Editor's note: This article first appeared in the Q4 2021 issue of Morningstar magazine. Click here to subscribe.
Disruptive change has gotten a lot of attention lately, as innovative companies have reshaped industries, posted impressive returns, and commanded lofty valuations. But it’s not a new concept for the best bottom-up investors, who are used to incorporating change into their analysis.
At the Morningstar Investment Conference in Chicago this September, Katie Reichart, director of equity strategies at Morningstar Research Services LLC, moderated a conversation on the topic between two former Morningstar Fund Manager of the Year winners: Bill Nygren, chief investment officer for U.S. equities at Harris Associates, and Dennis Lynch, head of Counterpoint Global at Morgan Stanley Investment Management, who joined the conversation remotely.
Nygren runs Oakmark OAKMX and Oakmark Select OAKLX, which have thrived as value has rebounded over the past 10 months. Lynch heads Morgan Stanley’s Counterpoint Global team, and his fleet of growth-leaning strategies excelled in 2020, with some gaining over 100% for the year. Both are stock-pickers who focus on company fundamentals, but their tolerance levels for heightened valuations lead to very different portfolios.
Their panel took place the morning after a spirited debate between Research Affiliates founder Rob Arnott and CEO of ARK Investment Management Cathie Wood, who sparred over Tesla TSLA and found little common ground. It was fun, and it made headlines—you can read it for yourself after this conversation. (“Bubble or Boom?” Page 72.)
Lynch and Nygren picked up on many of the same themes but often arrived at a more nuanced middle ground. Value and growth adherents alike will find food for thought in the discussion. Their conversation has been edited for length and clarity.
Katie Reichart: To start with the concept of disruptive change, how can you determine whether something is a fad or a long-term secular change?
Dennis Lynch: Persistence comes to mind. You want to wait some period of time before you get conviction in a trend. But most of our analysis is focused on the company itself and why it might benefit or why it has a moat or a competitive advantage, as opposed to the trend itself. It's good to talk about themes or tailwinds, but if there's not a company that's going to be able to fully take advantage of that, then it's not worth exploring.
Reichart: Bill, you're not necessarily looking to invest in disruptors, but obviously disruption can affect your holdings. What's your take?
Bill Nygren: I've been doing this long enough that I remember when newspapers were viewed as about the safest business that there could be. So, the idea that disruption is something new is a little bit off. Disruption has been going on throughout the American economy since the economy started. To try and differentiate between fads and what might be long-lasting tailwinds, I would say to look at the benefits for the customer. If a product is clearly superior, and the customer benefits from it, it's much more likely that it can be persistent.
Reichart: Dennis, what type of data do you need to see to confirm that something is going to be disruptive?
Lynch: Unit economics are important. Can the company be profitable? Beyond that, what is the ecosystem of advantages and disadvantages? Who's winning and not winning? And is there a net gain to the entire ecosystem? A lot of these approaches start off not necessarily as robust as the current solutions or offerings in a given area. But slowly but surely, through the iterative nature of the investment those companies are making, they creep up and create problems for the larger companies that are entrenched in how they're thinking, both culturally and from a process standpoint.
Reichart: Dennis, you run strategies across the market-cap spectrum and invest in some private companies. When you see a company that seems disruptive, but it's early stage, how certain do you need to be to make that initial investment?
Lynch: It's an advantage to be able to look across different parts of the market. The industry runs the risk of being segregated and compartmentalized: If you're a large-cap growth manager and you're not aware of the earlier-stage companies or even small companies that are already public, you run the risk that you don't fully understand the competitive landscape that's going to be emerging over the next three to five years.
Our investing in all those buckets is really the same, but when companies are earlier in their life cycle, you might be dealing with some different variables. Those companies may not be cash flow-positive; they haven’t hit scale yet in their business. But make no mistake: Negative cash flow is not necessarily inherently bad. Most companies need to go through a cycle of that kind of investment to get to the point where they’re tackling the large end markets that they have the potential to create and disrupt.
Reichart: Bill, you're running mostly large-cap money. How do you keep an eye on smaller-cap names that might prove threatening?
Nygren: Even though we don't invest at a private stage, our analysts spend a lot of time looking at private companies because they do affect the competitive landscape. I think one of the biggest differences between a value investor and a growth investor is how long it takes for our crystal ball to get cloudy enough that we say we just don't want to forecast beyond that period. At Oakmark, that number is about seven years, which is probably longer than most of our value peers. With these very early-stage companies, you need to have an opinion on a time frame much longer than seven years to justify current prices.
Negative cash flow doesn’t really scare us, even as a value investor. Most companies, even industrial companies, go through negative cash flow periods when they start out. The difference is that accounting allows them to report profits, because their investments tend to be in plant and equipment. But if you make the adjustments for that, as we’ve had to do on companies like Amazon.com AMZN or Netflix NFLX, these companies are building value, even though GAAP accounting doesn’t recognize it. We aren’t limiting ourselves to companies that are below market multiples and generating tons of cash today.
Reichart: Dennis, you own several companies that are not profitable. How far out are you looking with these?
Lynch: For all of our companies, we have what we call a midgame five-year outlook and a 10-year outlook, and we make assumptions as to where they'll be over those time frames. Of course, we're monitoring and interacting with the companies in the short term, trying to make sure that those assumptions will hold true.
Reichart: What do you think the risk is of some of these current disruptors getting disrupted themselves?
Lynch: We're constantly looking at what comes next. You have to be almost paranoid in your approach. A more positive way to say it would be intellectual curiosity. We love learning about new things and monitoring all of these changes. We have over 30 investment people and researchers that help drive the platform, and five of them are dedicated just to disruptive trend topics. They're not industry experts or sector experts. They look at things a little bit more dispassionately, without that sort of filter, and that complements the experts we have in those areas.
There are cases where being the first mover works, and then there are cases where a fast follower winds up doing better. People never thought search was going to be a profitable business, and then Google GOOGL made it very compelling.
Reichart: Bill, can you talk about cases where market disruption has presented opportunities not just for the disruptor, but elsewhere in the industry?
Nygren: When we're looking at industries that are in the midst of massive change, we look at whether the traditional companies are fighting that change or investing for it. We own Allison ALSN. They make transmissions for heavy-duty off-road trucks, and the move to electric vehicles will dramatically change that business. But if you look at how some of the companies that are on the leading edge in EVs are being valued as a multiple of the R&D dollars that have been spent already, and then you look at how much Allison is spending trying to become the leader in that market, you could argue that the market is valuing their EV business similarly to how the other pure EV companies are being valued.
There are a lot of examples where the business that’s getting disrupted might have leading technology in the disruptive area, like Fiserv FISV. Toast TOST became public yesterday at a $40 billion market cap. Meanwhile, Fiserv’s Clover is a pretty similar business to that, and Fiserv’s total market cap is only $80 billion, and it trades at less than a market multiple today.
Everybody likes to talk about Tesla. But there’s a lot of money going into EV R&D at Audi AUDVF and Porsche POAHY and BMW BMWYY, not to mention General Motors GM. It’s hard to believe that that R&D isn’t equally valuable. Oftentimes when there’s massive change going on, people are too quick to dismiss the efforts of the existing leaders.
Reichart: Dennis, you owned Tesla, but not for several years now. What are your thoughts on electric vehicles?
Lynch: I think it's a tough business. Selling cars that are expensive for the average customer, that require financing, is a little different than selling Internet ads. We did own Tesla for about three years. It was a small, more of a speculative-size position back when the first consumer reports came out around the product, and the company was starting to have a real revenue stream in front of it. But the constant need for capital from the capital markets does put you in a position, potentially, during times of uncertainty of relying on the kindness of strangers to continue the business model.
Cathie Wood would say it’s not just about selling cars. There might be more to it than that—energy storage, energy services, and things of that nature. Still, ultimately, it’s a car company, and there are a lot of other big car companies that scale. They do a lot of things differently that are interesting, but ultimately the capital intensity and the constant need for external financing for us became problematic.EVs are an area that we think is really tricky. We’ve been wrong, in the sense that the market price of Tesla since we sold it has done extraordinarily well. But I think it’s really going to be hard to pick an ultimate winner, especially at today’s prices in terms of market cap.
Reichart: Zoom ZM is another current disruptor, and it did very well for Dennis in 2020. Bill, you are a little more skeptical.
Nygren: When we weren't able to be in the office, we were using Zoom as much as anybody else was, and as a consumer, I loved the product. The concern that we had was that Zoom was being priced as if it were going to be the dominant market leader for a long time. But one conference call would be on Zoom, and then the next one on Google Meet, and then Microsoft MSFT Teams and BlueJeans, and they all look just about alike as a user.There was so much capital going into trying to dominate videoconferencing that we weren't comfortable underwriting the idea that 10 years from now, Zoom would be a clear market leader. That's the reason that we opt out of a lot of these investments: We feel that to justify the current price, you need to have an opinion about a market leadership position out past the time frame that we're comfortable making our estimates for.
Reichart: Dennis, do you think Zoom will still be the industry leader in 10 years?
Lynch: Well, I certainly hope so, since we still own it. Look, it's a legitimate concern. But Zoom's market position across domains is interesting. Consumers and corporate users are both using the same platform; not many companies are able to achieve that over time. They already have a nice leadership position, and they're hyperfocused on this one business. I do think Zoom's product is superior. The adoption has been superior. There are a lot of things that can go right, but certainly there are some things that can go wrong.
We invested in Zoom at the IPO and shortly thereafter. We didn’t expect there to be a pandemic and that massive adoption would occur with the speed with which it did. We own a lot less Zoom than we did initially, because it has gone up a lot, and the valuation has changed. But we still think there’s enough to go right to maintain a position. Position sizing matters. Rather than making a binary decision—I can own or I can’t own this—a more nuanced way is owning a little bit of something where things can go right, knowing that there are some things that can go wrong. That is not unreasonable when you have a world that has such disruption occurring and where these upside scenarios wind up being so large.
Sorting Through Stocks Reichart: We've heard a lot of commentary about market bubbles and comparisons to the tech bust. Do you think this time is different?
Nygren: Back in 2000, investors were willing to pay an unreasonably high multiple for large-cap growth, and that dominated the S&P. We were seeing traditional businesses getting knocked out of the large-cap universe by these small companies that had very, very high multiples on them. The pockets of the market to us today that look overvalued are not the FAANG stocks that dominate the market weighting in the S&P. We own a bunch of those. Other technology companies, areas like SPACs [special-purpose acquisition companies], have gotten to inflated valuations. There's this part of it that looks like speculative excess, and then we've got banks at 10 times earnings and oil stocks that have 15% free cash flow yields.
I’m not going to sit here and argue that it’s a generational opportunity to buy equities or anything like that. But given where interest rates are, owning an equity like the S&P that pays almost a 2% dividend yield and has earnings that are growing at 6% or 7% a year, compared to a long-term bond, is an easy choice to make.
Reichart: Dennis, you don't own a huge percentage in FAANGs. You do own some SPACs and other areas that Bill alluded to. What's your take on this question?
Lynch: My first point would be that we don't see any great opportunity in equities, but what are you going to do with your money? There just aren't a lot of great alternatives.
We used to own many of the largest companies in the world today—10, 15 years ago. We don’t own as much today. When you start having $1 trillion and $2 trillion valuations, if anything goes wrong, it’s a lot of market cap to need to be able to support through your fundamentals. So, I think more about the downside case on some of those companies because of their size. The other issue is that as they get that big, there is regulation and how that might change their ability to continue to compete. We don’t dislike those companies. But all things equal, I would rather own smaller companies with smaller market caps that we think could be much bigger over time than some of the larger companies that exist today.
I don’t think it’s like 1999. Back then, you had very little proof as to how the companies were going to make money, just more conceptual ideas coming public. Today, you tend to have real business models with interesting unit economics and large opportunities, but the prices aren’t what they were. So, we’re not expecting high returns, but when you have a negative real interest-rate environment, it’s really challenging.
Reichart: Dennis, you are invested in bitcoin to a small extent. You own Square SQ, which has bitcoin investments as well. We see what camp you're in. Bill, do you think cryptocurrency's a trend to be embraced or ignored?
Nygren: It would be hard to ignore it, but we can get into enough trouble investing in companies we think we understand pretty well. Despite spending time trying to understand cryptocurrency, trying to understand the basis for why bitcoin would be worth $45,000 a coin, we can't come up with an argument we're comfortable with to say this fits our criteria of something that we'd like to own. We're happy opting out, and I think people would be wise to not listen to me on topics where we've just decided we don't know enough to make an investment.
Reichart: Dennis, how do you come at it?
Lynch: It makes sense that Bill wouldn't like it. It's not a productive asset. It's highly speculative. Having said that, there are some interesting qualities to it that I think can add to a portfolio. As I mentioned earlier, you don't get in trouble making investments if you size them properly.
We talked about persistence earlier. Bitcoin’s kind of like Kenny from South Park. It dies every episode, and then it’s back again. As for adoption, it’s almost like bitcoin’s a virus and we’re all a little bit infected. Some people fully have gone there, and some people haven’t, but we all know about it. That’s interesting to me from a viral mechanism.
But more importantly, I think it’s demonstrated some antifragile qualities, antifragile being something that gains from disorder. I can envision it benefiting from different environments, whether people look at it as digital gold or people start to really question fiat currency. Most antifragile investments—the most famous ones being like those used in 2008, as in The Big Short—are structured like put options or out-of-the-money options. They’re specific bets that have very specific durations. What I like about bitcoin is that there are scenarios where it could do really well as a diversifier, but it’s not necessarily going to expire tomorrow. The government could just outlaw it; that’s one of the risks, of course. But there’s no contractual endpoint.Bitcoin is something that could go right when the rest of our portfolio is having something go wrong. To me, that’s compelling. Given bitcoin’s persistence, it’s worth a small speculation.
Ready for Change Reichart: A question from the audience: What behavioral biases are the most important to watch out for when evaluating disruptive companies?
Nygren: The behavioral bias that you need to be most concerned about is overreacting to short-term events. As value investors, we're always trying to take advantage of that when we think investors have overreacted to negative news. The overreaction potential with disruptive investments is that you get excited and lose your skeptical hat.
Lynch: When I've made mistakes in this area, it's because I've had an initial reluctance—that'll never work, or it's pie in the sky. When I have that sort of gut reaction, I like to explore why it might be wrong. Back in 2002 or 2003, Amazon sounded like the worst idea of all time. I thought it was like the poster child of everything that went wrong in the financial world back in the late '90s. I remember Bill Miller was pitching Amazon on CNBC. I was on paternity leave listening and started thinking about it differently, maybe because I was out of my daily routine. That wound up being our best idea ever.
Reichart: We have an audience question on inflation: How would sustained higher interest rates affect your outlook for innovative, fast-growing companies, which often have heavy investment needs?
Nygren: I think higher inflation and higher interest rates would be good for our portfolios because of the amount of financial-services companies we own, and oil companies would be beneficiaries. The biggest risk with higher interest rates is that higher interest rates make the future worth less. Not worthless, but worth a smaller amount than it would be with low interest rates. One of the reasons that high-growth companies have performed so well over the past decade, and it's been so difficult for value investors, is the duration effect: High-growth companies deserve to go up more in price when interest rates fall than low-growth companies do. A reversal of that could be quite difficult for the high-growth sector of the market.
Lynch: All things equal, that makes sense. I hope there are some nuances, too, though. It's not just about the overall trajectory; there can be some company-specific things that can continue to go right. How do you prepare for inflation? I think it's about owning companies you think have pricing power and that are in a good position competitively.
Reichart: Bill, you own a lot of financials. How worried are you about disruption in the financial sector?
Nygren: Most of the financial names we own are selling relatively close to stated book value. In a world where they get disrupted and their business goes down every year, they could liquidate for relatively close to the current stock price.
Second, I would say that a lot of the change that’s been going on has been good for the very large, traditional financial companies. Brian Moynihan [CEO of Bank of America BAC ] said that the pandemic has pulled forward mobile banking by a decade. If you go into a bank to a teller, it costs them $4 to process your check. If you do it at an ATM, it’s 40 cents. And if you do it on your phone, it’s 4 cents. The big banks are a disruptor there because they are so far ahead in mobilization for their clients. I don’t see a big downside for most of the companies that we own.
Reichart: What disruptive change theme or company do you think is going to be most relevant over the next five years?
Lynch: E-commerce penetration and software as a service as a solution for all sorts of enterprises, in terms of enabling them to serve their end users and build their businesses most effectively. Whether every company currently is a great investment in these areas is to be determined. But we're focused on those two as fundamental trends.
Nygren: I don't have a strong opinion on it, but I think one of the surprises that you're likely to see is that traditional companies will be able to do a good job maintaining their markets as they adopt new technology and even lead in new technology in spaces that we consider ripe for disruption.
Reichart: Thank you so much for sharing your views. This has been a great panel.
Laura Lallos is managing editor of Morningstar magazine.
Photography by Matthew Gilson.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.