Jason Kephart: Hi, I'm Jason Kephart, senior analyst on Morningstar's Multi-Asset and Alternatives Research Team, and I'm joined today by David Giroux, portfolio manager of T. Rowe Price Capital Appreciation, a fund that's been on a Joe DiMaggio-like streak over the last decade. It hasn't finished worse than 29th in the category over any single year over the last 10 years.
David, thank you for joining us.
David Giroux: Thank you. Thank you for the kind introduction as well.
Kephart: David, let's start with just a quick recap of 2018. It was a very difficult year for asset allocators with bonds kind of struggling in the first half of the year, and the fourth-quarter stocks jumped off a cliff, but your fund was able to hold up and actually make a little bit of money when most funds were down around 5%. So, what worked?
Giroux: Well, there's probably a couple of things that worked. One, obviously, we came into the year in 2018 being more conservatively positioned, so we're between 500- to 1,000-basis-points equities, and that actually helped the performance quite a bit. And then I see in Q4 when the market fell off, as you mentioned, Jason, we were able to go overweight equities, actually on Christmas Eve, and get the portfolio positioned well for the upturn we had in '19 so far. You think about what really went right, though, is early in Q1 last year, we made a big call on utilities. Utilities were really out of favor. Everybody thought the 10-year was going to go straight to 4%. We made a 600 basis-point overweight in utilities in Q1. We took that to 1,000 basis points by the end of Q3, and so, while the market from Q1 to Q4 was obviously down a lot, utilities were up a lot. It was that big utility bet was a big contributor to our alpha generation last year.
And, I'd also say the other thing is we added to Treasuries last year. We added Treasuries opportunistically, and obviously Treasuries having a positive return actually aided our bond portfolio last year as well.
Kephart: And so with the market rebounding so strongly this year, present or current weakness kind of aside, is it time to say, "Thank you, next" to utilities or do you still see value in that sector?
Giroux: We see a lot of value in utilities on a long-term basis. Now, they're not nearly as cheap as they were in that February-March time frame because the geopolitical economic environment is clearly changed, so they've been revalued up from 15 or 16 times to 20 times, but I still think utilities, especially relative to consumer staples, are a compelling long-term investment. What you're seeing in utilities is a really powerful flywheel developing where you're closing down a coal plant and you're replacing with a wind plant, and that is a positive benefit for customers. It's a positive benefit for weight-based growth, earnings growth. So you're seeing utilities that used to grow earnings consistently like 2% to 3% a year, now growing earnings 6%, 7% per year--almost in line with the market on a long-term basis with almost none of the downside risk.
So I would say, paying 20 times for utility when the market is 17 or 18 times earnings, 10% premium to the market, basically, it's almost the same EPS algorithm plus the dividend yield, and you have almost none of the downside. You have no FX risk, you have no secular risk, you have no FX risk. I still think utilities on a long-term basis are very good. We still have a 600-basis-point overweight, but nowhere near the overweight we had going into Q4 last year.
Kephart: Are there any other areas of equities that are more attractive on a valuation basis?
Giroux: You know, it's a good question, and I usually would have a good answer. Unfortunately, there's not really one any sector that looks compellingly attractive today. So, our largest overweights today are healthcare, utilities, and industrials. But if you look at industrials, it's not like we're making a call on industrials. It's a situation where we have a big bet in GE. We're really betting on the turnaround that Larry Culp's going to deliver there, we believe. We also own S&P Global, which is not really an industrial--It's an industrial business services company. So if you take those two companies out of industrials, you're really not overweight in industrials.
Healthcare. We like healthcare. We've liked healthcare. It's been a huge source of alpha-generation over this 10-year period that you talked about earlier. I'd say valuations are attractive there, but outside of maybe Becton Dickinson, I don't think there's anything incredibly attractive right now in healthcare. But still, it's a good relative place--a place you want to be on a long-term basis.
Kephart: And on the bond side, with the yield curve kind of flat and kind of flirting with inversions, what does that impact for the corporate credit market, and how's that affect the bond side of the portfolio?
Giroux: That's a great question. I'd say two things. Now that the yield curve is relatively flat, to your point, what we have done is we've taken all those longer-duration Treasuries we'd bought that have appreciated quite a bit. We actually shortened the duration of the portfolio. And another thing, again, at the end of last year, high-yield spreads were above normalized levels. I think they reached almost 600 basis points at one point. Even IG credits were trading more like in the midpoint of their long-term cycle. So, we added aggressively in Q4, not only to equities but high-yield, leveraged loans, and IG bonds at the same time.
Now what's transpired between December and kind of the first quarter of the year is spreads have come in a lot. So we've seen a lot of those investments actually have appreciated quite a bit on the IG and the high-yield side as spreads have converted. So the playbook we do is if spreads come in, you want to lower the duration. So your risk is actually a lot lower. Obviously, you have a 10-year instrument versus a three-year instrument. If spreads go up 10 bps, three years maybe gets hit a lot less hard than a 10-year instrument. So we've really lowered the duration of the bond portfolio. The portfolio duration was more than five years going into Q4 of last year. And I think right now we're like three and a half years and probably going lower.
Kephart: And for the rest of the year, your outlook--do you see more volatility, or do you want to stay more on the conservative side overall at the portfolio level?
Giroux: Yeah, we really have. We were at 63% equity exposure on Christmas Eve, and as the markets rally all the way back almost to all-time highs, we've basically taken that down from 63% to about 57%. But having added a lot of high-yield and IG in the meantime as well on the short duration side.
So when we look at the market today, we say the market is 16 times earnings on 2020 earnings, very, very late cycle, not that attractive. And again, I think one of the things people get wrong about valuation is you have to look at valuation in context to where you are in the cycle. So, 16 times 20 doesn't sound that bad, right? But the market, when it peaked in 2007, was at 15.5 times forward numbers, and the market fell almost 60% peak to trough. The market was at 20 times earnings in 2000-2003, but it was on 20 times trough earnings and the earning in the market doubled over the next four or five years.
So, 16 times late in the cycle is not necessarily a good sign. It's actually probably a negative sign, if you will. I think the combination of the benefits in tax cuts starting to wane a little bit, the fiscal stimulus starting to wane a little bit, and maybe a little bit more political uncertainty as we go into 2020 as well, and, obviously, the European economy seems to be on the verge of a recession as well--it's just not a great backdrop for risk assets in general. So that's why we have a more conservative position. Again two of the sectors we're most overweight are more-defensive sectors. I'd also say that again, we've taken the duration of IG and high-yield down in the portfolio to really minimize risk if you will.
Kephart: Great. Thank you very much for your time.
Giroux: My pleasure, thank you.
Kephart: For Morningstar, I'm Jason Kephart.