-CEO and CEO of its predecessor firm, BEA Associates, which he co-founded in 1972.

Priest makes the case for active investing in his new book, “Winning at Active Management: The Essential Roles of Culture, Philosophy and Technology,” co-authored by Epoch portfolio managers Steven D. Bleiberg and Michael A. Welhoelter, with John Keefe. Barron’s calls the book “a manifesto for stock pickers.”

New York City-based Epoch has nearly $43 billion in assets under management; assets under advisement total about $49 billion. One of its principal strategies, Global Equity Shareholder Yield — a dividend-like product, as Priest describes it — has had an annualized risk-adjusted rate of return of 7.9% since its 12/31/95 inception.

Back in 2007, the astute portfolio manager recognized that  dangerous doings in the subprime loan market signaled wide-ranging disaster ahead. That April, in a white paper, he wrote: “Mortgage-backed CDOs and RMBS [Residential Mortgage-backed Securities] are analogous to termites in their ability to silently wreak fatal, widespread and immediate havoc.… The ‘subprime canary’ has dropped, and that’s very bad news for the rest of the coal mine.”

(Related: Vanguard, the Unlikely Savior of Active Management)

In our interview, Priest, 75, discusses major reasons for active managers’ underperformance, along with his firm’s effective approach to selecting stocks.

Here are excerpts from our conversation:

THINKADVISOR: Are good times in store for active management?

WILLIAM PRIEST: Absolutely. When I see articles in favor of passive management, I rub my hands together: This is fantastic! You’ll still see a shift of assets from active to passive; that swing will go on till there’s some kind of accident in the passive world. But going forward, the opportunities for active managers will get better, not worse.

Why?

If you get into a world that’s passive, the opportunity for active is terrific because in a passive portfolio, such as an index fund, you own everything – the good stuff and the bad stuff.  You often own things that go broke in the course of a year. Opportunities for active management are created just by the lack of price discovery by indexation.

How do you win with active management?

Not all managers will deliver returns over the long run. But some will. To win, you need three things: a certain kind of organizational culture; an investment philosophy that’s tied to something very fundamental in that the financial theory behind it is demonstrable in its integrity; and — going forward in particular — the ability to show that the technology embedded in your business and investment process has scale capability and can generate insight.

So which strategy do you think will win out — active or passive?

The world is never going to be all one or all the other. We may wind up with a mix of maybe 60% passive and 40% active. I really have no idea. But there will always be active management.

Why has it been so difficult for active managers lately?

The last five years of active managers’ underperformance is explainable in terms of quantitative easing and the absolutely overwhelming performance from P/E multiple expansion – which I think is over.

Why?

QE essentially brought interest rates down to an [extremely] low level, and there has been an expansion in the value of financial assets. You could be a very good analyst, but you were overwhelmed by multiple expansion. Unless you realized that multiples were going to expand because of central bank policy – principally QE – you missed the market.

How has your firm’s strategies performed in the recent past?

I would be misleading you if I said the last five years haven’t had their challenges. We’ve had some products that have done exactly how you hoped they would: they had positive returns. But some haven’t. From inception, though, when [these] products were] launched, 10 or 15 years ago, the numbers are generally better than the market and there’s been slightly less volatility.

Why do you think P/E multiple expansion is over?

If it expands, it will be an incredibly small amount and will happen only because interest rates go even lower. The chances of that are very slim. The most important driver of P/E ratios is interest rates. When they’re low, P/E ratios are high; and vice-versa.

Why do active managers frequently underperform?

They often fail because they don’t do what they say they do. They’ll lay out an approach; but very often, if you look closely,  you’ll find that over time, they really didn’t do that on a consistent basis. One year they were value; two years later when value wasn’t working, they became growth. And when growth wasn’t working, they went back to value. Their process was inconsistent: they zigged and zagged.

Any other reason?

Many of their processes are based on accounting terminology, which basically is useless because it doesn’t tell you anything. The balance sheet is irrelevant to the value of a firm if you ignore the tax deductibility of interest.

So if P/E multiple expansion is over, just what does that mean for active management?

If multiple expansion is taken away, you’re in this world where the future growth in the stock market is going to be a function of dividends and earnings. Picking industries or stocks that are likely to have higher dividends and faster growth is largely going to require an active approach that focuses on a critical variable, which for us, is free cash flow. The most important thing to win is free cash flow.

Why?

Cash flow drives value. You can’t build a firm of value unless you generate cash flow. If you want to understand a business, follow the cash. You want to be able to watch the cash come in through a sale and look at how the costs are assigned to that revenue. What you wind up with is considered operating cash flow. But we use the term, free cash flow, which is slightly different.

In what way?

Free cash flow is the cash available for distribution to shareholders after all planned capital expenditures and all cash taxes. Accounting doesn’t really matter. It’s all about cash. Once you realize what the claims to that cash are in terms of capital expenditure commitments and cash taxes, you’re left with free cash flow. Companies with free cash flow do very well over the long run. Their stock might underperform from time to time, but it’s impossible for the companies themselves to go broke.

What does a firm do with its free cash flow?

There are five choices that any company anywhere has: Pay a cash dividend, buy back stock, pay down debt, make an acquisition or re-invest in the business. The trick is to find out which one or combination of those things to [execute] going forward. A key to that is the cost of capital.

You’ve written that dividends are “beautiful and sometimes dangerous.” What do you mean?

If a company is paying a dividend but isn’t generating sufficient cash flow to cover the dividend, that can be dangerous because it can be a kind of liquidation. We don’t like to buy companies that don’t have underlying growth rates of free cash flow. The minute that doesn’t exist, it becomes quite dangerous.

Please elaborate.

If you’re paying a dividend, you’re literally reducing the value of the firm. When a company declares a dividend, there’s a debit to retained earnings and a credit to cash. That means when the dividend it paid, there’s an immediate reduction on the stockholder’s equity section of the balance sheet. This has to be replenished from earnings growth or, from the way we look at it, free cash flow growth.

You write that one way of using mixes of fundamental and quantitative methodologies in your process is by “trying to filter out the needles and buy[ing] the haystack.” Please explain.

We cast a wide net — a fairly substantial screen — and out of it will fall hundreds of names that meet our particular standards. Think of the haystack — the universe of stocks – as coming out of the screen. In one case, the analyst’s job is to find needles in the haystack to include in the portfolio. In our more quantitatively driven strategies, the process is reversed: We try to filter out the needles and buy the haystack.

What does the latter process involve?

We do a number of tests. If it’s shown that a company can maintain a consistent premium over the cost of capital over time, that will be a very winning strategy. The trick is to find those needles that show persistency over time.

Talk about your interesting concept of “collecting the dots” and “connecting the dots.”

This is an important part of the future of active management: Today, we have the ability to collect and recombine all the data in digital form that’s held in the cloud. There are millions of algorithms you can put together with respect to investing, and you can test them all. So you may say, “I didn’t realize that this dot was connected to a different kind of dot.” But until you collect the dots, you can’t even begin to comprehend the connection.

And that’s when judgement comes in?

Yes. After you’ve collected a lot of dots and connect them through your insight and judgement, and technology, you can start to build a model and say, “Hey, this looks like it will win over time.” Again, to do that, the most important thing is [free] cash flow.

What’s your take on the broad question of human vs. computer when it comes to investing?

Technology augments human judgement; that is, machine plus human can beat machine. Let’s say that, in the investment industry, an analyst over a period of time has demonstrated excellent judgement and is able to pick four out of seven names that win. So, with that kind of judgement [and supplemented by a computer], maybe he could pick eight out of 14 names that win. He’ll see things that the machine hasn’t been programmed to see and will be better than the machine by itself. You want machine to serve man, but machine is not a replacement for judgement. It can augment the judgement process and, hopefully, increase the number of opportunities.

— Related on ThinkAdvisor:

Active vs. Passive? No Longer an Either/Or Choice for Advisors

Actively Going Passive, but at What Cost?

Vanguard, the Unlikely Savior of Active Management