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Investing Insights: Conference Highlights and Mind the Gap

Discussions with Mellody Hobson and Jeremy Grantham; Pfizer; and oil prices on this week's edition.

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Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.

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Christine Benz: Hi, I'm Christine Benz from Morningstar.com. I'm here at the Morningstar Investment Conference where we're just wrapping up day three. I'm joined today by Russ Kinnel, he's Morningstar's director of manager research. He's going to provide his perspective on the conference today.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, we were all treated to quite a gloomy take on the world at the end of the day yesterday from Jeremy Grantham. Let's talk about that, your takeaways from his presentation.

Kinnel: My main takeaway is I would like there to be Prozac smoothies on hand when you leave a Jeremy Grantham speech. It really was remarkable. We've heard him before talk about climate change, and he emphasized that again, where the climate change is coming. But he also pointed out all these other difficult things--rise in disease, decline in fertility, erosion of soil brought on by climate change. Really difficult. He talked about how there are investment themes based on that such as renewable energy, but it certainly was a very gloomy speech.

I think one of the takeaways, too, is just we tend to lock into the present and the way things are now and think things will only change incrementally in the future. When you hear someone say 40 years from now the world could be very different, it's kind of shocking and it's hard to accept, but I think it's something you want to be open to because that's the way the world really does work.

Benz: To stay adaptable, I thought it was interesting that in contrast with years past where the focus of his presentation has been on investments and what to be worried about in the investment market, this was a much broader discussion about what to be worried about in terms of our climate and in terms of the future of our world.

Kinnel: Yeah, I mean it's hard to argue when you hear that nine of the 10 hottest years in the history of earth came in the last decade, and statistics like that. You see the information on rising water levels and so many very hard-to-refute statistics. You realize that's going to have a tremendous impact on our world, and in our investments too. Obviously the investments are secondary to the fate of the world, but still, obviously that will impact a lot of businesses as well as our lives.

Benz: We just came out of a session with Diana Strandberg and David Herro, both great international value investors. I was really interested in their presentation, what were your main takeaways from it?

Kinnel: I continue to feel great about investing with these two, their funds are rated
Gold, we really like them. One of my takeaways was I really enjoyed them talking about the impact of Tencent. David Herro called it the greatest Internet property out there, and they talked about owning it via Naspers, which owns a partial stake in it.

I also like to hear value managers who are really doing a lot of research on Internet companies and tech, the FAANGs in general, because I feel like the FAANGs are really destroying a lot of companies in the value space. You see a real difference between the successful value managers and those who are struggling, and I think it's the ones who really understand what the FAANGs are doing are less likely to own those value traps. The ones who don't, maybe doing kind of reversion of the mean analysis, expecting things to snap back for these companies, but maybe they won't.

The ones I worry about are the managers who are investing in old school media, advertising companies, and some others where you look and see Google might eat their lunch, or in the case of a retailer, Amazon might eat their lunch. You at least want the managers to really understand what are the real threats here, because I think that's gonna be crucial for value managers to succeed.

Benz: Diana Strandberg from Dodge & Cox, and David Herro from Oakmark International, you think do exemplify value managers who will be adaptable in the decades ahead.

Kinnel: Yeah, I think so. I think you see that in their portfolios today. Not a lot of obvious value traps in the portfolios, and obviously they're spending a lot of time understanding the dominant companies out there, as well as obviously China and how that's going to affect the companies they own.

Benz: You and the team at Morningstar spend a lot of time on manager evaluation and selection. You moderated a panel yesterday on that topic. Let's talk about some of the conclusions that you came away with. I think a lot of advisors who are looking at client portfolios have a little bit of a crisis of confidence in active management. How can people think about making smart decisions with respect to choosing and sticking with actively managed funds?

Kinnel: There's certainly a theme of, we heard from the panelists who were there, were very focused on finding the areas where active has done the best. But I also talk about how they research active, and I think they really understand that doing the fundamental work, so not just looking at returns but understanding the people in the funds, not just the managers but the analysts, the traders, but I think the culture too. We heard Michelle Ward from Morningstar was talking about how she looks for firms whose goals are really long term and aligned with her values and Morningstar's values. I think that's really important, I see that there's a significant difference I think from say experienced investment professionals versus individual investors. Even more some investment professionals who are new to the job is they think more about stewardship and culture because on the long run that really matters, and you really want to invest with the managers and the firms that really understand that and are really shareholder focused, really long-term focused.

Benz: One thing that came out in your session was PIMCO Total Return is kind of a case study in how investors manage through big changes at a giant fund like that where we saw an exodus of assets from the fund in the wake of Bill Gross' departure. What came out of that discussion for you?

Kinnel: I thought it was really interesting, all three of my panelists, all of them held onto PIMCO Total Return at a time when there was a mass exodus, one of the greatest exoduses in the history of the fund world. They talked about how, yeah we thought Gross was important, but we knew all of these managers and analysts, and PIMCO was a very deep team with tremendous experience, tremendous breadth, and a big trading desk. In the fixed-income world trading is really important, especially if you do derivatives as much as PIMCO does.

They felt really confident that PIMCO still had all those important players, and they pointed out that that fund has done much better than most of the funds that people rushed into. I think it really illustrates why there's a difference between what the general public sees and what some consultants and others who are investment professionals see. One of those things is just all of the depth behind the manager. For PIMCO Total Return, most commonly you would see Bill Gross on CNBC and not necessarily understand just how much was behind him. Really we've seen since then that that fund and firm has really stabilized. The fund handles the outflow as well, and you didn't see other people leaving to follow Bill Gross. In fact I think if anything, analyst and manager turnover slowed down after Bill Gross' departure, which tells you something about the firm and Bill Gross.

Benz: Right, and Morningstar maintained a medalist rating on PIMCO Total Return even after Gross departed as well.

Kinnel: That's right. We had the fund rated Gold, he left, we lowered it to Bronze because we were concerned about how the team of new managers would mesh, whether people would leave and what impact outflows would have. Over time we've become more confident as we've seen everything stabilize, so we raised it to Silver. And then more recently we raised it back to Gold.

Benz: Russ, thank you so much for being here to share your perceptions.

Kinnel: You're welcome.

Benz: Thanks for watching, I'm Christine Benz for Morningstar.com.

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Laura Lutton: I'm Laura Lutton. I'm here at the Morningstar Investment Conference with Mellody Hobson, president of Ariel Investments. 

Thanks for joining us, Mellody.

Mellody Hobson: Thanks for having me.

Lutton: Tell us a little bit about what you're seeing in the marketplace and relative to the stocks that you hold in the Ariel portfolios.

Hobson: Well certainly on the domestic equity side, we're finding value, which is probably a little shocking to most people because we're in such an extended run here. But even at this stage, we are finding things to buy, and we think a lot of it has to do with the commoditization of the market by the index funds, really, means that if you are orphaned, you are truly orphaned and creates a value for us to buy. That's one thing we're seeing. The valuations on our portfolios are lower than that of our value indices as well as the broad market. We feel like we're insulated on the downside, of the market does have a comeuppance, but we also feel that we have upside in the portfolio because of that valuation differential. Whenever we've been in this position like this, it has generally been a good thing for our funds and the returns that come thereafter.

The overall market we would say, obviously, this has been quite a run, and you never know what will quite undo it. These bull markets do not go on forever even though we may think that they will. It will ultimately have its moment. But with that said, corporations are in pretty good financial shape. Their balance sheets were really cleaned up through the financial crisis. That means that to the extent that we have some trouble ahead at any point, I think they'll be able to withstand it pretty well.

Lutton: Do you think the tax cut is fully priced in at this point, or is there room ...

Hobson: We do not. We do not believe the tax cut is fully priced in. We think the tax cut will still continue to surprise people on the upside. Analysts have been slow to adjust, somewhat because they haven't known exactly how it was going to affect all of the companies as things have been worked out. I do think that part of the reason that we are seeing the market behave the way it has is because I think this tax cut has provided more stimulus to companies and to the overall economy.

Lutton: Just this week, Warren Buffett and Jamie Dimon came out with this call for companies to stop giving earnings guidance, said that causes too much short-term-ism in the market. You're a long term investor, you're on the board of JP Morgan. Tell us a little bit about your view of that call.

Hobson: It's so interesting because on the one hand, I think analysts like to have some kind of guide post, they like something to be able to direct their models to, etc. I think without guidance, it puts more onus on the analyst to do the work, and we're comfortable with that. If there were no guidance, I think that we would continue to be able to distinguish ourselves from the marketplace and our peers by just doing the work.

I do think the short-term-ism is something that is very problematic, it's something that very much concerns us. We have a turtle as a logo, and we talk about long-term, patient investing, and the velocity of money has just sped up. The holding periods are so much shorter, it's whiplash. I think as a result of that, they're short-changing themselves in terms of the returns that they could be getting, but are missing out on because they're trading too much.

Lutton: That gives you an advantage, right? If you're willing to be long term ...

Hobson: It does. We literally tell people we play time arbitrage, and we take advantage of these dislocations by having a longer term view. I think there's a bigger issue, and I think Buffett and Jamie Dimon are getting at it, which is what is really being compromised, what kind of returns are really being compromised. That could be a key to driving longer term outlooks.

Certainly, I think this quarter-to-quarter game that companies are playing is a losing game. When we go into meet with management teams, we do not talk to them about quarterly results. We're talking to them about big picture results. What is your company going to look like, three, five years from now, not three quarters from now, that means nothing to us, that's noise. That's not how you make real money. Real money, as Buffett says, is made over time.

Lutton: Gotta be long-term oriented.

Hobson: Exactly.

Lutton: Thank you Mellody for being here.

Hobson: Thanks.

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Jeff Ptak: From the 30th annual Morningstar Investment Conference in Chicago, I'm Jeff Ptak, global director of manager research for Morningstar. I'm very pleased to be joined today by Jeremy Grantham. Jeremy is chairman of the board of GMO. 

Jeremy, welcome. Thank you again so much for participating in this year's Morningstar Investment Conference.

Jeremy Grantham: Nice to be here.

Ptak: I wanted to start off maybe getting you to update your views on a commentary that you published in January of this year describing some of the necessary preconditions of a possible melt-up, a scenario in which the market would rally very, very sharply, and then perhaps fall precipitously afterward. 

Given some of the activity that we've seen in the market and the ensuing four or five months, where do you stand now?

Grantham: The easy part of that is the bubble collapsing. Historically, in order to get the market to have a really major decline, 50% in a couple of years, you've needed to have plenty of air in the pricing, a psychological energy. You need people to buy into some fairly preposterous thinking, it's revealed, from hindsight anyway. 

In '99 people believed it's a new golden era of the Internet. Greenspan described the Internet as driving away the dark clouds of ignorance. 1929, you had the same kind of euphoria. Without euphoria and crazy faith, without perfect fundamentals and an extrapolation that they'll go on forever, it's very hard to get a rapid decline of the kind that we had in 1929 and 2000, and to some extent in the housing market of '07 and '08. So that's the easy part. In other words, we're probably not going to have a rapid decline unless we have a blow off.

A blow off needs twice the rate of acceleration as normal, maintained for a little less than two years, like 21 months. In other cycles, that has produced enough oomph to be about 60% or more. It looked like we could do that, and certainly by the end of January, it looked very promising. By the end of January, it was rising so fast that if it had covered another 10 points, another 10% by the end of March, it would have been up 60 in the final 21 months. And that would have only been 3150 on the S&P.

If it moves slowly, that 60% target moves on up. So if it takes a full nine months, it was 3400. If it took 18 months from last December, it was 3700, and the chances of that happening are not as good today as they were back in December, January. The reason is, that the uncertainty that's been produced by the administration on important issues like global trade has served to constantly rattle and make nervous the investors. Unusually, this is balanced on the other hand by strong profit margins, by rising profit margins, the highest globally they have ever been by a synchronized, reasonable global economy.

You have some good data on one hand and you have some nerve-wracking input on the other. This is quite unusual to create a kind of nervous balance. So 1% forward, 1% back, 2% forward, 2% back. In that environment is anathema, you know, in terms of a bubble. A bubble needs crazy euphoria. This is not the environment in which it can happen. Now, I haven't written my 50% chance down below 35 or 30 for the following reason. If the midterms make the market relax a bit, but we also are entering the sweet spot of the presidential cycle, from October of this year through May of next year is an incredible period of seven months, which has averaged about 17% a year since 1932, since FDR. That is our last best chance of having a bubble melt-up.

When that passes, I think time is not on our side, and we will not do that. So what will happen? Where do the probabilities go that I take away from a bubble and a bust? They moved to a relatively historically unusual format, which is bumping along. You go down 15 and up 10, you go down 17 and up 13, you come back in five years and the market is down 15% or 20% profits, and maybe up 10 or 15. And the P/Es are close enough for government work. Everyone always likes to think that's going to happen. It very seldom does happen. The market likes to go up a lot or down a lot in real life. But I do think with this kind of creative tension that we have, we may be able to pull that off.

Ptak: What's an investor to do given that outlook? I know there's a great deal of uncertainties.

Grantham: Well, from GMO's point of view, our first choice is a melt-up, jump out, and have it meltdown rapidly, and jump back in. Our second choice is the bump-along because we are out of the U.S. equities, we're overweighted emerging and EAFE. There's nothing in my five-year forecast that says S&P down 20 to prevent emerging being up 20. It's easily cheap enough to have that sort of divergence with room to spare and maybe ether up 5. That is a dismal market for a pension fund, but it's not a dismal market for GMO's relative performance.

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Damien Conover: When we look at the large pharmaceutical market right now, one of the companies we really like as being undervalued is Pfizer. Pfizer is, I think, going through a paradigm shift. If you think about the company many years ago, it was facing a lot of patent losses. If you look at the company today, we look at the growth rate improving significantly. The patent losses aren't going to be as significant.

In tandem with this, Pfizer also has a great pipeline that's much stronger than it's been in many years focused on oncology products, immunology products, products that carry very strong pricing power. In the backdrop of this, the bottom-line earnings we anticipate will continue to grow robustly to support a very strong dividend yield over the next several years.

From valuation, we think Pfizer is worth $43.50. We base that on our discounted cash flow model, but we are also very cognizant of traditional multiples that are used in the big pharmaceutical landscape, which is the price to earnings ratio. If we look at Pfizer right now, it's trading at about 12 times next year's earnings, and that's a big discount to the overall group that's closer to 15 times. Nevertheless, Pfizer has a similar growth rate.

We think Pfizer is very well-positioned from a growth standpoint, and we continue to see the company with the strong, wide economic moat, really bolstered by that pipeline that is going after areas of unmet medical need.

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Karen Wallace: Hi, I'm Karen Wallace for Morningstar. The timing of investors' buys and sells can have a big impact on their investment performance. Joining me to discuss some current research on this topic is Russ Kinnel. He is the director of manager research for Morningstar, and he is also the editor of Morningstar FundInvestor.

Russ, thanks for being here.

Russ Kinnel: Glad to be here.

Wallace: You recently updated your Mind the Gap study. This is an annual study that comes out. What exactly are you looking at?

Kinnel: We are looking at investor returns versus total returns, which is essentially, asset-weighted or dollar-weighted returns versus time-weighted returns. As you said at the top, essentially, it's telling you about investor timing. Is it good timing? If it's good timing, the gap will be smaller or even positive. If it's bad timing, it will be negative, meaning they left some money on the table because they didn't make the most of their funds.

Wallace: You make a point in the piece to not put too much stock in an individual fund's investor returns, but when you look at it across a larger, a broader category asset class, it tells a fuller picture.

Kinnel: Yeah. We really like to look to see what's the typical investor doing, how are things working for them. But on an individual fund basis, there can be a fair amount of noise. Sometimes it tells you an interesting story, but you don't want to read too much into it.

Wallace: Russ, what are some of the big headlines, the big takeaways from this study?

Kinnel: We are seeing the gap has really been shrinking over the last few years and that trend has continued to where we have a small gap overall. I think that's really because we've had a nice steady bull run. The gap tends to expand the most when you have dramatic pivot years. Years like '08, '09 where people are essentially selling all the way down and then they miss out on the rally. That's really bad for them. But the last decade almost entirely the market's more or less has been going up and that's worked really well for investors. Whenever you have a relatively stable move in one direction, that works well for investor timing. That's what we are seeing in the numbers.

Wallace: So, it's easier to hold on to a fund when it's steadily rising?

Kinnel: That's right. Investors do worse when returns trigger either fear or greed. But if it's sort of steadily rising, you have a positive reinforcement mechanism.

Wallace: That makes sense. We saw the gap in domestic equity funds overall decline. What are some of the things that you found there?

Kinnel: As you say, the gap has shrunk to where it's a fairly small gap and that's really encouraging. I think it's largely the story about equities just rallying and people making a good use of their funds really.

Wallace: And balanced funds are an example of where investors have very good timing. They actually had a positive gap.

Kinnel: Right. So, we see balanced funds--every year we do this, we see really good results in balanced and specifically, where it's really good is the target-date funds. The reason, I think is that partly target-date funds are very stable, boring funds. They don't move a lot. They are super diversified. But on top of that, people hold them in a 401(k)--401(k)s are vehicles where you are investing every paycheck. So, really, you'd have to have people are held to the steady discipline of investing regularly. That's where you get the best results, because in downturns people are continuing to invest and obviously, you get more shares when in a downturn. We really see that works well. 

We've done the study globally. We see in other markets like Australia and South Korea where you have something similar to a 401(k), again you see really good results there. There's definitely something to that steady commitment of assets from investors.

Wallace: One surprise that you saw was municipal funds which had--the gap is shrinking but it's still fairly significant.

Kinnel: That's right. The gap is over 100 basis points, which is really odd, because if you look at muni bond returns, they are pretty steady, pretty boring. You don't see double-digit returns when they lose money. It's usually a very small amount. It's really unusual that such a boring space would have such a dramatic gap. But I think we've had a couple of events that have kind of thrown investors.

Obviously, muni investors are very risk-averse. Even a whiff of risk scares them. In this case, the last 10 years, we've had two events that scared people. One was the Puerto Rico crisis, and people withdrew a lot of money even though most of the big funds out there had very little Puerto Rico exposure. The muni market sold off. People got out. But really, they were missing out on the fact that the rest of the muni market was really strong. The previous event was when Meredith Whitney went on "60 Minutes" and predicted huge bankruptcies which never came to pass. Again, people got out at the wrong time. It's a little unusual, but it just speaks to how skittish the typical muni investor is.

Wallace: Those headlines were enough to spook people.

Kinnel: And not a good time to sell.

Wallace: Finally, I wanted to touch o the alts category, which had sort of an interesting profile that it had the worst investor return, but the best investor return gap. How did that work?

Kinnel: Essentially, we talked about how the gap is really telling you how people did at timing. Alts have done so poorly that really if you sold anywhere over the last 10 years, it's probably a good move. And so, essentially, that's what it's showing, is that the typical alts investor got almost a 0% return, but the typical alts fund lost about 1% a year. We are seeing that the people did pretty good with their timing. But of course, those returns are not going to make people happy. The alts world clearly has to do better.

Now, there is a caveat and that is that the 10-year figures go back to a point in time when there were not a lot of alts funds. You have to take it with a bit of a grain of salt. But even if you look at more recent results, you see that alts returns have not been very good, and I think clearly the alts world is going to have to do better if they want to keep investors in.

Wallace: When we roll all of this data up and look at it holistically, what kinds of lessons can investors take away from this?

Kinnel: There are a few lessons. Some are about the kind of funds and some are about the kind of investors. I think when we look at it by data we see that low-cost funds lead to better investor returns and better investor returns gaps, even by significantly more than the fees themselves. I think it's really smart investors finding good funds. We also find that low-volatility funds work better for people. The really high volatility funds don't work so well. Low cost, low volatility funds work for people.

And then the other part, I think, is just know yourself and know your fund. Know how much risk you can take, but also just go and look through funds' annual returns to see are these numbers I can stomach. You go back to '08 and other times of crisis and look at fund's individual calendar year reruns, you might be surprised because if you just look at the trailing returns, you might see an equity fund that's returned 9% a year and it looks great. But then you go and see, oh, but it actually lost 40% in '08. I have to be able to tolerate that to get to the good stuff.

Wallace: Right. Well, this is really interesting research. Thanks so much for being here to share it.

Kinnel: You're welcome.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

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Preston Caldwell: Over the last several months, oil prices have steadily climbed upward and now stand at about $66/bbl WTI. This is above the Morningstar energy team's long-term forecast of $55/bbl WTI. Yet we think the factors causing oil prices to be elevated are merely temporary factors. The long-term factors which underpin our low-cost, $55/bbl oil price thesis remain as strong as ever and are substantiated by deep research our team has done.

The factors propelling prices higher in the short term include geopolitical issues such as the collapse of Venezuelan oil production due to internal political and economic chaos as well anticipation of Iranian production falling due to the reimposition of sanctions by the Trump administration. 

Additionally, global demand has been somewhat stronger than expected. Short-term bottlenecks in U.S. shale production growth have also played a role, although we note that U.S. oil production still has grown about 1.3 million bbls/day over the last year, outpacing what we'd expect in a normal year.

Some analysts have speculated that U.S. shale's inability to quell the rise in oil prices reveals a fundamental flaw in shale's ability to provide sustainably lower cost oil. We think this reasoning is incorrect. Our team's deep analysis into the two key sides of the shale cost equation--cost per well and production per well--indicate that $55/bbl is the long-term marginal cost for shale. And, therefore, as these short-term issues in global oil markets fade away, we believe oil prices will likewise converge to $55/bbl, our below-consensus long-term oil price forecast.

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