David Giroux: ‘I Want to Look Forward, Not Backward’

Our guest this week is David Giroux. This is his second appearance on The Long View. We first spoke to him in February 2021 and are pleased to welcome him back. Giroux is head of investment strategy and chief investment officer for T. Rowe Price Investment Management. He is best known as the longtime lead manager of T. Rowe Price Capital Appreciation, a strategy that invests in a mix of stocks and bonds. Since taking that fund’s helm in June 2006, he has racked up an impressive track record, handily beating the fund’s benchmark and peers. Giroux also manages T. Rowe Price Capital Appreciation Equity ETF, a stock ETF that T. Rowe Price launched in June 2023. Giroux began his career at T. Rowe in 1998 after graduating from Hillsdale College, from which he received his bachelor’s degree in finance and political economy.

Background

Bio

T. Rowe Price Capital Appreciation, Morningstar.com

T. Rowe Price Capital Appreciation, T.Rowe Price

T. Rowe Price Capital Appreciation Fund Annual Report, Dec. 31, 2022

“David Giroux: ‘What Are the Market Inefficiencies That We Can Exploit?’” The Long View podcast, Morningstar.com, Feb. 2, 2021.

ETF

“A Top Mutual Fund Manager Now Runs a Promising New Active ETF,” by Adam Millson, Morningstar.com, Aug. 4, 2023.

T. Rowe Price Capital Appreciation Equity ETF

Valuation and Risk Management

“How a Top T. Rowe Manager Keeps Beating the Markets,” by Tom Lauricella, Morningstar.com, March 30, 2023.

“Inflation Is Overhyped, Says This Pro. 4 Things That Really Matter for Investors,” by Andrew Welsch, Barron’s, June 8, 2023.

Mobileye

Revvity

Danaher

Thermo Fisher Scientific

Euroimmun

BioLegend

Applied Systems

Yum Brands

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning at Morningstar.

Ptak: Our guest this week is David Giroux. This is David’s second appearance on The Long View. We first spoke to him in February 2021 and are pleased to welcome him back. David is head of investment strategy and chief investment officer for T. Rowe Price Investment Management. He is best known as the longtime lead manager of T. Rowe Price Capital Appreciation Fund, a strategy that invests in a mix of stocks and bonds. Since taking that fund’s helm in June 2006, he has racked up an impressive track record, handily beating the fund’s benchmark and peers. David also manages the T. Rowe Price Capital Appreciation Equity ETF, a stock ETF that T. Rowe launched in June of this year. David began his career at T. Rowe in 1998 after graduating from Hillsdale College, from which he received his bachelor’s degree in finance and political economy.

David, welcome back to The Long View.

David Giroux: Thank you for having me back and looking forward to the conversation today.

Ptak: Thank you so much. We’re really pleased to have you. We wanted to start off by maybe taking a step back, asking you to reflect a bit on the experience that you’ve had as a professional investor. You were in your early 30s when you started running T. Rowe Price Capital Appreciation Fund. This is back 2006, if I’m not mistaken. With the benefit of hindsight, what do you think you might have urged your younger self to do and conversely, warn the younger you to refrain from doing, given all that you’ve learned along the way?

Giroux: I’d probably highlight three things. I think I would say, one, you try to understand where the market is structurally inefficient and ruthlessly exploit those inefficiencies. We, over time, identified 17 structural market inefficiencies in equities and fixed income that we exploit day in, day out. When I started as a PM, I really didn’t understand these inefficiencies. I think I was really trying to play the same game everyone else was playing. I’ve really come to believe that when you’re playing the same game as everyone else, it’s really a losing game. So, I’d say that’s one.

Second, I think I would tell myself to work more closely with the quantitative resources at T. Rowe earlier in my career. I really didn’t do anything on that front really until late ‘09. I joke with people internally. There was a BFS era, before Farris Shuggi, and AFS, after Farris Shuggi, period at CAF. I’ve worked very, very closely with Farris Shuggi and the rest of the quant team at T. Rowe on so many proprietary projects over the last 14 years that have really meaningfully, positively contributed to CAF’s performance. Honestly, it changed the way I managed CAF for the better over time.

The third thing I’d just highlight is just make sure you have strong processes in place. And that means IRRs, reports, analytics, really robust risk management from day one. So, I’d just highlight those three things.

Benz: What do you look for when you’re assessing whether an analyst is ready to manage assets as a fund manager in addition to their research acumen?

Giroux: I’d highlight two things. I’d say, are they willing and able to invest against that macroeconomic consensus and/or into a period of near-term uncertainty when the returns look really, really good? Or do they need the market to validate their views before investing? I think most investors really struggle with this and need the market to validate their buys and sells prior to making them. In other words, I can’t recommend the stock until the stock is already up and it feels good. And I can’t recommend you sell the stock until the stock is already having some pain. So, I’d say, that’s one thing.

I think the only thing I’ve learned over time is that do they ask good questions during management meetings? I think getting stocks right is by getting three to four key things really right, and do they know what those three to four key things are and what is really noise? And being able to distinguish between noise and what really matters is really important for a portfolio manager.

Ptak: If I may, I wanted to go back to something that you mentioned before and planned on asking it, David, but you mentioned 17 inefficiencies. I think that you had mentioned something to that effect in our first conversation with you a couple of years ago. I’m just curious—you don’t have to go through and inventory every one of those 17 inefficiencies—but maybe if somebody was trying to understand which of those inefficiencies is most conspicuous in the way you run money, maybe apart from having a longer time horizon that perhaps the market at large would be, what’s the one that you would focus on in trying to explain what makes the Capital Appreciation strategy tick?

Giroux: Maybe I would highlight GARP investing as one. We are a portfolio that is, what I call, massively overweight GARP, both in CAF and our TCAF ETF. GARP investing over long periods of time generates the highest returns in the market—beats value, beats growth, and has better risk-adjusted returns than those two as well. So, yes.

Well, why does this inefficiency exist? Well, most managers are indexed against the Russell 1000 Value or the Russell 1000 Growth, especially in large caps. So, what happens is, a growth manager will say, well, I only want to own companies that are growing the top-line 10%. So, anything below that, I don’t want to invest in. The value investor will say, “I only want to buy things that are trading at these very, very low valuations. And boy, that GARP stock that you’re talking about, David, it’s $0.20 premium to the market and I can’t invest in that.” So, it’s a situation where there’s no natural home. Actually, even retail investors, they’re more focused on either maybe high-dividend stocks or high-vol stocks or stocks in the news. Hedge funds are more interested in owning, again, high-vol stocks, the more short-term focused. So, there’s no natural owner for these stocks. And as a result of that, you’re able to—this is about 13%, 14% of the S&P 500 today. These companies that have these incredible characteristics where they grow organically a little bit faster than the market; have probably better free cash to conversion; lower volatility; tend to deploy capital very, very well; very, very limited secular risk. And you’re basically buying companies that will grow earnings over a full cycle, let’s say 10% to 13%, which is 1.5 to 2 times the market, with much lower volatility, faster organic growth, better capital allocation, less secular risk for usually, let’s call it, between a market multiple and a 1.2 times market multiple. And if you just think about that, the risk/reward of those because of the structural imbalance of buyers and sellers just allows you to buy these incredible companies for valuations that they shouldn’t be trading for. They should structurally trade for 1.5 or 2 times the market given those characteristics.

Benz: The last time we spoke to you, we discussed a reorganization that T. Rowe had made, subdividing into multiple entities. Can you provide a quick update on how that process has unfolded and also any adjustments to your process that it has entailed? And also, maybe to back up, perhaps you can discuss the impetus for doing that subdivision.

Giroux: Yeah, happy to do that. The real reason for the reorganization into two separate investment organizations really came down to capacity. T. Rowe as an investment manager can only own up to about 19% of any individual stock. And while that was on a challenge in mega-caps or even most large caps, I think it was becoming more of a challenge in both small- and mid-cap stocks where many of our funds really could not own as much of the stock as they would like, and in some cases, they were unable to initiate a position and a name because other funds already own close to 19% of the company. While these issues were not impacting our ability to outperform at the time, and I would describe more as a nuisance, I think there was a real risk if we failed to act, a real risk five to 10 years down the road that this challenge could have a more profound impact on our funds’ ability to outperform.

I volunteered to join the new TRPIM entity, and I’m extremely happy that I did. As part of that transition, I added both Vivek Rajeswaran and Brian Solomon to the CAF team who were, honestly, exceptional analysts, who I had a lot of interaction with when they were analysts, and both of them had an investment philosophy that was very, very similar to mine. And now, today, the CAF strategy has three APMs, including Mike Signore, who, I guess, now been with me for eight years. And that really means that we just cover more names and in more in-depth way than we did in the past. Today, we’re running IRRs or analysis on around 100 names. And plus, we don’t have any of the capacity issues we had today because we’re really the only large CAF strategy at TRPIM. So, really, we can own whatever we want today and then whatever size we want. And that really wasn’t true at TRPIM, especially the last couple of years at TRPIM, before the split.

The good news is also from a process standpoint, just about all the people that I interact with on a daily basis came with me to TRPIM. Tammy Wiggs, who’s an amazing trader, who’s been working with me for 15 years now, she came and actually runs the desk at TRPIM; Jon Wood, who was a life sciences analyst he came with me. Farris Shuggi, who’s the new Head of Quant, which I talked about before, he came with me; Chen Tian, who’s our Quant leader at CAF, came with me, and a number of other analysts came with me as well. So, the impact from the people I interact with daily really was not impacted almost at all as part of this transition. So, it’s worked out extremely well for CAF, and obviously CAF shareholders as well.

Ptak: One thing that I would note for listeners—CAF, and correct me if I’m wrong, David, stands for Capital Appreciation Fund, and then TRPIM, which you’re referring to is T. Rowe Price Investment Management.

Giroux: Yes, thank you for the clarification.

Ptak: No worries. I wanted to ask you about a relatively new venture for you, which is managing an ETF. T. Rowe recently launched an active ETF that you manage called T. Rowe Price Capital Appreciation Equity ETF. Can you talk about the impetus for the ETF, other than the obvious reasons like the potential for lower costs and superior tax efficiency that that structure might boast? Why did you decide with your colleagues at T. Rowe to launch this?

Giroux: I think as you guys probably know, I think during my tenure running CAF the last 17 years, I think our stocks have outgrown the market as of June 30 by about 420 bps a year. I think we’ve beaten the market on equities 16 out of the last 17 years with the beta at or below 1. And as you can probably imagine, as a result of that performance, there have been a lot of requests from existing clients and prospects who just wanted to invest in the equity sleeve at CAF. And the challenge was, presplit, pre the transition from TRPA into TRPIM, we were to run into capacity challenges very, very early in the process. So, I was very adamant that we were not going to do that. But once we came to TRPIM, and TRPIM was established, and a lot of those capacity challenges went away, I said I would be open to thinking about this, but I would only do it under three circumstances. I said, we can’t do anything that will hurt CAF or existing CAF shareholders. We can’t do anything that will put too big a burden on me or my team. And we’re only going to do something if it’s highly differentiated that would be really good for clients. And in the end, after literally more than a year’s worth of work, we decided to launch TCAF because it hit all those requirements.

Honestly, I’m just really excited about this. We created a product that I think is far superior to an S&P 500 index fund across three different dimensions. Even though CAF equities have outperformed by 420 bps a year, we’re very confident in the CAF ETF that we can outperform by 100 bps per year after fees. Secondly, we’ve built the portfolio to be lower risk than the market, the S&P 500. We think we’ll be, over time, about 3% to 5% less risky than the market. And third, because we have a lower-than-average dividend yield, a focus on minimizing taxable gain distributions, we’ll actually be more tax-efficient than an S&P 500 fund. So, if you can create a product that generates higher return, lower risk, is more tax-efficient, I think we’ve created a product that is far, far superior to an S&P 500 index fund.

So, if you think about how are we doing this? Essentially, take the S&P 500, if you remove all the companies that have one or more of the following characteristics that limit their ability to outperform in the long term, it’s either they have problems with secular risk, they have bad capital allocation, they can’t grow the combination of EPS growth and dividend, at least high-single-digit through a cycle. Maybe they’re way too expensive. Some of the highest-risk companies are very, very poor risk-adjusted returns or they have poor management. If you think about those six characteristics, that actually eliminates about 375 companies in the S&P 500. Then we add back a handful of non-S&P 500 names. And then, we take those 130 names, and we optimize that down to 100 names based on the combo of expected return, odds of outperformance, risk, and concentration, and those 100 names are my investable universe, and those are the names I spend really 98% of my time on. Almost every new name that will go into CAF will come out of those 100 names that are now in the CAF ETF. I would also argue that there’s very limited incremental work to create TCAF as it leverages really my existing investable universe already.

Benz: So, sticking with TCAF, the ETF, there’s some overlap between the new ETF’s holdings and the equity sleeve of the flagship T. Rowe Price Capital Appreciation Fund, which has been closed since 2014. So, given that you can’t shut an ETF to new inflows, how do you think about ensuring that you’re running manageable sums without exceeding the stock strategy’s capacity?

Giroux: It’s a great question. It’s something that we’re very, very focused on early in the process to see if this was going to work. So, prior to launching the TCAF strategy, Chen Tian, who’s basically the head of Quant on CAF and we did a series of analysis, looked at capacity at different sizes. And we basically came to the inclusion because this is, again, more of a large-cap-focused strategy that we could get to $50 billion to $100 billion in TCAF over time and really have no meaningful capacity challenge outside of a couple of names. The good news here, again, TCAF, you get 100 names versus 64 in CAF today, which makes capacity less of an issue. And the other important thing here is, because this product is so focused on tax efficiency, we expect turnover in TCAF to be significantly less than in CAF over time. So, you think about CAF, on the equity side, we might have turnover of 40%, 50% in CAF, whereas in TCAF, it would be more like 5% to 15% over time.

Ptak: Maybe just to jump in—that’s actually interesting to me that the turnover would be lower on the ETF just because I would tend to think given the creation of a redemption mechanism in your ability to avoid incurrence of cap gains distributions, it would actually afford you the latitude to trade a bit more if you wanted to. So, how come you expect it to be less, if I may ask?

Giroux: Sure, I’m happy to. I think there are attractive features of ETFs that allow you to minimize gains. But what I would tell you, first of all, I’d say, one, we don’t have a lot of redemptions early in the process. I’d say that’s one. And there are efficiencies of ETFs, but you can’t eliminate all taxable gains through some of those efficiencies. So, again, we’re very, very focused on trying to make sure that we really pay out almost no taxable gains over time. Again, there are features, but those features are not unlimited, I would say.

Benz: The new ETF spans 100 holdings, which is more than the number you hold in the stock sleeve of the mutual fund version, the traditional mutual fund. So, what’s the rationale for that?

Giroux: Well, first of all, I think we did not want this to be a clone of the CAF equity sleeve, and it’s not. Again, more names, some different names. I think one thing, again, going back to the principle—we don’t want anything to hurt existing CAF shareholders. And so, the existing CAF franchise today is an $80 billion franchise. So, we didn’t want the market to see what we were doing every day in CAF. We just didn’t want to do that. We thought that could hurt CAF. And I think what we also came down to is, what we’re trying to do within TCAF is, the 100 names is really the optimal number of names. It balances the odds of outperformance with the magnitude of outperformance, all while minimizing turnover and maximizing tax efficiency. And the 100 names really is a function of our backtest more than anything else.

Ptak: Do you think differently about individual position risk management when you’re running an all-equity strategy like the ETF versus how you approach it in the fund where, I suppose, you could say you arguably have a cushion thanks to the nonequity sleeve, a good chunk of which consists of bonds?

Giroux: No, I think that’s another important point. I think we’re willing to take bigger bets in CAF than we’re in TCAF because we have that cushion of the fixed-income portfolio. So, think about that in 2022, while we outperformed in our equities—it was a tough year—we barely outperformed in equities in 2022, but our fixed-income investments outperformed by 1,000 points. So, what we found over time is, you have a period of time maybe where your fixed-income investments aren’t as strong, but your equities are really, really strong. So, having that balance allows you to take maybe a little bit larger size bets in CAF than you’re going to make in TCAF. I would say that for an important point. But I think that’s the heart of the issue. Not having that ballast, not having that fixed-income portfolio in TCAF, probably you want to take little bit smaller bets just from a risk management perspective.

Benz: We wanted to switch over and ask you about valuation and position management through the lens of two holdings that might look pricey by traditional valuation measures, Amazon being one and automotive technology maker, Mobileye, the other. So, let’s start with valuation. What do the traditional valuation measures not convey about the potential reward for the risk you court with those investments?

Giroux: It’s a great question. So, what I would say is, I spend probably 99% of my time trying to identify stocks with excellent risk-adjusted return potential over the next four to five years. So, really what I’m focused on is trying to think about what is the earnings power, what is the price/book value, what is the free cash flow power? In 2028, five years down the road, and what is a very reasonable multiple the stock would trade for at the end of 2027? And that leads to an expected return that we’re going to generate from that stock over that period of time. Again, that IRR drives a lot of our decision-making, not how the stock is going to outperform tomorrow, next week, next month, but that five-year IRR that really drives a lot of our decision-making. As you think about TCAF and CAF, we tend to have a large, a very, very large overweight into companies that have more predictable numbers, predictable GARP, utilities where earnings growth is more predictable. The multiple assumption even four to five years out has a more narrow range of outcomes. And again, as we talked about before, 40% to 50% of the portfolio today is in GARP utilities, which again is more than 2x the weight of the market.

The two names you’ve identified are names that, you highlight, they don’t look as attractive on what we would call a near-term, next-couple-of-months P/E or even a price/book measure. In the case of Amazon, I think it’s quite clear that Amazon, I would describe, is massively underearning from a margin perspective, especially in its core retail business in both in North America and outside the U.S., and outside the U.S., they’re still losing money. They added a lot of capacity during COVID, their distribution infrastructure was not optimized. And with demand slow post-COVID, they were also losing a ton of money on noncore projects.

If we look out five years, we think Amazon can get to high-single-digit operating margins in North American retail, as they have this high-margin advertising business that we think generates, let’s call it, 50% to 60% operating margins, that continues to grow faster than the core retail business. So, that high-single-digit margin, it actually implies a very low-single-digit margin in their core retail business, which again, probably is a little bit conservatism on our behalf. We also think the core retail business can grow in the high single digits. The cloud-computing business can grow in the low teens over that period of time. And so, what happens is, when you go out to 2027, and their margins are more normalized and maybe their growth rate is slowing a little bit, we’re targeting a very reasonable valuation of a low-20s multiple for retail, actually close to where a Walmart might trade, and a mid-20s multiple for the cloud business. And when you do all that math, it leads you to, let’s call it, a low- to midteens IRR from here, which is pretty compelling relative to what we think the market will do.

Mobileye is a little bit different. Mobileye is just very, very early in their adoption of the core technology. As you highlight, they’re a leading manufacturer basically of semiconductors and systems that enable what we call L2+ all the way to L4 autonomous driving. They’ve already signed five large OEMs, and they clearly have the leading share here, and they’re in active discussion with another nine OEMs. So, when we look out to 2028, the stock is trading today in the low-teens multiple on earnings, so again, very, very reasonable multiple. Even you go out to 2028, the penetration of things like their L4 Chauffeur solution, which is hands-off driving, will still be in the very, very low single digits in developed markets. And L2, which is their supervision product, which is you can take your hands off the wheel, but you still have to be aware, even in our model, we only assume a 5% or 6% penetration in 2028. So, we think even five years in the future, they’re going to still be very, very early in their adoption curve. So, we think the company can actually maintain a 25 and 30 multiple. If it does that, the stock is going to more than double over the next five years from here. So, again, trying to think five years out is really how we’re approaching with Amazon and Mobileye.

Ptak: I wanted to stick with Mobileye. It looks like various T. Rowe funds owned it for a little while between, call it, 2015 and 2017. But then I think it was acquired by Intel. Intel spun it off last year, if I’m not mistaken. Can you talk about the arc that your research process followed and how you and your team came to the conclusion that it merited investment in the fund?

Giroux: So, again, we were involved in Mobileye in 2015 and 2017. The stock was a little more expensive at the time. If you remember, higher multiples. It was early in the adoption. It was less clear how successful they were going to be. So, obviously, Intel took it out at a very, very elevated price and it brought it back to the market. Again, I think we were a little bit surprised, pleasantly surprised, at the valuation. I think Mobileye ended up coming out in the low 20s, I believe. I should probably remember these numbers. But I think low- to mid-20s if memory serves. And so, we were aggressive, bought a lot of the stock, as much as we could. There’s not a great float with Mobileye. But again, we were doing the same analysis looking at, OK, what kind of penetration rate do we need to generate a really attractive return from here till 2028? And at 22, the assumptions were, boy, we think they can get to 5% market share or 5% penetration. Boy, this is going to be at that time, we think we’re going to make 4x our money. Now, the stock is doubled since then. So, now, we’re only going to make twice our money, probably in the next four or five years.

But again, I think if you have a 10-year view, there’s no reason why L2 penetration on most of the vehicles that are sold in most developed markets out there between China, the U.S., Europe, Japan, Australia should all have Level 2 technology. And I would argue probably a good portion of those, especially at the high end, will have L4 technology that really allows the driver to do other things in the car, especially on the highway. And that L4 solution is a $3,000, $4,000 solution that provides a lot of value for both the driver and the OEM. And I think penetration is going to be a lot higher than people think on a long-term basis.

Benz: The S&P is very bunched in its top names and the tech sector was recently consuming almost 30% of the benchmark. This can present a challenge or maybe an opportunity, as managers might be reluctant to concentrate to that degree. How have you approached this?

Giroux: Well, what I would say is, again, our goal, especially in TCAF, and obviously in CAF as well, our aim is to outperform the market. So, we look at all these through the lens of bets. So, you might have a small position, you might have a small name like Mobileye, which is not in the S&P 500, and you’re owning 30 or 40 basis points of it, given maybe the risk profile and also maybe liquidity in that kind of name. And then, you have some of these companies—Apple 7% or 8% of the market, Amazon 3% of the market—and what you’re really trying to do is you’re still making bets. So, I would say, I’m not worried about the concentration. We’re going to make bets relative to that. And if those stocks do well regardless of whether they’re 10% of the market or 30% of the market or 40% of the market, we just got to make sure we’re owning the right ones and making the right bets relative to the market so we can have a pretty good odds of outperforming the market. And if you look at today, some of those big names, we don’t own any Tesla. We think Tesla is extremely overvalued today, whereas we think Amazon and Microsoft, where we have roughly about 100 basis points overweight, both in CAF and TCAF combined, are quite compelling. We have a modest overweight in Google and a modest underweight in Apple in TCAF. So, I don’t worry about the concentration. We’re just have to make sure we’re making bets where we see the best relative value and make sure that we’re aware of the risks involved in all those names.

Ptak: I wanted to ask you about another name, Revvity. You’ve owned it—it’s the former PerkinElmer—for a long time and made good money in it. But the stock price, if I’m not mistaken, has nearly gotten cut in half since 2021. Can you walk through the bear case that seems to be getting priced into that stock, whether it’s questions about the firm’s strategic direction, capital allocation, or other factors, whatever they happen to be, and why you still have conviction in it, notwithstanding concerns that the market seems to be registering in the way the stock has traded?

Giroux: Happy to do that. So, as you do point out, our first purchases of Revvity back when it was PerkinElmer were in the 40s. So, even with comeback, it’s still been a very, very good stock over time. So, the issue with Revvity, and why has the stock fallen so much? Last year, Revvity announced they’re going to exit some of their legacy businesses. They basically exited about 30% of their revenue base at the company. And these were businesses that were both had more capital expenditures, were slower growth, more cyclicality. And basically, by exiting that 30% of the business, they left Revvity with this really amazing portfolio of high-margin, life science reagents, high-growth diagnostics, actually great software business. And their operating margins, say, are 30% with a clear path to 35%.

So, it was absolutely the right decision on a long-term basis. But in the very short term, it was dilutive. People thought they were going to earn $6.50. And now they’re going to earn more like $5, a little less than $5. So, it was dilutive transaction. And that’s caused the stock to come under some pressure. In addition, really after a great 2020 and 2022, the life science tool space is going through what can best be described as a pause after this really strong period of time. We’re seeing some weakness in capital expenditures, spanning some weakness in SMID biotech, and imprint corrections with both consumables and bioproduction. Now against that backdrop, Revvity is doing really well. They’re growing this year midsingle-digits, which is, again, below what they hope to do long-term. But they’re going to outgrow this year, Danaher, Waters, Agilent, Thermo, who are all growing at either negative or low-single-digit kind of growth.

So, what’s the bear case on Revvity from here? The reason why the stock is where it is today is not just because its life science weakness, but it’s also because they have about 17% of their revenues in China, and that’s greater than their peers. So, if you’re worried about China, you short Revvity regardless of valuation. Now, again, life science tools in China have been really, really weak this year after a really strong couple of years. There are some anticorruption crackdowns in China that are really hurting capital spending in a hospital environment. The good news here is their portfolio is really well-positioned with a lot of reagents, reproductive health, diagnostics, really no competition, very little capital spending. So, yes, they have some China exposure, but at the same time, they have probably the best China exposure with less capital expenditures. And I would also argue, you couldn’t even do the math and say, if all the China went away, Revvity would still be 26 times earnings. That’s too cheap even. So, the market is basically valuing the China business at a negative, which doesn’t make any sense.

The other bearer case, I think, you would say is, OK, we went through this period of time where all the tools the company had really incredible growth in the 2020 to 2022 period. And people say, well, the growth is going to be much slower going forward. And I agree that the growth will not be as strong as it was in the 2020 to 2022 period, but I still think it’s going to be much, much faster than it was until, let’s call it, 2010-19 for Revvity, for Danaher or for Thermo, principally because all these companies have really reshaped their portfolio. We talked about Revvity, they’ve got rid of 30% of their business. They added a number of high-growth companies like Euroimmun and BioLegend to their business.

So, again, when I first got involved with Revvity, it was a 4% to 5% organic growth company trading for about 20 times earnings. And today, we think it’s more like an 8% organic growth company with midteens earnings growth with very low volatility. So, again, I think the market is saying, well, this is a 4% grower or implying that. I think that’s way too low, honestly.

Benz: I wanted to ask about utilities. The capital appreciation fund stake in the utility sector has fluctuated in recent years, but it has tended to be a favorite hunting ground for you. For example, the fund recently held more than double the market weight in utilities, and you’ve been increasing your stake recently, which spans eight names in the ETF and four in the fund. Can you talk in general terms about why in your experience, utilities tend to become mispriced and what has piqued your interest again lately?

Giroux: Happy to do that. So, again, as you correctly point out, whenever utilities fall out of favor, we tend to get pretty excited about that. I think there’s just this giant misconception in the marketplace about utilities. So, there was a time, roughly from 1986 to 2002, where utilities had basically no earnings growth. The only thing you were getting from utilities was the dividend.

it really made sense. It made sense to look at these as like a bond proxy because if the only return you were getting was the dividend, then you should price these things off where yields were. But that’s really changed dramatically. A lot of utilities, they’ve gotten rid of their unregulated assets. We’re going through this really powerful transition from coal and gas to renewables, wind, solar, storage, hydrogen. And because of climate change, unfortunately, these utilities need to spend a lot of money to basically harden their grids from storms, from fire that we saw, obviously, what happened to Hawaiian Electric. And so, that’s really driving a really powerful capital-expenditures cycle. The rate-based growth is growing at, let’s call, 7%, 8% for some of these companies. And as a result of that, even though the bill pressure is only about 2% to 3%, which is more in line with inflation. So, there are a handful, more than a handful of really high-quality utilities that have been, and we expect to continue to grow, let’s call it, 6% to 7% per year from an EPS growth perspective, and they’re offering today a 3.5% or 4% kind of dividend yield. That’s a 10% to 11% total return even if you assume multiples stay really, really depressed.

Again, if you go back from 2006 in the market to 2023, earnings growth for the market has only been 6%. I would argue, the long-term equity market return should be about 8.5%, 7% kind of earnings growth, maybe a 0.5% dividend. Utilities are actually now outgrowing the market. And the market just hasn’t awoken to that possibility or probability anymore that you have these utilities that will grow earnings and dividends at a fast rate from the market over time and with half the market’s volatility, no China risk, no foreign-exchange risk, and half the beta of the market. And the market today wants to put them at a discount to the market. It doesn’t make any sense.

I would also say, we look at a little bit of an arbitrage. We look at utilities and we say relative staples. So, utilities grow faster than staples. They’re a better ESG story. They don’t have any GLP-1 risk, per se. They have no foreign-exchange risk. They have no China risk. And yet, they trade at a discount. And I think over time, in an efficient market, if you have something that has less risk, that has higher returns, higher growth, less volatility, that should over time trade for a premium to staples. Over time, I think that’s the arbitrage. So, we have a massive underweight in both TCAF and CAF to staples and a massive overweight to utilities. And I think that’s going to be a winning proposition over the next five years.

Ptak: I have a random question for you. I think the last time we spoke to you, you spoke admiringly of Berkshire Hathaway, but it doesn’t appear you’ve ever owned it, if I’m not mistaken. I think that you may have fleetingly owned some debt from the Energy sub if I’m not mistaken, but it was a small position. You didn’t own it for long in the Capital Appreciation Fund. So, I’m just curious what’s kept you from investing in Berkshire, given your admiration for what they built there?

Giroux: Well, what I would say is, I have an admiration for Warren Buffett as an investor. The way I learned investing when I was back in college, I read 40 books on investing. It probably helped me get my job at T. Rowe that I have today reading those 40 books. And that foundation, the idea of margin to safety—actually, I think a lot of what Buffett talked about was maybe more GARP-y stocks, if you think about what the portfolio looked like in the 1950s, 1960s at Berkshire. So, I have a lot of admiration for the way he thinks.

The challenge with Berkshire, and the reason why we’ve never been interested in Berkshire is it just trades at a massive premium to some of the parts. A lot of that earnings are coming from insurance, which is a low-multiple business. And again, I think actually, if you think about the Mobileye discussion we had earlier, I think over time, even if you don’t go to fully autonomous vehicles, L2 and L3-enabled vehicles reduce 80% of accidents. So, over time, as more and more cars have L2 and L3 technology, the number of accidents we have to deal with as a country, as a world, should go down dramatically, which should reduce the need and the cost of insurance, which is a very, very negative case for their Geico subsidiary on a longer-term basis. We’re definitely big admirer of Warren Buffett. I think we think about investing a lot the same way that he does. But I don’t think Berkshire is a good value here.

Benz: We wanted to switch over to ask about asset allocation and fixed-income investments. This is the sharpest increase in interest rates that you’ve seen so far in your career. And bond yields are now much more inviting than they were just 18 months ago. Can you talk about how that’s informed the way you think about the reward for risk in stocks versus bonds, and also, how that’s expressing itself in the way that you’ve allocated the Capital Appreciation Fund’s assets?

Giroux: First of all, I’d say it’s a great question. So, if you just take a step back, if you go back to the end of 2021, we had zero Treasuries. Basically, the majority of our fixed-income portfolio was in leveraged loans, and we had a very short-duration, high-yield book. And I think our duration was about 1.29 years. And I think the fixed-income portfolio was about 18% of the strategy. That was an environment where rates were really low. And honestly, a lot of people thought they would stay low. So, we took a contrarian view on that and had a very, very low duration fixed income. It really helped us a lot.

Again, to your point, we fast forward today, and we’re basically at the polar opposite of that environment. Today, real rates are over 2%. Everybody is scared of inflation, horrible sentiment, and yields are very, very attractive. We tend to invest in the highest-quality high yield, the highest-quality leveraged loans, things that are really money good under almost any economic scenario that you could possibly imagine. And today, Christine, to your question, we’re getting, let’s call it, on the super high-quality high yield, 6.5%, 7% kind of yields, and in high-quality leveraged loans, more like 8% to 9% kind of current yields. If you think about that combination, let’s call it the combination of a 7.5% kind of yield, and I talked about long-term equity market returns being in that kind of 8.5%, you’re getting today 80% to 90% of the market’s return for about 10% to 15% of the market’s risk. And that’s super attractive to us. Again, that’s not what the environment looked like two years ago.

So, as a result of this, we’ve taken the fixed-income part of the portfolio from 18% of the portfolio to about 33% of the portfolio today. And that’s a record high for the 17 years I’ve managed the strategy. Again, I would argue that a lot of these cyclical reasons why we’ve had higher inflation in the last couple of years are either in the process of correcting or are correcting. The massive stimulus has worked its way through the system. The Fed kept rates too low for too long. They’re trying to fix that now. The supply chain issue is just not an issue anymore. We had this horrible owners’ equivalent rent issue in CPI that really surprised everybody at the upside for both ‘22 and ‘23. That’s gone in the right direction. The second derivative of apartment rents is negative now. And I just don’t believe the Fed needs to keep rates at 5% forever to get inflation back to 2%. And again, if you take a longer-term view—again, I’m going to make the argument that one of the most powerful things about AI is how much more productive it’s going to make us. And I think if you think about the second half of this decade, I think you’re going to see AI maybe help reduce some of the labor challenges we face in this country right now. And that probably helps push inflation back to that 2% target over time as well.

Ptak: I wanted to jump to high yield. You mentioned BBs, and I think in our previous conversation, you walked through your fondness for that part of the sub-investment-grade credit market. Maybe you could just for the benefit of listeners that didn’t hear that first conversation, you can talk about how it is you developed that fondness for BBs. And then, secondarily, I just wanted to ask you briefly about the adequacy of credit spreads, whether they’re wide enough, how you get comfort that they are wide enough that you’re going to get good reward for risk that you’re taking in high yield?

Giroux: I’ll talk about high yield and leveraged loans in the context. So, again, I mentioned Farris Shuggi in our Quant team before. So, I think it was back in 2009 or 2010, we did an analysis of every asset class, every sector, every part of the fixed-income market, and we said, where is the best risk-adjusted return? Even if you take out the last 20 years where rates came down, if you just assume rates did not come down, because we assume that would not repeat, where is the best risk/reward in the marketplace? And the highest risk-adjusted return of anything you can invest in, from an asset-class perspective and a sector perspective, is BBs. They just have the highest return versus the lowest risk.

We can go into the inefficiency here, but part of the inefficiency is, again, there’s less natural owners of BBs. Insurance companies own a lot of investment-grade credits, but they can’t own as much high yield and BBs because the capital charges for holding a BB credit are much higher than holding a BBB credit. Even high-yield managers who are charged with beating the index, one of the ways they try to beat the index is owning less BBs. So, you have this structural place where there’s a supply/demand imbalance. You have these companies that you earn, let’s call it today, 200 to 250 bps over Treasuries that have extremely low default rate. We’re talking about companies like Hilton, Yum Brands—TransDigm is technically not a BB, but it trades like BB—companies that have these huge enterprise values, very, very low risk. So, that’s part of the inefficiency we’re trying to take advantage of. Things that have no natural home where there’s a supply/demand imbalance. And again, today we’re earning on Yum, Hilton paper 6.5%, maybe 7% kind of yields. That’s really, really attractive to us.

In loans, loans are a little bit different. Some of the loans actually have a little bit higher yield today because the short-term rate is higher than the long-term rate. But today, high-quality credits, like an Applied Systems or a HUB, you’re earning 8% to 9% kind of yields. And that is equitylike returns over time. And you asked, are you compensated enough for the risk? So, again, we’re playing in the ultrahigh quality. But let me talk about applied. Applied is the dominant 50% market share of the software that runs insurance brokerage firms—50% market share, double-digit growth. The enterprise value of that company is probably worth somewhere between 20 to 25 times. It is a trophy asset. Probably the best company I actually own in all high yield or leveraged loans. They’re leveraged about 7 times.

So, rating agencies will look at it and say, hey, you’re leveraged 7 times, so you got to be single B or CCC. But I look at it and say, I’m earning 8% or 9% yields. I have almost no economic sensitivity, high retention rates, and I’m covered from an equity-cushion perspective, probably, honestly, 13 or 14 times. I would much rather own that Applied Systems bank debt or HUB bank debt that has these giant cushions than buy a BB or single-rated piece of financial paper. I think I’ve always made the argument that the Applied Systems, the HUBs, actually are a lower risk than owning a bank, as in financial institution debt, that might be investment-grade. I think actually the results of the last couple of years probably help validate that view. So, I think that’s the inefficiency. You just want to have a large amount of equity cushion and have a high-quality business model. That’s where we’re focused in high yield and leveraged funds. And honestly, that’s where the market is inefficient, too.

Benz: You referenced Yum Brands, and we wanted to ask about when you double up, where you own both the equity and the bond of a certain company, as is the case with Yum Brands. Your process is bottom-up. But how do you make the call on when to do that, when to own both the equity and the fixed income? And how do you ensure that your exposure to the firm concerned is manageable? How do you think about the risks there?

Giroux: Great question. I would say we look at it two separate decisions. We make two different decisions. We do have systems—and we talk about risk analytics—that allow us to monitor the total portfolio risk of a certain name. When we do have a situation where we own Hilton equity, we own Hilton debt, we own Yum and we own actually Yum debt as well. But I think Yum is a great example of where the analysis we do on the equity side helps us understand the fixed-income side better. So, again, we model out Yum all the way out to 2028, and we look at the earnings power of the company.

One of the things that’s really interesting is, when rates were low, Christine, it made a lot of sense for Yum to stay at 5 times leveraged. Again, most of their earnings come from royalties’ payments. But when rates were low, it made sense for them to maintain that 5 times leverage, take on a little bit of incremental debt every year to buy back even more stock, because you actually grew faster. But as my APM or one of my APMs, Mike Signore, figured out, as rates kept rising, it no longer made sense for Yum Brands to take on incremental debt to buy back stock. It actually made sense to basically not pay down debt, but actually it made sense just to buy back stock using your free cash plan and pay your dividend, but no longer take on incremental debt. It actually would be earnings dilutive to take on incremental debt to buy back more stock. And that was a really important sign.

So, what’s happened with Yum, is they’re still buying back stock, they’re still paying dividends, but not taking on incremental debt anymore. So, their leverage is slowly but surely, if rates stay here, going from 5 times to 4 times, and maybe even below. So, what’s interesting about that from our perspective is, if Yum gets the 4 times leverage over time, they’re probably going to be an investment-grade company. And Yum’s debt today trades at about 195, 200 bps over. If they become investment-grade, that probably goes to 150 over. And so, if you own some long-duration Yum debt, which we do—think we own the 2043 debt—the power of having a long-duration instrument and having credit spreads decline 50 bps can generate incredible returns when that happens. So, again, it’s an insight that was developed from a member of my team, a really solid APM and led us to own more and more Yum debt over time.

Ptak: I wanted to ask you one more question if we can. You’ve had a remarkably successful career. By the same token, the same probably could have been said at different junctures in the past about other managers, only to see them stumble. So, do you think there’s anything to be learned from those episodes, the rise and fall of star managers, if you will? And if so, does it inform the way you approach your job?

Giroux: I think it’s a wonderful question and honestly, something I think a lot about and something actually, I felt I have a lot of personal fear about. Because you’ve witnessed, I’ve witnessed, a lot of high-profile managers, star managers who struggle, and I really work every day to avoid that. People who know me, just know I’m not wired to rest on my laurels or take it easy. I’m just not wired that way. I think we talked about last time when I was on the podcast, I had won couple of Morningstar Manager of the Year awards, trophies. I gave one away to my APM, Steven Krichbaum, and one is in a bag somewhere down in the basement that I don’t know where it is, honestly. And then, I’ve won 18 or 19 awards from Lipper. I’ve never asked for a plaque. I’ve never received a plaque. I don’t want a plaque. I don’t want reminders of past performance making me soft. That’s really important for me. I want to look forward, not backward. That’s really, really important.

I think what’s interesting too is I think if you think about us, I want to get better every year. So, over my career, we beat the Morningstar peers by about 420 bps a year. But actually, if you look at the last five years, we’ve actually beat the Morningstar peers by 530 bps. And this year, we’re actually even better than that. I think the evidence would say we’re getting better, not getting worse over time, that I’m getting—hopefully, we’re getting better over time.

Another thing, again, I’m laser-focused on, that really drives me even more is, we’ve outperformed our peers for 15 straight years against our Morningstar peers. If we’re successful this year to be the 16th year in a row we’ve outperformed our peers and really tie a record of all the strategies that are still around today—only the Pioneer Fund, they outperformed 16 years in a row from the late 1930s to the early 1950s. So, the idea that this year we could tie that record, that almost a 90-year record, and hopefully break that at the end of ‘24, that’s something I’m really driven to do.

Third, I think you really have to surround yourself with really amazing talent that challenge you and make you better. I think I just have this great team around me that they’re not afraid to challenge me, they’re not afraid to disagree with me, and they make me much better. Again, one of the best things about being at TRPIM, I have this great team with me that makes me better. Chen Tian, Mike Signore, Vivek Rajeswaran, Tammy Wiggs, Brian Solomon, Nikhil Shah, Farris Shuggi. They all make me better. We’re a great team. And there are no “yes men” or “yes people” in that group. And again, I think every year we’re a big believer in this idea of continuous improvement. I believe and we practice it. Every year we want to add new analytics to the toolbox. Every year we want to improve our process. Every year we want to get better at thinking about the outside view of the market. Every year we want to discover new market inefficiencies we can exploit.

The last thing I would say is—and it puts a little pressure on me, honestly—is there are so many people that are counting on me: clients, friends, family, my mother, my colleagues, my colleagues’ families, people I grew up with, advisors, and they’ve kind of become accustomed, they’ve come used to generating incredible returns over time. You do it for 15 to 16 years in a row, they expect you to do it next 15 to 16 years. And I have this horrible fear of letting them down. And I’m going to do everything in my power every day that I’m doing this job to make sure that I never let them down. I think if I underperform, my mom is going to be pissed. So, I got to make sure I keep delivering for my clients and my family. And we’re going to continue to work as hard as we possibly can as a team to continue to do that.

Ptak: You sure haven’t let us down. This has been a very enjoyable conversation. Thanks so much, David, for sharing your time and insights with us today. We greatly appreciate it.

Giroux: I enjoyed the conversation as always. Thank you.

Benz: Thanks so much, David.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)