Our guest this week is Joel Tillinghast, portfolio manager at Fidelity. Joel manages a number of equity funds focused on intrinsic value and mostly small-cap stocks—perhaps most notably, the Low-Priced Stock Fund, which he has managed since 1989. Joel originally joined Fidelity as an equities analyst in 1986 after famously cold-calling Peter Lynch to secure a job interview. He earned his bachelor’s in economics from Wesleyan University and MBA from the Kellogg School of Management at Northwestern and is a CFA charter holder. Joel’s track record is simply impressive. Morningstar recognized him in 2021 as Outstanding Portfolio Manager and in 2002, as Domestic Stock Fund Manager of the Year. After more than 40 years in investing, Joel is slated to retire as a full-time portfolio manager at the end of 2023. We’re so excited to host him on the podcast today to discuss his career and his insights.
Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing, by Joel Tillinghast
Value and Small-Cap Investing
“Don’t Judge a Stock by Its Price! That’s one of Tillinghast’s Stock-Picking Secrets,” by Anupam Nagar, economictimes.indiantimes.com, April 17, 2021.
“Happy Results Turned Up Everywhere You Looked,” by Tim Gray, nytimes.com, Jan. 17, 2020.
“Peter Lynch Protégé Joel Tillinghast: How to Avoid Value Traps,” by Johnny Hopkins, aquirersmultiple.com, June 25, 2018.
“Fidelity’s Joel Tillinghast Was Out of Favor. Then the Meme-Stock Craze Happened,” by Justin Baer, wsj.com, Aug. 4, 2021.
“5 Traits of Successful Investors,” by Joel Tillinghast, oprah.com.
Adam Fleck: Hi and welcome to The Long View. I’m Adam Fleck, director of research for ratings and ESG at Morningstar Research Services. I’m filling in this week for Jeff Ptak.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Fleck: Our guest this week is Joel Tillinghast, portfolio manager at Fidelity. Joel manages a number of equity funds focused on intrinsic value and mostly small-cap stocks. Perhaps most notably the Low-Priced Stock Fund, which he has managed since 1989. Joel originally joined Fidelity as an equities analyst in 1986 after famously cold-calling Peter Lynch to secure a job interview. He earned his bachelor’s in economics from Wesleyan University and MBA from the Kellogg School of Management at Northwestern and is a CFA charter holder. Joel’s track record is simply impressive. Morningstar recognized him in 2021 as Outstanding Portfolio Manager and in 2002, as Domestic Stock Fund Manager of the Year. After more than 40 years in investing, Joel is slated to retire as a full-time portfolio manager at the end of 2023 and we’re so excited to host him on the podcast today to discuss his career and his insights. Joel, thank you for being on the podcast today.
Joel Tillinghast: Thank you for having me.
Fleck: Joel, when I think of the most successful fund managers, your name is absolutely on my short list. You’ve had a very impressive track record beating the market for nearly 35 years, running the Low-Priced Stock Fund. And my first question is, what do you think has driven the mispricing of stocks over that time? What did the other investors most often miss that allowed you to buy names for such low prices in your view?
Tillinghast: So many investors get caught up in the short-term outlook and don’t think at all about what a company is worth. If you looked at analyst notes you’d think that analysts only think about competitive positioning and barriers to entry with an immediate view, and there’s a lot of social pressure to invest in larger-cap, flashier stocks that are well-followed and are doing exciting things for financial TV.
Benz: A related question is Peter Lynch famously said or suggested that individual investors should focus on those companies that they know and invest in companies that they know. Would you say that that is good advice today?
Tillinghast: I’d say that is evergreen superb advice. Most financial disasters come from not knowing what you owned.
Benz: So that’s the starting point, right? It shouldn’t be the ending point.
Tillinghast: It is the starting point and even professional investors who’ve been working a long time discover, “I didn’t really know that.”
Fleck: It’s one of the hardest things in investing, I think, is to know which rocks to turn over and which ones are most important. I’ve heard it said as well that sometimes investing in the boring names is where you might be able to find value, and you mentioned obviously analysts being attracted to the flashier names and maybe your rockstar status as an analyst can be cemented there. But have you found that to be true as well, is that those boring names that sometimes people aren’t turning over the right rocks?
Tillinghast: Yeah, I think they’re more inefficiently priced and a lot of investors want instant gratification, even professional investors. So, it’s a place where good analysis can really pay off.
Fleck: Do you think as information has proliferated, we’ve got more mandatory disclosures, we’ve got online access, information on the internet, lots and lots more people sharing that information and increasingly a capability to manage big data sets and analyze that. Has that made it more challenging to be a value investor to find those mispricings in the last 10 or 20 years?
Tillinghast: Having more data is a good thing in principle. It’s a great thing in principle for all types of investors, especially value investors who like to think that we’re data-driven or fact-driven. The problem is a lot of the data, and even a lot of the analysis is trivial and ephemeral. So many analysts are incredibly distracted, and so are so many portfolio managers. They get numb to the fact that they’re not spending enough time thinking about the competitive position of the company, thinking about what a company is worth, thinking about the quality of management, or whether it’s like the baseball game where they’re better players, but if they just made a great play, then they’re a great player and if they made a crappy play, then your all-star player is a bum for now. So, more data is good but combating distraction and focusing attention on the important things is really the most important thing.
Benz: As you reflect on mistakes that you’ve made over your career, can you highlight one or two mistakes that you made, but that you learned from to become a better investor?
Tillinghast: Don’t be cruel, but you’ve got to be cruel to yourself so you don’t do it again. HealthSouth rehab was the biggest mistake that I ever made in terms of cost. HealthSouth was a rollup of a bunch of rehab clinics headed up by a charismatic guy named Richard Scrushy. The stock was trading at 10 or 12 times analyst-adjusted earnings. But the GAAP earnings were maybe a tenth of the analyst-adjusted earnings and the free cash flows were kind of not there. And so, my takeaway was look at free cash flow, look at GAAP earnings first. And some of the adjustments are valid. And if I see free cash flow that looks like analyst-adjusted earnings, I’ll believe that, but most of the time you have to say do I really believe these adjustments? If the company has had nonrecurring adjustments in 10 of the last 10 years, are they really nonrecurring, are they going to stop whatever it is? So, look to free cash flow was a conclusion from HealthSouth. And don’t invest with bad guys. It turned out that HealthSouth was cheating the government and Scrushy sold his stock back to the company in an off-market transaction just before they reported disastrous results. Like what kind of fiduciary duty is that? Doesn’t get a high rating in my books, but I’m cranky because I lost a bundle of money for the fund holders, which includes myself.
Benz: I’m curious, did your instincts flash a warning signal before the company really hit the skids?
Tillinghast: There were yellow flags that one of the investor relations officers had been an actor on a TV show called The Wonder Years. They had great parties for the employees with a band that Scrushy played in. Seeing the cash flow statements and I saw that there wasn’t the kind of free cash flow that I wanted but didn’t weight that back as much as I should have.
Fleck: Yeah, certainly a situation where yellow flags became pretty glaring red flags, eventually. I’m curious—you’ve called this out before in some of your writing about ensuring you’re investing with good management teams. And I think that story is a terrific one to highlight how it could all go wrong. How do you, when you’re approaching a potential investment, find those yellow or red flags? How do you determine whether a management team is really good or not?
Tillinghast: It’s always a subjective judgment. I start with track records and especially look at their track record over a business cycle during recessions because that’s when bad stuff is going to come out. Bad stuff can come out anytime, but it especially comes out in recessions. The other thing to do, is look at their investor presentations and annual reports. You think not enough people, even Street and Fidelity analysts read the annual report enough. In the presentation and annual report, are they thinking at all about how to build a competitive moat? How to build a great company? Are they trying to protect against risks that are not on the immediate horizon? So even though it’s sort of fantasy now, it’s a good sign if they have a thought about what will artificial intelligence do to our business, even if they’re not an IT business where, this is right upon us.
Benz: I’m curious, are you asking and looking at companies specifically through that lens? Like, is this a company that is vulnerable to AI, what are its defenses against AI?
Tillinghast: I’m starting to, but I really want a management that doesn’t get caught up in the, “Are we going to have a recession or are we not going to have a recession?” But saying “If we have a recession then this is what we’ll do and this is how we’ll cope and this is how we think it will affect us.” Because I have no edge in telling you whether there’s a recession and most management teams have no edge other than high-frequency data, which everyone gets at the same time. Are they thinking about things before controlling risk before? Silicon Valley Bank should have been thinking apparently about liquidity, and they really should have been thinking about asset liability management. And if they had a better-quality Treasury department—like JPMorgan, by reputation, does—they would have noted that in the ‘80s, hundreds of banks and savings and loans went under because they had mismatched asset liabilities and there was a whole industry of asset liability management, and it was a glamor profession. In fact, I was involved in that before I came to Fidelity.
Fleck: Those who don’t read history are doomed to repeat it, is the old adage.
Tillinghast: But you can tell a management because if they get totally lost in thinking about what if and if they come up with focus on how do you make a great company or conversely, how do companies in your industry go bankrupt? Obviously don’t do it, whatever that is, don’t do it. It’s my best question for judging management qualities. Sometimes they tell me things that I hadn’t thought of, although sometimes it’s a startling grasp of the obvious with retail stores, if you lose track of customer preferences, then you’re toast.
Fleck: Absolutely. It’s interesting thinking about not just the quality of management you mentioned there, the moat, the competitive advantage. And you’ve talked about how we’re in an inflationary macro environment, but I think really in any environment you want to try to find businesses with that moat, with pricing power. What are some of the hallmarks you look to when you’re trying to determine if a company will have that pricing power over time?
Tillinghast: Companies with the best pricing power offer something that is unique and do not make a market price commodity. It’s hard to find a substitute for them. Pricing power also comes from people thinking that’s a great value.
Fleck: More like the Costco argument of pricing power.
Tillinghast: Yeah, the Costco where people who have large families, look at Costco and say the membership is this and they save hundreds of dollars every year, and sometimes get better quality.
Fleck: Yeah, and that membership fee covers their margin.
Fleck: Brings up their margin, absolutely.
Tillinghast: Or when I was paying $10 a month for Netflix, I thought, this is amazing. I don’t like all the programming; in fact, I don’t like a lot of their programming, but $10 a month, that’s a bargain. How much of their pricing power have they used up? That’s a question for an analyst to answer whether there’s more to go for from the current increase. You want something that customers think is a great value that’s unique and distinctive.
Fleck: And I guess in that way brings me right back to, Christine, your point about investing in what you know and investors often know what that value is and what they’re willing to pay for and that’s good insight to have.
Benz: Wanted to ask about small-value stocks, specifically periods of rising interest rates, like the current one, have historically been beneficial for small-cap value stocks. Is that historical macro environment something that enters your mind as an investor or is that just a backdrop for individual-level analysis?
Tillinghast: Like most people, I like to see things that confirm my view, and so I love the thought that small value’s time is approaching or we’re in it. The thought that higher interest rates compress PEs and the already-low PE stocks get less compression. I think that’s generally true, but it’s very episodic, unless you’re shifting asset classes. If Contrafund decided that small value is the place to be, I don’t know how he would execute that.
Fleck: Yeah, I think that’s fair. While we’re on the topic of fund management, the Low-Priced Stock Fund has seen relatively stable management fees in recent years, and that’s something that you’ve talked about and something certainly that’s pressured the industry. I think it’s only down a couple of basis points even over the past five years. When you exclude out the performance fees, where do you expect that to go in the future? Is there continued pressure, do you think, on active fees? Is there a natural bottom or is this a never-ending race for efficiency in your mind?
Tillinghast: I would expect fees to continue gently down. There’s economies-of-scale arguments that I think are fair. I don’t think fee increases can be justified unless there is visible proof that this has it all over passive and as a group they don’t. What’s amazed me is how high private equity, and hedge fund, and all the other chic things that the Ivy League endowments go for—how high the fees are. The Ivy League needs a Jack Bogle moment.
Fleck: On that point on active versus passive, I think you’ve said in the past that taking a long-term holding in passive is buying a slice of ignorance. You’ve also said, of course, buying index fund might be a reasonable thing for many people to do that don’t want to dig into individual stocks. But we’ve got a lot of advisors listening who would probably like to know your thoughts as to what should drive the decision for investors to own a broad market index fund versus an actively managed fund.
Tillinghast: How much attention are you willing to give to investment management? If you just want to check in every month or every quarter, an index fund might be the best idea for you, and all I can say that would be value added is: try to save enough, try to save more. If you’ve identified a good manager who can add value, I think that’s a small edge. But not everybody is able to or wants to identify a better manager or better stocks; it depends on what you want to spend your time on. If it’s not how you want to spend your time, the index fund is a great idea. If you’re willing to do more work to find things where you have a bit of an edge, then I think it can be rewarding.
Benz: Do you think it’s reasonable for investors to blend the two where perhaps they say well for x percentage of my portfolio, I’ll just go with a cheap index tracker and then pick my spots where I’m adding an active fund where I think the manager has a better shot at adding value. Do you think that’s a rational way for advisors to approach portfolio construction for their clients?
Tillinghast: I think it is. I think also it depends on what asset categories the advisor is talking about. If you’re talking about small caps or risky credit, that’s a terrible place to have an index fund. I do not want a credit index that gives higher weights to the most over-indebted companies—that seems wrong to me. There are so many cash-flow negative companies in the Russell 2000 that I think it really rewards an active approach. But not everybody has to have risky credit or small caps. And so, it also depends on what asset classes you’re talking about.
Fleck: The fund, the Low-Priced Stock Fund, obviously as you’ve sifted through a lot of those small-cap stocks, I think by necessity has to have a large amount of holdings given the size of the fund and by last count there’s more than 800 stocks in the fund. How do you avoid as you buy that many stocks, diluting your best ideas when you have more than 800?
Tillinghast: Every stock that gets purchased has something intriguing. It’s usually statistically cheap valuation or a differentiated competitive position. Sometimes more rarely, it’s just a management team—wow, they’re good. I buy incrementally. I don’t think that I’ve ever bought—except maybe on an IPO or a deal—25 basis points of one security in one order, or it’s a very short list. It’s usually incremental where I add more as there’s more information. I use the small holdings to level-set for subgroups so it can spot the most appealing holdings in somewhat homogenous groups like energy or banking and maybe retail. I try to narrow the field, but also to level-set. This is what a regional bank looks like and this is what a better regional bank looks like. I try to migrate toward the better ones in the group. And it’s shades of grey, because all the banks make loans—except maybe Silicon Valley Bank, so they did do that, because that also got them into trouble. All the banks take deposits and so what’s a good bank? Well, the income is good, but that can be cyclical. So, it helps me level-set. Am I diluting the holdings? If you compared the largest 10 holdings in the fund, they are larger cap, but the weightings of Low-Priced top 10 are probably the same or higher than many small-cap and midcap funds. And if I think a stock is great, it’s not diluting it, it’s part of the process of sorting out what does a good bank look like? What does a good energy company look like? And they want it to be bet on. This is a good energy company or a good bank rather than gas prices are going up, they’re going down; interest rates are going up, they’re going down.
Fleck: Yeah, the nature of long-term holding—certainly I think that’s really important. That’s a very fair point.
Tillinghast: They were worried that it was diluting the best holdings. Actually, I do think that at the top it’s more concentrated than many small-cap funds, midcap funds.
Fleck: I think it’s a very fair counterpoint. Absolutely. And to your point, it sounds like there’s a lot of mosaic of information that comes from following that many companies as well, where you can tap into the knowledge of different management teams, different information that you’re seeing, and I think maybe that goes unnoticed by many who are just looking at the sheer number of companies.
Tillinghast: Another California bank might have said we don’t know what to make good Silicon Valley’s credit underwriting, although they also said they couldn’t compete with them on the relationship that they seem to build. So, I took no action either way on that, but sometimes you do turn up information, foreshadowed some of what happened.
Benz: I wanted to ask about the business of keeping tabs on the holdings in the portfolio. You have a large number of stock holdings and you also typically maintain some non-U.S. stock exposure and you tap into a huge team of analysts, more than 100 people supporting the fund around the world. So how do you ensure that the analysts are channeling your way of thinking about things?
Tillinghast: The Fidelity analyst job is really difficult because portfolio managers have different approaches and they have different time horizons and analysts have to serve them all. Sometimes I wonder whether I could do the analyst job today because there are so many portfolio managers to serve, whereas for me, serving Peter Lynch was job one, serving Bruce Johnstone was job two. Then there were half a dozen other portfolio managers who were very important and I tried to do my best for them also, but it was a much shorter list than we have today. Once the analyst understands different perspectives, they find the approach that resonates with them, and I think that that’s critical. They’re looking in and saying you’re a value investor and momentum makes more sense to me but here’s the facts that you need. And I try to push them to think longer term; I try to push them to compare price with value; I try to push them to or show by example that the best way to have a CEO meeting is to start with a strategy question and not ask about the quarter. And, in fact, save that for the CFO even if the quarter is catastrophic or awesome, start with the strategy that caused the catastrophe or boom time.
Fleck: It’s a really great point. And you mentioned working with Peter Lynch, of course, and going back to that point, in your years working with him what do you think was the most important lesson that you learned?
Tillinghast: I learned so much from Peter and I think some of it is: be curious; be open-minded, always; be skeptical enough to spot your mistakes; be flexible enough to fix them quickly; and there’s no shame in making mistakes. I think there’s no shame in making mistakes as long as you recognize them and fix them.
Benz: When you think about your own influence on the firm and the people who will be there after you’ve retired, what do you hope your main lessons will be for them?
Tillinghast: I don’t think everyone will take them, but I’m hoping that Morgan and Sam especially will absorb that. Stick to the long view; compare price with value; think about risks that are not immediately in view; favor founder-led companies that offer something that customers think is very valuable. Dare to explore companies where management doesn’t give much guidance and where there aren’t many analysts. I think a lot of analysts are afraid to go where the management doesn’t spoon-feed them and the Street isn’t there to say, “3.45 is the consensus number.” Don’t hold too many highly path-dependent companies, especially if they don’t have moats. I hope that they’ll take some of that, especially take the longer view. We have an internal rating system and one thing that I advocated that we have is long-term winner where they do try to identify superior companies that will turn into compounders.
Fleck: It’s an interesting point. We’ve seen so much recently of that long-term versus short-term, maybe most highlighted by the meme GameStop situation. I know you were a holder in GameStop before all of that. Do you think that was a lesson for younger investors, that they need to be longer term? Or do you think perhaps those younger investors, are you worried they might not have the patience to actually hold some of these and really dig in?
Tillinghast: Patience is always the exception, and not just among younger investors. I have a shorter personal attention span than I had before social media and Outlook notifications. And I think more reflective investors of all ages will see the frequent trading on no information produces terrible results. And they’ll ask why and what they can do to fix it, and they’ll find an approach that works for them. The part that I worry about more generally is company managers who get caught up in short-term stuff and neglect the strategy.
Fleck: Not so much perhaps the investors, they’ll figure it out. But if it bleeds into feedback to the managers, now they have trouble of destroying value, perhaps?
Tillinghast: The Darwinian approach that overstates the matter is if you do stupid things with your money, you’ll lose it all and you won’t be a factor. Unless, as PT Barnum said, there’s a sucker born every minute. But I think most people don’t say I’m going to do something stupid. They try things and figure out what works. And I think the reflective ones will see trading all that much takes so much effort, it’s hard to have an edge; try a different approach.
Benz: You mentioned a few years ago, we talked about artificial intelligence earlier, but you mentioned that you’d be interested in an artificial intelligence product too: “Tell you more about potential management and business resilience.” As AI and machine learning have evolved, have you found these tools helpful as you expected? What do you view as the potential for further contribution?
Tillinghast: I’m fascinated by artificial intelligence. Any tools going to depend on the database used to train it, and mostly these are numerical not qualitative databases and so the answers to qualitative questions have tended to disappoint. Language models don’t do original research but try to summarize the conclusions of research that somebody has already done. An example that I can give—while trapped at home, I found that I really liked Perry Mason, and it occurred to me that a lot of the clients, but especially a lot of them murderers, were women. And I asked the artificial intelligence ChatGPT, how many of the murderers on Perry Mason were women? And it said there is at least one, but most murderers are men, which is statistically true.
Fleck: But not on Perry Mason.
Tillinghast: Yes, but they really couldn’t answer that because nobody has gone through and tabulated of the 260 episodes the murderer was a woman in however many cases, and the Perry client was a woman in however many cases. And there isn’t a database that has them. Even IMDB doesn’t tell you this is the solution. So, for tech things like that, ChatGPT is not very helpful. I enjoy playing with ChatGPT because it’s like talking to a glib Harvard graduate who doesn’t care that much about the truth but does say some fascinating things. As long as your crap detector is on, it’s great. But I worry about people who don’t have the crap detector and I worry about using it to set policy where you’re talking about people’s health or their life savings, rather than how many female murderers there are on Perry Mason.
Fleck: It’s certainly in the wrong hands. I think that’s the biggest fear now and maybe as we get into even perhaps generative AI, where it can start to make its own conclusions that it’s drawing, it’s going to be really difficult, I think, to be able to tell like you said, what’s crap from fact and how much of that might build up over time and start to feed the model itself. It can be a little bit scary to think about.
Tillinghast: And sometimes you have to train it to do the steps, where if you’re trying to estimate the future earnings of a company, most human analysts will start with the sales forecast and estimate the costs and arrive at an earnings forecast. But AI model doesn’t know that you should subtract cost of goods sold and SG&A from sales. They separately derive them unless you instruct them to. So sometimes you have to order the questions in order to get it to answer your question, and sometimes it still can’t.
Fleck: Let’s get out of the land of AI where we spend a lot of time there. Let’s go back to the investing landscape. You’ve noted before that an increasing feature of the American economy is that it’s become a winner-take-all oligopolistic type of market. Is that something you’re you’re still seeing and, if so, what does that mean for small-cap investing?
Tillinghast: It makes it harder to find great investments in small-cap universe. I guess the only positive side that I can see is if you find one of those winner-take-all early, the winnings can be a lot bigger. There’s a longer tale for that, but there were a lot fewer of them, speaking my biases, I don’t think that’s good for the American economy, but I can’t affect that so I just have to live with it.
Fleck: You mentioned a few of them too—you’ve seen a number of public companies fall dramatically. Is that something that you expect to continue as well? The private markets have become more liquid, easier to invest in. Has that made your job more challenging as well?
Tillinghast: Private equity has lower reporting and regulatory requirements. It accepts much higher leverage than public companies. It doesn’t have to be continuously valued, which is marvelous for people who don’t want to be mark to market, which is a lot of people as Silicon Valley Bank showed. My personal guess is the ship won’t go much further. One Ivy League endowment, public American Equities, are just 2.25% of the endowment assets. So small caps are a niche asset within this niche asset class. For comparison, the university holds about 10 times as much as that 2.25% in leveraged buyouts, and they also hold about 10 times as much in venture capital. The horse is already out of the barn. It could continue because the lack of marketability is a continuing draw. The lower reporting requirements and ability to take higher leverage, I was hoping that it was the only good thing to come out of the SPAC boom, which otherwise was like, hold on to your wallets.
Benz: Has that universe of nonpublic companies had to be part of your due-diligence process increasingly, have you had to keep track of some of the companies that might be competitors to the companies in your portfolio?
Tillinghast: Sometimes, but it is harder to get them and to get information about them unless they have public bonds. So yeah, it’s kind of hard, and since Fidelity gets approached on a lot of private placements, which I generally don’t participate in, but that can be a useful thing.
Fleck: Just from an information perspective, give you a bit of an edge there. You said a couple of years ago that you didn’t consider yourself very good at investing in momentum stocks. We’ve talked a bit about momentum stocks today. As I see it, one of the hardest things as an analyst that I’ve ever thought about, or even as an investor, is when the stories have played out and it’s time to sell. So maybe you could walk us through how you make that decision. Is it purely valuation based or are there other considerations as part of that?
Tillinghast: I don’t think people use the same discipline in selling that they do in buying. I don’t think that they always use the same process when they make buy-and-sell decisions. People who I worry about most are the ones that don’t have a consistent process, haven’t thought about what is a consistent process for making buy-and-sell decisions. Decision rules are going to contradict each other to overstylize. A momentum investor wants something that is getting better right now in a very showy and public way— awesome standing ovation from the bleachers. And someone who is a good momentum investor says that the best part is once the stock is well past fair value, where they know that it’s worth a third less, but things are just so awesome that nobody cares about that for that moment. Momentum investors, the very best investors often sell something that’s excellent to make room for something spectacular and there’s a momentum way of doing that. I’m kind of bad because I am thinking about the value, so I tend to sell too early, but I also tend to sell too late where it’s like, wow, it was growing 60%, now it’s growing 30%, now it’s growing 20%. Twenty percent is still a great growth rate and anchoring on that.
Whereas a great momentum investor says, “It was growing at 60%, now it’s only 30%. I’ve got to find something else that’s growing 60%.” And so, they sell something that’s good for something that’s fantastic. And it’s easier for me to do that with value stocks where it’s 80% to fair value, I can sell that if you can give me a stock with high visibility that is half what it’s worth. That’s kind of a tough thing. I’m not sure that I always do it, but the best investors that I’ve seen by whatever criteria a stock is superb, they sell excellent stocks to make room for superb. And I can’t do it with momentum because it’s fast-paced, it’s very path-dependent. So, I can’t execute it. And I’m probably describing it wrong. You’d have to ask a real momentum investor, because I’m just speculating.
Fleck: I think it’s really insightful though, thank you.
Benz: You’ve outlined four elements of value. The first is profitability or income, the second is lifespan, the third is growth, and the fourth is certainty. Do all four of those criteria need to be met to make a successful investment? Or is there a balance where perhaps the potential investment has really high profitability expectations but low certainty, for example?
Tillinghast: If you’re Warren Buffett, they need all of that. All of that, all the time. The life of a fund manager has a bunch of constraints and most people can’t wait until those rare stocks come out to them. The other problem is the four elements describe an ideal and unhappily, when all four elements are present, you rarely find a great bargain until the trust busters go after them. Visa has a fantastic oligopoly and they can jack up prices in Europe and nobody will stop them and the earnings will continue to surge and the cash flows will be amazing. But it’s not a statistically cheap stock, although you could argue that the value is so great because of that future growth. Value is a forecast. You want the elements to be strong enough that you believe your forecast and not all forecasts are equally believable. Anybody’s forecast about an oil company is going to have less certainty than a forecast about Visa or Microsoft or a number of deservedly high multiple stocks. The art of investing is to find the biggest discount to intrinsic value using forecasts you find most believable. The short answer is no, I often buy stocks knowing that they’re flawed and they’re missing one of the elements. And that’s part of why there’s such a long tail, because I know that there is something flawed and I’m hoping that everything will align and I can add to it.
Fleck: Joel, you mentioned Visa and their pricing power globally in Europe, and it reminded me that your fund often holds a large amount of international stocks in the portfolio. What do you think are the strongest benefits and the most significant challenges when you’re researching and holding international investments?
Tillinghast: International stocks broadly are statistically cheaper than American stocks. You can get diversification. If you go with the Peter Lynch thought that if you study 10 stocks, one or two will be action buys, one or two will be action sells, and half a dozen will leave you indifferent. So, if you have a bigger universe of companies to choose from, you’ll have more possibilities and you’re more likely to end up on the optimal frontier or whatever the jargon is. You have more choices; you can make a better choice. The home bias is not irrational because cultures are not the same. The languages are not the same. In most foreign countries where English is not a language of business, I rely on translators, either human or mechanical, and those can buzz the nuances or they can produce bizarre combinations of thoughts, words. Oh yes, so that’s how they say that. One example was in a meeting where a Japanese translator was discussing a discount for volume and said, “Kickbacks. We get a larger kickback when the volume increases.” And I had to explain to her, we call it “rebate.” Kickback implies something illegal, even though they’re close, but they’re not the same.
Fleck: Not quite.
Tillinghast: She went to University of Tokyo. She’s a smart, smart lady. So, home biases, cultural things. In Hong Kong there’s only one or two bits of freehold land. There’s an Anglican church that is freehold land. Everything else pretty much is a long-term, 100-year lease. What does this mean? Putting it as a charitable thing, OK, in 100 years they’re going to renew it. But really, you don’t own the land. Is this just a cross-cultural way of seeing the same thing? Or is there a wrinkle that I really don’t like? You don’t own the land in Hong Kong. You just own the buildings, but if you don’t own the land, then you’re kind of up a creek at the end of the lease.
Fleck: Absolutely. That’s a great point.
Benz: I had asked earlier about lessons that you hope will last after your retirement, and I’m wondering if you can talk specifically about your successors at the Low-Priced Stock Fund. The advice that you’ve given them and also if you can talk about the challenges that you think Sam and Morgan are likely to face. And maybe also talk about what new insights that you think they bring to the fund that might make it a little different going forward than it was under your stewardship?
Tillinghast: The same generic thoughts that I have for Fidelity in general: Stick to the long view. One thing where they’re great is they’ve been at work getting the analysts to do update calls and review all of the fund’s holdings. The coverage has never been better in terms of analysts’ contacts with companies, and frequency and attempting to understand what the business strategy is. One of the challenges is that analysts have a wide variety of audiences they’re trying to serve and a lot of their processes are, if they’re an energy analyst, they’re trying to make a bet on natural gas prices are going to croak or oil prices are going up. Morgan and Sam are more focused on getting inputs from the analysts, which is good, but they’re also trying to follow the analyst recommendations and if the analyst recommendations are driven by something that’s not a value approach, they have to work harder to get them to say, well, what is the NAV consistent prices for price decks for all your gas producers? What is the NAV at consistent prices across geographies and basins?
So, we’re choosing the ones with the highest free cash flow yield, the greatest predictability, biggest discounts. Sometimes that’s new work and trying to build systems so that they can have at their fingertips databases that help them get to that and they can say you’re bearish on natural gas, but here’s a natural gas producer at 50% of the estimated NAV—that looks pretty good. They need to build the systems that work for them. Morgan has years of experience in consumer and I worked with her for ages. Consumer is a large overweight in the fund. And I think she’ll bring a lot of expertise in that area. In the trivia category she used to have a Museum of Weird Food in her cubicle where Heinz would have the green and purple ketchup and other companies would give her samples of foods that would appeal either to 8-year-olds or someone with very different tastes. Sam has been working internationally for many years and is much closer with the Japanese companies in particular, but a lot of the international companies, and I think that’s fantastic. They’re both very hands on and pragmatic, and I think having more research attention to the companies is good.
Fleck: Joel, as you move away from full-time portfolio management at the end of this year, last question: what are your plans? What are you looking forward to spending your time doing?
Tillinghast: I have no big plans. I love the thought of spending more time with friends, family. I love the thought of spending more time, gardening, reading, traveling. I have no trips to New Zealand or around the world planned. or things that some friends have done.
Fleck: Time is the greatest asset, no doubt. Well, Joel, thank you very much for your time today—very insightful.
Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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