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The Long View: les valeurs technologiques US sont très risquées - Ariel Investments

Dans cet entretien (en anglais), la responsable des investissements internationaux d’Ariel Investment, expose ses vues sur les actions mondiales et partage quelques idées.

Jeffrey Ptak 20.09.2019

Voici la retranscription d'un entretien en anglais par Jeff Ptak et Christine Benz de Morningstar, avec Rupal Bhansali, responsable des investissements internationaux d'Ariel Investments. Cet entretien a été initialement publié sur Morningstar.com le 28 août 2019.

 

Jeffrey Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.

Ptak: Our guest on the podcast today is Rupal Bhansali, chief investment officer and portfolio manager of Ariel's international- and global-equity strategies. She manages Ariel International and Ariel Global and also oversees Ariel's global equities research team. Rupal has nearly three decades worth of experience. Prior to joining Ariel, she managed international-equity portfolios and served in leadership positions at MacKay Shields and Oppenheimer Capital. She also has experience in the hedge fund world, including a stint at Soros Fund Management. Rupal, thanks so much for being here and welcome to The Long View.

Rupal Bhansali: Happy to be here.

Ptak: So, maybe for starters just so we have a foundation for the conversation, many of our listeners will be familiar with you, but not all of them. It might be helpful to get a very concise description of your investment philosophy, how it is you actually run money for the clients that you serve. Can you give a quick description of how that works?

Bhansali: Sure. We are nonconsensus investors, which means that we always believe in doing original differentiated research to underpin our investment thesis, because in this profession of investing, being correct by consensus is not the way to get any payoff. That's already in the price. So, that underpins everything that we do. We must have a nonconsensus point of view. That also means that our portfolios tend to be rather eclectic. We tend to run concentrated high-conviction strategies. And because we are nonconsensus, our portfolios tend not to look like everybody else's, which means that you're getting the power of active management to its fullest degree. Because in my view, active is nothing but the biggest nonconsensus points of view that you have versus a benchmark, that's what's expressed in your portfolio.

In particular, we're also very risk-aware managers. I think a lot of traditional long-only managers tend to focus on returns, which is, what can go right, how much can stock go up? We of course do that. But in addition to that, we believe in asking the question and thinking about what can go wrong, and stress-testing the downside and thinking about the downside risk. And that makes us very risk-aware managers. So, we've always believed in delivering to risk-adjusted returns, not just returns.

Ptak: And so, in terms of other telltales, things that people would notice about you, it seems notable that you trade infrequently. I know that professional investors like to think of themselves as a patient lot, but they tend to be a bit trigger-happy. Maybe walk through what your typical time horizon is, because it seems like that's another thing that's somewhat differentiating about how you invest.

Bhansali: Well, in some ways, if you have a great business, the time horizon is infinite. Why trade it into something, you know, which is less attractive? Ultimately, what we're trying to do is create a best-ideas portfolio on behalf of our clients. And if it's an international strategy, we restrict ourselves to the international universe; if it's global, we pick from around the world. And in that context, therefore, the horizon is determined by how long it takes for our nonconsensus point of view to become consensus, i.e., if I've bought things where pessimistic or bad news is being priced in or the worst-case scenario is being priced in, i.e., all the risks that are in the business I'm being paid to take, that's what my buy discipline is. I'm trying to buy the stocks there, because the bad news is in the price, but the good news is not. As the good news plays out, and sometimes it takes a couple of years, sometimes it can take a couple of quarters, like in 2012, you know, we bought Japan when nobody wanted to touch it, it was a proverbial submerging market into '12. By 2013, '14, '15, Japan was one of the best-performing markets in the world. So, there some of our nonconsensus point of view became consensus in a matter of, I would say, two or three years.

On the other hand, our negative view on emerging markets took almost five or six years to play out. We were very underweight emerging markets. We thought it was a very crowded trade. We were not being paid to take the risks. So, we were very underweight. But back in the day, five, six years ago, people thought that was a default overweight in the portfolios, because that's where the growth was, and there was a growth scarcity in the world. But whenever people over-index on one variable, they ignore another variable, which is equally important, which is not just the upside or the growth, which I told you a lot of long-only managers focus on, but the downside risks--currency risks, political risk, balance-sheet risk--was simply not being priced into the stocks. And emerging markets as an asset class has completely disappointed as the risks are becoming more--people are becoming more conscious of the risks and pricing that in. So, this is a way in which to think about investing is, it's not so much about a horizon. It's more to do with a thesis. We care about more if our thesis will play out, not when they will play out.

Benz: So, I'd like to talk about philosophically why you align so much with risk management. What are the factors that drove you to investing in a very risk-conscious style? Are you thinking about your underlying investors, in that when they experience volatility, they sometimes get spooked out of their seats? What are the factors that attract you to having a very risk-conscious approach?

Bhansali: Two things. First and foremost, because I'm an equity investor, I am long risk. That's my status in life, because equity investors are the risk bearers of first resort in the cap structure. The bondholders don't get paid if the government does not get paid their taxes or the vendors don't get paid their bills. It's the equity investor who suffers. And so, I always, I think, as an equity investor, you have to keep risk front and center.

But the other reason to do it is because risk is a costliest cost, in the sense that if you have an investment portfolio that's worth $100, and if it declines 50%, now you're starting at $50. In order to make up for what you lost, even if you have an idea that goes up 50%, because you lost 50%, when you make 50%, you're only back to $75. That's the power of compounding that you always lose money from a higher number 100, but you make money from a lower number 50. Now, you need to come up with a 100% idea to just break even. Imagine if you lost less money. Let's say that $100 portfolio only declined 20% to $80. And now, if you have 100% idea to invest in, and you put it to work in that $80, you're now making $160, i.e., you've delivered 60% capital appreciation as opposed to the drawdown that you would experience if you lost a lot of money.

So, compounding means that avoiding losers and losses is more important than picking winners and making gains. And it's because of that arithmetic that every investor whether they are conscious of it or not, the arithmetic of compounding dictates that you pay more attention to losers and losses. And, in fact, in our investment approach, our first stance and throughout our investment process, we're extremely risk-aware, because as I mentioned to you earlier, risk proves to be much more costly, because you lose from a higher number, you make from a lower number.

Ptak: So, being risk-minded has been somewhat disadvantageous in recent years, just given monetary policy and other factors. And so, I guess my question is, should the expectation of a professional investor be that they adapt to changing environments and regimes, such as what we've witnessed over the past decade or so? Should a client be able to say to you, "Hey, you really should have recognized that we were entering a much more risk-tolerant phase, and therefore you should be loosening up a bit with your risk controls to make sure that you're taking maximum advantage of what the market would present to you."

Bhansali: So, I think trying to predict what the market is going to do is a fool's errand. I think Q4 of 2018 revealed that in full form. Nobody saw that big correction coming. To the best of my knowledge, I think everybody was very surprised by it. It happened very fast and furious. And that's exactly how drawdowns occur. I don't think people saw the 2008 correction coming, either. So, risk management is like an insurance policy that you have to buy all along. You can't suddenly think of buying fire insurance when the house is already burned down. And yes, it acts as a drag. You know, insurance always feels like--so, risk management always feels like a cost. But it's really an investment, you know, to protect when really bad things happen. And unfortunately, the world has become so complacent about risk that I would argue that every investor should tell their managers, “I am willing to give up on some returns if you're taking excessive risks to do so.” So, I'm very much in favor of the view of the world in which you look at risk-adjusted returns, not just returns. And that's how it always should be.

Benz: You've said you run negative screens, and the idea is to remove bad firms like those with poor governance, operating histories, or other defects from consideration. How does the performance of your eligible universe compare to the performance of the screened-out universe, so eliminating those companies that you've negatively screened out?

Bhansali: We actually do that on a periodic basis. It's not perfect statistical analysis, because the control universe is not perfect. Sometimes things move from one list to the other over time. But nonetheless, it's a valid question. What we routinely find--and the last time I found this was in the late 1990s. As you know, I've been managing money now for over 20 years. So, you've seen very different market cycles. I distinctly remember in the TMT bubble sort of period, in a market environment where growth and momentum was very much in favor, the stocks that were the most riskiest were the ones that were performing the best. And that's exactly what we find of late, where the riskier investment opportunities are performing better. But you know, we all know it's a risk-on market.

But I think what you want to pay attention to is not what's going on contemporaneously. Precisely when these things are performing well is when an active manager has to make a decision whether to stay away from it. If you're not getting paid to take those risks, you should walk away from them. This is what we did in 2006. We started selling out of our banking stocks as early as in '06. And we had spectacular performance in 2008 when a lot of value investors lost their shirt, not to mention a lot of investors in general. And that's because we could see, unlike a growth manager who kept admiring the growth rates of the banking back in the day when they were growing like a weed or a value investor who typically loves banks because they trade at low multiples, we did neither. We paid attention to risk. And what is the singular thing that everybody tells you after '08? Banks were taking on too much risk. So, if you did not proactively protect your portfolios, you got wiped out in a very material way. And that's exactly what I mean about risk management is an insurance policy.

People think that managing risk is like a minute before midnight some clock is going to go off and tell you, go buy risk protection. It doesn't work that way in the real world. And so, I would argue that this negative screening that you described is really our attempt to identify proactively all the risks that we could get exposed to. And if they are overwhelming and large, we just walk away from them, at no price will be catch. This is a mistake that I think a lot of value investors tend to make, which is catch the falling knives. Before you know it, deep value becomes distressed value, relative value becomes deep value. And we try to avoid that kind of value investing. We call it valuation investing. A lot of these other value investors call themselves relative value, reversion-to-mean value, statistical value, price-to-book value, deep value, distressed value. I mean, just by putting value at the end of that spectrum does not make you a value investor. Value investing at the core is about having a margin of safety. And it's about intrinsic value, always trying to understand what you're getting, not just what you're paying. And if what you're getting in the banking sector back then was a lot of risk, what you paid for it should also fall.

So, this is why as intrinsic value investors today in our portfolios, we are completely and utterly underweight banks, which traditionally is a sector that value investors were overweight. That's because its intrinsic value, we think the risk profile, the growth profile, the return profile in the banking sector is fundamentally compromised. In fact, in Europe, which is seeing negative interest rates as we well know, it is extremely hard for a bank to make money, and then they have to incur costs, and then they have to pay bills and fines and litigation risks, and the underwriting cycle is going to turn against them, because now the macroeconomic slowdown is sort of beginning to appear in full force, starting with Germany, and that tends to percolate in the rest of Europe.

So, I would say that we are very different kind of investors where we think about risk in a very holistic way. It's not just valuation risk, which is, of course, a big source of risk, but we think about business-model risk, regulatory risk. The banking sector faces a lot of these risks, and that's run in the price.

Ptak: I'd like to get back to some of the specific issues that you just mentioned in that answer. But before we do so, we'll have some individual investors who are listening to this podcast and maybe they'll want to know how they create their own negative screens. So, like, if you had to boil it down to a few essential things that they should be including in their screening based on the experience that you've had at Ariel and previously, what would you recommend they include in their screens?

Bhansali: So, we approach research as business analysts, not as financial analysts or security analysts. A lot of people do stock-price navel-gazing, trying to screen on valuations. Information that everybody has is not worth having. It's in the price. So, before I answer what they should do, I want to tell them what not to do. Valuation is not a good screen. It's a sanity check. After you know what you're getting, you cannot know what you're going to pay for it beforehand. A lot of people do very detailed financial modeling and think that the world happens in a spreadsheet, which can actually be a "GIGO," garbage in garbage out. So, I would say that your best bet is to be an industry specialist, understand the business from the inside out, because things happen in the business first. And whatever disruption, exposure to risk and returns and growth that you might have in the business will manifest itself in the numbers. When they show up in the financial statements, the stock prices will correspond to it as the results get announced. So, we like to do research at the front end not at the back end.

In order to identify risk, it's a mosaic, it's not a formula. And in that sense, I would caution people from trying to think in terms of DIY. Investing has become far more sophisticated, far more global in nature, and that's why we are organized as global sector teams. So, what Toyota tells us, we try to validate with whether the Volkswagen is telling us the same thing, and GM is telling us the same thing. And if it's disconnected or disjointed, it's our job to figure out what's the truth. And so, from that perspective, this global sector research--you know, a lot of investors in the U.S. were taken aback by deflation. They had never experienced it; they didn't know how to think about it or deal with it. But as global investors who cover 50 countries around the world, we see 50 times as much. So, we have experienced deflation.

Japan was the first country in the world to do QE. We've been there before as international global investors. So, we knew that one of the sectors that would be really badly affected is the banking sector. Japanese banks have never really reclaimed their former glory. Now, they are surviving, but they're not thriving. And that's exactly the playbook that is playing out in Europe, which has hurt a lot of investor portfolios and is a sector that I told you we negatively screened out for these reasons. But if you're just looking at a very narrow universe, and you don't have this macro awareness, this larger playbook in your head based on experience and expertise, it's extremely hard for you to connect the dots.

One of the easier ways to eliminate companies, though, beyond this business-model risk that I mentioned, where the business is fundamentally changing. Consumer staples is another example where the business model is fundamentally changing, where people are used to thinking of it as a very safe defensive quality sector, right? And yet, look at Kraft Heinz (KHC). There was a business-model risk that manifested itself in financial leverage risk that is now manifesting itself in stock valuation risk, right? It's just a series of things, but it's a business that suffered. They're not able to generate enough revenues, they're not able to cut their E&P costs. Once your product does not appeal to the consumer, it's going to show up in the numbers, it's going to show up in the stock price. So, if you had understood what was going on in the Kraft Heinz business, the rest would have followed suit.

A similar thing is playing out in Apple (AAPL). Apple's flagship product, iPhone X did not sell well. And yet, people are used to looking at Apple from the lens of yesteryears, and thinking of it as a technology company, with its ecosystem, et cetera. Well, once your flagship product starts to disappoint, your entire ecosystem has a challenge, because services revenue, which is what people are pinning their hopes on, is a function of the installed base. If your installed base is shrinking--and this is what Yahoo found out. I think a lot of people think, and they argue with me and say, well, Apple, I'm not going to give up my iPhone. Well, I'm not asking you to. It's a treadmill, a consumer electronics company like Apple, which is to say that, if you don't sell a new piece of hardware, there is no revenue that you book. So, all that has to happen is the replacement cycle of an iPhone has to extend itself from, say, two years to three years and that's a third less in revenues. That's not a stretch at all.

So, in the case of Apple, people think it's a low-risk, high-quality business model. And we would argue it's the opposite. And there is a very high amount of business disruption risk for that company, partly because of this lawsuit that's now coming up where Spotify (SPOT) and others are suing the company for acting monopolistic in terms of the distribution platform that it offers, and the pricing that it charges for it. And it's got competitive risks, because the competitive profile, the specs of the iPhone are not as competitive vis-à-vis the Samsung Galaxy, vis-à-vis Xiaomi's phones, and other phones in the Chinese market, which is a big source of incremental growth for them, and they are priced a premium without having premium specifications that compete effectively.

So, I'm giving you these examples of what we find in the business, which so far is not manifesting itself in the numbers. But that's exactly the setup for a Nokia back in the day. That's exactly the setup for a Blackberry back in the day. We were all addicted to these things. We cannot imagine a future without a Blackberry. And yet, as time has passed on, we saw consumer electronics companies tend to be hit or miss. And that's what Apple is. It's a consumer electronics company. It is not a software company as people would like to believe.

Microsoft (MSFT), on the other hand, is a software company. And we cannot do without Outlook and Excel and PowerPoint and Word. And every month, we're going to pay a subscription revenue for it. So, I think all tech companies are not the same, and the market needs to figure out where is the risk and where is the reward. And this is a kind of analysis people need to do in the negative screening, to figure out which businesses are exposed to what risks. It takes a lot of research.

Benz: So, one thing I know that you do as part of your process is that you have kind of a devil's advocate built in. Does that come in to play when you are trying to sort of figure out what these business risks are? Can you walk us through an example of how that has worked, where someone has been advocating for X name in the portfolio, but the devil's advocate actually shot it down?

Bhansali: Well, absolutely. And you're right. We think it's another example of the risk management, except at the process level where before a stock goes wrong, we proactively appoint a devil's advocate to give us a push back, so that we have thought through 360 degrees what can go right and wrong before the stock market does that to us right at the back end. And so, a good example of that is a financial institution that I was the lead analyst on, State Street (STT), which is a custodian bank. And the narrative--and this is about a couple of years ago--the narrative in the marketplace, and the consensus view was, you know, the custodian industry is consolidating, and typically a consolidated industry, the players that remain, and it's a scale business, should have better economics. That was one element of the thesis. But the other element and a big one was that they were undergoing an IT transformation. They were installing a state-of-the-art IT system. And as you know, custodians, the bulk of their business is transaction processing, right? So, if you can lower the cost of transaction processing, the expectation and the consensus view was espoused by the company as well, that this is going to be a source of competitive advantage, because as we go through this process, we are going to be able to onboard a new client, take market share, and so on and so forth.

So, that was sort of the initial point of view based on the research. And the devil's advocate in that equation, and rightly so, was our tech analyst, because, again, this was an IT transformation program. So, we figured that was the right business domain expertise to bring to bear. And what the IT analyst pointed out to me being the financials analyst is, "Well, who is the vendor behind this IT program? You know, they're going to the cloud. But is that sort of proprietary? Or is there something more standard off the shelf?" And the more we found out about that IT initiative, it was, indeed, all the questions that the IT analysts had asked me, which is, it was not a proprietary IT infrastructure. In fact, they were going towards this migration, because they had a spaghetti of IT systems that they had inherited, because of a lot of M&A transactions they've done over the years. And so, they needed to move to a standardized IT platform to remove a disadvantage of higher cost of maintaining all these multiple disparate legacy systems that you could not consolidate.

If you looked at their competitor in the form of say, Northern Trust (NTRS), which of course is here in our backyard in Chicago, they had not grown through acquisition, but through organic means. So, their IT platform had already been optimized and standardized for that low-cost and high-flexibility outcomes. So, they didn't have to do anything. They didn't have to spend that multibillion dollar amount, whereas State Street did. So, what appeared to be an offensive move on the part of State Street to install the state-of-the-art IT was actually a defensive move, something that they had to do not because it was going to give them a competitive advantage, which was my going-in thesis, but in fact, it was to remove a competitive disadvantage.

So, that is a power of research. I know it sounds a bit nuanced. But hopefully, I've made my point as to how a devil's advocate can bring a very different point of view. And of course, once we talked to their team, and we understood this development, we concluded that, indeed, this was not an investment thesis that was viable. So, we walked away from it. And now you get a chance after a couple of years, which is why investing so long term, to validate. Was that initial point of view and that conclusion that we drew correct or incorrect? Did State Street actually gain market share? Did it not? Turns out it has not. And that was our assessment going into it. So, I hope I've given you a sense for how research is done on a differentiated basis using a devil's advocate point of view, not necessarily sometimes to make money, but sometimes to avoid losing money.

Benz: So, what you've described so far does seem like a very research-intensive approach. But can you talk about what you view as your team's differentiators, relative to some better-resourced competitors, whether a Capital Group or a Fidelity or other big players with scores of analysts?

Bhansali: So, Christine, that's a great question. I grew up in this profession in the 1990s. And I think that one of the biggest misunderstandings in the marketplace is that collecting information is a source of alpha. That may have been the case in the ’70s and ’80s, when information was not readily available, and you needed feet on the street and offices all over the world to collect information. But in today's day and age information is at your fingertips. Connecting information is more important than collecting information. And from that standpoint, it's not about having a large number of people, it's having the right kind of people with the right expertise, who can connect the dots that others have not, which means you brainstorm, you debate with the devil's advocate, and the like.

So, in fact, I would argue that our competitive advantage is that we actually have all our research analysts in one location, in New York, and we can debate and connect the dots that others have not, because research now has not only become global--so, you can't have teams in different geographies doing their own narrow sleeve of investing. In research, you have to be part of a global team that is constantly interacting and swapping notes. I would argue that this notion that institutional investors have access to information that is differential is absolutely a myth. You cannot have it. Thanks to Reg FD [Regulation Fair Disclosure], thanks to the Internet, everything is at your fingertips.

So, in today's day and age, in order to generate alpha, you don't have to be a superior database, which is a repository of information, a collection of information. You have to be a superior search engine, which means you need to know what questions to ask because the answers are there to be found. And I would argue that, therefore, our team which is organized by industry with deep domain expertise--for example, my financials analyst is someone who actually audited financial institutions, who has looked at these balance sheets and business models from the inside out, as opposed to just the outside in. I was a banker in my earlier career in life. So, I've actually made loans. When you understand banking from that lens, it's just completely different than someone who's just trying to approach it as a financial analyst.

So, I mentioned to you earlier also that because we cover the globe, we cover 50 countries around the world, we see 50 times as much. And I think that this ability to apply what you have learned is very important. A lot of people, besides thinking about geographic footprint and quantity of analysts, also think somehow qualifications, the more number of qualifications you have, the better. I disagree with that assessment. It's not what you know, it's how you apply it. If a lot of people have seen this playbook of Japan but have not applied how deflation played out in the banking sector in the world, what's the point of your knowledge of that equation, you'd not apply it to the benefit of clients' portfolios. So, that's kind of our job to constantly be an organic interpreter of information. And that's also our edge.

Differently put, a lot of investors--and quant comes to mind, where computers can do certain things cheaper--is that they are data-point investors. The past becomes a prologue for the future. We, on the other hand, as fundamental investors are trying to develop a differentiated original nonconsensus point of view, driven by our forward-looking assessment of business and risks, focus on inflection points, not data points. Inflection points means where is the future going to look different than the past? And if it is, then that's an opportunity to arbitrage either by avoiding it or by owning it. So, a good example, historically, a lot of people think that consumer staples is high-quality, low-risk. And I would argue with you--and this is an industry that has pricing power and all these brand equity, et cetera--well, if brand is the way to own companies, why don't we own Macy's (M), which is a brand, or Sears, which is a brand. Gillette had pricing power till it didn't. In fact, Harry's shaving club has taken a lot of market share, thanks to the arrival of Instagram and social-media strategies. And, of course, for the first time in the history of Gillette, a couple of years ago, they had to lower prices on their blades as opposed to raise them. So, I'm giving you an example of how historical data-point investing thinking that this is safe, and that is risky, is a misnomer. Markets are very dynamic, markets evolve. If history was always going to be the prologue to the future, and we know it's not, then we could all be just reversion-to-mean investors. And we know that does not work in markets.

Benz: So, getting back to your point about how you don't want to be data collectors or data gatherers. Can we infer from that that you don't do a lot of site visits with company management or channel checks, those sorts of things? You just don't put a lot of value on that sort of data collection?

Bhansali: The opposite.

Benz: OK.

Bhansali: We collect a lot of data. We don't confuse it with being a source of alpha. That's table stakes. So, yeah, just like anybody else, we travel the world, we talk to the companies. We are business analysts. We need to figure out what's going on in the business. Absolutely. We just don't confuse what is table stakes with alpha.

Ptak: So, when you ask yourself--I mean, the sell side does a lot of that same work. I'm sure that you take pride in the work that you do and how it's differentiated. But it seems like you could probably save a few bucks by just collecting up the information that's served up to you by the sell side or other providers, instead of going out and doing that on your own. So, how have you concluded that when you actually go out and see these companies and make these checks, that you're conferring the sort of value and your investors are conferring the sort of value that it makes it worth your while.

Bhansali: So, it's not mutually exclusive. We are open to receiving information from the sell side, we are open to receiving it from any source that's out there. It can be a book. It can be a TED Talk. It can be a CEO interview. It can be anything. I mean, information comes in many forms. So, the issue is not whether the information is coming from us going and doing a channel check, or it's done by a sell side through a survey. The crux of the matter is, how do you interpret all available information. And that really is where you can generate a lot of alpha, if something is misunderstood, and therefore mispriced. I just gave you the example of State Street. It's a very mainstream company, everybody follows it. And I just gave you that we came to very a different conclusion from the same set of facts, because we looked at it from a different lens.

I'll give you another example. The auto industry, which is deemed to be a consumer discretionary sector. Everybody knows that. I'm not telling you anything original or differentiated, and that's obviously going to be the consensus view, there's boom, bust, and it's going to be priced as cyclical, et cetera. However, if there is an exception to the rule where what is perceived to be a consumer discretionary is actually a consumer staple. Well, now, you have potentially money to be made. And that exception to the rule in the auto component sector is the tire industry. People have sold out the tire companies like Michelin (MGDDF), which is one of our largest holdings, as if it's like any other auto cyclical component story. Well, the fact of the matter is, a tire has to be replaced every couple of years. There is no discretion in that matter. So, it's a staple, except it does not have to be bought every day, but once every couple of years. But I'm giving you this example where, this is a staple priced as a discretionary.

Ptak: We had talked to the top of the conversation about the risk-minded approach that you take to investing, and I would imagine that part of that is looking at potential worst cases with some of your high-conviction names. You just mentioned some of the tire makers that you invest meaningfully in. And so, maybe walk through an example of those worst cases that you can have with those types of firms and how you were able to surmount any concerns that might have arisen.

Bhansali: Great question, Jeff. For example, we don't like all tire companies. In fact, we would eliminate Goodyear (GT) because it's extremely risky. It's risky because its manufacturing process is not well evolved. They have not invested in technology and R&D and training their workers, which is why they are having difficulty in ramping to the higher rim-size models of tires, which are now more prevalent as more and more people buy SUVs, and premium cars, which have bigger rim size tires compared to passenger cars, which are the traditional 16-inch tire market, which has commoditized and that's not where the money is.

So, for example, even though we like, this tire company, Michelin, we absolutely have eliminated Goodyear. Not only does it have manufacturing issues, it has balance-sheet issues. It's an extremely leveraged company. And we think that that's going to make it even harder for it to reinvest in order to come back with this sort of R&D that it needs to get more installed-base market share, which results in aftermarket market share.

On the other hand, I would say that there are many companies in the telecoms industry, for example, where we have found a lot of value. A lot of the bad news in the telecom sector has played out in the last 10, 15 years as people did cord-cutting. And so, the fixed-line revenues, which are very reliable source of revenues for the telco sector, kind of disappeared, and as they disappointed, the stocks sort of tend to derate. But I'm a big believer, just like all good things come to an end, all bad things come to an end, too. Whoever wanted to cord cut has pretty much done so. And if you have a fixed-line phone in your offices, you're going to keep that because you needed that phone. And the bulk of the revenues for the telecom sector is coming from, say, the smartphone, wireless revenues, or Internet broadband connectivity, especially in the international markets, there's no cable TV company offering Internet, it's the telcos incumbents.

So, research is a constant continuum. You're constantly trying to figure out what is misunderstood and therefore mispriced. And you're correct, the market is reasonably efficient. There are many, many companies out there that are very well understood and well-priced. In fact, I would argue overpriced, we would not touch them. But there is always a group of companies, which is misunderstood and mispriced, and that's going to where we try to zero in our efforts on and figure out if we can have a known-consensus point of view that proves correct, we'll generate the alpha, you know, the upside with limited downside.

So, it varies by geography, by country. We are an all-cap strategy. We can roam free anywhere in the world, in any market-cap spectrum. I can find a small-cap company in Mexico to own one day because suddenly the political regime changes in America, Mexico's persona non grata, the currency crashes, stocks crash, and I can pick up what I thought was a great business to begin with, but now it's sold off, because of this externality. On the other hand, there can be things happening where a lot of the good news is priced in. In fact, I would argue Japan has gone in that direction now, where in 2012-13, a lot of people were extremely afraid of investing in Japan because a lot of bad news was playing out. Now, Japan is kicking butt. I mean, GDP data is terrific. Stocks are doing extremely well. But I would argue it's sort of an artificially scarce marketplace creation, because the GPIF [Government Pension Investment Fund], which is the largest sovereign wealth fund in that country, the pension plan, just keeps putting money to work in equities without regard to valuations. When stock prices are driven by flows, which is how passive and quant tend to invest as opposed to fundamentals, which is how active tends to invest, the larger the gap between the two, the greater the mispricings that will get exposed over time.

Benz: So, you mentioned you're all-cap strategy. We were a little surprised in looking at the portfolio, it's quite large-cap-oriented, even though you're not running giant pools of assets. So, let's talk about how you end up there that you don't end up with a larger emphasis on small- and mid-cap stocks?

Bhansali: That's a great question. You know, I've always believed that people--there's a myth out there that there is no inefficiency to be found in larger mega-caps. So many of the companies I have mentioned are very mainstream companies, presumably very well researched, and yet very misunderstood or not well understood. I sort of compare it to how people think of celebrities. Familiarity is not knowledge is the way I think about it. So, if you ask someone walking on the street, do you know Brad Pitt? Do you know, Angelina Jolie? They'll probably say, of course, I know them. But then you really repeat that question and you say, "Do you know them?" Well, they don't know them, they know of them. I mean, we find in the research spectrum that people think they know GE, or they know IBM, or they know Microsoft, they know Apple, and actually they don't. They're familiar with them, but they've not actually understood all the business drivers, risks and what they get from it, et cetera. And when we dig deep and try to really understand all these things that I've just talked about in so many different stories, we find that large caps actually suffer from the syndrome of familiarity substituting for knowledge.

Benz: You've been warning for a while now about a rotation away from the so-called FAANG universe to what you call a MANG universe. We can get into the specifics of the companies that constitute MANG. But let's just talk about what would be the inception point for that thesis to play out for rotation away from the FAANG stocks to happen, in your view.

Bhansali: Again, I think for any long-term investor, it is more important to get your thesis right. So, it's more about if a thesis is going to play out, not necessarily when a thesis is going to play out. Because in a portfolio there are always theses that develop at different points in time. So, when one is not working, the other is, and you get that diversification benefit just from that standpoint. I would say that the MANG thesis should work out at any point in time because value is its own catalyst. If something is undervalued and mispriced, eventually markets are efficient, and they will price that in. So, I would say that, especially today, and I just say that in the context of what's been a very risk-on market in the last couple of months, which is driven much more by externality rather than company-specific drivers--again, this whole notion of flows rather than fundamentals--I would say, the fundamentals in the FAANG stocks are derating at a rapid pace. Facebook (FB) and Google (GOOG), which is the F and the G of the FAANG are facing significant regulatory risks. And I think Facebook already announced that they're going to have 1,000 basis points reduction of margins because they have to make more investments to take care of some of the compliance costs that have come their way.

You take the example of Netflix (NFLX), which used to be a sort of monopolistic provider of streaming videos, Disney+ is coming along. Now, yes, it does not exist today, but it's in the works. So, you can disregard it and be in denial about that competitive risk, which is not in the price. Interestingly, as we saw in the latest Netflix numbers, they actually lost subscribers in the U.S. Just think about it, for a growth company, forget not growing, it actually declined. These are huge sources of business-model risks. Not to mention, Netflix has negative free cash flow generation, it's a cash-burn story, it is making losses, not earnings from that standpoint, and it is investing heavily in content. All of these are extremely risky business models both from an operating leverage standpoint, because you know, consumer discretionary, you can cut your subscription as we just saw this last quarter, there is financial leverage, because they are borrowing money to fund the negative cash burn that's going on in the business. None of these risks are priced in.

Now, on the flip side, you look at MANG, which is Michelin, Ahold (AHODF), the food retailer; NTT DoCoMo (DCMYY), the wireless telephone company in Japan; and Glaxo (GSK), which is the healthcare company in U.K. And M, by the way, was Michelin in France. All of these companies a lot of the bad news, the concerns, the worst case scenarios, the pessimism is sort of already in the stories, in the price, which means even if they were to materialize, like I just mentioned, people are extremely scared about the auto industry peaking and all auto component stocks suffering as a consequence, I already told you, not only is that a misplaced point of view, it's not going to materialize. When the opposite happens, you get the upside and you're paid and protected on the downside. And that's true of all of these different stories within the MANG acronym, which is Ahold, NTT DoCoMo and Glaxo.

On the contrary, not only do you find that the earnings expectations are quite low, which means the risk of disappointment itself is low, the valuation is low, what you have to pay for them. And in the meantime, it's like low teens, somewhere between 9 times to 12 times earnings, if not 14 for some of these stocks. On the flip side, they are extremely high-cash-generative business models with strong balance sheets, so they can pay a lot of dividends to us. And in the long run, dividends account for half the total returns of the stock market.

In a stock like Glaxo, I clip a coupon of 5%. In a stock like Michelin, it's 4%. In NTT DoCoMo, in Japanese yen terms, it's 5% dividend yields. So, I'm just giving you a sense for you can make money in the markets, you just have to be a contrarian, and you have to be correct.

Ptak: I think you've written previously about portfolio construction. And one of the things that struck me is I think that you mentioned that you keep a slug of names in the portfolio that may not necessarily be high-conviction from a risk/return standpoint but have important diversifying properties. And so, I'm curious how big a slug of the portfolio do those types of names typically occupy just as investors set expectations about your portfolio?

Bhansali: Actually, no. Every portfolio position is a high-conviction decision. It is managing to risk and return, not just returns, which is why sometimes we will own stocks which may not have a lot of returns but have very limited risk. And that's what we mean by we will always pay attention to both simultaneously.

So, a good example of that is, it's entirely possible that Berkshire Hathaway (BRK.B), which is a top-10 holding in the global strategy [Ariel Global], may not have the same upside potential as say the Michelin example that I just gave you. But Berkshire also has less downside risks potentially than say a Michelin. So, for both of those reasons, because we are always trying to manage the portfolio from both the risk and return standpoint, and I also believe that when you run a relatively concentrated portfolio like we do, the top 10 holdings can account for a significant portion, in effect, you are exposed to concentration risk, and that also can be a form of risk. So, we have to be sensitized to it and manage to it. And one of the ways in which to diversify your concentration risk is to be diversified into investment thesis.

The thesis underpinning Berkshire Hathaway and the business model of Berkshire Hathaway and the underlying drivers of what's going to cause that business to perform and therefore the stock to do certain things is completely different from Microsoft, which is completely different from Glaxo, which is completely different from Michelin. All of these investment theses stand on their own merits from a risk and reward standpoint. And so, that's how we construct the portfolio.

So, I would actually articulate our portfolio construction as being different than many others out there, where we do not want our portfolio to become a gigantic binary thematic bet on one thing at the expense of everything else. So, a lot of investors invest in, say, a theme like supercycle in commodities, or you know, cloud computing. And if they make that one big call right, you make a lot of money, but if you don't, there is no act two. We believe that's a very dangerous form of portfolio construction. So, that's what I mean by we will own stocks with very diversified investment theses. But that does not mean a diluted investment thesis. It's a high conviction in everything that we own, in whatever position size we own it.

Benz: One question I have is, some investors--certainly a lot of individual investors I talk to--are having a crisis of confidence about why they should invest overseas at all. They say, well, my U.S. stock component has performed so much better, U.S. businesses are pretty global themselves. Can you talk about why you think investors should have globally diversified portfolios?

Bhansali: Ultimately, investors should have a best-ideas portfolio, and risk and reward is what drives portfolio construction and outcomes. I think that in the U.S. context, because companies have had better return and growth profiles historically, and because the dollar has been a very strong currency, all sources of returns have acted in one direction. And that sort of gives you a misleading picture. Precisely, of all the things that worked out in the U.S. have not worked out abroad, because the risks are still sort of priced in, the growth has been somewhat anemic, and the currency has corrected as opposed to being a source of positive returns, it's actually caused you negative returns from a dollar-translated perspective. But these things tend to be cyclical, they are not secular. And also, competitive advantage in every sector is not concentrated in the U.S. I just gave you this classic example, if you wanted to own the tire company based on the thesis I mentioned to you, it's a consumer staple not a discretionary, and if you were only restricting yourself to the U.S., you'd be forced to own Goodyear, which is not a very idiosyncratically good name to own. The best tire companies are actually abroad, I would argue, Michelin and Bridgestone (BRDCF). So, confining yourself artificially and arbitrarily is just the wrong thing to do because good ideas don't have borders.

And the other observation I would make is that currency and dividend yields tend to be a very big source of return, again, over the fullness of time and over a couple of decades, the dollar has generally been a declining currency, rather than appreciating one. The last decade was an anomalous one. I think that if that reverses, not to mention, in the international context, dividend yields are quite high relative to the U.S. counterparts. So, all of those things, I think, are underappreciated upside potential sources of alpha that will fructify, I think, in the decade to come as opposed to the decade that's past. And investing should always be done with the view towards the future. The past is not a prologue, as the SEC forewarns us. I would say the same thing is true of the retail investor. They're looking at it based on the past lens and they should look at it from a forward-looking lens. We, for example, are overweight international equities within our global strategies where we can make an asset-allocation choice between how much to put to work in the U.S. versus abroad. On a best-ideas basis, we are finding more opportunity abroad than in the U.S., just one manifestation of this point of view.

Benz: So, a related question is, if you think the FAANG stocks are overvalued and may correct at some point in time, which has the potential to take down the broad U.S. market indexes quite a bit, would you foresee an environment where that happened and foreign stocks performed well? Because the performance pattern has not been that, right? Where the U.S. market takes a tumble, foreign stocks usually behave in sympathy.

Bhansali: Well, I think there is something to be said for the fact that I think the best days of investing based on beta are behind us. Broad stock market indices are quite overvalued and rich, and a lot of expectations are built into those prices. And so, you're more likely to be set up for disappointment, rather than an upside surprise. So, I do believe it's going to be a market of stocks rather than a stock market that you want to really be curated around. And that means giving up on this notion that passive is panacea, I think active is going to have a resurgence and a renaissance because it's going to be about curating your portfolio with a handful of companies that can decouple from that broader sell-off, that broader sell-down and still generate positive returns and alpha, as opposed to sort of having a blanket approach. Just invest internationally versus domestically. I do believe bottoms-up stock selection is going to be the way for the next decade, which has not been the case for the past decade.

Ptak: So, passive investing is mirroring the markets in aggregate, and those markets consist largely still to this point of active investors. I guess, what sustenance should investors draw from the fact that active has struggled and yet there may be better times ahead? After all, the indexes should really explain what's happening with active investors in aggregate, should they not? I guess, I'm trying to get a sense of why it is you feel like the struggles of active are somewhat cyclical in nature and some of those pressures will abate in the years ahead.

Bhansali: So, two things. One is that when the disproportionate flows are going in favor of passive and to a certain extent quant as opposed to bottoms-up stock-picking fundamental-research-oriented active investors, valuations in the market get driven by flows not by fundamentals, and the bid-ask spread can be quite large between the two. And so, it's not dissimilar to the housing market crisis that we had just about a decade ago, where people thought the appraised value is the value at which I'll be able to sell my house. Well, when you actually go to sell your house, that's when you discover what price you can get for it, not the appraised value. I would say that is akin to passive thinking. They can liquidate at NAV of all the prices that the benchmark has sort of as an aggregate. And it's only when you go to liquidate that you realize people are not willing to pay that amount for these sorts of stocks, which are being valued based on flows as opposed to fundamentals.

And a precursor of that came about in Q4 of 2018, when people for the first time redeemed, they found that the prices gapped down because of this wider bid-ask spread between flows and fundamentals. That's why I think what active is willing to pay versus what passive wants to charge you for, I think that the biggest mistake and myth in the marketplace is that passive is low cost. It's only low cost from an entry-cost standpoint. We have never tested exit cost. Exit cost is what is the bid-ask spread on the way out. If there is no buyer for these stocks at these rich valuations that a Netflix or a Salesforce (CRM) is really trading at, it's only when you actually have transactions that are driven by active investors that you really figure out what are the true clearing prices.

Again, I think it's very symptomatic of the housing market, where everybody had valued their houses at a certain price. But when they actually went to sell and when everybody tries to sell it, guess what, it'll actually overreact on the downside even greater. So, that's what I would worry about, the exit cost when you're trying to redeem, that's manifesting itself in the bond market already. In Europe, a couple of people tried to liquidate some of their bond funds, which had taken a lot of duration risk and liquidity risk, and when they actually tried to liquidate from those bonds, there was a big gap between the bid-ask spread. That's going to play out in equity markets, too.

Ptak: Well, Rupal, this has been great. Thank you so much for your time and insights and for joining us on The Long View today.

Bhansali: Happy to be here, and great questions. Thank you.

 

Benz: Thank you, Rupal.

 

 

 

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify or wherever you get your podcast.

 

Benz: You can follow us on Twitter @Christine_Benz.

 

Ptak: And @syouth1, which is S-Y-O-U-T-H and the number one. 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.

 

 

 

 

 

About the Podcast: The Long View is a podcast from Morningstar. Each week, hosts Christine Benz and Jeff Ptak conduct an in-depth discussion with a thought leader from the world of investing or personal finance. The podcast is produced by George Castady and Scott Halver.

 

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A propos de l'auteur

Jeffrey Ptak

Jeffrey Ptak  est directeur mondial de la recherche sur les fonds de Morningstar.

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