Boston Company's David Daglio says the Dreyfus Opportunistic Midcap and Smal Cap funds see content producers winning, while a negative payor mix shift will keep health care under pressure.
Ryan Leggio: Hi. I'm Ryan Leggio. I'm a mutual fund analyst at Morningstar.
We're here at the 2011 Morningstar Investment Conference, and joining me today is one of the panelist on our Undiscovered Managers Panel, David Daglio from The Boston Company. He manages the Dreyfus Opportunistic Midcap Value Fund and the Dreyfus Opportunistic Small Cap Fund.
David, thanks so much for joining us today.
David Daglio: Great. A pleasure to be here, Ryan.
Leggio: Well, as I mentioned, you're one of the panelists on our Undiscovered Managers Fund, so a lot of investors may not know you or the firm all that well.
Can you talk a little bit about what makes your process unique and how you've built such a fine track record at both your mid- and small-cap funds over the last couple of years?
Daglio: Well, Ryan, we think about three things when we buy any security and then in managing the fund. The first and the most important is we're intrinsic value investors. What that means is that we go and look, at maybe times when the market isn't looking. We're buying stocks that are traced at a large discount to an intrinsic value, and intrinsic value is represented based on the long-run, mid-cycle earnings of a business, intersected against its true assets and liabilities. That's the first thing.
The second thing is this is a research-driven process. We're bottom-up, fundamental research investors.
Then lastly, when we think about risk, it's in the name, "opportunistic." It means that capital risk is more important than benchmark risk. So, when we see areas in the market, financials in 2008 or 2009; commodities in 2007, where we see significant capital risk for clients, we avoid them altogether.
Leggio: As you mentioned, the fund has the word "opportunistic" in the name. Can you talk a little bit about how you were transitioning the funds from 2008 and early 2009 when you were looking at companies, on a normalized earnings basis, that looked really cheap?
Daglio: Boy, as I go back, that was a really fun time to be an investor, probably not a fun time to be in the markets, but it was a fun time to be an investor. So, let me start out with 2007. What we saw in 2007 was generally higher-quality businesses, more stable businesses, were intrinsically valued the most attractively.
Then as the credit crisis played out, the portfolio morphed into what people would consider more cyclical businesses, because we saw better intrinsic value there.
One of our best performing sectors and industries was in the auto sector. Those got very depressed and recovered actually quite quickly, even faster than we thought.
One of the things the team did well in 2009 was make this transition, and the intrinsic value approach helps you with that.
The second thing we did very well is we traded around a portfolio where the risk/reward was the best. So, as stocks appreciated very quickly in 2009, and some did, we moved into stocks that had not done as well. This positioned us to outperform again in 2010 with really a different group of securities.
Leggio: Absolutely, and I think something analysts and investors have noticed about the fund was the turnover during that period. So, it sounds like, that isn't a permanent condition really of the fund. A high turnover. It really is dependent upon the opportunities you're finding in the market?
Daglio: Yes. I mean, in some ways it sounds a little tongue-in-cheek. We'd love to see the same amount of turnover again because that means the market is giving us enormous amount of opportunities and reprice them. Year-to-date, we're running at about 100% turnover in the fund, and that's more of a transitory, steady-state level for us.
Leggio: Well, let's talk about how the fund is positioned today. Clearly, the risk/reward profile of the securities, even though you have turned over the fund, is significantly different than it was back in early 2009, and maybe even compared to 12 months ago. Can you talk a little bit about where the fund is positioned now, especially given the recent pull back in the mid- and small-cap space over the last couple of weeks?
Daglio: We have made a lot of changes in the portfolio in the last 45 days. A lot has happened in the market. Generally, valuations have gotten much more attractive. Across the fund, we're seeing an enormous amount of opportunities. The most interesting to us today are in consumer, technology and industrials.
Inside of industrials, we're finding really a smattering of different industries. We want to have a U.S. focus. The U.S. economy looks to us much more stable and more predictable than clearly emerging markets and definitely versus Europe. We're finding businesses with very high return on investment capital that are trading well below their long-run earnings potential.
The second area which looks very attractive to us is consumer. Inside of the consumer sector, in 2008, we had been in the more cyclical businesses. This would have been retail. Recently, we have moved more into media. Inside of media, the content providers are winning, and for the first time the content providers are able to not just sell into the traditional TV that you turn on, but now can resell into the Netflix channel and maybe even potentially into the Amazon channel. That's opened up about 20% more incremental sales for them at no marginal cost; and that's exciting and really is revaluing those businesses.
Leggio: So, it sounds like because of the ability for you to really pick and choose the areas of your market--you are relatively concentrated--that the risk/reward profile looks still pretty good to you on both the mid- and small-cap front?
Daglio: Yes. I will be very candid. It does not look as good as it did in 2009, but I think in 2009 the risk, the really Armageddon risk, was much higher on securities. We look at risk/reward every day in the portfolio, and today it looks better than it has on average, but worse than it did in 2009, and we are risk/reward managers, and so we're really trying to put the best risk/reward stocks in the portfolio at all times for clients, and so that's a very important statistics for us.
Leggio: My last question then, we've talked a lot about risk. What are the areas in the market that you're looking at right now, either sectors or industries, where you are turning over the rocks and the valuations just aren't there and maybe the areas you're kind of staying away from right now in the funds?
Daglio: Capital risk is one of our tenants, and under capital risk we really don't want to be in areas of the market where clients can lose a lot of money. Where we see the greatest opportunity to lose a lot of money is inside of traditional REITs. Those are trading at a two-thirds premium to the rest of the market, and the businesses aren't as attractive we view over the long run.
The second area is health care, and this is a little controversial. Health care, we look at the demographic trends and think they are quite negative. Even though we have an aging population, the problem is that the aging population is largely getting their health care paid for by Medicare and Medicaid, and the profit is one-half of what it is under private pay. So, we think the mix shift is quite negative there. The recent rally has allowed us to sell some winners here, and we're going to stay underweight for quite some time.
Leggio: Well, David thanks so much for joining us today at the Morningstar Investment Conference. I am sure we'll be following you, and hopefully after this interview, you'll be more known now to investors. Thanks very much.
Daglio: Great. Thanks for the time Ryan.
Leggio: And thank you for joining us. This is Ryan Leggio for Morningstar.
