Sarah Ketterer: 'Forget Value, Think Valuation'

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Our guest this week is Sarah Ketterer. She is CEO and fundamental portfolio manager at Causeway Capital Management, the firm she co-founded in 2001. In her role, she is responsible for overseeing investment research across all sectors and is a member of the firm's operating committee. As a part of her duties, Ketterer manages Causeway's flagship international value strategy, including the Causeway International Value fund, which she has run since its 2001 inception. Prior to founding Causeway, she was a senior leader and portfolio manager at Hotchkis & Wiley. She earned her bachelor's degree in economics and political science from Stanford University and an MBA from the Tuck School, Dartmouth College.

Background

Investment Approach

"A Topnotch Foreign Large-Value Vehicle for the Long Haul," by William Samuel Rocco, Morningstar.com, Nov. 8, 2021.

"Growth and Value Equity Opportunities: Morningstar Investment Conference," by Charles Paikert, familywealthreport.com, May 23, 2022.

"Combining our Time-Tested Abilities in Developed and Emerging International Markets," causewaycap.com.

"Investors Should Be Ready to Buy When We Are Clearly in a Recession," by Cristoph Gisiger, causewaycap.com, Dec. 6, 2022.

"Where to Invest $10,000 Right Now," by Suzanne Woolley, Bloomberg.com, May 18, 2022.

Value Investing and Turnarounds

"'We Started Jumping Out of Our Shoes': Auto Share Drop Revs Up Value Shop," by Vicky Ge Huang, citywireusa.com, April 2, 2018.

"Buy 'Dull' Cash-Flowing Stocks, Causeway's Ketterer Says," by John Gittelsohn, financialpost.com, June 5, 2022.

"Top Global Value Manager Sarah Ketterer Identifies Some 'Outstanding' Bear Market Opportunities," Wealthtrack podcast, wealthtrack.com, July 8, 2022.

"Why This Top Manager Thinks Markets Are Less Risky Now," by Katie Rushkewicz Reichart, Morningstar.com, May 17, 2022.

"Where a Value Manager and a Growth Manager See Opportunities, Risks Now," by Dinah Wisenberg Brin, thinkadvisor.com, May 23, 2022.

"Activist Investors Descend on 'Bargain Basement' UK Companies," by Harriet Agnew and Arash Massoudi, ft.com, Feb. 1, 2022.

Portfolio Positioning

"Sarah Ketterer's 5 Favorite Energy Stocks," by Sydnee Gatewood, gurufocus.com, June 20, 2022.

"Sarah Ketterer's 5 Favorite Tech Stocks," by Sydnee Gatewood, gurufocus.com, June 15, 2021.

Transcript

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Jeff Ptak: And I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Ptak: Our guest this week is Sarah Ketterer. Sarah is CEO and fundamental portfolio manager at Causeway Capital Management, the firm she co-founded in 2001. In her role, Sarah is responsible for overseeing investment research across all sectors and is a member of the firm's operating committee. As a part of her duties, Sarah manages Causeway's flagship International Value strategy, including the Causeway International Value Fund, which she has run since its 2001 inception. Prior to founding Causeway, Sarah was a senior leader and portfolio manager at Hotchkis & Wiley. She earned her bachelor's degree in economics and political science from Stanford University and an MBA from the Tuck School, Dartmouth College.

Sarah, welcome to The Long View.

Sarah Ketterer: Thanks for inviting me.

Ptak: It's our pleasure. Thanks again for being here. So, I wanted to start off big picture. Regrettably, you're a rarity in the fund world—a woman who is a long-tenured lead portfolio manager. Why aren't there more women running funds and what do you think should be done to promote better representation in the future?

Ketterer: Jeff and Christine, there will be more women. About a decade ago, my colleagues and I realized we had to cede the hiring pipeline to get more women. Regular channels just weren't yielding enough diversity. So, we were one of the earliest partners for an organization called Girls Who Invest. And we've taken an intern each summer for the past eight years. We hired one of them, interestingly, as a full-time research analyst. I never thought this would happen. But she was so talented, and it proves that this pipeline concept works. And we also sponsor women investing networks like WIIIN, which is, Women in Institutional Investment Network, and we partner in 100 Women in Finance events. So, we'll do whatever it takes to get the word out. Part of this is just promotion and making sure women understand this is a great career path. Because the personal qualities you need for success in asset management, in my opinion, are very gender neutral. Things like things like intelligence, analytical thinking and insatiable curiosity, pattern recognition, patience, and intuition.

Benz: We wanted to switch over to talk about your investment approach. Wondering if you were to leave behind a set of instructions for someone who wanted to emulate your investment style, what would that manual say?

Ketterer: If I was limited to four words, it would say, forget value; think valuation. And then, if I had more space on the page, I'd add that you focus, as we do at Causeway, on the valuation of the company, assuming this business can engage in operational restructuring and/or participate in a cyclical recovery. So, if operating more efficiency or when the business cycle improves, what would that do to revenues, earnings, and cash flows? And then, this is important—how much of that improvement, if any, is embedded in the current share price?

Ptak: What do you think is the most critical aspect of what you do in running money that you're seldom asked about?

Ketterer: I think those who are most unfamiliar with Causeway don't understand why we emphasize the convergence of fundamental and quantitative research. So, our investment process in fundamental value equity can't even get out of bed without our quantitative colleagues helping us. The visual of that's odd. But think about—we're covering the world; we have a global equity mandate, and we need the quantitative tools that our quant colleagues can provide to help us with screening thousands of stocks. We need to zero in on the amount of risk measured as incremental risk the stock will add to the portfolio. And for every candidate we're analyzing. Some stocks end up bringing risks that we wouldn't have otherwise anticipated. And that's the beauty of having a fully professional risk model. So, we have a multifactor risk model, and then our quants do fascinating things that help us with alternative data. And think about fundamental, just this idea of stock-picking is pointless without risk control, because the unintended risk can aggregate in the portfolio. And conversely, quantitative investing is very analytical. It's very statistically based, but it often needs the type of in-depth understanding that fundamental can bring and, in particular, to help identify more factors that will lead to alpha outperformance versus the benchmark. So, the two of them together—think of it as one plus one is three—that's fundamental plus quant, and that's what people often don't understand about Causeway, is that we don't just talk about this, we practice it.

Ptak: Maybe to quickly follow up on that. As you know, there's lots of managers, lots of firms that are racing to incorporate quantitative techniques into the way they invest, and this can include some shops that have really been fundamentalists to this point. They haven't really used algorithmic approaches. What has experience taught you is the best way to incorporate quantitative techniques into a fundamental investing process of the sort that you practice there?

Ketterer: My fundamental colleagues and I are all skeptics, and that's what it takes to be a value investor. You question everything. So, probably the most important criteria for quant credibility is just proof. Just to give you an example, we use a tool called the ARM score, and it measures analyst earnings revisions, and it's a very useful tool because it can give us better sense of timing when the sell-side, the earnings estimates, particularly for predictive analysts, those estimates are rising, that shows upward momentum. And, conversely, when they're falling, we need to know this, but we need to know it in a much more sophisticated way than just staring at an aggregate of sell-side estimates. And those scores, we fundamentally, we're a little skeptical of how is this going to help us. But as an alpha factor, or as a risk factor, they've been useful, and they help us with timing, particularly in selling stocks. Because when there's a tremendous wave of upgrades, it's often prudent to be a little bit slower in the sale to take advantage of all that enthusiasm. We didn't incorporate this fundamental until we looked carefully. We made our quant colleagues give us elaborate information on the efficacy of this ARM score before we incorporated it into our process. So, quant has to prove it before we can use it.

Benz: Wanted to follow up on your assertion that fund management, investment analysis is a fabulous career path. I'm curious why you think women tend to be so underrepresented in those areas. My sense is that some women self-select out of those areas because they perceive it as perhaps highly remunerative but really a grind and not great from a work-life balance standpoint. What's your take on why women tend to be so thinly represented in the investment management profession?

Ketterer: It's a good question, and I've often wondered because my colleagues and I have gone to women MBA forums, and we've seen all these women who take the swag and they're interested and are expecting floods of resumes and it just doesn't happen. But I do think the asset-management industry until like the last five years hasn't promoted itself well enough. And the travel might also be an impediment. I think about what I ask my research colleagues to do. What I have done and through my career is we got to get on the road. We really do need to see companies. Even with video conferencing, it's not the same as being there on site, particularly for a company that makes something, you do want to see the facilities and get a sense of the business, not to mention the kind of body language you have when you have someone's full torso in front of you. But at least the travels plant. So, think about some more difficult careers, say, investment banking where the phone may ring, and a client needs you to show up tomorrow. I don't know how you balance work-life with that sort of demand on your time. And asset management is very different. The meetings we have with our clients and what we choose to do in terms of research, whether we're traveling domestically or internationally, it's all planned. And therefore, that creates a much more beneficial environment around which to keep work and life and family all in balance.

Ptak: You don't trade a lot—and I'm speaking of your portfolio—portfolio turnover is typically between 30% and 60%, give or take. Can you talk about the incentive structure, or I should say, what incentive structure you think is needed to ensure that you reward the sort of things that promote diligence and patience and discourage practices that might cause you to shorten your holding periods?

Ketterer: The portfolio turnover is a byproduct of our bottom-up stock-selection process. So, as I mentioned earlier, our quantitative colleagues help us sift through thousands of stocks globally and isolate those that have very specific characteristics that we believe are indicative of ultimate outperformance. And then, our fundamental group has to go through those companies, and we divide ourselves into six fundamental research clusters. These are groups that have very specific sector and industry expertise. And tearing apart these businesses and meeting with management and the competitors, the suppliers, the customers, whatever is relevant for the company creating a valuation model. And all of that leads to a two-year price target. So, we have to look out two years in order to assess what the business will be worth then, because often there's something wrong with the company. It's not a balance sheet problem, because we emphasize companies with superior financial strength; but rather something operationally is out of balance, temporarily out of whack, and we believe the management team can fix it. And that's often the reason why we're in a stock. It's not just because it's undervalued, but we think it will become fully valued once this problem is overcome.

So, that two-year price target allows us to put a stock on a ranking. We use our multifactor risk model to give us a risk score for every stock, and then we rank on risk-adjusted return. So, the highest-ranking stocks on risk-adjusted return are those that we clearly want to emphasize in client portfolios, and those are the stocks that typically get the largest weights. But of course, these are all variables, and they can change. The share price will clearly change. It may go up. It may go down. Our two-year price target, we update those every 90 days, and those are changing. So, that means these stocks are changing in ranking literally all day long, all the time and unless all markets are closed. And the more a stock moves, either one direction or another, will determine how much trading we need to do. So, typically, the more volatile our share price is, the more trading.

But in order for a company to get through the process of operational restructuring, improving its operations, ameliorating whatever may be holding back its revenue growth, not to mention margins, earnings, cash flow, that takes time. That's usually a two-year process. So, that's one of the reasons why we hold stocks roughly three years, on average, in our international portfolios and a little bit less time in global because we had so many more candidates. Because it just takes these management teams a significant period, but not too long. Clients are patient. They can wait two years for the restructuring that ultimately leads to share price performance.

Benz: Can you talk about the importance of firm structure and culture to investment decision-making? It seems like one of the key choices facing you is who you're going to try to sell to and how you'll sell to them. How have you approached that decision so as to ensure that you can run money in the way that you think is prudent?

Ketterer: In 2001, when we started Causeway, we built an institutionally robust investment culture and process, and we aimed it at an institutional audience, even in our mutual funds. We often have clients, institutional clients, who are guided by investment consultants, and those consultants are also looking for that level of rigor. They want a firm that's run professionally, that has a disciplined process, one that's transparent and repeatable and doesn't depend on any one or two people.

We also avoid some of the, I think, string for what we do best. We're best at bottom-up investment research from a fundamental perspective combined with incredible quantitative risk control, or in our quant portfolios, excellent quant alpha research and portfolio management. But we're not particularly good at tactical. So, we don't hold large quantities of cash in portfolios. In fact, we stay fully invested. That's less than 5% cash in portfolios at all times and often much less than that, because markets naturally rise. There are periods when they don't, but over time, they tend to go up with GDP.

And so, we're not making tactical bets. And then, we insist upon having this elaborate and very, I'd say, very in-depth risk model in order to ensure we have portfolio diversification. Years ago, 25 years ago, I remember when clients were more interested in what percentage we had in certain markets or in certain industries, but that doesn't cover all the risks. If you think about there are over 90 different factors in our own multi-factor risk model, and we need to ensure portfolio diversification. So, our risk model is capturing the level of additional systematic risk each stock is bringing to the portfolio and that to me is one of the most professional and prudent steps we could take. And we've had this in place for over 20 years, and I think others are catching up. But again, fundamental doesn't exist without quant. The two together are far more powerful than either of them individually.

Ptak: Since you mentioned it, how do you ensure that your risk model doesn't strangle stock selection, so to speak, especially when it comes to more idiosyncratic types of situations where maybe you want to own more of a name because it's so invitingly cheaper, maybe you're finding more abundant bargains in one part of the market than another, even if your model doesn't love you crowding into a particular name or a particular sector of the market?

Ketterer: You bring up a good point, because it's not as if this is completely a smooth relationship between fundamental and quant. And our quant portfolio managers, at least one of them attends one of our two fundamental portfolio manager meetings each week, and at that time, the full risk model is opened up and we all look at it through an app we have called PM Portal, developed internally, and there we see how much risk we're taking across a wide spectrum of ways of measuring it. And from the big announcement of COVID and the lockdowns in early March of 2020, it became very clear that we had, although an overweight to cyclical risk—so think about the cyclicality risk factor—that turned out to be disastrous because markets sold off, as you know, so severely in early 2020, and it was more economically sensitive stocks or cyclical risks that took the biggest beating. And what we chose to do as a fundamental research effort is find more great cyclical companies that had been "baby, you're thrown out with the bathwater," and add them to the portfolio. We added companies like Airbus, we hadn't been able to own for years, but nobody wanted to own the duopoly in commercial aircraft manufacturing. I think one of the best companies in Europe—they just threw it out. So, we gladly took it. But to your point, it added to cyclicality risk.

All of a sudden, we've gone from having a lot to having a lot more and that sent off alarm bells in the quad models. But we chose, we fundamentally chose to override that because the upside potential—think about the two-year price target—was so large. We were assuming both a slide into an abyss and then a recovery, and that recovery was so significant given the amount of cost-cutting we were anticipating these companies would be forced to do, that they get a point of record high margins at the recovery. So, we had very punchy price targets, which led to very large expected returns, which more than compensated for the additional risk we were taking.

Benz: Sarah, you referenced you're very bottom-up. You don't invest top-down. But the world is a big place, and you probably do have to make more choices about macro environment than would say, a U.S.-only stock manager. So, how do you draw the line in practice? For instance, what macro factors do you allow in and which do you try to avoid considering as part of your process?

Ketterer: We leave some of the macro to our financials cluster, my colleague Conor Muldoon who runs financials and a portion of materials, he is very good at this. And because banks and insurance companies are so dependent on the macro, that makes sense to have some of it lodged there. But we do discuss this as a portfolio management team. We get tremendous input from the outside world, sell-side economists, academics, consultants. And I admit you can't escape macro. It is ubiquitous. And we have to, in our developed-market stocks, we have better expectations of country macro risk in our discount rates via our cost of equity. So both in the risk-free rate and the equity risk premium, and yet for emerging markets, where macro really can swamp the bottom-up, you might argue with me that 2012 European financial crisis, just being in Europe was terrible. And if it was Southern Europe, even worse. It didn't matter what stock you have. But that's not really accurate. We find that in the developed world a great stock can overcome its country's problems, whatever it may be, even Brexit. But that's not so true in emerging markets.

So, for emerging markets, our quant colleagues, they calculate macro risk scores for all emerging markets and with very specific macro variables, and then they weight them. One of the heavyweights is on current account surplus or deficit, which makes a lot of sense, indicating a country's financial viability. And they do work around currency. So, again, the quants are hugely helpful to us fundamentally for client mandates that include emerging markets, because that's where the top-down is just essential.

Ptak: Macro speaking, we are going through a weird time. Inflation spiked, but now it seems to be subsiding. Supply chains were snarled but have gotten sort of straightened out. Yet, we're also seeing signs of demand slipping. What kind of questions are you asking management teams to get a better feel for the profit outlook than the numbers alone would allow? Maybe you can talk about that in the context of your position in railway transport supplier, Alstom.

Ketterer: This is a stock covered by our industrials cluster led by my colleague Jonathan Eng, and Mike Cho is our transport expert, and they expected a company that had made… Often we look again for where there's a stumble where we think a company can ride itself and carry on and see some improvement. Alstom also bought the Bombardier transportation business, and it looked like it was going to be a difficult integration and proved to be such. But this is a company with a backlog of orders for equipment in high-speed trains, metros, trams, e-busses. They have a signaling-equipment business, and they've got a services business. So, for them, understanding what's in those contracts, those are the questions we ask—describe the backlog, where can you get hurt, where do you have the ability to pass on inflation increases—and it's kind of a mixed bag for a lot of these companies. I'd say, especially in manufacturing, they're partially hedged. That's sort of a generalization, but they're also exposed and somewhat depends on how extreme inflation is and the location of some of these costs. Europe, for example, is over 60% of sales for Alstom.

But we look at that as ultimately a positive. We get beyond the supply chain disruptions and the energy crisis. We have a company that's in exactly the right place for the type of environmental spending we expect the Europeans to be doing, and ultimately the U.S. and other countries as well. Rail has a huge place in the world of transport because of its low- to no-carbon existence. So, this company will find a way to get through its, I'd say, older orders that aren't very attractively priced and zero margin and meanwhile is taking on much better business. It's being well managed. Its financial strength is sufficient to make it through this period. And then, what we look for and what we saw in their last earnings was an improvement in free cash flow generation, and that is the key. Because ultimately, all of our companies, we expect, once they generate enough free cash flow, they need to return that to shareholders, because we want that money on behalf of our clients to reinvest in high-ranking candidates.

Benz: In your most recent commentary, you stated, "We believe equity markets have yet to discount the full economic impact of the interest rate increases and monetary liquidity reduction needed to shrink inflation." Inflation seems to be easing. Does that change your view?

Ketterer: I don't think inflation is easing much, and we hear faint signs of any improvement in inflation. I'd say, if anything, the labor situation is still really acutely problematic for so many of our companies. I'll mention one of our successes for clients, a company called Compass Group, and they are a catering firm globally, 60%-plus North America and another 25% or thereabouts of the revenues in Europe. They are generating plenty of free cash, but they can't get enough labor, and the labor cost situation, they have to pass that on, and they can't always do it. So, their only real sustainable competitive advantage is that they're big and they have so much scale, and many of their smaller competitors are having even greater cost problems.

We're expecting—as an organization our house view is that central banks around the world with the exception of China's Bank of China the rest need to be in a tightening mode with the Fed at the head of the pack, and not just rate rises but the reduction in central bank balance sheets will lead to a lowering of the inflation rate through constraining economic growth, and China is already constrained. So, it's going to be a bit rough the next 12 months, and we think markets are just now beginning to understand this. They did through June. It was sort of fill up of optimism that's happened in July and August. But it's very clear, especially when you listen carefully to what Jerome Powell has to say, the Fed is committed to lowering inflation, and I don't think there's any ambiguity here that what brought markets into a buoyant state of massive multiple re-rating upward, particularly in the U.S., amplified by the expansion of monetary policy in 2020 and 2021—actually through early March of 2022, we'll see the other side of that with the contraction. And taking liquidity out of the financial system tends to lead to lower valuations across the board, particularly for long-duration stocks where cash flow from the business are all promised far out into the future, as opposed to what we're looking for at Causeway, which is companies generating cash today.

Ptak: As your views solidified in the way you describe coming to see inflation as a thornier problem than certainly it's been in recent years, did that have any impact on the way you position the portfolio, which consists, I would imagine, of a mix of price takers, price makers? Or do you look at that as just something that relatively sturdy set of businesses that you prefer should be able to manage through, especially at a reasonable enough valuation and with a long enough time horizon?

Ketterer: It very much depends on the business. Again, I'd say, if there's a common thread through our portfolios, it's companies where either they don't have yet but were expecting or they have arrived, the management team, who can—through the self-help process of operational restructuring—improve the outcomes. And that may include better pricing, that may include massive cuts in costs that prior managements couldn't enact. And all of that, that's how we think about value investing. It's all weather. It doesn't depend on the economic cycle. It doesn't depend really where inflation is, unless it's crazily out of control and then we're having a different conversation. But in this environment where central banks are now acting, we will get to an acceptable level of inflation one way or another. But for our companies, they have so much work to do at the micro level, that's why we bought them because we believe that they can improve their business and do so within the next two years.

Benz: You're a value investor. I guess, I should say, a valuation-focused investor. I'm curious how has your definition of value evolved through the years? For instance, do you own a name now that the younger you would have thought was not value? And, conversely, would you have owned stocks in the past that seemed cheap, but you wouldn't touch with a 10-foot pole now?

Ketterer: We've watched what's happened to value investing in the post-global financial crisis years, really the last 13 in the U.S., from 2009 onward with some small breaks. Investors have reacted to the massive increase in money supply, and they've been willing to take on a lot more risk. We brought in our mentality from the late '90s, because Causeway started in 2001, and we took that right into the next two decades. But I think that we were a little out of date, say, in the last several years prior to the pandemic, so say, 2017, 2018, 2019 where we just were shocked at the valuations, and we didn't want to participate. And yet we still had to be fully invested, and that often pushes us into stocks that are just going to be more trouble than they're worth.

That wasn't true of the whole portfolio. But now, because we spend so much more time on the ability of management to turn the business around, we've found a model that will work whatever, wherever, and any economic environment. So, no, I don't think we own anything today I wouldn't have wanted to own before. And we aren't lenient. We're not relaxing our definition of value, because it's naturally evolved with markets to encompass this concept of valuation. And it's just what I and my colleagues talk to our incoming analysts, and it’s the first thing we tell them is being cheap isn't enough. A cheap stock can get you into terrible trouble. The key is to find a business that is reasonably well situated. It's got a competitive environment that we think is attractive. It may not be perfect, but great management, or at least management capable of enacting the types of operational improvements that have to happen, and then a balance sheet that can withstand what could be unanticipated other events.

We saw one problem, like it might have been a product recall, but then we didn't expect a pandemic to shut them down and/or the closure of the Chinese economy to outsiders and the cessation of air traffic. The key for us is, and we've been very good at this over the years, is having that margin of safety, making sure that we're buying the stock at a low enough valuation and the balance sheet is there as it was. For example, in 2015 after Dieselgate, we ended up doubling our weight in Volkswagen. The stock has long gone out of client portfolios. But the reason why is because we saw this extraordinary balance sheet with so much net cash, and I think it was something like EUR 30 billion. That's what gave us the confidence to see the new management in the door and see what they could do to fix all the problems. I think that way of investing will always be attractive and can't be replicated passively. A passive value index is a bunch of cheap stocks based on price/book or price/earnings. And that would not be my idea of long-term success, because how do you know that they aren't cheap for a reason.

Ptak: I think we want to dig into that some more, talking about that within the context of turnarounds and the role firm management can play in the success of an investment you make. But before you get there, I wanted to ask you about something that you've alluded to before, which is the way you array your research team into clusters that focus on sectors, which of course boast focus and depth. But we've had other guests on who have strongly advocated generalism. Rather than debate that—which approach is superior or not—can you talk about the trade-offs specialization entails and things you do to ensure that your teams don't fall prey to things like relativism?

Ketterer: I would state that question slightly different and say how do you keep your clusters from becoming silos where all they can do is think about industrials, or all they can do is think about financials. And part of that is just cross-fertilization of ideas and people and having… For example, one of my portfolio manager colleagues, Alessandro Valentini, is not only in cluster one, he is immersed in financials, in particular insurance, but he is also running our healthcare cluster. And, of course, there's overlap. There are health insurers in the U.S., but it's intellectually important to keep people inter-cluster connected. My colleague, Ellen Lee, who heads up our consumer cluster, she is also working in utilities, and she has come from the energy area. And we rotate people so that they get experience across a number of different global sectors and that also avoids relativism. They don't think about how cheap their utility stock is versus other utilities. They work within a ranking system.

If my colleague, Steve Nguyen, who is one of our portfolio managers who heads up our utilities cluster, finds a great stock, and right now he is grappling with a really tough but great company listed in Italy called Enel. They're an integrated operator. They sell electricity and gas in Europe and Latin America with a bit in North America. He doesn't think about them versus other utilities as much as one of the company-specific reasons we want to be there, how does that get embedded in the two-year price target and then we have a risk score and then where does that stock rank? And it happens to rank very highly, in part due to the concerns about Italy that are hanging over the share price. But we think those are somewhat unfounded, enough so that we're willing to take the risk of owning the stock. And there's so much upside in the business, it's Latin American business that isn't even in the price. But he also will talk to the other portfolio managers and Conor Muldoon, who heads up our financials and materials. He used to cover utilities. So, he will talk to Steve, and he has got Ellen. So, we take these cluster heads and the analysts as well. We've got a number of cluster-one analysts who work in technology in cluster two; they start on fintech and then they're expanding.

I don't think of them as silos at all, and Harry Hartford, who is our head of fundamental research, doesn't either. There are areas of expertise. You have to really understand your business in depth. And I'll go back to the utilities example again. What makes Steve so competent is that utilities are in complex regulatory environments and sweeping it as a generalist could be a little dangerous because it's really important to understand the specific regulatory environment and compare it to others. That's one comparison that makes a lot of sense. Sometimes we get some premonition of what's going to happen in one region based on what has just happened in another, because regulators talk to each other. So, that's how I think about avoiding relativism. We work with a ranking system, so, our stocks have to—think about they all have boxing gloves on, and our risk-adjusted return basis means they have to compete with each other. They have to knock the other one out to get in the portfolio. And stocks that perform well tend to descend in that ranking. And so, our portfolio management team, we sell those stocks and reinvest; sell proceeds in the higher-ranking stocks. And it doesn't make any difference. There's no internal politics that drive that. It's all about the veracity and the robust nature of the analysis that underpin the two-year price target and then the risk adjustment that gets attached to that and the ultimate risk-adjusted return.

Benz: Jeff referenced that we want to delve into turnarounds. Turnaround candidates can probably be plotted on a spectrum where there's invitingly cheap and then there's hot mess. So, what has experience taught you to focus on when you're assessing whether a business that's not executing can actually be turned around? Can you give an example from the portfolio?

Ketterer: There's so many. I think one of the toughest stocks that we've had to deal with lately in the last four years has been the U.K.-listed aerospace company Rolls-Royce. They make aircraft engines, and they specialize in widebody aircraft engines. And the reason why we bought this stock, and this was prior to the pandemic, was because they had a problem with one of their engine series and they had a recall. And so, this stock fell, and this company has very few competitors—Pratt & Whitney and GE. So, there aren't many of them, and that's often a good sign in terms of pricing. And it's a razors and blades business, so the engines aren't the area of high margin. It's the service. It's effectively the company gets paid on flying hours. But then the pandemic struck. and planes grounded. And especially the international routes, investors were very negative.

So, we watched this company go from what had been a pretty reasonable financial strength situation to terrible and having to raise capital. And the CEO who was brought into fix the engine problems, Warren East came from a great U.K. company called ARM Holdings. So, he had an excellent track record. But this became a huge operational restructuring story, and it still is to this day. The company has sold off businesses that are noncore. They've had to cut costs in ways that I think they never anticipated they would. But in many cases, that was quite healthy. They've had to reconstitute their board. They have a new board chairperson. And I think in the next two to three years, it might be one of the portfolio's best stocks. But it's been painful for clients. And in part due to a comment I made earlier, we saw one problem that we were convinced was easy to overcome because the company had proven it could do that. What we didn't see was a pandemic. And then, the Chinese lockdown and the delaying of opening of that economy, because so much widebody traffic is in Asia that has also hung over the company. So, just one problem after another. And the company is now bringing in another CEO—because Warren has done all he can—who will be even more disciplined in terms of enacting operational restructuring.

But this is a longer wait than usual, and I only bring it up just because it's been such a tough situation. You don't want to sell a great company out of the portfolio. And when you know it has the ability to generate cash and there's nothing wrong with the business. They're just these exogenous events that have happened in succession then maybe you call it a perfect storm. But we take a long view on stocks like this and especially when we can see that the board is really on the side of shareholders here and determined to get to an outcome that's very satisfactory.

Ptak: Wanted to shift and talk about another aspect of what you do, which is portfolio construction and maintenance. I think we referenced the fact that you typically hold 60 or so stocks, don't concentrate too much. Can you talk about why you structure the portfolio in this manner and how you decide on portfolio weightings? I was particularly curious about trims and adds maybe in the context of a name like Total Energy, which I think it's a name that got cut in half earlier in 2020 but has bounced since then. And it seems like an interesting case study and maybe how you would go and add to/take away from positions and managing the overall portfolio.

Ketterer: Let's just start with the number of stocks. Some of this is through our prior, the 10 years we managed money prior to Causeway, but Harry Hartford and I and our colleagues, we all embrace it, we want reasonable amount of concentration. If you think about the 50-stock portfolio, the average weight could be a couple of percentage points, and we want slightly more diversification than that. So, we are somewhere around 60 stocks, but we let that fluctuate based on attractive candidates or not. And so, if we have fewer attractive candidates, we're not going to hold stocks that we don't think have the risk-adjusted return that make them viable in the portfolio. And we have this abundance of undervalued stocks with great companies, we might end up with even more. So, it somewhat depends on what the opportunities are. But we don't want to go too high because then we dilute this position sizes, and it's just deleterious. It's just harder.

If you think about our research team, there are 25 of us doing fundamental research, and we just can't have time and effort put into a stock and then find that the weight is so small that it doesn't make much of a difference to performance. So, that explains the trade-off between diversification and bang for the buck in terms of weights. And as for energy, energy has been very challenging from really from 2014 onward when we saw the last oil price peak and then decline. It's obviously—oil and gas extremely related to its commodity. That's the major input that goes into models. And I think it was January, maybe early February of 2020 as oil prices were diving toward zero, we saw opportunities elsewhere. As I mentioned, there's some great companies in businesses that aren't necessarily related to a commodity. I mentioned Airbus earlier where the market was just decimating the share price. So, we used some energy proceeds for that. But it became apparent as, especially in November of 2020, with the first of the MRNA vaccines and the success that brought that we were going to see an economic upturn.

So, that gave us an opportunity to add energy back to the portfolio. But part of this was having a number of conversations, particular with the European integrated, the oil majors, about how they were going to make a determination with their cash flow of how much they would return to shareholders in dividends and share buybacks as opposed to investing in renewable energy—which is the future for them—and to what degree with those renewable projects would the returns be as good as what they were earning in the conventional oil and gas. And it took us some time to get that information, but we came reasonably satisfied with it. And that allowed us to build up weights just in time for the Russian invasion of Ukraine in February of this year, which was pretty shocking from all three of them. BP, who added the largest exposure of them all, I think, GBP 25 billion in Russia in Rosneft, and then Total and Shell all had exposure. So, they sold off, and we thought that was silly, because what they lost in Russia, they more than made up in oil price. So, those share prices went up and we took advantage of that for clients. When we started seeing Brent tipping above $100 a barrel, we just think there's a point at which naturally supply comes on, and we've learned these lessons from our past experiences with oil and gas. It's always a good idea to take some of that weight down, because there will be another opportunity. We still like these companies, all of them, in particular the Europeans, because they are generating so much cash, and what they're doing in renewables, we think they will get plenty of public sector support for, which should improve returns on or offshore wind or solar. And the need for it is obviously absolutely urgent.

Benz: The portfolio looks a little richer valuation-wise than has been typical for you over the past decade or so. How do you get comfort that the multiples your holdings are trading at afford you the margin of safety you'd normally demand?

Ketterer: We're just about to put out a paper to clients on this because we've been asked this question and it's insightful, because yeah, it looks as if we have less value in the portfolio than we might have had in prior years. But value is somewhat of a backward-looking measurement. And we think there might be 45% or a little more of our portfolios in what we call underearners. So, these are companies that for reasons that are usually to do with some sort of exogenous event like a pandemic and/or it could be the economic cycle. They're earning much less than they would in a normal period.

And the example I'd give is, Amadeus. They are a travel software, effectively. They're a fantastic company. Spanish-listed. Their U.S. equivalent, Sabre—we own that in our global portfolios. We like this business. Again, it's software, so it's capital light, and they're one of the few high-quality software companies in Europe. The stock has held up quite well this year on expected travel recovery or continued travel recovery. But we are a long way from where we were in 2019. We don't think this company will get to 2019 revenues—its level of sales in 2019 until 2024, and that to us means it's underearning. We know they have excellent technology. They have a very loyal client base. So, we think that trading at 17 times next year's earnings, it may look a little pricey, but that's because the earnings are understated. The travel industry, I think in 2020 lost something like $5 trillion and 63 million jobs, and there's still so much recovery ahead. Usually, air traffic—and that's just part of their business because their travel software is for air and for airlines, hotels, rental cars—the air traffic typically grows, it's something like 2 times GDP. So, we'll have our slowdown and then our recovery, and that's when earnings will really pick up for this stock. My guess is, by the time the earnings get to recovery, we'll probably have moved on. But now, it looks expensive when we think it's simply underearning.

And I'll just note that that's different from a growth stock where they've never seen these levels of earnings before. Cyclical companies or companies that have had a setback like a pandemic— something that doesn't seem like it should happen regularly—they've earned this before, and that's why we're so confident. It's not like we're taking some risk, the company can grow into this huge valuation. They've done it before.

Ptak: Maybe wanted to widen out for our last couple of questions with you. I was curious, what's a stock or topic where you're the contra, holding a view that's basically opposite the consensus on your team?

Ketterer: Well, I've been a China bowl. My colleagues are so incredibly talented, and a number of them are very, very skeptical, much more than I am. So, I'd say that's probably the contra. Several of them see property collapse and government nationalization of the entire property sector and banks shoving bad loans under the carpet. They see a stagnating growth environment and aging population. And I just have a much more optimistic view. I haven't been there, literally haven't done any company meetings since 2019. I haven't been able to without really horrendous quarantines, which I don't need to do. But I've got six colleagues there and it so calls, we set up an office in 2020, and we have people on the ground now. But what I did see was 8 to 10 million college grads every year, 40%-plus of them are STEM grads. They work incredibly hard. There's a vibrant private sector, plenty of domestic capital and lots of founder-run companies who care about their share price.

So, yeah, sometimes that A share market can get frothy, and it will rise and crash. But there are so many companies there. And what blew me away was how many were quite large, and they will dominate an area, maybe some niche in the semiconductor component area. You never even heard of them, and they're just phenomenal businesses. So, I think the private sector will, as it's done in the past, be the source of prosperity for China and the country will not go down the drain. I'm interested in owning some of these companies. And what happened in early 2021 or mid-2021 when Beijing made what was an entire industry, the for-profit education industry non-for-profit, has left a very bad taste in people's mouths, and for good reason. That's a taking of value for shareholders and not to mention a really egregious regulatory strike on an industry. But again, I just look at anecdotally and empirically what I've seen makes me much more optimistic.

Benz: There's a school of thought that the market has gotten more efficient over time. Do you agree? And more generally, has the competition for attractive bargains intensified over time?

Ketterer: Yes, I think it has become more efficient, but part of that has to do with the amount of money that's poured into it. Sometimes you'll read articles about dry powder in private equity, but just think about in public markets that we all have clients who have got money they need to put to work. Often these are retirement accounts that we're ensuring grow. There just is more and more money to put to work, and that creates a hunt, an insatiable hunt for upside. But I will say, my "but" on this is that the value segment isn't as brutally competitive as the overall markets, because it's been so bad until recently. Really November of 2020 was the beginning of the improvement. We have a rise and there will be another growth spurt in the markets, but it's not as competitive in value because most investors couldn't be bothered. Everyone wants to be in an exciting cocktail conversation parts of the market, innovation, and sass and whatever else, and buying aircraft engine companies is not their thing, or companies that make rail equipment. But there are so many opportunities there. So, I'm secretly kind of pleased that the stampede went to another section of the market and is highly competitive there, because what we're looking at Causeway has many fewer eyes on it and at least if we do our job right, gives our clients an opportunity to make some serious money.

Ptak: Well, Sarah, this has been a very interesting conversation. Thanks so much for sharing your time and insights with us. We've enjoyed speaking with you.

Ketterer: Thank you.

Benz: Thanks so much, Sarah.

Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Christine_Benz.

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

Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

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.

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