Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research for Morningstar, with the live panel broadcast, Three Takes on Today's Market. I'll do the introductions briefly, and then we'll dive right in, since you're not here to hear me read introductions, you're here to hear what these three investment professionals have to say.
All the way down on the far end is Charlie Bobrinskoy, who is vice chairman and director of research for Ariel Investments, also co-portfolio manager at the Ariel Focus Fund, right here in Chicagoland. Next to him is Tom Forester who runs the Forester Capital Management and the famed Forester Value Fund, one of the only equity funds do not lose money, if I am correct, in 2008. Right here, immediately to my left is Doug Ramsey, Director of Research for the Leuthold Group and co-manager of the Leuthold Global Fund.
Thanks for joining me, guys. Much appreciated.
So just to set the stage, we have three really different approaches here, which actually made coming up with questions a little tough. Charlie, you run a very focused fund with the top position at maybe 7% or 8% of assets, a very small number of names; your top position, Tom, is maybe around 3%-ish of assets; and you [Doug], of course, are doing top down kind of macro asset allocation.
So I have found over time that portfolio managers tend to gravitate to a style that kind of resonates with their personality. So I'd maybe like to just talk a little bit about why you've chosen to run money the way you do.
Charles Bobrinskoy: Sure. Ours actually comes less from personality than from philosophy. It's the Buffett idea of, in this world you may only get 20 great investment ideas in your lifetime, and it's better to invest in those 20 ideas than your 21st or let along your 100 best.
Secondly is the idea of knowledge, of really being smart about what you invest in. It's a lot easier to invest in 25 or 30 names that you can know really well rather than trying to be smart about a lot of things. So those two ideas have brought the whole firm around this idea of concentrated portfolios, somewhere between 20 and 40, 45 stocks.
Tom Forester: Well, we like safety. I've got most of my net worth tied up in the funds, and so we double down on Charlie, we've got about 40 names in our portfolio, which some people tell me why so many names, and other people say how come you don't have more? So we think we're about right, but we think the diversification gives us a lot of protection in the case that we happen to be wrong, and that does happen from time to time. It doesn't hurt the portfolio nearly as much.
Douglas Ramsey: You know, I think safety and conservatism for us is also a big driver of the way we manage assets. We maybe just accomplish it, I think, in a different way. Even your 20 or 30 best ideas 10 years ago were at ridiculously overvalued levels, and with our approach to flexible asset allocation, we can move away from those.
We were as low as only 13% equities in our Domestic TAA fund in early 2000, allowing us to wait for the types of opportunities that developed, let's say, for example, October 2002, with the low or the low last year, March of '09. So it's that ability to be flexible with actually managing the equity exposure as a result of that desire for safety.
Dorsey: So we will start with the top down then, and we will start with you, Doug, the macro guy on the panel.
Dorsey: If you had to pick one big picture issue that's kind of keeping you up at night, what is it?
Ramsey: At this point dollar weakness. It's pretty clear that we have authorities that are not very focused on the exchange value of the dollar, that the desire to avoid deflation at all costs is really what's driving Ben Bernanke. In fact, last night on 60 Minutes, he estimated that he has a 100% chance or the 100% ability to avoid deflation, which I think is, to me that's a difficult one to buy into.
So, we've actually protected ourselves, and by the way, I think in periods of moderate inflation, equities can actually be a decent hedge against the loss of purchasing power. Now, not when you get above 7% or 8% or 9% inflation, but I think at moderate levels of inflation, equities can be a reasonable hedge. We've also got a small position in physical gold in our global fund and, in fact, all of our TAA funds, as a hedge against further U.S. dollar debasement.
So, we think this cyclical bull market is intact and that it pushes higher. We've actually got a target of 1410 for the S&P for 2011. But the question becomes down the road, even if those equity prices do go up, will they retain the same purchasing power that they have had in the past. So, that would be the one big late-at-night issue for me.
Dorsey: So, in your view in the inflation/deflation punchout, inflation is the knockout one?
Ramsey: Longer term, yes. I think the thing to watch is monetary velocity. Watch the money supply. I mean at this point, all of the Fed is pumped in. It's not yet showing up in the system in terms of lending and money supply. So, I don't think there is an imminent threat, but I think looking out to 2012-2013, it is a real threat.
Dorsey: What keeps you up in night, Tom?
Forester: Several things, but I'll just pick one. I think one is really, it gets back to too much debt. The way that that plays out, you see that it's the reason that Bernanke is trying to keep things going at all costs. Because he knows that at the end of the day, whether it's real estate, whether it's mortgages going bad, whether it's banks taking write-offs on that, whether it's an overlevered consumer, he needs to keep the ball going so that the debt can be serviced. Because the debt stops being serviced, the banks are really in trouble and you go back into a late '08 early '09 scenario. So it kind of forces his hand.
You're also seeing that getting played around the globe, because basically Europe is in the same issue. The reason that the Greece got in trouble was too much debt. The reason Ireland got in trouble was too much debt. The reason that we're having trouble in Portugal and Spain is too much debt. So that's really what keeps me up because that's what's driving all the decisions.
We asked this in the office the other day: These must be normal times because the market's back up, right? Oh, yeah, yeah, yeah. Oh, okay, when was the last time that the Fed was talking about printing money? Well, jeez, I don't remember the last time. When was the last time they were talking about printing $600 billion? Well, never. So, these probably aren't exactly normal times, are they? So, that keeps me up at night.
Bobrinskoy: Combination of the fixed-income bubble and the municipal bond crash that I think is coming. I think we've got state municipalities that really, at this point, have no chance of meeting their obligations. The State of Illinois cannot meet its pension obligations, [and] California, a couple of other states. And yet the bonds trade as if they are solid credit. So, I am very worried.
My one recommendation for people watching is if you own any 10-year municipal bonds, you should think about selling them, because they're being priced as if they are AAA credits and there is just lot of risk. I think they are being priced as if people assume that the federal government is going to come in and backstop them, and that might happen, but it's not absolutely certain that it will. It's not clear the people of Texas and Nebraska are going to feel okay about bailing out the taxpayers of California and Illinois.
So, I worry a lot about what's going to happen when the musical chairs game stops, because the State of Illinois just cannot meet its current obligations.
Dorsey: How does that affect your thinking in security selection as a bottom-up equity guy? I sympathize completely with what you're saying about fixed income as an asset class [or] long-dated munis in particular, but how does that filter into your thinking about security selection?
Bobrinskoy: Yes. Everything is always a risk/reward trade-off, and to me right now equities, in particular, high-quality equities just represent a much better risk/reward trade-off versus bonds and fixed income. So the high-quality names that we're going to talk, about something like a Johnson & Johnson or IBM give you the upside with some risk. There is no doubt there is risk, but there is still the upside that we think is not being factored in. You have to put your money somewhere. I'm not saying there is no risk in the stock market, but versus the alternatives, where the flows have been going into fixed income, the equity market just is a much more attractive place to be.
Dorsey: Doug, as an asset allocator, would you agree?
Ramsey: Yeah. I do hear what Charlie is saying in terms of the good value and the large-cap high-quality stocks. I would probably, though, emphasize quality within more of a cyclical bent, because I think, if you study what unfolded, during the great meltdown, second half of '08. Really there were two distinct phases of what I'll just call defensive stocks outperforming, I mean consumer staples, health care, utilities, many of which are high quality and pretty undervalued, but there are really two phases.
There was a flight-to-quality associated with the normal discounting of just a typical garden-variety recession, and then there was a second parabolic move into those stocks. Now, remember, they were still going down, but not nearly as rapidly as everything else. That second move...
Dorsey: ...a different kind of parabola.
Ramsey: Exactly. So really that second move and let's just say from October of '08 through March of '09, in my mind – and keep in mind, we had several days during that period where the Treasury bill yield went negative. So if there was such a flight-to-quality into Treasuries, it also embedded itself in the stock market, and to-date, we've really only unwound in defensive stocks that parabolic, that real panic associated with the fear of the Great Depression 2. So I'd just be selective. I mean I certainly agree, we do those valuation studies as well. It's just I think there is still another leg for the higher quality, but more cyclically-oriented stocks to outperform.
Forester: I wanted to just throw one thing in there, because I agree with Charlie on the muni issues and whatnot. We've really taken a look at the portfolio because we own some insurance companies, and one of the ways insurance companies make their money is by buying fixed income obviously, and a large portion of that tends to be munis.
So we've gone back into the supplemental things that they send out on quarters about their investment portfolio and whatnot, trying to take a look at what are the durations of their portfolios, what exposure do they have for this exact issue. We own Travelers and Allstate, and some of the health-care insurers, and fortunately, those tend to be shorter-term liabilities, so they tend to be shorter-term assets.
But it's something we're keeping a short leash on right now, and I know Allstate has a little bit of a life insurance portion to them, but we would be looking to lighten up on life insurers at this point, and it isn't something that we're actively looking to add more on because of that sort of a risk.
Dorsey: Yeah, I was just going to follow-up on that when you were talking about the short term exposure that an Allstate or Travelers has with the P&C and the auto portfolios. So life insurers would be an equity that's very exposed to possible defaults in muni land. Other equity groups you can think of? I mean life is certainly an area that you probably start steering away from. That was one that came first to my mind, anyways.
Forester: We've been thinking that through, lately, and it's not a direct, but it's an indirect, if you will, and it's always surprised me a little bit at how reliant some stocks are on states, for example, and even some of our companies have a lot of international exposure, so they're exposed to countries, and I hadn't quite appreciated, like in Europe, for example, with the pharmaceuticals, where because they are are a national run health program, they can dictate prices oftentimes to the Pfizers of the world and what have you, and say to them, look, we like your drugs and we want them in our system, but we're going to give you a haircut and while traditionally it's been, say, 12%, now it's going to be a 22%, and it really does trickle down to these guys. And I guess, I hadn't realized just how much pricing power a lot of the governments have and that dribbles into the states as well.
Bobrinskoy: It's an obvious one, but last year my favorite short was Ambac and this year it's MBIA, which the stock has done well, but if these states start going under, MBIA I don't think can be solvent. The stock is up big this year, because they've remained liquid but I just – when you start seeing these defaults, they are leveraged 100 to 1 in terms of their guarantees of municipalities. I just don't think they've got the capital to cover those defaults.
Dorsey: So before we move off the fixed income topic, I wanted to ask you a question that's befuddled me all year. Bond fund flows, obviously, have been just off the charts this year and last year. I mean, investors are pouring money into bonds as if the bond market was going to shut down tomorrow, and they can never buy another one. This has befuddled me because I think if I can buy a 3.5% fixed coupon, an investment grade corporate, or I can buy 7% to 8% rising coupon, in terms of a free cash yield, the math doesn't seem real tough to me. I don't have a great explanation, other than performance-chasing for this. Do you have any insight you want to give me?
Forester: Well, one of our stocks that we like and has done well is Altria, and they've been paying a 6%, 7% yield forever, and they're only paying about 10 to 11 times earnings, something like that, and so for us, we like that a lot better than paying 2.5% or 3% now, but 2.5% for 10-year Treasuries. We think that the fixed income world has become, on a risk-reward basis, all risk, no return. So, we tend to shy away from that.
Dorsey: So, why has the money kept going in the bond funds, though? I mean, I agree with you, but every week I look at the fund flows and I just – I can't explain it, other than simple performance chasing. I mean, a 10-year chart of Treasuries looks a lot better than a 10-year chart of J&J.
Bobrinskoy: Usually we don't like to point to flows as the explanation, but that is the explanation here. It's entire classes of investors, particularly corporate pension plans, who've gone from being predominantly equities to much more 50-50, huge swings into corporate bonds. The Chinese, obviously, big buyers of corporate securities, and then retail investors, who just are risk averse and have seen the very good performance from fixed income. So the flows have driven. There is a limited amount of supply of high yield and municipal and corporate bonds that have just driven prices to what we think are levels that make no sense.
Ramsey: I was just going to say, I mean, unlike chasing the tech funds and the large growth in the late '90s, the additional thing that concerns me is I'm not sure on the part of a lot of the retail public, that there's an appreciation of the mechanics of a bond and its relationship to an interest rate, and you'll have people calling up, what's the interest rate on my bond fund? Well, it doesn't quite work like that. I mean, there's price exposure there that I think, sadly, that's going to be learned here in the next two or three years.
I think the other point is, I mean, there is a modern-era case of extremely low interest rates dropping in half again, and that's happened in Japan. So, it seems to me there's this asymmetric expectation that if we've now flat lined, in terms of economic growth or some especially bearish case of the, so to speak, new normal, yeah, there is certainly a case that the 10-year bond yield could go down to 1.5% in a very unusual scenario.
Dorsey: So you're saying is that a high probability case?
Ramsey: No. It's not, not at all. We did it simple thought exercise, not a forecast. But if you take today's 10-year bond yield, weasked the question, well, what kind of action would you have to see over the next five years to get a 6% return out of that 10-year bond yield? Well, you'd need the 10-year, which is currently, let's call, it 285, you'd need that yield to go all the way down in the next five years to 17 basis points. You'd be collecting your coupons every six months and then you'd be looking at a five-year time horizon with trying to reinvest those proceeds into a five-year Treasury note at, who knows, 10 basis points. But just again, I think it's just this asymmetric return expectation. Yeah, I mean, there's a maybe less than 5% probability of a Japan deflationary spiral happening, but to make bonds work out you really need to bet on that happening.
Dorsey: So that's a great one that's just worth highlighting maybe for the folks watching. Because the 10-year return on the Treasury is around 6%ish, that to get that over the next five years you have to believe that the 10-year Treasury will trade at 17 basis points.
Ramsey: Correct. To get a 6% return, just a 6% return.
Dorsey: So do you think that?
Forester: I would say, lastly, then that one reason why I think that bonds did so well is that in the summer Bernanke came out and started talking about QE2 and basically saying we're going to buy 10-year Treasuries. And so he couldn't do that until after the election, but everybody else could start ahead of him. I think that a lot of the hedge funds started jumping into that trade, yields went down, prices went up, and as soon as you get some momentum going, everybody else kind of followed, and I think it was a self-fulfilling prophecy. And I think it's reversed now because it was buy the rumor sell the fact.
Dorsey: So I think we've covered the ground on fixed income valuations rather thoroughly here. Moving on to equity valuations, you guys [Forester and Bobrinskoy] are mainly bottom-up shops, you're [Ramsey] more of a top-down shop. But just before we get into specific stocks and process, any general thoughts on sort of market level valuations, high, low and fairly valued, indifferent?
Forester: The S&P is trading, call it, 15 plus or minus, and historically that's kind of middle of the range, if you will. It's not ridiculously cheap. Certainly, it's not 35 times like it was in the early 2,000s and whatnot. So normally we would be somewhat neutral to positive. Retail sales have been up. There has been a little bit of momentum going on in the economy. So normally that would be good for us.
I think our concern, though, is, is that the federal government is running a deficit of, I don't know, 8% give or take, and you've got the Federal Reserve printing money and pumping more money into the economy. And so it's not an economy that stands on its own two feet. And so, in normal times, I would say it's neutral. In these times, where there is a lot of extreme life support, if you will, going on still in the economy, I would actually say things are fairly expensive right now.
Bobrinskoy: We'd be more bullish than that. We would tend to look forward and use that 12.5 multiple on the S&P for the overall market. You're right, on a trailing basis it's more like 15. But companies have bought a lot of stock and they have so much cash on their balance sheet, we think they are going to buy a lot of stock in, which is going to improve earnings without them doing anything on the operating side.
There has been so much ... so much improvement in productivity that we think it's not hard at all for the S&P to go from 82 to 92 in terms of earnings. And in this interest rate environment, those kinds of 8%, 9% earnings yields just seem very attractive to us, and we think there is a real good chance that people are going to get frustrated with these very low or what we think will be negative returns in fixed income, and the money will start coming back into the market, and we'll get multiples that are more like mid-teens forward multiples.
Ramsey: I'll just preface with this: we use a normalized earnings number, so my numbers are going to sound a little bit different than what they were using. But the S&P 500 currently on our five-year average earnings trades at 18 times, and that is right on its 60-year median. So, we'd say U.S. equities, large-cap equities, are right at fair value.
We think as confidence returns and people become convinced this is not going to be something that unwinds into an economic double-dip, there is room for that number to go somewhat higher; not back to '07 levels, certainly not back to '99, 2000, but I think there is room for valuation expansion.
I'd say the same thing about emerging markets. They're also right about 18 times normalized earnings, and again that sounds high, but we're just averaging over five years. So I think they are around fair value, room for multiples to expand.
To me the big valuation opportunity and the big disparity is, developed countries outside the U.S., because currently they're more like 13.5-14 times.
In the past, 1990 bear market low and the 2000 bear market low, those bear markets bottomed with those stocks--and here I'm talking about some of the big usual suspects, I mean Japan, Germany, France, all the European countries, Australia. Collectively they bottomed at around 18 times this normalized number.
So, even though we've had a very nice rebound, I mean 80% rebound on average in those markets in the last 21 months, we're not even back up to where we bottomed in 1990 and '02. So those big companies outside the U.S. in developed markets, I think, have a lot of room to close that valuation gap.
Dorsey: That's a really interesting point, because I was having dinner with a portfolio manager I know in London about a month ago who manages an all-Europe fund, and he is buying things like small metals distributors and Dominos Pizza, stuff that's not really affected by the PIIGS crisis, and their numbers are off the charts, and he was looking to getting outflows all year, because basically people aren't looking at our performance or our holdings, they're just saying, my Lord, Ireland is going to default, I'm taking money out.
Has that resulted in more opportunities you think in European names? Have more European names been popping up on your screens, Tom and Charlie?
Forester: We run an international fund as well, and certainly we own a fair amount of European stocks, and quite frankly, the valuations in Europe are quite attractive. It's because of the environment that you're in, but you see many more single-digit P/E stocks over in Europe than you do in the United States right now. So there is a lot of attractiveness.
Dorsey: So you'd say – again, it's a very big picture question -- but by and large you're seeing more value in Europe than you are in U.S. stocks?
Forester: Yeah, I would say, yeah.
Bobrinskoy: We tend to be pretty domestically focused, and our clients pay us to invest where we have expertise and so more of that's in the U.S.
But, yeah, I think the larger companies are getting great growth internationally, but more in the emerging markets than they are in Europe. Most of our managers are talking about the U.K. still being pretty slow. There is still being some long-term challenges in non-German Continental Europe. So, I think we directionally would say an IBM is going to get more growth out of ex-U.S. international ex-Europe than we are out of Europe.
Dorsey: Got you.
So let me move on to a couple of questions about investment process, which I always find fascinating. Then we'll talk about some specific positions maybe kind of towards the end of the panel.
There has been some interesting work in behavioral finance over the years, talking about the difference between confidence and information. That the more information you have, the more confidence you have in your decisions, even though your decisions may not actually be any better, just because you have more information.
So how do you each manage this tension between wanting to know more and having a finite amount of time? How do you find that point on the curve of diminishing returns when it's time to stop reading Ks or stop running models and start making decisions?
Forester: For ourselves, we're a bottoms-up value guy, and we look at valuations, and so we start with things that are cheap. That's really are our initial screen because we think that's where the performance is longer term. You buy something that's way undervalued; it comes back up to fair valuation, and you get both the market return, and you get that spread as well.
So we start at very attractive valuations and then we start doing our fundamental analysis on the company. I think when we understand the big picture of what's driving their earnings and we feel that the valuation – there's way more risk in the valuation than is warranted, at that point we start feeling pretty comfortable.
And it isn't that we need to know that this drug is going to sell 10% more or something like that, we just need to know that there's a lot of fear in that, and the valuation is way too low for the amount of risk that's in the stock, and that's how we really get our outperformance is buying that valuation. We know that we can't know everything, and so we allow the stock's valuation to do some of the work for us.
Bobrinskoy: We think that if you have to have a 20-page computer model to tell you that the stock is cheap, then it's not cheap enough. In general, the things we've done right and the things we've done wrong were because we got the big issues right or wrong. We spend a lot of time focusing on those issues not on the footnote on page 47 of the 10-K or the 20 page earnings model.
I can't think of a single situation in the past, where we've made a great investment because of some tiny piece of information that we've learned in the second year of research. It's always because we got the big themes right.
Dorsey: It's a very, very good lesson.
Ramsey: I think in my case, I probably migrated to the macro work and also to the quantitative, in part, because I never really gained a satisfactory answer to that question of how much is enough on the analysis work, because there is so much in terms of company analysis that is done, I think after the gut decision is probably already made, and then really it just becomes analysis for the sake of analysis. But in terms of my brief career of doing fundamental company work, I'm not sure that I ever hit that sweet spot in the curve.
Now, in the case of quantitative models, we've got a couple there are pretty elaborate. Our major trend index, which our Founder Steve Leuthold has been compiling and tabulating on a weekly basis for almost 50 years, there are 190 indicators in that model. So you can argue we still haven't hit that sweet spot as to what's too much information. But to some extent, I think as a quantitative manager we can circumvent that issue to some extent.
Dorsey: Other process question, and any of you all can jump in on this front. How do you avoid commitment bias? You own a security for a long time, and we've seen more than few managers--I hate to say, but Chris Davis with AIG, Bill Nygren with WaMu. Positions they owned for quite some time, and yet they kind of missed something that others who had not arguably known the company as well did see. How do you avoid that--I guess the vernacular would be--falling in love with your stocks? You're both [Bobrinskoy and Forester] low-turnover...
Bobrinskoy: The first place to start is to realize that you have the commitment bias; we all have it, and so then you have to put things into the process to counteract it. So the devil's advocate is something that we've put in--somebody whose job it is to point out the bear case on your investment.
The second is the re-examination of names, to go back to the original research and thesis and valuation and see if anything has changed.
Then third is just to understand that you have this bias and therefore, you have to look for non-confirming information. So, we try hard to spend as much time with the analysts who hate our stocks as the ones who like them, because the normal tendency is to do the opposite.
Forester: We have two things in our process that try to get at that, and you're right, we all have it. You know, we are human. The first would be, when a stock hits fair valuation, it's definitely a candidate for getting rid of. We've owned McDonald's for about five years now, and it's been a great stock, but it's gotten to fair valuation, and we've been looking for something replace it with, and we've recently done that. It's hard to get to rid of a winner because you feel good about it, but it's sticking to your discipline.
The second thing is time. If we hold a stock for two or three years, we're starting to look at, is it doing what we thought it was going to do? Do we think it can go further? It's kind of like, you start of thinking of when do we sell this, is it time now? So, the benefit of the doubt kind of comes off if you've held it for three years, that "okay, it's worked; now, maybe it's not going to work going forward." So, what's the case for keeping it? So, it's got to stand on its own two feet almost every day instead of just when you initially bought it.
Bobrinskoy: I'd also just jump in again. I think it's important, though, some people when a stock hasn't worked will sell it because of that, and in the last two years that's been absolutely the wrong thing to do. In our industry, most of the best investments have come from stocks that got killed in '08 and early '09. So, a lot of our names that have been quintupled or quadrupled were because we held on to things or bought more of mistakes. So, you've always got to be looking forward.
Dorsey: Doug, do you feel your quantitative approach sort of helps you avoid commitment bias or does the same thing creep in?
Ramsey: Absolutely, it does, but it leads to a recommitment bias. So, I can say we don't have commitment bias when something--we are group rotators. When a group falls into neutral status per our monthly model, no questions asked. It is sold.
Now the issue becomes, in attempting to identify short-term themes or intermediate-term themes, we're looking to typically own groups for an 18- to 24-month exposure period, capturing on business cycle leadership in that group. In the course of doing that, we're going to have some missteps, and I can think back to first half of '08, investing in the oil and gas refiners wrongly, and we quickly sold them out and also the regional banks.
So, the issue becomes, no problem with commitment, we sell them, but when they pop back on to the attractive list, it's once bitten, twice shy, and it's very hard for us to go back into – well, last time we were in regional banks, we took a 25% haircut in just three months. Do we really want to go back into this group? So, it's overcoming that sort of recommitment bias. You know, just really being like a defensive back, just having no conscious and no memory as to getting burned recently, I think, is a key with applying these quantitative models.
Dorsey: Sort of wiping the slate clean.
Ramsey: Exactly. It's hard to do, even for quants, because there is certainly an amount of discretion within our quantitative framework.
Dorsey: I think it's probably something that the fundamental guys, you all face as well, I mean, you have to have a wipe-the-slate-clean approach, whether the stock you looked at a couple of years ago, didn't buy, the stock you own--to not factor in and all that stuff that you already know about it and approach it with a fresh slate.
Forester: Sure. It's like baseball. You've got to keep swinging. You may have gone up against a pitcher, and he struck you out last time. So what? This is a new inning, a new time at bat. So, if you bought a stock before, and it didn't work out for you, it doesn't mean that it isn't a great stock today.