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Michael Reckmeyer and Matthew Hand: How to Protect Downside Amid Lofty Valuations and Paltry Yields

Two Wellington Management portfolio managers discuss how they manage risk at Vanguard Wellesley Income, why they’ve taken a liking to busted growth stocks, and where they’re finding durable sources of income.

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Our guests this week are Michael Reckmeyer and Matthew Hand. Mike and Matt are managing directors at Wellington Management, where they oversee a number of prominent values investing mandates, including the stock sleeve of Vanguard Wellesley Income Fund, as well as Wellington's portion of Vanguard Equity Income Fund, among other duties. Mike's investing career began in 1984 at the State of Michigan Pension Fund, followed by eight years at Kemper Financial Services, after which he joined Wellington in 1994. He received both his bachelor's degree and MBA from the University of Wisconsin-Madison and is a CFA charterholder. Matt joined Wellington in 2004 after graduating from the University of Pennsylvania. Like Mike, Matt is also a CFA charterholder.

Background

Michael Reckmeyer bio

Matthew Hand bio

Wellington Management

“Four Fantastic Income Funds,” by Russell Kinnel and Christine Benz, Morningstar.com, Aug. 11, 2020

Funds Mentioned

Vanguard Wellington

Vanguard Wellesley Income

Vanguard Equity Income

Hartford Equity Income

Other References

Jack Bogle bio

Gus Sauter: Efficient Markets Are a Good Thing,” The Long View Podcast with Christine Benz and Jeffrey Ptak, Morningstar.com, Dec. 4, 2019.

“The Wildly Popular Trades Behind the Market’s Swoon and Surge,” by Gregory Zuckerman and Gunjan Banerji, wsj.com, Sept. 13, 2020

Securities Mentioned in the Podcast

ADP https://www.morningstar.com/stocks/xnas/adp/quote

Archer-Daniels-Midland https://www.morningstar.com/stocks/xetr/adm/quote

Cisco https://www.morningstar.com/stocks/xnas/csco/quote

Comcast https://www.morningstar.com/stocks/xnas/cmcsa/quote

Crown Castle International https://www.morningstar.com/stocks/xnys/cci/quote

Dominion Energy https://www.morningstar.com/stocks/xnys/d/quote

Intel https://www.morningstar.com/stocks/xnas/intc/quote

Lockheed Martin https://www.morningstar.com/stocks/xnys/lmt/quote

Medtronic https://www.morningstar.com/stocks/xnys/mdt/quote

Philip Morris https://www.morningstar.com/stocks/xnys/pm/quote

Progressive https://www.morningstar.com/stocks/xnys/pgr/quote

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.

Ptak: Our guests this week are Michael Reckmeyer and Matthew Hand. Mike and Matt are managing directors at Wellington Management, where they oversee a number of prominent values investing mandates, including the stock sleeve of Vanguard Wellesley Income Fund, as well as Wellington's portion of Vanguard Equity Income Fund, among other duties. Mike's investing career began in 1984 at the State of Michigan Pension Fund, followed by eight years at Kemper Financial Services, after which he joined Wellington in 1994. He received both his bachelor's degree and MBA from the University of Wisconsin-Madison and is a CFA charterholder. Matt joined Wellington in 2004 after graduating from the University of Pennsylvania. Like Mike, Matt is also a CFA charterholder.

Mike and Matt, welcome to The Long View.

Matthew Hand: Good to be here. Thanks.

Michael Reckmeyer: Thank you for your time today.

Ptak: We don't usually get started with biographical or organizational details, but in this case, it might be helpful to do so as Wellington isn't going to be quite as familiar to some of our listeners as are some of the other fund families that are maybe household names. So, give us a quick thumbnail of Wellington, a firm that manages around $1 trillion in assets and tell us how you and your team fit in.

Reckmeyer: Yes, Jeff, thank you. So, Wellington, we're a privately based company located in Boston and as you mentioned, around about $1 trillion of assets, and that's about 55% equities and 45% fixed income. And we're not as well-known because we actually do not have our own mutual funds. We are the largest subadvisor of other people's assets in the world. And as a result of that, people don't know us from that perspective. Vanguard is our largest client. We manage $350 billion for Vanguard, and its relationship we've had going back 40 years. In fact, Wellington and Vanguard were one firm at one point. In 1975, Jack Bogle, we split the firm, and he started the Vanguard organization. And since then, there's been a strong relationship with Vanguard and Wellington throughout that time period.

So, as a team, there are seven people on our team. We call it the value-equity income or dividend-orientated team, and we're located in Radnor, Pennsylvania, just outside of Philadelphia. And we're just a couple miles away from the Vanguard complex. And how we're structured is we essentially consider ourselves a boutique within the larger Wellington organization. As a team, we do all of our own fundamental analysis on the companies through remodeling, valuations, stock selection. But the benefit we have is we can leverage the resources of Wellington with our central research analysts or fixed-income credit analysts or ESG personnel. And so we have the broader perspectives that we add to our investment criteria. And the benefit that I have as a portfolio manager is, I believe, this brings the best available information to me for which to base our investment decisions.

Benz: Wellington has very much a team-driven approach, which certainly has its advantages. But who does the buck stop with when it comes to the performance of the strategies you manage? And how do you inculcate ownership for those decisions in your team? And more broadly, how do you foster accountability throughout the firm?

Reckmeyer: As a team, I am the ultimate decision-maker for our team. But we have daily interactions about all the stocks within our portfolio and opportunities that we see. But the ultimate decision comes upon me. But in terms of how we try to incent the team, all of the team members are incented with performance incentives. We try to align our goals with the clients' goals and that's namely to outperform our benchmarks and do so in a risk-adjusted manner that is consistent with our clients' expectations and our objectives and approach.

Ptak: You alluded to the fact that you run yourselves--operate like a boutique, but then you draw on the broader resources of the firm, including what sounds like a centralized analyst pool. And so, ensuring that you've inculcated that mindset of ownership for whatever sort of research and analysis they're furnishing to you, how has that worked out in practice? Maybe you can just paint the picture for us of how you've managed that handoff between the broader Wellington and then the smaller boutique that you're a part of?

Reckmeyer: Well, we actually think it's very seamless. Wellington, we strive on collaboration. We have daily meetings with all the firm. We have a weekly sector meeting and as a team we meet daily. All the information that we generate will be put into a common database that is accessible to everybody within the firm. And this allows a dialogue among all the different investor personnels within the teams and the central resource people. So, we actually think it enhances the overall investment discussion.

Hand: Yeah, and I would just add that I think our goal is to be part of the investment discussion to contribute to the broader investment discussion and certainly utilize the depth and breadth of resources that are available to us from Wellington, both on the equity side but also fixed income, other areas like ESG, and really just build a better mosaic and more confidence in our investment cases and more understanding of potential downsides in our process, which really focuses on protecting the downside while capitalizing on long-term sustainable dividends and capital-appreciation potential.

Ptak: And then when I look at your biographical details, based on my understanding of how you operate, it seems like you're both player/coaches in your own regard, right? You followed industries for a number of years. I would imagine that some of the idea generation and primary research work you yourselves, or some of your battery mates that are a part of the nucleus that you work most closely with, you're doing some of that work with additional supports from the broader firm. Is that a way to think about how it is you source and implement ideas?

Reckmeyer: The sourcing of ideas can come from different perspectives. It could be something our team analysts come up with. It could be something that the portfolio managers on our team find. But also, the essential research analysts, they're always recommending their best ideas also. So, we're indifferent as to where the ideas come from. We're just trying to find the best opportunities in the marketplace that meet our clients' objectives.

Benz: What's an issue or topic that the two of you constructively disagree on where you've arrived at different conclusions? And how have you worked that out in managing the portfolio?

Reckmeyer: That's a good question. Often, situations are not black and white for investing. And we had a situation in the first half of the year. We had a chemical company that Matt was following that we liked. We stress-tested a dividend for a normal economic downturn. We felt the dividend was fine. But actually, as we got into the COVID dislocation, the downturn was much more severe than what we anticipated. When we re-ran our stress tests, we came directly to the conclusion--Matt felt the dividend was sustainable in that environment and I was more uncertain. I was less confident of their ability to maintain that in the downturn. And at the same time that happened, we were seeing a lot of other opportunities present themselves just because of the broad-based downturn in the marketplaces and some of those opportunities also had situations where dividends were attractive but were sustainable. The decision I made was to exit that name and reinvest those proceeds into other opportunities that had very attractive appreciation potential, as well as has a strong and sustainable dividend yield.

Hand: I think a hallmark of what our team really tries to do is challenging our assumptions and thinking about what could go wrong and really avoiding the dividend cuts and value traps as best as we can. And so, we have debates and constructive discussions all the time. And as Mike said, it's not usually cut and dry. They're discussions that evolve over time and analysis that we consistently look at and challenge ourselves. I would say that those types of disagreements and debates are really central to our process. And it's something that's really welcome within our team and beyond, and I think makes us better.

Ptak: Since you mentioned the pandemic and the need to stress-test or doubly stress-test some of the assumptions, what other changes to your process has that ushered in? I know that you're going to say that it didn't cause any sort of seismic shifts in the way you approach things. But I have to imagine that maybe there's some adjustment that you've done with the pandemic having been the catalyst for that. Are there some examples of things that maybe you’ve fine-tuned?

Reckmeyer: We've been running the annual stress tests on our portfolios since the GFC. So, it's something that we developed back then and we do it every year. Even when times are great, we're always trying to look at the downside, because we've learned that sometimes you can't anticipate unexpected events, whether it be 9/11 or the COVID dislocation. So, we always run assuming, looking at the downside scenario. When we went into the COVID crisis, we had to readjust all of our assumptions. We base our downside on a normal economic recession. But the COVID dislocation was much worse than that. We had to refine when we do our downside scenarios, and with that we did make some adjustments to the portfolio. And as well during that dislocation, some opportunities presented themselves that we took advantage of. We try to be always looking at the downside but being opportunistic when the opportunities do present themselves.

Benz: I asked about how you handle areas where you disagree, but can you talk about an issue where the two of you might be in lockstep and how you've sought to stress-test that by seeking out contrary opinions at the firm or outside the firm?

Hand: Yeah, sure. As Mike discussed, the strategy really focused on downside protection. We're always trying to understand the other side of an argument in an investment thesis and what can go wrong. And that's part of the benefit to us of being part of Wellington is having a lot of resources that can help with that and allow us to really challenge our assumptions. And I think one example of that that's a pretty good one is in the middle of last year, our purchase of Archer-Daniels-Midland, the agricultural company. It's a company with a relatively low return on capital, and there were some significant questions about agricultural markets during that time. And we saw a company with fundamentals in the sector that were closer to trough and an idiosyncratic profit-improvement story that could drive returns on capital and earnings per share higher, all else equal, both on normalized earnings but also trough, which was pretty important to us. And for our team, I think we were pretty well aligned on what the company was doing and where they were going, but we have a lot of experts internally that could help us out.

And I think about David Chang who manages some commodity portfolios for Wellington, he and his team are extraordinarily knowledgeable on agricultural sector. And that was extraordinarily helpful to us over time. Or Kira Connors, who's an industry analyst on the fixed-income side and is really familiar with the ADM balance sheet and the idiosyncrasies of it for an ag business that is somewhat complicated and really helping us gain comfort, both in the long-term potential of the investment but also the downside case.

Ptak: I wanted to shift gears and talk for a moment about a stock you took a stake in, that's payroll service provider Automatic Data Processing, ADP for short. It looks like you took that stake in the second quarter. And my question is, can you trace the arc of the decision that was made to add that name to the portfolio from, I guess you'd call it discovery to execution? For instance, when you started looking at it, was it an idea that was sourced by an analyst and what drew that analyst to it; why did you buy when do you did; how did you think about the milestones for continuing to own your stake in it albeit it's a recent purchase? It's always helpful to trace the arc of ownership of a fund in a position and that seemed like a decent one to start with. Is that one you can speak to?

Reckmeyer: Sure, that'd be great. Thank you. So, ADP, it's a high-quality company, high returns on capital, strong balance sheet. But historically, it was just too expensive for us. The valuation was too rich. But what happened with the dislocation when the markets sold off, ADP stock declined by about 40%. So, that brought the valuation into our framework. And at the same time, because of the collapse in the stock price, the dividend yield increased from what was 2% to an over 3% dividend yield. So, just as we were going through the dislocation in the marketplace, we identified the stock and started to do work on this. But the benefit we have is we have Bruce Glazer, who is a GIA or central research analyst, and we could tap into his knowledge base about the company. He's been following this for years. He's much more up to speed about the fundamentals of the company. We interacted with him. We were able to set up some meetings with the company to further delve into some of the issues surrounding the company. And it was through this interaction, we decided to take a position in the name.

This is a situation just where we monitor some stocks that they might not meet our criteria right now, but theoretically, they could if they would fall into our valuation framework. And by having the central research analysts it enables us to ramp up quickly on certain situations if the marketplace does create a dislocation.

Benz: Would you say that that's representative of the arc of ideas, the way that they travel before they enter the portfolio? You monitor something in that way and then when it falls into a more attractive valuation level, you begin to look at it more seriously?

Reckmeyer: That often is the case. We consider ourselves contrarian investors. And so, we're looking for companies where there's a dislocation in the stock price. And often you have some stocks that would be characterized more as growth stocks, and they stumble to whatever the issue is, falls in valuation that we will try to take advantage of it. That's why we have the benefits of all these different companies flowing through our offices. And even if we don't own it right now, we can listen and try to understand what the fundamentals are, what the strategy is for the companies, because we never know when we're going to get an opportunity to take advantage of that. And by having our firmwide resources that allows our team to ramp up and take advantage of those situations.

Ptak: I wanted to shift gears if we could and talk a bit about portfolio construction and risk management, how you approach that? Maybe we'll focus on Vanguard Wellesley Income, which as we mentioned earlier, you manage the equity sleeve of. It's actively managed, but it follows a pretty straightforward approach. The portfolio is split roughly 35-65 between higher-yielding stocks and investment-grade bonds and you hold that mix more or less steady. It's been very successful over the long haul. But my question is now that yields are pinned as low as they are and valuations by many measures look lofty, why should income-minded investors who maybe have come to rely on the fund feel quite as confident in the strategy's future prospects?

Reckmeyer: Just in terms of how we're going to run the fund, we're not going to change the fundamentals of the fund. The fixed-income side, that's a heavy focus on investment-grade securities and government-backed securities. And the equity side, we're focused on high-quality dividend-paying stocks, the dividends are sustainable and rising. And we think this combination does provide downside protection when the markets come under stress. But the low interest-rate environment, the 0% yields right now, they are a challenge to the fixed-income marketplace. The dividend yield of the fund is right around 2% right now.

How we look at that going forward is if you assume stable rates, we would expect to see some appreciation of the yield component. And this comes about from the equity side of the portfolio. Our equities, we believe, will over time increase their dividends on a regular basis. Longer term, we think the dividend-growth rate will be similar to that of the earnings-growth rate. And as well as our expectation is over a longer term, the equity component will also give some capital appreciation to the fund. So, this should help to enable some modest growth to fund as well as it should be seen a modest increase in the payout ratio.

Ptak: So, to step back for a moment, and we can talk about some of those particular aspects of how it is you build a portfolio and it will be managed going forward, acknowledging that you're not planning on making any major changes. We understand that. But stepping back, what would you say to those who are now questioning utility of investment-grade bonds given how low yields are? I think in particular they're questioning whether those bonds can continue to serve as the effective diversifiers they've been in the event of a stock sell-off, and I suppose what gives you confidence in that from a fundamental standpoint. And I asked this, recognizing that you're just managing the equity sleeve, important as that is, not the whole portfolio. But when you think about the whole proposition of the portfolio and why bonds will continue to be the bulwark they've been, why do you think that would be fundamentally if you were to try to counter some of those who have been raising questions?

Reckmeyer: When you see equity market sell-offs, you do typically see interest rates decline. And so, the recent market sell-off is the prospects of slower economic growth or concerns such as that. So, we do think in that environment the high-quality nature portfolio on the fixed-income side will offer some buffer. We still have the Federal Reserve offering a backstop of the fixed-income markets, and credit spreads--you look within investment grade are right about in the middle of their range. So, we do think they will offer some support for when you do get dislocations in the equity market.

Benz: It looks like over the decade through 2019, about 40% of Wellesley's total return came from income and the remainder from capital appreciation. The portfolio was recently yielding about 2% with not quite 3% coming from the equity component and about half as much coming from bonds. So, that's not a lot of yield. What kind of challenge is this going to present for you, for the fund going forward? And what are the implications in terms of how you build the portfolio?

Reckmeyer: Well, one of the challenges the fund faces, it is the prospects of higher interest rates. So, over the next couple of few years, the Federal Reserve has talked about trying to keep rates pegged to around a zero bond to help pay for deficits and help to stimulate the economy. But longer term, rising deficits as well as prospects of inflationary pressures, it would be a clear headwind to the fixed-income portfolios. So, in talking to my counterparts in the fixed-income side, well from the fixed-income portfolio, Mike Stack and Loren Moran, they're actively looking at that. And when they determine that the risks are starting to increase for higher rates, they will look to shorten the duration of the fixed-income sleeve. So, this would help to mitigate, but it would not completely neutralize the impact of rising rates. It will still be a headwind.

What we'd hope to happen, if that were to happen, is typically rising rates are associated with stronger economic growth and that stronger economic growth would suggest improving earnings prospects, an environment hoping the equity markets would increase. So, if that's the case, the hope would be that the equity markets would offer some offset to the fixed-income piece of the business, offer more of a balanced overall return profile.

Ptak: It may be a bit of an off-the-wall question, but just in thinking about interest-rate risk, or I suppose duration risk, in the equity sleeve of the portfolio, is that something that you're cognizant of and is it a topic of conversation with the portfolio managers you mentioned who are on the fixed-income side when it comes to Wellesley Income? I guess I'm thinking about the overall quality profile of the portfolio. You own more tech and healthcare than you used to. It can be argued that some of those cash flows are pushed further into the distance just because these are competitively advantaged businesses that throw off lots of cash. And therefore, it could be argued that maybe there is more duration to those names. So, when you take that together with a longer duration of the fixed-income side, maybe the strategy as a whole is longer duration than you're comfortable with. So, is that a conversation that you have as a group ever?

Reckmeyer: We don't talk a lot about the duration of the equity portfolio, but I guess, theoretically, from a dividend-discount perspective, if interest rates were to rise, that would put pressure on the discount rates and some of these stocks with very high multiples, I would think could be vulnerable in that type of environment. So, it would be the case for this portfolio, if you have rising rates that would affect all equities. But because our valuations are lower than the overall marketplace and we're not chasing some of these stocks where the multiples are rich. It would be a headwind for us, but it could be more of a headwind for the broader market overall.

Benz: One of the benefits of Wellesley's focus on income is stability. The fund has not been especially volatile, and it's also avoided deep drawdowns. The worst month-to-month loss was around 19% during the Global Financial Crisis. So, do you think differently about downside protection with yields as low as they are today? For instance, do you demand a wider margin of safety before investing, in effect, reducing your reliance on income?

Reckmeyer: Well, from the equity side, we're not going to reach for yield. The worst-performing stocks in the marketplace are the dividend cutters. So, we're trying to focus on stocks where the dividends are sustainable and growing over time. But there are circumstances where we're willing to sacrifice some yield for growth. We like to look at our portfolio from a total return perspective where we're looking at the sum of growth plus dividend yields to give us total return. And there are situations where we're willing to sacrifice some yield for better growth. We actually think that that is longer term a better value proposition for shareholders. We think a total return approach is superior from a longer-term capital-appreciation approach than one just focusing solely on the dividends alone.

Hand: And on the team, I'd say we always have thought about downside. And under Mike's leadership we've been looking at downside scenarios and risk to earnings and stock prices throughout the last decade. And so, it's something we've always been focused on and continue to focus on because you can never be sure what might cause that downturn. And so, it's the focus of our team that that's always been that way, continues to be, and that's why the downside analysis and the focus on sustainable dividends has been so important to the process.

Ptak: I'm curious--I think I was looking at the portfolio as of June 30, and I think this is a fairly representative example where you own the common shares in a name. I think Dominion Energy is the one I was looking at. It was not quite $0.5 billion worth of common. But then also on the fixed-income side, it looked like there was $170 million or so of short, intermediate, and long-term debt the same firm had issued. And I would imagine there's a certain—potentially--there's a tension there between how it is the firm manages the balance sheet. Obviously, you would like to see a nice and growing dividend over time. But one of the ways that they can achieve that is by levering up, which I'd imagine your batterymates in the fixed-income side wouldn't like. And so, I guess, in practice in situations where you're owning both the common and the debt of the same firm, how have you tended to work out your respective priorities and practice where maybe there would be a certain thing that you would want to see from the management team in terms of capital allocation but the folks in the fixed-income side might want the exact opposite thing?

Reckmeyer: We do monitor the combined exposures across the portfolio between the fixed income and equity counterparts. We have maximum hold positions, both fixed income and equities, and our largest position is well below that. So, from the fixed-income side, they operate with a pretty granular portfolio. They have about 350 unique issuers. They try to take some significant bets within the portfolio. In general, our alignment with fixed income would be pretty similar because we're focused on quality balance sheets, sustainability of the dividends. And we don't want to see a company be downgraded. We don't want to see a company going to junk status. That's not our framework. Actually, in this case, because they're focused on investment-grade securities, our companies tend to be investment grade as well. We're actually in alignment. But we do interact. When there is leverage on a company, our analysts will interact with their fixed-income counterparts on a regular basis just to make sure we understand the risks and that we are in alignment with their expectations.

Hand: And Dominion is a good example. Our analysts on the fixed-income side--Chris Melendez--does a terrific job and has been really helpful in the last year about updates in the utility sector and a lot of changes at certain companies, Dominion included. We absolutely utilize research and collaborate with him as well to really build the investment thesis that we have on the equity side. So, it's a give and take that I think is additive to both sides of the equation.

Benz: The fund's bond sleeve consists mainly of mid-grade corporates rated A and BBB. That part of the market has gotten increasingly correlated with the types of high-dividend stocks that you tend to own in Wellesley's equity sleeve. How conscious is your team of this relationship? And is it the sort of thing that would warrant adjustments to the way that you pick securities and build your component of the portfolio?

Reckmeyer: As I mentioned before, we'll look at the combined exposure of the overall fund. So, that's our primary focus on monitoring those exposures between the two different asset classes.

Ptak: I wanted to shift to stock selection if we could. You're value investors, but it's also striking how many of the names you own would have been considered growth stocks not too long ago, and just running through Wellesley's top holdings, and this would hold I think for some of the other mandates that you manage, that would be true of Cisco, Comcast, Intel, Medtronic, Lockheed Martin, Progressive Insurance, all of which would have been found in the popular growth indexes about a decade ago. So, can you talk a bit about how you've evolved as value investors with stocks like these increasingly coming into your orbit? I don't know if this is of a piece with the ADP story that you relayed earlier, where it might have been thought of as a growth name but was too expensive for you to own and then it sold off and got cheap enough and the dividend large enough for you to consider. And so, does that hold for some of these other names that I had mentioned?

Reckmeyer: It does. As I mentioned, we do take a contrarian perspective. And when you find high-quality companies where the valuation has dislocation, we'll try to take advantage of it. And a good example of that is with Comcast. This is also a company that we admired what the company is doing, but the valuation was just too rich. But a couple years ago, they made the acquisition of Sky and as a result of that the stock declined by about 30%. With the valuation collapse, and as well with the lower stock price, the dividend yields increased. That came into our framework, and it was an attractive opportunity for us to add to the portfolio. So, we try to look for these situations where often high-quality companies do stumble and try to take advantage of them.

Benz: The equity sleeve of Wellesley's portfolio isn't as cheap in absolute terms as it used to be. And that mirrors the increase in valuations we've seen in the broader market and even in some popular dividend indexes. How do you get comfort with the price risk that the strategy is courting today in a big picture way?

Reckmeyer: You're correct. Valuations have extended for the markets over time. How we get more comfortable is when we buy a security in the portfolio, we're trying to find a security that's selling at a meaningful discount to the marketplace at the time of purchase and our overall portfolio is at a discount valuation to the S&P 500. So, we do feel that with a lower valuation, that does give us some downside protection versus the overall marketplace. We also believe that looking at the other criteria of our portfolio, our dividend yield is well above that of the S&P 500 yield, our expected growth rate of the portfolio is similar to that or better than that of the S&P. So, we feel the combined total return of our portfolio is superior to that S&P. Yet despite these better long-term prospects, we're at a discounted valuation to the marketplace. So, we do think that over time, the structure of this portfolio should enable us to outperform our longer-term basis.

Ptak: I think that's a good composite summary of what the portfolio looks like. I do want to drill down and talk about one example of a name that maybe bucks the trend a little bit that being Crown Castle International, which is a name you started buying in late 2017 and have ridden to nice gains in the time since. The stock boasts--I think, recently, it was around 3% dividend yield. They've increased the dividend each year you've owned it. It's profitably growing, but it also looks pricey at a 7 times book, 23 times cash, 11.5 times sales, 91 times trailing earnings, for what that's worth. That wouldn't seem to leave a lot of margin for error. So, my question is, can you talk about your thesis for this holding within the broader context of the portfolio in risk management? I would imagine that this is sort of one of those trade-offs that you make as a portfolio manager, where you're willing to court a little bit more price risk as perhaps you are in this name provided that it's offset somewhere else in the portfolio with something that's maybe nice and cheap on an absolute basis. Is that the case?

Hand: I can talk about it. Generally, we prefer to look at REITs with cash flow multiples. You referenced the multiple before and that has changed dramatically in the last three years. I will say, when we initiated the position, towers are not a core real estate sector, or at least weren't considered to be at the time and there was some controversy around a potential Sprint T-Mobile merger and what that would mean for near-term growth prospects, something that given the continued demand growth for data is something that we were comfortable with. And we were able to buy the stock at about a 16 times forward AFFO multiple with a dividend yield around 4%. So, a really attractive combination for a company that has growth into a total return into the double digits at a very reasonable multiple versus the market in absolute and certainly versus the REIT sector.

So, the multiple has gone up. But I would say I think that's more fair that it's now priced more in line with some of the more core real estate sectors. And while the multiple is higher, it's not egregious at this point. And from a portfolio perspective, this is a company that is a steady grower, resilient cash flows even through economic cycles--something that's very important to us--and a stated goal of 7% to 8% dividend per share growth. So, it fits really well with the portfolio objective that we have. If I think about earlier questions about rates, REITs are a sector where, in general, the yields have been there, but valuations have been high. We haven't found a lot of good ideas in the real estate sector in recent years. Crown Castle was a unique one. But that's a sector that really can benefit if rates stay low for a long time. So, we think at the current valuation and with a strong dividend capable of growing that it has a good place in the portfolio for our clients.

Benz: One of Wellesley's holdings, Philip Morris, has lagged in recent years and it's one of the few blemishes on what is otherwise a very strong stock selection record. The stock doesn't look too expensive today at around 14 times forward earnings. Given that would you want to see the firm buy back shares more aggressively right now?

Hand: I don't want to talk necessarily about the forward outlook. But if we look historically, the company's performance in constant currency has actually been strong both on revenue growth and EPS growth. And for a business that's 100% virtually outside the U.S., that's had a meaningful impact on earnings per share and also the dividend payout. It's a company that has performed well but lost a lot of earnings per share to currency, and therefore the dividend payout remains pretty high and we are comfortable with the dividend. But for them to have done repurchases historically, that would have required some additions of debt to the balance sheet and probably taking the leverage ratio up. In general, that's not something that we favor. Dividend sustainability is key to our process. I think what they have done--which is measure dividend increases over the last couple years, including one this week--has been something we've been happy to see and if circumstances change, maybe that answer can change, too. But I think that the dividend payout and the sustainability of the dividend are key parts of the investment thesis. So, I'm not surprised to have seen them not repurchase stock historically.

Ptak: I wanted to talk about energy for a moment. You've owned integrated oil, let's call it, for years, but you recently slashed your stake in one of the names that's been a fixture in the portfolio. It seems like a good time to see if you can update us on how your thinking has evolved, maybe not in that particular name but just on integrated oil in general.

Reckmeyer: Sure. When you look at the supply/demand of the energy sector, we think it's going to be challenged for the next several quarters. Inventories are still high, dependent on the pace of economic recovery. Demand may take a while to get back to where it was in 2019. And taking a longer-term perspective, even once the inventories come back in balance sometime next year, the prospects of Iran coming in the marketplace, they have close to 2 million barrels that are idle right now that could come back in the marketplace, which would further complicate the longer-term supply/demand of the sector.

This is an area where we have reduced exposures over the past year and particularly in the first half this year. We like to see situations where the dividends are sustainable. But with the collapse of oil, the collapse is much worse than what our stress tests were assuming. Oil got down to the single-digit dollars per barrel. We got to revise some of our assumptions, and when we looked at our stress tests, we thought some of those defensive characteristics were being compromised. So, we have reduced exposures to that particular sector.

Benz: A number of the firms that you invest in boast competitive advantages of some kind. The moat might be brand equity, scale efficiencies, intellectual property, or some kind of network effect. Based on what you've observed over time, are these advantages as durable as they once were, and if not, how does that inform the assumptions you might make in modeling a security?

Reckmeyer: It's good question. There are some secular headwinds in the marketplace. And we try to be aware of these and if there are secular headwinds, make sure that we're cognizant of this and factor this into our assumptions. And we're using focus on just what's the implication of Amazon--they're disrupting several different industries, the retail space, shopping centers. We've been aware of that for a while, and we just avoided that whole area. It's a secular headwind. And while you're seeing this when you have economic downturns like we've seen right now, these secular headwinds tend to accelerate. And so, this is an area that we've tended to avoid. The one area we've had within the retail space, we've been focusing on the home centers. There, I think, they have more durable moats around them. Their performance has been stronger than we would have thought actually coming into this economic downturn. But we try to avoid those situations where the secular headwinds are ahead of us, just because it just makes forecasting long-term prospects more challenging.

Hand: Yeah, that's a great question. We try to take a contrarian view on things but certainly pay a lot of attention to developments in sectors and whether they'd be transitory or structural and understanding things that may be changing over the long term. While it may not impact the short-term earnings estimates as an example, it certainly can impact long-term estimates and the multiple that the stock deserves. So, it's things that we pay attention to. I think the answer is different by company and by sector. But it's certainly something we pay a lot of attention to and try to have a view and continue to evolve that view as we get more information.

Ptak: We had Vanguard's ex-CIO Gus Sauter on the podcast some months back and he was retelling some stories about debates he'd had with his then boss, who you mentioned, the late Jack Bogle. One concern, portfolio turnover. Bogle, as you know, was one to decry managers’ tendency to overtrade, but Gus countered as he explained in our episode that higher turnover might simply reflect the reality that exploitable opportunities weren't as large as before and therefore, managers had to make up for that by trading more. You don't trade stocks much. Your average holding period, I think, is five or six years. But do you think to compete, the managers of this fund, if you have to imagine the successors of the fund, will need to trade more often in the future for the reason that Gus mentioned?

Reckmeyer: Well, we don't target turnover. It's just an outcome of our process. And so, if you go before the GFC, our turnover was running 30% or 40%. In the GFC, it spiked to about 60% as major stocks reached their target prices. We were selling those or putting those proceeds into better appreciation, potential opportunities. In the last several years, our turnover has declined to about 15% to 20%. It has spiked recently to about 35% with the COVID dislocation. And once again, it's a function of the opportunities that are available to us.

With a stock market correction, we took the opportunity to purchase several new names in the portfolio, add to existing names where the valuation became attractive. So, turnover is purely a function of the opportunities that we see and how we can exploit those opportunities that are presented to us.

Hand: Yeah, the March-April time frame is a good example. We try to be disciplined to the process and disciplined to valuation as well. And when the market was moving in March and April, within Wellesley on the equity sleeve, we added six new names to the portfolio over that time, and they're stocks that we've known for a long time, companies that we've admired, that maybe didn't meet our valuation hurdle as an example. But things changed pretty quickly in that time frame and so we were prepared and certainly willing to act. Turnover can move based on that. But as Mike says, we don't manage to that.

Benz: Your firm manages hundreds of billions in equity assets. That probably gives you a good vantage point to observe changes and trading patterns and the overall complexion of the market. So, has the boom in commission-free trading been apparent to you and your colleagues? And is it something that you've been able to take advantage of?

Reckmeyer: I don't have any real insight there. We see some of these stocks, these high-fliers-- there have been several articles about Tesla and the implications behind that. But what I'm doing is I'm just looking at the opportunity set that's presented to me, our criteria. A lot of those situations where you've had retail investors, suppose they have more of an impact in stocks, that really hasn’t impacted our securities. So, we're just looking at what's in our framework.

Ptak: To broaden out, when you think about who's on the other side of your trades, how has that changed over time? Is that something that you spend time thinking about as a portfolio manager as you're reflecting on why a name is mispriced the way you think it is?

Reckmeyer: We do not think who's on the other side of the trade. When the opportunities present themselves, we just try to look at the fundamentals. That's where we have a strong team in place to do the analytical analysis. It's a natural leveraged resource of our firm to try look at counterpoints and arguments why stocks are under pressure. And we try to understand those because often there's controversy and we need to gain conviction in names that are under pressure. And then, we look at the valuation of the companies. So, we just look at things from a fundamental perspective. We try not to outthink ourselves and try to figure out why someone is selling on the other side of the trade.

Ptak: Well, Mike, Matt, this has been a very interesting discussion. Thank you so much for your time and valuable insights. We really, really appreciate it.

Reckmeyer: Thank you for your time today.

Hand: Thanks for your time and interest. Appreciate it.

Benz: Thank you so much.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

Benz: You can follow us on Twitter @Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.