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Finding Picks in Challenged Industries

Ryan Leggio

Ryan Leggio: Hi. I'm Ryan Leggio. I'm a mutual fund analyst at Morningstar.

I'm here at the Morningstar 2011 Investment Conference, and I have the pleasure of having Michael Keller from Brown Brothers Harriman with me today. He was one of the panelists on the Undiscovered Managers panel. Michael, thanks so much for joining us.

Michael Keller: Thanks for having me here.

Leggio: I think a big question that a lot of investors have right now is, where are we today? The markets have been pretty volatile over the last couple of weeks. Where are you currently finding values and how does the risk-return profile of the fund look today compared to a year ago?

Keller: Well, we certainly are less cheap than we had been a year ago, and in our portfolio, we're on a weighted average basis trading around 77% or 78% of intrinsic value. So, not demonstrably cheap, but also not exorbitantly expensive.

We are still finding opportunities. For us, it's always about the companies, not necessarily about trying to get the macro picture right. So, where we've been focusing our time is finding some bargains in different areas, and two of the areas we've been focused on this year have been financials and health care.

Leggio: Let's dig into health care. A lot of uncertainty still in that area. Some investors are worried about the regulations still to come for a lot of these types of companies. What specific companies are you finding values in?

Keller: So, two that I had mentioned, names we've added to this year, have been Novartis and Baxter. Both are companies that we believe have a long and fairly visible organic growth run ahead of them and have global opportunities really to expand the markets they sell into. As more and more people have access to higher levels of care, higher standards of care, I think that creates a lot of unit growth for those companies over time.

In your question, you mentioned the regulatory pressures, and some of the externalities that are confronting that industry, and that's certainly something we need to carefully assess, because there is reimbursement pressure by governments; there's also pricing pressure by governments that's applied to these companies around the world.

So, you sort of have that balance of unit growth, driven by market expansion, but pricing and regulatory pressure is another aspect you need to be aware of. But I think in both the case of Baxter and Novartis, being focused on medically necessary products, having a R&D--these are companies that are still willing to put a lot of money behind R&D, and that's bringing out a robust pipeline for both companies, which are turning into revenue streams over time. That's what we'd like to continue to see them do, to grow organically mid-single digits, even perhaps high-single-digit rates over time, and really create value for our us as shareholders. So, those are being two that we've been adding to, and there are certainly others in health care that we are doing some work on.

Leggio: In terms of the financial sector, there seems to be kind of a disagreement among value investors. You own two household names, Wells Fargo and US Bancorp, and yet we've heard some managers here at the conference this year make the case for the kind of hated names, Citigroup or Bank of America. I guess the question is, why not the hated names and is a Wells Fargo and US Bancorp as cheap as a Citigroup or a Bank of America?

Keller: Well, they are not as cheap, but in our process, we are not necessarily focused on what's the cheapest. We don't go looking for trouble to put it quite simply. We would avoid typically a deeper value name and prefer to own something--granted at a reasonable price--but prefer to own something where we feel our capital is better protected.

So, with USB and Wells Fargo, the two that you mentioned, which are both significant holdings for us, and we've been adding to this year, those are deposit-funded banks. They have a pretty basic and essential business/service they are offering to consumers and business. It's deposit gathering and lending and investment. And in both cases these are efficiently run banks.

On a normalized basis, they have some of the best ROAs in the industry, and depending where we shake out these capital requirements, we assume over time they will return to some of the best ROEs in the industry. So, these are two businesses, two banks, where we feel our capital is better protected. We are less tempted by things that are optically cheap because there are still a lot of problems on the credit side with some of those banks, but I think three years from now, we'll be looking at USB and Wells Fargo and saying, gosh, we were able to get them at some great prices there in 2011 in the midst of regulatory concerns, concerns of a double dip, housing markets seeming to stall out again. So, those are the challenges that I think are actually creating the opportunities and that's something we've been doing actively.

Leggio: The last thing I want to ask you about were risks in the market today, and I know a big part of your process is to make sure that there aren't permanent impairments of capital with the investments that you make. What are the big risks right now that you're thinking about and that maybe regular investors or financial advisors should be thinking about in the market today?

Keller: I don't think the risks change much over time. You have to worry about economic slowdown and whether that's driven by a credit event like we've had or maybe that's driven by interest rates flying up or inflation creating a crowd out effect or an emerging-market slowdown. I mean, a lot of these things, some of them feel like they are at the door right now. So, you have to be mindful of the macro setting, and the risks that it could create for the portfolio, but we've always taken a different approach. We don't say, well, let's make our best guess about the macro situation and then invest accordingly. We say, we know what kind of companies we want to own and the price we want to pay for them. Let's make sure we understand what the macro environment could present as fundamental challenges for these companies to help us build out our risk-reward upside downside type of study.

But we wouldn't use the macro environment to necessarily guide us as we are really bottom-up oriented. So, I think at the moment things feel less sanguine than they did a few months ago, and we are certainly cognizant of that, but we are a bottom-up fundamental investor, and we still see opportunities at the company-specific level. You use those external inputs to help you frame out a better and more coherent and cohesive risk equation, but we don't really let those concerns drive us out of specific actions.

Leggio: Michael, thanks so much for being with us today.

Keller: Thank you, Ryan.

Leggio: Thank you for being with us. This is Ryan Leggio for Morningstar.