Past Glories The Wall Street Journal's Jason Zweig informs me that I understated my case in "The Strange and Happy Tale of Voya Corporate Leaders Trust."
To recap, that fund bought 30 stocks at its 1935 inception, to be held indefinitely. Management has not traded those positions, although if its holdings were acquired by another firm in a stock-for-stock deal, it would retain the new owner’s equity. My column observed that the fund’s founders were poor futurists. They not only bypassed all financials when creating the original portfolio but also skipped IBM and automobile manufacturers.
Per Zweig, these omissions were deliberate. He responds that when Voya Corporate Leaders LEXCX was set up “it excluded autos as well as radio & electronics, not to mention airplane stocks.” The fund’s stodginess wasn’t accidental. Its founders purposefully avoided the most exciting, high-growth sectors of the '30s to invest instead in established industries such as steel, oil, and utilities.
This would seem to make the fund’s long-term success all the more remarkable. How could an unmanaged fund that looked backward rather than forward when creating its portfolio and that invested in businesses that averaged slower revenue growth than did the overall U.S. economy have posted such competitive results? (The fund’s long-term total returns roughly match those of the S&P 500.)
Two reasons why the fund has thrived are trivial: 1) It has (partially) modernized through corporate actions; and 2) It has been lucky. The third reason, however, merits further discussion. Sluggish revenue growth may not necessarily boost a stock’s price but neither should it be regarded as an unquestioned drawback. The reality is more complicated than “high growth good, slow growth bad.”
Value Investing's Argument The obvious claim in support of slow-growth strategies is that equities don't have fixed prices. Their quotes reflect investors' collective beliefs. Effectively, outperforming the market means not concluding that the New England Patriots will beat the Washington Redskins, because others already expect that, but instead judging the accuracy of the point spread. The first decision is easy; the second is not.
Such is the logic of value investing. It is a compelling proposition, particularly when coupled with evidence that most investors are happier owning growth companies, which tend to issue good news, than they are holding value stocks. The implication is that because of these psychological factors, higher-growth businesses will be perpetually overrated. To revert to the football analogy, the Patriots will be too highly favored. Take the Redskins and the points.
Avoiding Competition However, the merits of value investing can only go so far in explaining Corporate Leaders' longevity. The fund, after all, holds most of its securities for several decades. No matter how attractively its stocks were priced at the time of their purchases, they wouldn't have been good long-term investments if their businesses didn't perform fairly well. Somehow, they overcame the handicap of operating in fading industries. Former Fidelity Magellan FMAGX manager Peter Lynch explained why such companies could not only survive but sometimes even thrive: lesser competition. (Thanks to reader Lawrence Hamtil for reminding me of this quote.) In Beating the Street, Lynch wrote:
A great industry that’s growing fast such as computers or medical technology, attracts too much attention and too many competitors … As a place to invest, I’ll take a lousy industry over a great industry anytime. In a lousy industry that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.
Lynch overstated the matter, as he had a book to sell. Nothing beats landing the right company in the right high-growth industry, such as Amazon.com with e-tailing, or Apple with personal devices. But the point remains. The business prospects for well-run firms that operate in mundane industries are better than is generally believed because those companies aren’t hounded by new rivals. Nobody enters their field; the competition exists solely among those firms that already exist.
Management's Contributions A related benefit is that the CEOs who manage such business are unlikely to be empire builders. As evidenced by the WeWork debacle, those in charge of high-growth businesses can be rather cavalier with shareholders' monies. After all, what's a few billion dollars spent when the potential profits are so great? Those who manage firms in slow-growth sectors pay closer attention to the bottom line.
Another advantage of investing in mature sectors is that their companies are rarely complete busts. The same precept does not hold for the smaller players within glamorous industries. For every Amazon or Apple, there are dozens of failed rivals who raise large amounts of capital and then expire, with no return to shareholders. In contrast, slow-growth businesses usually close their doors only after having paid substantial dividends and often with assets that can be sold.
These arguments also apply to national economies. Just as slow-growth industries possess unappreciated investment attributes, so too do slow-growth countries (as measured by gross domestic product changes). Particularly important is stewardship. For investors, a country’s GDP growth rate is only the beginning. For its stocks to thrive, corporate managements must convert their revenues into profits by controlling costs, resisting the temptation to build empires, and conveying the bulk of profits for outside shareholders, as opposed to (ahem) friends and family.
Thus, Vanguard Total International Stock Index VGTSX, covering the developed markets, has underperformed Vanguard Emerging Markets Stock Index VEIEX only mildly over the trailing 10- and 15-year periods, although the latter’s countries have notched far higher growth rates. And U.S. stock market indexes have thrashed both, although the United States hasn’t been a high-GDP growth country even by the modest standards of developed nations. That result quite clearly owes in large part to U.S. management’s emphasis on delivering shareholder value.
Lynch's hyperbole notwithstanding, identifying and investing in high-growth industries (or countries) is a sensible idea. There's nothing wrong with riding a tailwind. However, as demonstrated by Voya Corporate Leaders Trust, investment rewards aren't reserved for those who can predict the future. Seeking companies that treat their shareholders well, in the here and now, can also be a successful starting point. John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.