Lynch: 'Active Management Is a Tough Business'

Gregg Warren: Hi, I'm Gregg Warren, senior stock analyst for Morningstar's institutional equity research business. I'm here with Dennis Lynch today from Morgan Stanley Institutional Growth Fund. He's been kind enough to participate in a panel discussion we’re having here at the Morningstar Investment Conference talking about the Ultimate Stock-Pickers.

Thanks for joining us, Dennis.

Dennis Lynch: Thanks for having me.

Warren: My first question here is a bit more broad, and it's looking at sort of the state of active management kind of where we are right now. It's been under pressure I’d say the past 10, maybe even 15 years. There is a secular trend towards passive that’s been around for at least the past few decades. The advent of ETFs and the growth of ETFs really started about a decade or so ago and really coincided with poor performance on the part of active managers. How as an active manager yourself, how does this impact your business? How do you feel, you need to change things or not change things in order to compete against this trend?

Lynch: Well, I think active management is a tough business. And if you look at the statistics historically there is only a very small percentage of active managers that are adding value over time. So it doesn’t completely surprise me that you've seen this trend emerge, and really for most people active management might be a challenge because there is going to be some volatility relative to benchmarks that comes with it, even when you are successful. You are going to have periods of time as an active manager where you are not doing well. It's hard for people to live through that. So I think that, I understand why it's happening. It doesn’t necessarily change anything we do in terms of our approach.

We are going to continue to be long-term active in the sense that we have portfolios very different than the benchmarks. We're still very much focused because we have a lot of skin in the game in our products. Our team has most of its--I personally rather have most of my equity exposure through our products. So, I think if you have the right combination of factors and long-term active and high skin in the game, I think active management there is place for it, for sure. But I do see why relatively speaking you have seen this trend given the overall industry results.

Warren: As we move forward the expectation is that passive is going to continue to grow; it's going to continue to take up a bigger piece of the pie. That just seems to be the trend line that we are on right now. Do you think that this is going to knock out a lot of say, closet indexers that have been out there hugging the benchmarks and maybe even make your job a little bit...I don’t want to say easier, but affords you opportunities to find better stock ideas, when there are dislocations or disruptions in the market?

Lynch: We are not sure, is the answer. I mean, the landscape's changing, and I think there is an argument to be made like you just suggested, that maybe that creates opportunity. One could also argue that getting rid of some of the people that aren’t doing as well, makes the overall opportunity harder in a sense because now you are competing against a more efficient--generally more efficient industry. So I'm not really sure what I think there yet. I am still trying to figure that out. But we're basically going to stick to our approach, look for companies that are highly unique, collect them, and hopefully own them for many years when we are right. And hopefully if we are able to do that with our strong incentives I think, we'll still be able to attract people to our products.

Warren: OK. Now you've put up some pretty impressive numbers historically. I think your 10-year annualized return at the end of last month was about 200-some basis points above the S&P 500, I know you use the Russell as a benchmark as well, but it has also been beating that. Your three- and five-year numbers are still fairly solid even though your nearer-term results have been a bit more difficult. Let's think about what's happened, I mean the first quarter was pretty much a big disruption in the market given the impact from global. What was really sort of driving the variance in your performance there? And how do you feel your portfolio's positioned--I mean, it seems like within the large-growth category it does tend to have a bit more volatility, but it's still generating great returns over the long run.

Lynch: Well certainly in the recent past and particularly in the first quarter I think there has been a general preference I think among investors and market participants to focus on stability and low volatility. If you look at year-to-date at the ETF flows and the fund flows, they are very much skewed towards those kinds of what people call factors. And I think I am not exactly sure what prompted the sort of dramatic sell off in high-growth companies in particular in the beginning of the year. But that can happen from time to time; it can happen with high-growth companies. It can also happen with what are perceived to be stable companies. And I think that this is sort of ultimately this trend towards stability and low volatility is really a reflection of the 10-year bond being so low and people looking at equities as a substitute, which is a little dangerous. Because equities have more downside I think, certainly through volatility.

So I think that’s the current trend, that’s the predominant market trend. I think we saw a pretty big sort of hiccup in the high-growth stocks in particular earlier this year. None of that changes how we look about at the companies, whether we think they are attractive fundamentally or from a valuation standpoint and ultimately during a window like that we actually did add to a few ideas on the margin because of that market volatility. And I think that ultimately if you are going to be an equity investor you've got to accept some volatility. And I think the general preference towards low volatility and perceived quality might be a little dangerous, because there is nothing worse actually than thinking you are being safe and having it wind up not be safe.

In the 2008 timeframe, I remember we took a hit for a few months in particular, and it was really brutal to live through, and we talked to some of our clients and they weren’t as focused on that--they were actually more focused on the fact their bond portfolios were down dramatically and those weren’t supposed to go down. So I think there is a little bit of that dynamic playing out in the equity markets right now. We think that’s leading to opportunity more in some of these higher-growth ideas and maybe that’s starting to change in the more recent past. You are seeing some strategic and financial takeouts, acquisitions of some of the companies that have really underperformed pretty significantly over these last few years in the kind of high-growth software and Internet areas, some of the smaller and mid-cap type names.

Warren: OK. Well, it's interesting, too, because I had a conversation with Steven Yacktman earlier who is also on the panel and we were talking about where consumer-staples stocks are right now and they would be sort of that--they are low volatilities, but looking at where the multiples are right now, they are at pretty much at historic highs. And there is going to be reversion of the mean once risk-taking increases in other parts of the market.

Now, when we look at your portfolio overall, you've got Internet-oriented names like Facebook, LinkedIn, Twitter. I think they are about 40% of your total portfolio at the end of last year, you also have sort of disruptive companies like Amazon.com or Tesla in there as well. Now these are all sorts of businesses that either have a shorter track record or are still growing in fits and starts in different ways. How do you, or I should say, do you try to sort of balance out your weightings in these kinds of names with names that may not be as volatile when you are sort of looking at it from portfolio-construction perspective?

Lynch: I mean certainly when you look at those names they jump out at you because they tend to be either controversial or exciting to some people, and depending on where they are trading we may or may not be interested in them. Certainly we think they are attractive enough to own at this point in time. But over time what we try to do is have a balance between those kinds of ideas, where we think there is maybe little more risk but there is really big upside and as well also own what we would call established franchises that have little more stable-type qualities, a little more like in some of the cases consumer-staples or services-type businesses. But one thing I'd point out there, too--so I think over time we try to do a balance. We try to have a balance in the portfolio between those kinds of ideas, established franchises, and what I'd call those high-growth companies, emerging franchises.

But you also have to be aware where the opportunity set is, and we are pretty forward-looking, and we still think that some of those areas are very interesting and I think overall the idea of Internet as a category has some limitations to it. Amazon and Facebook are very different types of companies or even this concept like last year's FANG. It's very--the media likes to come up with and create sort of almost short-term correlations in companies that often don’t necessarily have real fundamental correlation but have, they are doing well simultaneously. And so when we look overall we're thinking not just about whether we own Internet but what some of the true end markets that those companies are tackling represent, and then we also try to be on that. I think the number of names that have in that area seems almost a little overstated because it would be very different if we own, let's say, 40% in Home Depot and Lowe's.

Then you'd say, OK, whoa, wait a minute--you have a really big bet here on kind of one end market in a very specific spending area of the economy, versus maybe having some exposure to consumer spending in retail through Amazon and also increasingly for Amazon exposure to corporate spending and IT spending, or Facebook through being exposed to advertising. Some of those other companies, cars being some of end markets, auto being an end market of one of the companies you just mentioned. So they all have very different end markets and I think that that’s important to understand as you sometimes lump together the high-growth or the sort of the Internet. I think we are more focused on five years from now, are these going to all do well for the same reason, or are they going to have very different outcomes for different reasons? I think most of them still have that capability based on their fundamentals.