Fuss: Think Like a Psychologist

Jason Stipp: I'm Jason Stipp for Morningstar. It's Beat the Market Week on Morningstar.com. We are checking in with some successful managers to learn about their processes and also where they see the market today.

Today on the phone I've got Dan Fuss from Loomis Sayles. He is going to talk a little bit about his process and why his fund has been so successful over time.

Dan, thanks for joining me.

Dan Fuss: Well you are welcome. Thank you, Jason.

Stipp: Dan, your fund, a Gold-rated fund, Loomis Sayles Bond, has a fantastic long-term record. It's in the top 10% over the 10- and 15-year periods in that multisector bond category. Let's talk a little bit about your process to selecting bonds and the attributes that you look for in your bond picks.

Fuss: Thanks, Jason. First of all, we're what's known, I guess, as a value buyer. Now what is value? Nobody would buy a security that lacked value. So what is it? It's easiest to illustrate in the corporate arena, but it applies across the board.

Number one, you want some sort of yield advantage relative to the rest of the world, normally contrasted with say the Treasury curve or similar corporates.

Number two, and very, very important, is which way is the credit going, at least at this point in time and what do we think might happen going forward. Those first two are very important. 

Now part of the "Does the bond sell at a reasonable price?" is also not just because what the absolute yield, say in this case, yield to maturity is and what the credit direction is, but what various options are embedded in the bond for the issuer, such as call at certain prices and other things that would favor the issuer as opposed to the buyer? And then what possible options, if any, does the buyer have that are embedded in the contract? The most common of those is an option to either put the bonds back to the issuer or another significant one is to convert into another security from the issuer normally common stock, but sometimes some other security. Those are the most common.

And it's the mix of these things, Jason, that indicate at the point in time the attractiveness of the security at a different level of interest rates than we have now. Let's say that interest rates are 3 percentage points higher, so that the 10-year Treasury yield instead of being at 2.62% or 2.63% is at 5.62% or 5.63%, quite a ways from here, but still very reasonable in history.

Then you have a whole another dynamic in that you have a world populated with discount bonds. The first four factors certainly are still very, very important. But now the math of finance kicks in with a set of possibilities and probabilities that are not buried in the yield table and are not strictly related to the market. But that's a different environment. Right now it's really more standard; everything is selling pretty close to where it ought to.

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Stipp: Dan, when you are looking for values, when you're looking for something that's selling at a price that's less than what you think its worth, usually it means that there something that the market is missing or there is some risk that you think isn't as big of a risk as other people think. So what are some of the decisions you are making about risk? If you are buying something that's undervalued, some might say it's undervalued for a reason. So what are the risks of your process, and how do you manage them?

Fuss: The most significant risk is twofold. Number one, it's the credit; number two, it's the indenture itself. We have to bear in mind that the issuer or their representative, this is true with nearly every publicly issued bond I know, drew up the contract. And so you better look out for Page 69, Paragraph 3, Subparagraph 1, Sub-subparagraph "a", that kind of stuff. What is there you don't know. 

And I guess I'd have to add a third one, depending on where you are on the credit spectrum and the level of rates, you have to look out for what is not written-down, but unfriendly moves by the issuer to coerce the holders to substitute their bonds for something else, in other words, adverse selection on the dynamics there.

Stipp: Dan, could you talk about an example that illustrates some of the tenets of your process, either a historical example or something more recent so that we can understand some of the steps you go through in making a pick?

Fuss: One of the best to see that was done in very large size was the situation, say, two-and-a-half years ago with a government bond. It happened to be the Irish government and Europay and 10 years or so maturity during the sell-off of the peripheral debt in Europe.

Now here the credit aspect is not so much going out and counting the number of widgets being sold per hour. It was more on the political side as to what would the European Central Bank do and how would the political process play out. But there was a mechanical aspect to it, in that, the bonds were held heavily by European banks, and they're worried about their credit that they would receive and what they would have to put up in the way of reserves. And there was worry about whether the credits would stay at investment-grade or go to BB+, et cetera.

Fortunately for us, and perhaps it reflects the fact that we're in Boston, we happened to have done a lot of work over the years on Irish government securities and corporate securities. So we had sort of a home-court advantage there, you might say, and we figured out that the securities depending on the level of interest rates were worth relatively EUR 1.03- EUR 1.04. Well they were selling mega points below that. So this is a case of standing in front of a herd of charging buffalo and trying to pick the right ones as they come at you. But you have to be a very good shot.

On the corporate side, when you get a similar situation, here I can't use the name, but if it coincides with a less liquid market, with no bid or a limited bid in the market, usually it's a limited bid, seldom is it a no-bid. And you have an adverse development with a corporate security and you have enough of them in what I would say fragile hands. They could be fragile because of their client base. They could be fragile because of outflows from a pooled vehicle, a mutual fund or something similar, or these days, and this is really new in the last six, seven years, they could be very popular in one of the indices, particularly high-yield mutual funds but to a much greater degree the high-yield ETFs, and they happen to get withdrawals.

Then by knowing the credit, being very much more than happy with the price, you can add a lot of value by bringing the bid. Now if there's no other meaningful bid, the obvious question is what if you change your mind? Who do you sell them to? You are the only bid. So you have to be ready. When you do that kind of buying, normally you say, "We are in this for four, five, six years." Sometimes longer, sometimes shorter. But normally you're going to be there for a full cycle while things play out.

Now once in a while, as I say, you get a surprise one way or the other. And if it's a negative surprise that would really damage the credit, you need to have a procedure in place. You need to have a team in place that can work with the analysts on the company to decide what to do. So you need that as your safety net. And on the positive side, it's the market itself that will handle it. That particular niche of activity happens to be something that we've been doing. Our corporate culture is a research culture, and we are very specific risk-focused people. So if you are specific risk-focused, you darn well better know your specifics and be able to deal with the changes that come in the future that were not foreseen at the time of purchase.

I'm giving you an inordinately long answer here, Jason, because right there I was pretty much summing up our process, insofar as it goes from idea stage to portfolio management to trading and it's a circular process. And that's critical.

For our process to be successful, it has to incorporate everything that a psychologist would look at in how human beings prefer to react and how they relate, and that you just never see in a write-up. So that's the answer.

Stipp: Dan, you mentioned some really interesting things there, and I think part of it involves the level of research. A part of it involves the patience and knowing how to be flexible when things change. Can you talk a little bit about why you think this process has worked so well over a long period of time?

Fuss: We've been very fortunate. We've assembled a good team of people, and we've been able to shift our focus to the areas of the market without letting go of our base knowledge. The real secret to what I think is something that anybody can copy and some people do, but maybe not to the degree that we do. And the degree that we do, we have been doing it for a long time, let me put it that way. And if you have on staff or the guy next door happens to be an industrial psychologist, he would understand or she would understand how it is that we manage this process because it's the people first and then that's how they interrelate.

This is run straight out of a Myers-Briggs textbook, if you're familiar with temperament. And because functions, even though many of the individuals wouldn't necessarily really, really fit a certain temperament profile, the function itself has a profile. The most obvious ones are research itself and the last analysis is perception. 

Now, a lot of work has to go into developing a perception. Let's keep it fairly simple here. You are dealing with a widget company, Mega Widget. Mega Widget is one thing. But you also have to know the industry. So you learn all the others. So you learn the industry from Mega Widget to Bezeweezee Widget, and this happens to be a global industry. Now reality is that you are going to know an awful lot less about a very good manufacturer in China than you do about U.S. Widget here in this country or Euro Widget in Europe. So you have to shade your credibilities.

But what you're doing is putting together a picture, a perception, of how the widget business, if there's a high degree of covariance within the industry--and there normally is much stronger than you might think--how that fits into the world today. And then within the widget business, how do those companies relate to each other and what will cause things to change, and what might cause other people to come into the widget business? What are the barriers? I can go on and on.

But it's a perceptive process. As you might tell from my voice, this is something I really feel strongly about and this is something that we integrated into our process starting in 1982. And the other extreme on this, just to stick with that characteristic or that preference, is an action one, a judgment one, and that's in trading. And how you handle the interrelationship between a strongly perceptive--a continual adding of information all the time at the increment--and one that is geared to action now--you buy or sell at this price--you need a buffer in between there. They have to relate directly to each other 80% of the time, but you need a cushion in there. And that cushion is what the portfolio manager and the people who work with the portfolio manager provide.

Stipp: For an investor in your fund, thinking about what they should expect from this fund, what should they know about when maybe the fund won't look as good or won't do as well, just so they can set the right expectations for how to use a fund like Loomis Sayles Bond?

Fuss: For Loomis Sayles Bond, the principal underlying cause of the ups and downs on a shorter-term basis is the liquidity in the market itself, mostly in the corporate market, but also across markets. When the market liquidity really goes out with a jolt, the best all-time example being, the fall of 2008, then, you don't get realistic quotes on the bonds, and the mutual fund has to price them every night. So you price them to the bid side, and there is no bid. So they are priced off large sheets of bonds where there is one known trade and whatever that trade was that's where the bid is for that and everything else in its category.

So in the fall of '08 for example, you had AAA, long corporates. Johnson & Johnson, for example, being priced down severely at the same time long Treasuries were going up. Long treasuries were trading. Long corporates weren't, and yet they are dealt with as a very marketable security. That provided the biggest bump on the downside and the best all-time opportunity to be a buyer. It was very good for the separate accounts and because it added a lot of value in the following years, and very scary for the mutual funds because people were picking up the paper in the morning and saying, oh my goodness, my mutual fund is down.

Fortunately in the fall of '08, you didn't have the amplifying effect of the ETFs that you have now. Now apart from that, take that one out, the other notable characteristic of Loomis Sayles Bond is it's seldom right with the market. It can move more on the upside. It can move more on the downside. It also goes up and down markets and down and up markets. So the covariance with the general bond market is lower than you find in most fixed-income funds, and also the covariance is lower relative to other funds of its nature, the multisector funds. So it is so issue-specific that apart from the liquidity function of markets, it moved sort of randomly. 

Now the benefit of that is that, if you're in a situation where dollar-cost averaging comes into play, if it's a monthly investment of type program, wonderful. If you are in a situation where you are going to put in the money once and take it all out at once and you have no idea when that's going to be, if it's in the next few years, not so wonderful. So, if you are putting the money in this year for the kid's college education next year, then that's not a real good idea. If it's for 20 years from now, yes, that's a real good idea.

So if you have a short-term focus and you want to look at the bond market for the next one year, then this is not a good idea. If you want to grow the principal and income per unit of original investment, this fund was designed to do that. It has done that, and I think our process is suited to continuing that.