David Giroux: 'What Are the Market Inefficiencies We Can Exploit?'
A two-time Morningstar Fund Manager of the Year winner on the benefits of concentration, the attractions of utilities and BB bonds, and his team's focus on "return on time spent."
Our guest today is David Giroux. David is chief investment officer of U.S. Equity and Multi-Asset at T. Rowe Price and co-chair of the Equity Research Advisory Committee. He also is the longtime lead manager of T. Rowe Price Capital Appreciation Fund, a strategy that invests in a mix of stocks and bonds. Since taking that fund's helm in June 2006, David has racked up an impressive track record, handily beating the fund's benchmark and peers. In recognition of those achievements, Morningstar analysts named David Fund Manager of the Year twice, in 2012 and 2017. David began his career at T. Rowe in 1998 after graduating from Hillsdale College, from which he received his bachelor's degree in finance and political economy.
“Morningstar Announces 2012 Fund Manager of the Year Award Winners,” by Scott Burns, Morningstar.com, Jan. 3, 2013.
“Announcing Morningstar’s 2017 U.S. Fund Managers of the Year,” by Laura Pavlenko Lutton, Morningstar.com, Jan. 28, 2018
“This Fund Manager Is Among the Greats,” by Leo Acheson, Morningstar.com, Dec. 2, 2020.
“2021 Global Market Outlook: Managing to the Other Side,” by David Giroux, Justin Thomson, and Mark Vaselkiv, troweprice.com, Dec. 14, 2020.
“What it’s Like to Buy $9 billion in Stocks During a Market Crash—This Fund Manager Did Just That,” by Philip van Doorn, marketwatch.com, June 4, 2020.
“Is T. Rowe’s Split a Smart Way to Handle Growth?” by Katie Rushkewicz Reichart, Morningstar.com, Nov. 19, 2020.
Portfolio Construction & Stock-Picking
“Why Every Growth Stock Portfolio Should be Overweight in Utilities,” by Sergei Klebnikov, forbes.com, Nov. 21, 2019.
“Finding Overlooked Opportunities in the COVID-19 Market,” by David Giroux, troweprice.com, Sept. 10, 2020.
“An Investor Bought Billions in Stocks When it Really Hurt,” by Tim Gray, nytimes.com, July 10, 2020.
“Creativity in a Low-Yield Era,” by David Giroux and Mark Vaselkiv, troweprice.com, Jan, 21, 2020.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.
Ptak: Our guest today is David Giroux. David is chief investment officer of U.S. Equity and Multi-Asset at T. Rowe Price and co-chair of the Equity Research Advisory Committee. He also is the longtime lead manager of the T. Rowe Price Capital Appreciation Fund, a strategy that invests in a mix of stocks and bonds. Since taking that fund's helm in June 2006, David has racked up an impressive track record, handily beating the fund's benchmark and peers. In recognition of those achievements, Morningstar analysts named David Fund Manager of the Year twice, in 2012 and 2017. David began his career at T. Rowe in 1998 after graduating from Hillsdale College, from which he received his bachelor's degree in finance and political economy.
David, welcome to The Long View.
David Giroux: Thank you for having me. And really a pleasure to do this with you guys today.
Ptak: Well, thank you. To start on a personal note, can you talk about your journey to investment management? You joined T. Rowe Price after graduating from a liberal arts school in Michigan. That's different than the path money managers tend to take, which often winds through business school or the sell-side. So, how'd you manage to land at T. Rowe? And as you reflect on it, has the atypical journey you followed helped you professionally?
Giroux: It's a good question. When I went to college in 1994, I really thought I wanted to do something in either history or politics. And that was really the college I chose. Really midway through that college experience, I kind of just discovered investing. And it was something that was just amazing opportunities like, well, this is really what I want to do with the rest of my life. And I ended up reading, I think, in college, like 35 different investment books about Ben Graham and Warren Buffett, and just really consumed all I possibly could around investing. I had two really amazing professors, a gentleman by the name of Howard Morris and Jeff Barham, were really instrumental also in my journey, if you will, into finance, and just really enjoyed finance.
And so, right after that process, I decided I really wanted to be an investor. I reached out to T. Rowe, and at the time, they had an opportunity. They were looking for an associate analyst. And the rest is history, if you will. I'm not sure how that has changed the kind of investor that I am. I will say a lot of those books that I read were very value-focused, a little bit contrarian, a little bit kind of GARPy. And if you think about the kind of investor we are today, or investor that I am today and the way I manage Cap Appreciation, we run it that kind of contrarian, value, kind of GARPy kind of strategy, it's the core of what we do.
Benz: Can you talk about the importance of generalism across asset classes, industries, and so forth, to your success as an analyst and later as a portfolio manager, and what has experience taught you is the right mix of specialization and generalism when it comes to investment management?
Giroux: Christine, it's a really good question. It's something I think about a lot. I think it's actually something I've changed pretty dramatically from when I first became a portfolio manager to where I am today. I hold a lot of different kind of title material, but my real job is being an analyst. I'm a big believer in what I call the micro part of investing where you get to know somebody really well, deep insights, model the company out for five years, take a longer-term horizon. I think if you do that kind of analysis, you can find those situations as dozens of companies where the odds of outperforming are so substantial over a five-year period of time where you have 75% hit rates over a five-year horizon.
And so, when we think about the general aspect of investing, there's different ways you can think about that. So, we've already talked about a little bit about the micro. When I am a general, we do want to identify the kind of pawns, if you will, where the odds of success are really, really high. You want to go fishing in a pond with a lot of fish, not in a pond with not a lot of fish. And so, we've identified a lot of different kinds of areas of the market--names, categorizations--where we want to focus our time and attention on those areas, and then do the deep dive, generate deep insights to identify those stocks that are the best risk/reward in the marketplace. I think that the generalist kind of portfolio manager who's not an expert on those companies, who says, ah, rates are going to go up, so I need to go buy these companies. And that may work. But I think that's far less likely to generate real alpha for clients on a longer-term basis.
Ptak: We're going to talk more about investment process and decision-making later in the conversation. But before we got to that, given we're in the thick of outlook season with many firms publishing their economic and market forecasts for 2020 and beyond, we thought it made sense to talk about that. Last month, T. Rowe published its outlook, which you helped co-author. So, let's start with this: Stocks and bonds look expensive by many measures. Given this, where do you and your colleagues at T. Rowe think we can expect to earn a good return and why?
Giroux: Well, I think the comment is correct. When we look at investment-grade bonds and the Treasuries, it's a very negatively skewed risk-adjusted return. You have rates stay low, you get a low return and if rates go up, you lose money, and there's not a lot of room if rates go down. The thing that's going on with the equity market in general. Even if we got to 2022, which would be a more normalized earnings year, fully pricing in a recovery, you're already at 20 times that number even before you account for tax increases. So, the traditional S&P 500, or small caps, or Treasuries, or IG, they're all expensive. They don't have really great risk-adjusted returns from here. But again, we can invest at T. Rowe independent of that index. There are parts of the market that are exceedingly expensive. We can talk about a Tesla or an Apple or SAAS software companies or some of the more recent IPOs. But there's also parts of the market today that are very, very attractive that are actually trading at very low valuations, usually because they don't correspond with the macro sentiment of the market. Whether it be a guard stock, and these guard stocks that we really love in our portfolio that generate really good risk-adjusted performance over a long period of time, look really cheap. Utilities are at a 40-year low versus investment-grade yields. And even within the cyclical bucket, there are parts of the market, like financial, that look actually pretty decent, not as decent as they looked two or three months ago, but still very good relative to other parts of the market. We don't invest in markets; I don't invest in indexes. We invest where we find real good fundamental value at an individual company or an individual bond level. And that's what we've done historically; this is what we'll continue to do going forward.
Benz: You've previously written about the linkage between economic forecasting and investing. People often struggle to predict things like GDP, inflation, and interest rates. But even when they get those things right, they may make the wrong investing call. And we saw a lot of that coming out of the global financial crisis where macro forecasters were correct that growth would be slow, but wrong in favoring bonds over stocks. So, is there a way to get both calls right and profit as an investor?
Giroux: Christine, I think it's a really good question. And it really goes to market inefficiency. We look at everything through a market inefficiency lens. And I think your point is a really good point. The market at times will take a view on a macro outcome, you know, we're going into recession, rates are going to go up, rates are going to go down. What you often find happen in these situations is that that macro environment, that macro view, it becomes the only outcome. It's 100 to zero--in 2008 in Q1, everybody thought the 10-year was going to go to 4 and went to 2, right? Every thought going into '18, we'd have a great stock market. End of '18, the market was basically pricing in a 25% decline, maybe pricing in a recession, if you will. So, that macroeconomic consensus is often wrong. And really what we try to do is when you get to the extreme where the market says this is the only outcome and it's already priced in, we tend to take the other side of that argument.
Again, in Q2 of 2018, when everybody hated utilities, we were buying utilities, because the risk-adjusted return looked so good. They were already at the lowest valuation in a decade--if rates went higher, you can have a lot of downside. But rates went lower, you made a lot of money. In the same way, in Q4 of '18, the markets were: we're going into a recession, we're going to price in a 25% decline in earnings. We went overweight equities to get aside of that, ended up being right. So, it's almost like when the market gets to these extreme views, you almost want to take the other side of it. Even today we find ourselves in an environment where the market is-- we're going to have bigger inflows this year--that may play out. That maybe the exactly, but the market forgets about valuation. All those cyclicals that the market wants to buy today, they're already up. The thing is very high valuations not only in '21 earnings, but '22 earnings. So, really, what you want to be doing is usually from a macro perspective, doing the opposite of what the market wants. That's where the best risk-adjusted returns are, historically speaking.
Ptak: Many retirees are wrestling with the question of how to meet their goals when stocks and bonds both look rich, something we talked about earlier. In addition, safe sources of income are hard to come by and they can't necessarily afford a big drawdown. As an allocator of capital and someone involved in forging T. Rowe's market outlook, how would you advise someone in that situation?
Giroux: Well, the first thing I would do, and this is maybe a little bit of a plug, I mean, I would advise them to buy the Capital Appreciation strategy, because that's exactly what we're trying to do. We're trying to give you the best return possible with the lowest risk and the lowest drawdown risk. That's what we're trying to do for our clients on a long-term basis. But maybe more specifically to your question--stocks are expensive, bonds are expensive, where do you see value? And I would say the two areas we see value today would be like leveraged loans. Leveraged loans are floating-rate instruments. They have yields that are twice that of investment-grade bonds, 3.5 times the yield of Treasury bonds. You don't take any kind of interest-rate risk because they're floating in nature as we talked about, and they're exposed. They don’t have a lot of energy in them, there's not a lot of energy-leveraged loans, there's not a lot of retail-leveraged loans. So, they get a pretty good index of companies, if you will. So, again, a 3.8%, 3.9% kind of yield isn't great, but relative to the alternatives I think leveraged loans makes a lot of sense. And T. Rowe has an amazing leveraged loans strategy run by Paul Massaro here.
I would also say--and again, I made a comment earlier--that if people are looking for income, not only income, but appreciation over a long period of time is, utilities today, where you can get 3.5%, 3.4% kind of dividend yield, where the underlying earnings for these companies are growing at 6%, maybe 7%, and the valuations are at 40-year lows versus investment grade-bonds. Those are two areas where somebody's looking for either income or looking for income and appreciation and not looking for a lot of downside risk, can probably do quite well.
Benz: T. Rowe Price recently announced that it was in essence subdividing itself and forming a new entity, which you'll be a part of. Can you talk about the impetus for this change and what goals it will advance?
Giroux: Sure. So, when I joined T. Rowe Price back in 1998, and maybe my memory is a little bit off on this, but we had maybe a little less than $100 billion in assets at the time. Today, again, with less filing, I think we had $1.3 trillion in assets. During that period of time, my 22-year career at T. Rowe, a lot of our funds outperformed. And that's driven, if you think about it, the equivalent having incremental flows, even though we are an active manager versus a passive manager, we continued to have positive flows. So, our market share has gotten a lot larger over time since when I joined, I mean, materially larger over time.
The challenge has been that the number of public companies over that 22-year period of my career has been shrinking almost every year. So, take-outs are substantially greater in most years than new IPOs. So, we have a diminished universe of companies. And I would actually argue maybe even a little bit lower-quality group of companies, because usually the lower-quality companies are still staying around, if you will. And so, we've been able to overcome that challenge of being bigger or taking more market share over my career, because we continue to invest in fundamental research. We continue to invest in fundamental research in the dot-com bubble, in the great financial crisis, and even now, when a lot of our sell-side and our buy-side competitors are really moving away in some cases from fundamental research, we’re continuing to aggressively hire. So, we've been able to overcome those challenges.
But long term, a portfolio manager needs to be able to buy the companies they want and in the quantity they want as is consistent with their risk objectives. And I think there's a real risk, not tomorrow, not next year, but there is a real risk five years down the road, 10 years down the road that if we didn't make this transition now, maybe we wouldn't be able to overcome these challenges anymore. And I would also say just because that is an important aspect--if you think about when I was an analyst, or an associate analyst, back in the late ‘90s, early 2000s, I only probably interacted with 10 portfolio managers. There's a lot less complexity in my job in terms of selling my ideas to the platform. Today, an analyst might have to sell those ideas to 20, 25 portfolio managers. And that creates more complexity, it means that there's a little less one-on-one interaction. I think one of the big benefits of TRPIM splitting off from TRPA, T. Rowe the existing, if you will, is going to be the reduction in complexity, having fewer analysts interacting with fewer portfolio managers, really getting back to kind of the way T. Rowe Price was back when I joined the organization. Again, getting more one-on-one, less email. I'm really looking forward to that.
Ptak: How have you worked through the process of determining who and what you want to bring with you to the new entity?
Giroux: Well, the who to bring into the new entity, I'd say there's a couple of things maybe CAF-specific. Obviously, my whole team is coming. And Farris Shuggi, who is a quantitative analyst, a really dear friend, who has been a really instrumental person in helping me shape how CAF should invest from an asset class perspective, a factor perspective--he's coming to the new entity as well. And I think what was really important is when we think about dividing the research platform, obviously, there's some analysts who are more small- and mid-cap, obviously, the TRPIM platform, most of the portfolios here will be more SMID-focused. So, if you're a SMID analyst, it's more likely you're going to be going to the TRPIM platform.
Again, I think, Jeff, you and Christine, I think you know the strategy that I run, as being an analyst, we're a little bit less dependent upon the analyst pool relative to the average portfolio manager, because we're doing a lot of our own work in addition to working with the analysts. And so, we're not investing in every sector in the S&P 500. We're a little bit more concentrated not only in our names but in sectors we participate in. So, it's really important that the areas that I care a lot about, not only in the short term but in the long term, we have good resources there. And the answer is, we really do it. So, a lot of the people who I interact with on a day-to-day basis from a sector basis, from an analyst perspective, a lot of those people are coming with us. In addition, we obviously got a much larger team, as we recently added Brian Solomon to our team as well. So, I think, in many respects, we're getting all the benefits of proof capacity, easy to trade, but you're also not really losing all the resources that you really care most about.
Benz: You're T. Rowe's chief investment officer for U.S. equity and multi-asset strategies. Can you talk about what you view as the most essential aspects of that job, and whether you'll approach it any differently now that you're under the umbrella of the new entity?
Giroux: Well, the answer to the second question is, first, there'll be nothing different about what we do. So, again, when I think about the role of a CIO, I'm also the head of investment strategy at T. Rowe and will be at the new entity as well. There is value for clients to hear me talk about stocks versus bonds, or economics, or politics. But honestly, Christine, that's not where I add the most value. I actually view that as a little bit of low value to the organization’s endeavor. Where I really think we can add value, where I really try to add value to the organization is that there's something big going on, whether it'd be tax reform, whether it'd be coronavirus, whether it'd be a certain area really out of favor. What I tend to do is I do a deep, deep dive into something and try to figure out what the market doesn't understand, what are the market inefficiencies we can exploit, and then try to share those insights across the platform.
So, obviously, in 2017, we helped get the platform comfortable with the idea that tax reform was going to happen, these were the big beneficiaries, whether it'd be from an analyst or from a portfolio manager, we got on the right side of that trade. In February and March of this year, I realized that the only thing that was really important at that time was really the pandemic; what did COVID-19 mean? There was a tremendous amount of fear, rightful fear. We had people going on the news saying 2 million people are going to die this year, 80% of people will get COVID, vaccine is not going to come until the end of '22, and then you have to wait until '23 to get it distributed. So, really, I thought everything and did 25 different calls with doctors on the frontline, some doctors right outside of Italy, right outside of Lombardy region. I talked to virologists. I talked to R&D people who used to work in pharma, talked to professors of medicine, if you will, about this. And we really came up as a result of the 25 calls with a really differentiated view that was very, very different from the consensus.
We had a view, based on those calls with these experts, that a vaccine could be done in less than 12 months. Not only that we would see a vaccine, but that it wasn't actually hard to produce. Because relative to flu, this was actually an easier putt, if you will, because this does mutate, but it mutates less than flu. So, we came to the view really early, much earlier than the market, that this would be something that we'd be able to live with it, that we'd have tremendous collateral damage, but it wouldn't be a situation where we wouldn't be back to normal until '23 or '24. And that helped not only me, I think, but I think other people on the platform had that insight, maybe get a little more aggressive with their equity exposure, or even the kind of equity they had in March. Or during that period of time, we were also looking at industrials and cyclicals and semis, and saying, how long did it take in the great financial crisis to get back to kind of peak earnings, and if this cycle was like the great financial crisis, what were the internal rate of returns for buying stocks in March to that one or two-year view? And we highlighted that to the platform that like, Hey, this is a template. This is what happened in that cycle. If this cycle plays out just like that, you can make 30%, 40% returns the next two years buying these names. So, it's going deep, probably little bit of history. That's really what I think the true value-add of, at least how I approach the CIO role, head of investment strategy. There's just deep insights when you have something that the market doesn't understand, it's exploitable, and you can share with the whole platform.
Ptak: We're going to talk about portfolio construction in a moment, specifically, T. Rowe Price Capital Appreciation strategy that you've managed for years. Before we did that though, I wanted to follow up on an earlier answer that you gave when we were asking what a retirement income investor is to do, and you offered a few useful ideas--leveraged loans, utilities, being a few of those. But the other thing you said was to look at the T. Rowe Price Capital Appreciation strategy. But we would note that it's closed. So, I guess, Christine and I are curious, given that it is closed, if somebody was retirement-income-minded and they were looking to outsource those duties to another strategy in your platform or a set of capabilities you would highlight, I mean, which are those?
Giroux: Well, I'd say, we are close to new investors, but obviously, the existing strategies and existing firms that already have exposure to CAF, you can still get exposure to CAF. We still have positive flows. So, if you go through certain platforms that you already had exposure to that are existing clients, it is possible to get exposure to CAF. But having said that, if you don't have access to one of those platforms, or one of those partners that T. Rowe has, there are other strategies I would think that would make sense. Again, I already mentioned a leveraged-loan strategy would make sense. I would honestly say that buying a utility ETF would make a lot of sense these days.
Other strategies at T. Rowe--we have a dividend growth strategy. And again, maybe when combined with a leveraged-loan strategy, tend to have a little lower risk profile than that of the overall market; has a very good manager, has a very good track record. So, maybe dividend growth, maybe utility ETF, maybe the leverage loan strategy at T. Rowe would all make sense if you can't get access to CAF.
Benz: Can you talk about how you arrived at the somewhat idiosyncratic approach to portfolio construction that you followed? Most balanced portfolios are kind of a staid mix of U.S. blue chip stocks and high-quality bonds, but yours isn't that. So, let's talk about how you settled on the style that you employ at the fund.
Giroux: Christine, everything we do, we have three objectives for the strategy, and I maybe talked to this. We want to outperform the market on a risk-adjusted basis every year. You give us money today; we will not lose money on a three-year basis. And over a full market cycle, we want to be able to generate equity-like returns with much less risk. So, when you think about portfolio construction in that construct, what you really need to solve for is where are the best risk-adjusted returns in the marketplace, what are the sectors, what are the kind of names, what are the factor exposures, what are the asset classes that deliver the best risk-adjusted returns? I’m really trying to get as much positive return as they possibly can but with minimizing downside risk.
So, a portfolio of just blue chip, large S&P 500 companies, that is not the optimal way to achieve that objective, if you will. So, everything we do is trying to find those names that have those really attractive characteristics. And, for example, again, if you think about the heart of what the Capital Appreciation Strategy is, is we're always overweight, kind of, GARP-y stocks. And GARP-y stocks that are not growth or value, somewhere in the middle, it's that inefficiency in the marketplace that allows these great companies that can grow earnings or cash flows faster than the market, lower cyclicality, lower downside risks, they should trade for higher valuations than they do. So, that is an area where you typically can outperform the market in a GARP portfolio over time, but you have a lot less downside risk. I would also say when we think about things like BBs, or leveraged loans, or writing covered calls, those all have very attractive risk-adjusted returns over time. So, again, you're trying to find those areas that have the highest return spread versus the risk you take. That's really how we built the portfolio. It's not S&P 500, and a Barclays Agg. That's not the optimal way to achieve those three objectives.
Ptak: So, when you've had clients follow up on a question similar to the one Christine just asked, essentially asking you why these growth-at-a-reasonable-price stocks or BB-rated bonds misprice, how have you answered that?
Giroux: Both of those are great examples of market inefficiencies. We really don't like to share our views on market inefficiencies that much--we kind of hold that dear, if you will. So, the question is, I think what drives in many respects the multiple companies is a little bit supply and demand. So, the reason why this 13% of the S&P 500 that I call GARP, trades where it does, and it should trade higher, is that a value manager will often look and say, Well, these companies, they trade for 10% or 20% premium to the market, that’s too expensive, so I can't invest in those stocks. Growth manager says, you know what, these companies, they're only growing organically like 4% or 5% organically. I want to own companies that are growing 10% organically.
So, in many cases, there's no natural buyer for these companies. So, that depresses their valuation to a level where, again, if you think about the market, the market, typically, in non-recession years, grows earnings at 6% to 7% kind of clip, gives you a 2% dividend yield. So, for a small premium to that, which you'd able to generate, is find the companies that are growing earnings at 10% plus, maybe a little bit more dividend yield, and have much less downside risk, because there's an inefficiency. The two big market participants kind of shunned these companies a little bit. So, what happens is, over time, they just compound wealth, and in many cases, the market becomes a little bit smarter over time and says, Oh, it used to trade for 18 times earnings, but it's actually a really good company, and you should trade for 20 or 21 times or 22 times. So, you get the compounding of the earnings and the dividend and usually, like the multiple expands.
Some of our largest investments… When we first bought Thermo, maybe it was 300-basis-point position of the fund was trading at 12 or 13 times earnings. Today, again, earnings are a little bit messed up for Thermo today because they're doing so well with the testing. But Thermo's multiples basically doubled. Pfizer's multiples up 50%. So, these companies have compounded wealth at a double-digit clip than the multiples expanded. And the only other part of it is, as we think about it, is retail investors who, and they're not likely to own Thermo, they're not likely to own Marsh Mac, they're not likely to own Pfizer. They're more like to own Tesla or Apple.
So, again, all the forces of the market tend to ignore, for lack of a better term, these really amazing companies that have really great risk-adjusted returns. They're compounding wealth at 50% higher rate than the market, or 40% higher rates than the market with much lower risk, they should trade for much higher valuations.
Jeff, your question on the BBs--so, BBs are probably the highest risk-adjusted return of any asset class which we invest. So, I would say, well, why wouldn’t a high-yield manager always be overweight BBs? And the answer is BBs tend to underperform the high-yield index three out of every five years, but the two years they outperform, they tend to outperform by a ton, because the CCCs and Bs are down a lot and the BBs do much better in that kind of down-market environment. So, over a full market cycle BBs kind of tend to do right along the high-yield returns but with much less risk. The reason why most managers are unwilling to be overweight BBs is because they don't underperform three out of every five years. So, that's another inefficiency that we're trying to take advantage of in the marketplace. Again, I’m not going to go through all these, but there are 16 market inefficiencies that we focus on, we talked about three of them already, that we think are kind of exploitable, that are doing things a little bit different than everybody else that allows us to generate the returns that we have over a long period of time.
Benz: Well, speaking of inefficiencies, I'm curious if convertible bonds are another of those areas. Convertible bonds have long played a role in your strategy. Do you find that there's still an underutilized, maybe misunderstood, tool in the fund world and, if so, why is that?
Giroux: Actually, when I took over the strategy in 2006, I think convertibles were about 20% of the portfolio at the time. And unfortunately, there were some accounting changes that went into effect, maybe I don't know, three or four years after I took over the strategy, and it really just killed a lot of convertible issuance. So, convertible bonds, outside of mandatory convertible bonds, are a much smaller part of our portfolio. I think today we're like 1% convertible bonds.
What convertible bonds are today, are really a way for highly volatile companies to monetize that volatility at a very, very low cost of capital. So, sometimes you'll see these companies issue a convertible bond--say the stock has to go up 40% to get in the money, you're only earning 25 basis points yield. It doesn't make a lot of sense. I really do wish that the accounting rules have not changed. We saw a lot more investment-grade, larger-cap convertibles, because, actually to the point I raised earlier, convertibles historically have had a very good risk-adjusted return. But unfortunately, they're just a very small part of the market today. And really what convertible bonds have turned into is this monetization of volatility for a lot of high-volatile companies. So, that's not really in our kind of wheelhouse, if you will.
Ptak: I wanted to shift over to fixed income for a moment and ask, do you think differently about duration management as a tool when it comes to managing the bond sleeve, given that rates have continued to go lower and remain pinned down?
Giroux: Well, again, I'm not convinced rates are going to be low forever. When we think about duration, again, I think that is a macro consensus that rates will stay low. I think if you ask most people that, that is a very high odds. Is that true? We'll see. Again, the market thought – in '18 the rates were going from 3% to 4%. So, now, everybody's convinced the yields are going to go up 1% to 2%, but not above 2%. We'll see. What I would tell you about rates today is that the risk/reward on Treasuries or IG [investment grade] is so poor, it gets a situation where if rates stay static, you make very, very low returns. If rates revert back to more normalized levels, you lose a lot of money. And if rates go down, you don't have a lot of room for rates to go down. So, it's really hard to get a really great return. So, it's a really negatively skewed risk-adjusted return, which is the exact opposite of where we were in '18 or even '13 when the 10-year was at 3%. Because at that point, even if rates rose 100 bps over two years, you made zero return. If rates stayed where they were, you made 30% return. And if rates went down, you made a big return. It was a very positively skewed risk-adjusted return. So, as a result of that, we have a very short duration in our fixed-income portfolio, probably the shortest duration we've had since I've been running this strategy.
Our duration today is 1.5 years, just because that skew is so negative on a lot of traditional fixed income. The thing about this is that an investor who bought a 10-year Treasury on Dec. 31, at 92 basis points, and holds that for the rest of the year, assuming rates stay where they are today, they're going to have a negative return for the year, because the depreciation of the bond yields have risen from 92 bps to 110, overwhelms that 90 basis points of yield they were getting at the time. So, this is a time to be short duration in your fixed-income portfolio. And if you're going to take duration risk, take duration risk in your equity sleeve, not in your fixed-income sleeve. Duration risk in equities is really cheap, given how attractive utilities are priced today relative to investment-grade or Treasuries.
Benz: If you were starting from scratch, and you had no clients breathing down your neck, no prospectus limitations, no career risk, and so forth. What would your portfolio look like? And how might it look different from your portfolio today?
Giroux: Well, let me answer the question just in a couple of different ways. One, first of all, I would say, I don't worry about career risk, not because I have a good track record, but I want to do what's best for my clients on the next five years. And that means trying to generate the most alpha I possibly can on a risk-adjusted basis. And if that means there's more risk to my career, so be it. And again, I would also say, I have wonderful clients. I enjoy interacting with my clients. None of those things change how we manage the portfolio.
So, what I would tell you is, I manage the portfolio because I own a lot of it, it's my largest holding, my family's largest holding, it's my friend's largest holding, and I want to do the best job I possibly can for them. That's the only thing. And so, I build the portfolio today, as in the past, that again tries to achieve the objectives that we're looking for: really good risk-adjusted returns, being contrarian in certain areas of the market, likes or doesn't like, having a short duration in the portfolio. If I were not employed at T. Rowe Price and I was trying to build a portfolio, it would look a lot like the portfolio we have today.
Now, let me answer the question a little bit differently, too. If we had to start over and someone said, you'd have to build the portfolio from the ground up, and you didn't have these objectives, how would you do it differently? What I would say is, I've always been a big fan of Berkshire Hathaway, always been a big fan of Berkshire Hathaway, even going back to 1996 when I was reading all those Berkshire Hathaway letters that my professor Howard Morris had told me I should read. I really liked that aspect of: do you own public companies, do you own private companies, do you have permanent capital, even closed-end funds structure as opposed to an open-end structure, and invest on a much longer time horizon. If we had to rebuild CAF today, and if someone's giving me an option, I think we would do it a little bit differently. But we can't do that as we kind of established these objectives, clients understand what they want from us, and the objectives that we have for the strategy are very, very difficult. And so, it really requires a lot of alpha generation, requires a lot of the ability to go across asset classes, finding where the best value is, it requires a lot of work.
Ptak: We're going to shift back to stock-picking, if we can. Our research has found that the stocks sleeve the Capital Appreciation Fund has done exceptionally well over time. You've been a really good stock-picker. To what extent do you think that's been at least partly about knowing your own limitations? And what's an example where you think the portfolio has benefited from you simply staying away?
Giroux: Well, again, I would say a couple of things there. I think over my career our equity sleeve has outperformed the market by over 400 basis points per year. And I think, again, I think really what that comes down to is an amazing platform at T. Rowe that really spits out really great ideas. So, we have this great platform. And I think we complement that with the really good micro work. And then, we also complement that with understanding where the--I keep using this analogy--what are the lakes with the most fish in them, where the highest odds of generating alpha are? We've done a lot of work identifying those areas.
Thinking about all those things are some of the ways--and again, I keep going back to this as well--where's the market inefficient? If we understand those market inefficiencies that we're trying to exploit, we're really playing a very different game than everybody else in the marketplace. And I think that's what's allowed us to be able to generate the alpha we have over the period of time we have with the consistency we've had.
Now, Jeff, to your question about areas where it's best not to ignore, if you will--one of the things I think we've done a lot of work on and have been very public about is, it used to be 31% of the market; now it's about 25% of the market, are companies that are secularly challenged, if you will. These are companies that their business model is going under stress, whether it'd be retail, or whether it'd be, old tech, if you will, whether it'd be cable systems or cable networks, and parts of commercial real estate. I think what we've said is that part of the market, it's really hard to make money there. That is a pond with not a lot of fish in it. And I'm going to spend my time ignoring that.
So, you look at CAF from a portfolio composition perspective, you look at it today and you say, the biggest bets we have in the portfolio are kind of GARP-y stocks relative to the market. And the biggest underweight would be secularly challenged companies that are not creating value over time, where time is not your friend. And we try to avoid those stocks. It's not just avoiding them that creates alpha. It's the ability to take all that time and resources that I had at my disposal, and focus on the 100 companies that are the most likely, what we call, the core CAF stocks, that are the most likely to create value for our clients on a long-term basis. We spend a lot of time with this concept of ROTS, return on time spent. And again, if you don't have to worry about that 25% of the market, you spend all your time with those 100 companies that really matter to your portfolio, the odds of success within those 100 companies is even higher over time.
Benz: Most active stock funds don't keep up with their benchmarks after fees. Some ascribe that to benchmark hugging. Do you think that's the case? Or are there other factors at play?
Giroux: Well, I think there's a couple of factors. I think benchmark hugging is clearly one thing. And I think about this industry, and this is an industry that tends to, even if you're average, you can still make an incredible living being average in this industry relative to schoolteachers or a doctor, a number of other professions. This is a very high-paying profession that we're in. And so, I think a lot of people look at it and they say, I want to take a little bit of a bet, but I don't want to take a lot of bets. If I don't take a lot of bets, I can never get fired, right? And so, that all encourages benchmark hugging, if you will.
I think the other thing, again, I would say--and this comes from experience—is I think a lot of portfolio managers, they're not in the weeds on their companies. They let their analysts be in the weeds, and they try not to be in the weeds. And again, from my experience, I think that's a mistake. I think the last thing I would say, and it really goes back to kind of this macro outlook, almost this tyranny of the consensus macro outlook, is I think, most portfolio managers, whatever the consensus macro is, they assume that's going to play out and they're always investing in concert with whatever that macro outlook is. So, Wayne Gretzky always talked about, I want to skate towards not where the puck is, I want to skate to where the puck is going to be. And what you find is, if you're always getting to where the puck is, or always investing in concert with what the macro sentiment is, you're buying financials in Q1 or Q2 of 2018, you're buying defensive stocks in March of this year. You're buying defensive stocks in Q4, December of 2018. Being able to be a contrarian on that also, I think, it really destroys a lot of values. So, I think all those things come into play. But I think it's a combination of all of those things.
Ptak: You mentioned some of the aspects and dynamics of working with analysts. What's a recent example of an analyst turning you around on an idea? For instance, a purchase you wouldn't have made, or a sale you'd have made, but for an analyst argument otherwise, and how representative is that of how your process tends to work?
Giroux: I must go back in time a little bit, but I don't want to speak anything that we haven't publicly disclosed. But we interact with the analysts. We spend a lot of time, especially with those analysts that cover those CAF 100 stocks that are the core of what we do. We spend a lot of time with those analysts. Without mentioning an example—I’ll give you a more recent example, but I won't tell you the name. We had a view on a certain company in the healthcare arena that it was kind of a recovery play, that we thought had a lot of upside. And I think we bought it very well in the downturn. And I think our analyst came back and said, look, the growth expectations the market has for this company are just too hot, and their competitors are getting stronger. So, the multiple you're using is too high and the growth rate you're using is too hot. And that led us to reduce that position size. And that's a great example of working collaboratively with the analysts.
But I think there's a lot more situations where we're sitting down with the analysts, we're talking about their areas, we want to know what's underperformed, what’s disliked, what is underappreciated. We come out of those meetings, and we're actually buying a name. In many ways, we'll sit down with an analyst, spend an hour with them, we'll focus on a name, they'll say: this is underpriced, it looks attractive, it fits with your strategy. Then we'll spend the next week doing deep dives in the company, looking at valuation, doing calls with experts, understanding the three or four things that are the most important around that company. We will build a model, we'll build the model out for five years, we will project expected five-year return. And again, that's more of how it tends to work, if you will.
Benz: In what aspect of your approach do you feel you differ the most from your fellow portfolio managers at T. Rowe? Was this always the case and how have you gotten comfortable with those differences? And then, on the flip side, what's something you've learned from your peers that's now a bigger part of your process than was true at the outset of your career?
Giroux: Well, let me answer the second question first, actually. It's been my privilege--and again, it's been my privilege over my career to really learn from some of the best portfolio managers, whether it'd be a gentleman, Bob Smith, who used to run a growth stock strategy; whether it'd be Brian Berghuis, who continues to run a mid-cap growth strategy; the late Jack Laporte, who ran our New Horizons strategy; or even Henry Ellenbogen, who ran the New Horizons strategy, who's actually not at T. Rowe anymore. But I think what defines all those portfolio managers and what really led them to generate the amazing alpha that they generated was, I would say, a couple things. It's a little longer-term horizon than that of the market. I think we've tried to become more long-term in our outlook over time. Also, again, if you look at all those guys relative to their benchmark, they tended to be a little bit more GARP-y. The term that somebody used is: plodders--they just plod along, they create value in the low teens and maybe a little bit of a multiple, maybe mid-teens-kind of value, and then lower risk.
And so, I think, watching the magic what Brian Berghuis has done, what Jack Laporte did, what Bob Smith did--again, in a little bit different asset classes--have been really instrumental in terms of how we invest and how our strategies evolved over time, I would say. I would also say, and I mentioned this earlier, working with Farris Shuggi on the quantitative side, understanding the factors, understanding: I have these objectives, these objectives are very, very difficult to achieve, what is the best way to do that from a factor exposure, a sector exposure to someone like Farris Shuggi, who has been a very instrumental part of our success over the last decade or more. And I apologize, Christine, I think I forgot the first part of your question. Can you repeat the first part of your question? I apologize.
Benz: Sure. The first part of the question was, in what aspect of your approach do you feel like you differ the most from your fellow portfolio managers at T. Rowe Price? And was that always the case? And how did you make peace with the way in which you're different?
Giroux: T. Rowe has a tremendous number of strategies that have created a lot of value for clients over a long period of time. So, I don't want to be critical of anybody relative to myself. I mean, what I would say is, we have chosen to have a more concentrated strategy than other portfolio managers. I personally believe that you don't need to have a 100-stock portfolio to get diversification. I think one of things we've always found is, your best 40 ideas are really good, but then when you start going the 40 through 50, 50 through 60, 70 through 80, the quality of those ideas tend to go downhill a little bit. So, we've chosen to have a more concentrated strategy relative to a lot of other strategies here.
There are other strategies at T. Rowe that are concentrated in nature. But we have one of the more concentrated strategies at T. Rowe. And again, it goes back to those objectives: the only way I can outperform, achieve all those objectives is we really need to outperform the equity market by 300 basis points a year. And we've done that. I think last year was 700 basis points of outperformance. The last 14, 15 years it has been 400 basis points of outperformance. But you can't outperform by 400 basis points a year or 300 basis points per year if you have 100 stocks. It's very, very hard to do that. You really need to be a little more concentrated. So, again, we have amazing portfolio managers here T. Rowe Price. We have amazing fundamental research at T. Rowe Price. So, we just chose to be a little bit more concentrated than my fellow portfolio managers.
Ptak: We did have a couple of more questions for you. I did want to ask about a specific stock, General Electric, which is one of the fund's top holdings. It looks like you've owned it since late 2017 or so. The stock has fared poorly as the company deals with operational and legal setbacks of various kinds. I'm sure valuation colors your thesis, but when you see a firm where management hasn't executed or the strategy hasn't worked, how does that inform your approach to that name?
Giroux: Let me say a couple of things on GE. One is that we did start a small position in 2017 when there was an activist involved, but then we actually quickly exited as we did more work on it. So, we really started a position when Larry Culp was named CEO in '18, end of '18. So, I know this sounds kind of crazy. But we own about $2 billion today of GE stock. My cost basis on GE is $6.30 today. So, it's actually been a pretty big value creator, if you think about the stock is at $11.40. Our cost basis on that last $2 billion of stock is $6.30. So, our timing has been pretty good on GE, I would say. But there was a period of time for 10 years where we basically ignored GE, just like we ignored the secular challenge nowadays for one simple reason: GE's history on capital allocation was so poor.
I mean the last decade of GE… It's actually kind of sad in terms of how poor that company deployed capital whether it'd be on Alstom, whether it'd be the oil and gas acquisitions they made. It's just really, really poor and they ran something for earnings not cash. And for all those reasons we basically ignored GE for almost a decade. And it was a big source of alpha generator. But what changed obviously is when you had Larry Culp. Larry Culp ran Danaher. I was an analyst covering Danaher. I owned Danaher in the portfolio for a long time, created a lot of value. This was a classic fixer-upper, if you will. And I think we did tremendous amount of due diligence when we bought GE with a view that we had a five-year view, we always invest with a five-year view, we don't invest to try to maximize performance tomorrow, next month, next year. But when we were buying GE hands over fist in March or parts of this year, when it was $6 or less, we had a view that the stock could be worth high teens or low 20s with conservative assumptions on that five-year view. And that was so far superior to everything else. I think at the time, the five-year IRR was in the 30s.
So, obviously, it's a stock that rebounded a little bit. We own a little less than we did back then. But at the same time, we still think GE has a stock that can be an $18, $19, $20 stock if we look out to 2024 without any kind of heroic assumptions. And again, I think the world post-COVID will return to more normal. People will want to travel, maybe they want to travel a lot. And they will be a really big beneficiary of them. But they're doing all the right things from cash management. So, all those bad practices they kept at GE for 10 years, they're gone. Cash flow is more important than earnings, not the other way around. Capital allocation is focused on the right things--paying down debt, reducing liabilities. They've divested the right things, investing in the right things. I feel really confident about GE on a longer-term horizon.
Benz: For our last question, I wanted to ask about overconfidence. You have been able to sustain a very high level of investment performance throughout your tenure at the helm of T. Rowe Price Capital Appreciation. We've found that managers can stumble for a lot of reasons, but overconfidence probably ranks near the top. Can you talk about steps that you've taken in addition to closing the fund to new investors to mitigate the risk of overconfidence creeping in?
Giroux: Well, what I would say is from an overconfidence question is, I'm very hard on myself. I'm always very, very hard on myself. So, in many respects, you never feel good. You never really should feel good investing--you want to always aim to get better. So, I think one of the things that we've done over time, and we try to get better every year. Not better because a stock went down, that was bad; the stock went up, that was good. But from a process standpoint. So, every year, we try to learn from our process to get better and better and better. We try to find more market inefficiencies we can exploit. And so, it doesn't guarantee we're always going to outperform the market, it doesn't always guarantee we're going to outdo what we've done. But I think the fact that we have a process in place that continues to get better every year with a great team, a great platform, I think it reduces that risk of overconfidence. Because, again, I speak for myself here, but you never sit back and look back, and rest on your laurels. It's always, I want to do better tomorrow.
I've been lucky enough to win a couple of awards from Morningstar. But, I don't actually have those out in my house. They are in a closet somewhere, because I don't want to be reminded of my past success. I want to be focused on delivering better value tomorrow than I did last year. And if you're hard on yourself, you want to get better every year, you have a good process, you don't rest on your laurels. I am spending just as much time if not more on the micro aspects of my companies than I was two or three years ago, regardless of how good the track record has been. So, we're not letting up. Again, doesn't guarantee we're going to continue to do well, doesn't mean that all our GARP stocks or utilities are going to do well every year or every month. But having a really good process in place, increases the odds of success over the next five years. And that's really what we're focused on.
Ptak: Well, David, this has been a fascinating discussion. Thanks so much for taking the time to share your insights with us. We really enjoyed it.
Giroux: Well, those were really good questions. I've enjoyed it as well.
Benz: Thanks so much, David.
Giroux: Thank you.
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.
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Benz: And at @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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