Focus on Long-Term Quality, Not Short-Term Rates

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's Beat the Market Week on Morningstar.com. We recently talked to Matt Coffina, editor of Morningstar StockInvestor, about his overall investing philosophy, but now we're going to talk to him more in-depth about what he’s seeing today and where the current opportunities lie.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let’s start with equity valuations. Even after a bit of a sell-off, do you still see stocks as being fundamentally fairly valued? Where do you see the market today?

Coffina: I'd say stocks as a whole are fairly valued to somewhat fully valued. I think that from the current valuation levels, the market’s still capable of producing a real return. So after inflation, maybe 4% to 5.5% over the very long run, which would be below historical standards, but still pretty good in absolute terms and certainly better than you're going to do in long-term bonds or really any other alternatives that are out there. And I think stocks are still the best place to be for long-term value creation, but certainly the market’s fairly to fully valued.

I don't think that it's positioned to deliver 6.5% annual real returns that we've seen historically based on current valuation levels.

Glaser: Are those valuations pretty even across sectors, across industries, or is it fairly lumpy?

Coffina: That would have been an easier question to answer a couple of weeks ago, where I would say the conservative sectors were really being underappreciated. Things like utilities to some extent, but also certain pockets of health care or consumer defensive, real estate investment trusts, areas like that of the market were being underappreciated, whereas relatively faster-growing companies, especially in cloud software, biotech, emerging businesses like 3-D printing, those kind of stocks have gotten way ahead of themselves valuation-wise.

Now in the last two weeks, we've seen a bit of a rotation in the other direction. Some of those momentum stocks and the stocks that have done really well in 2013 have begun to sell off pretty steeply, in a lot of cases, down 20% or more, and those more conservative stocks that the Unilevers and Philip Morris Internationals of the world are trading up to the point where they're not quite as deeply undervalued as they were.

Looking at the current market today, I'd say that those momentum, very-fast-growing companies that investors had been very enthusiastic about, by and large there aren't that many values to be found there. I'd say that a lot of the stocks are still pretty overpriced, and we could have a lot farther to fall, but then at the same time, the conservative stocks are still probably somewhat more attractive than that first group, but not as much as they were.

I'd say we're getting closer to a point where the market's valuations are fairer across the universe.

Glaser: You mentioned this rotation out of some of the more speculative names into the more defensive names. Has that created any opportunities in the tech space, the biotech space, or has it just gone from being very overvalued to just merely overvalued?

Coffina: I think you need to be careful. I think a lot of the stocks that had these amazing runs over the last year or two are still quite overvalued. Again, I'd point to lot of the social networks, cloud software, 3-D printing, a lot of biotech, those areas tend to still be quite fully valued.

That said, I'd say anything that did well in 2013 is under pressure right now, and anything associated with the growth outlook, there are some stocks that are worth looking at. Within our portfolios, I'd say Baidu is a great example of a company with a very long runway for growth. The stock has come under pressure along with other names that are seen as having a lot of momentum in growth. The company is trading at a very reasonable valuation, something like 20 times forward earnings, while still growing 50% a year.

Another example would be MasterCard. It has finally come down to a point where it's trading at a reasonable discount to our fair value estimate. Again I think to a certain extent, investors are throwing out the good with the bad, and companies that were fairly valued are now becoming cheap. But then there are still a lot of companies out there that were ridiculously overvalued and now are only very overvalued.

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Glaser: One of the big question marks has been when the Federal Reserve is going to start to raise short-term interest rates. Do you care when rates rise or if they're going to rise? What impact is that going to have on your portfolio?

Coffina: Yes, that's a great way to phrase it because I don't really care. We tend to look out five and 10 years into the future when deciding which companies to buy and which companies to hold, and I think it's inevitable that short-term interest rates are going to rise. They were in the midsingle digits prior to the financial crisis. That's a more normal level in a more normal economy. And I do think at some point the economy is going to recover and we're going to be in a more normal situation.

I think sooner or later, short-term interest rates are headed up to at least 3% to 4% or 5%, that kind of range. We certainly own some stocks that are considered more rate-sensitive, stocks like HCP, a real estate investment trust. On the other hand, we own some companies like Charles Schwab or ADP or Paychex that would benefit from higher short-term interest rates.

I think we have a more or less balanced exposure from a fundamental perspective to higher interest rates. At the end of the day, I think people are focusing much too much attention on when exactly short-term interest rates are going to rise and instead they should be looking five and 10 years in the future and say, when the short-term rates rise in early 2015, late 2015, early 2016, nobody is going to remember in 2020 what happened, and we will be in a totally different situation there.

I think it's much better to focus on the fundamentals of individual companies keeping in mind your interest-rate exposure. You certainly don't want to make huge bets on short-term interest rates staying low forever, nor would I want to make big bets on short-term interest rates rising significantly in the next couple of months. But I think the further out in time you look, the less important it becomes. And since we have a very long-term investment horizon, it's not something that certainly keeps me up at night.

Glaser: Other than Baidu and MasterCard, what other firms do you think are relatively attractively valued right now?

Coffina: A lot of the stocks that I had been buying were more in the defensive side, Unilever, Philip Morris International, Coca-Cola, these are some of the stocks that I liked a lot early in the year. I think Coca-Cola is still reasonably valued, but Unilever and Philips Morris International are looking much closer to fairly valued at this point.

There's not a huge number of opportunities out there to be honest even as we sit today. The stock that I most recently purchased for our Hare Portfolio was BlackRock. This is the largest asset manager in the world. It's a situation where the stock will be greatly affected by the market’s performance in the short run, the performance of both stock and bond markets globally. And you could expect that BlackRock will be more volatile than the market as a whole. In the short run, I think the BlackRock's total returns as being maybe 1.2 to 1.5 times whatever the S&P 500 returns.

However, over the longer run, I think BlackRock enjoys a lot of tailwinds, including asset inflows, especially through its exchange-traded fund product, through the iShares brand, leading the market on the ETF side. Also the company pays a fairly generous dividend north of 2.5%. It repurchases maybe to 2% to 3% of the float every year. And you add all of these things together, also the company has some operating leverage inherent in its business model, and the top line should naturally benefit as the stock market and bonds tend to have positive returns over the longer run. Their assets under management should tend to grow in line with that and they will be earning fees on that.

In the short run, I think BlackRock delivers the same return as the market, times maybe 1.2 to 1.5, but over the long run I think it delivers the same return as the market plus maybe 5 percentage points. So over a long enough time horizon, I think 10, 15, 20 years into the future, BlackRock is very, very likely to outperform the market. And it's really just a question of when you want to buy it. I think the market is about fairly to fully valued. I think it’s a fine time to buy BlackRock. I think the company itself is trading at a very reasonable valuation.

Now if we’re in for a severe bear market, it's pretty well assured that BlackRock is going to trade down and there will be better opportunities to buy it in the future. And for that reason, I've started BlackRock at a relatively modest position size where we have room to add significantly to our position. If the whole market was really cheap like we had in 2008-09, BlackRock is the kind of company I'd be happy to put a very large weighting to in our portfolio. But until then, I think it's still a reasonable risk/reward trade-off in the current market.

Glaser: Finally, what do you see as the biggest risk facing investors today?

Coffina: Generally speaking, the biggest risk investors face comes from within. I think if the market trades down significantly and investors panic and sell off at a bottom, that's really the easiest way to destroy your long-term plan, to destroy the performance of your portfolio over the long run.

At the same time, investors that run into the market right after a strong bull run just because stocks have been doing well, they want a piece of the action and they buy a lot of stocks now, not being prepared to hold through those future downturns. I think that's another way to really destroy your investment strategy and your returns over the long run.

First and foremost, I think investors need to be careful that they're not going to buy stocks just because they're up over the last five years, because if they do that they're very prone to selling just because they're down in future times, and there most assuredly will be downturns in the future.

In terms of our specific strategy, if you can get past that typical investor mindset, which often leads to buying high and selling low, the biggest risk to our specific strategy is really companies with a deteriorating economic moat. So we invest exclusively in companies with high quality, companies with strong competitive positions. But over time, sometimes competitors encroach on those competitive positions, and economic moats can weaken. We can be wrong about economic moats in the first place. Sometimes we think the company had an advantage and it turns out that it didn't really. That's certainly the biggest risk to our specific performance.

First of all, investors shouldn't be involved in stocks unless they have a long-term horizon, they're willing to be disciplined, they're willing to hold through whatever future downturns may come, and if they're willing to do that I think the biggest challenge that investors face is making sure that the companies that they buy really do have strong competitive positions and that they're trading at reasonable valuations.

Glaser: Matt, I really appreciate you taking the time today.

Coffina: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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