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Our guest on the podcast today is is Dennis Lynch. Lynch is the head of Counterpoint Global at Morgan Stanley Investment Management. He joined Morgan Stanley in 1998 and has 25 years of investment experience. In his role, Lynch and his team run a number of growth equity strategies under the Morgan Stanley banner, including Morgan Stanley Institutional Advantage, Morgan Stanley Institutional Growth, and Morgan Stanley Institutional Discovery funds. All told, he and his team manage nearly $30 billion across their various mandates. On the strength of his track record, Morningstar named Lynch and his team Domestic Stock Fund Manager of the Year in 2013. Lynch received a B.A. in political science from Hamilton College and an MBA with honors and finance from Columbia University. We're pleased to have him join us today.
Dennis Lynch bio
Morgan Stanley Counterpoint Global
Morgan Stanley Institutional Growth Fund
Morgan Stanley Institutional Discovery Fund
“A Closer Look at a Fund Manager of the Year” by Janet Yang; Morningstar; Feb. 3, 2014
Team Members Referenced
Kristian Heugh bio
Sam Chainani bio
David Cohen bio
Stan Delaney bio
Innovation vs. Mission Creep
“Facebook stock jumps 12.6 percent as share lockup expires” by Alexei Oreskovic; Reuters; Nov. 14, 2012
"Shared Reading" and ESG
“Earth Has a Hidden Plastic Problem—Scientists Are Hunting It Down” by Andrea Thompson; Scientific American; Aug. 13, 2018
“ESG and Sustainable Investing Report” by Kristian Heugh and Marc Fox; Morgan Stanley Investment Management; Mar. 7, 2019
Disruptive Technologies and Forces
“The EDGE: Automation/Robotics” by Morgan Stanley Counterpoint Global; Dec. 18, 2018
“Three Big Things: The Most Important Forces Shaping the World” by Morgan Housel; Collaborative Fund; Oct. 4, 2019
"What is a Tech Company?" by Ben Thompson; Stratechery; Sept. 3, 2019
Jeff 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 this week is Dennis Lynch. Dennis is the head of Counterpoint Global at Morgan Stanley Investment Management. He joined Morgan Stanley in 1998 and has 25 years of investment experience. In his role, Dennis and his team run a number of growth equity strategies under the Morgan Stanley banner, including the Morgan Stanley Institutional Advantage, Morgan Stanley Institutional Growth, and Morgan Stanley Institutional Discovery funds. All told, he and his team managed nearly $30 billion across their various mandates. On the strength of his track record, Morningstar named Dennis and his team Domestic Stock Fund Manager of the Year in 2013. Dennis received a B.A. in political science from Hamilton College and an MBA with honors and finance from Columbia University. And we're pleased to have him join us today.
Dennis, welcome to The Long View.
Dennis Lynch: Thanks for having me.
Ptak: So, you run a number of growth equity strategies for Morgan Stanley. So, maybe just widening out to start with, when you're helping prospective investors that you encounter form expectations of what the strategies aim to deliver, say, versus a benchmark over a market cycle, is there an excess return or an alpha you target? What is that conversation of helping these investors to form expectations sound like?
Lynch: Sure. We don't target necessarily a specific tracking error and then a specific outperformance target. I think over time our hope is, we're going to meaningfully outperform, and I would say that would be something along the lines of 200 to 300 basis points. But it's not usually as specific as that. I think the conversations are a little more focused on the team's longer-term record, how we think we're different than other competitors. It's a very competitive industry. And so, we're constantly having to think and evolve in terms of how we look at the opportunity sets we're dealing with. And so, I think the conversation is more around what the team stands for, how we do what we do and then we believe if we follow those differentiated factors that we will hopefully add value over the longer term.
Ptak: That's perfectly reasonable. So, if we were to try to decompose that and think about where the excess return, the alpha would come from, the sources being multiple earnings growth, shareholder yield, recognizing that you're running growth money and so the multiples are going to be elevated, how would one think about that? I would think that your primary source of value-add is trying to exploit situations where perhaps earnings growth potential is misperceived for whatever reason by the Street, is that fair?
Lynch: I think so. I think longer term if we're going to be adding value, it's going to be because we've come up with a better sense of what the company's end games are and how big they can be over time relative to the market's current expectations. So, it's really a lot of work around how big a company can be in relation to its competitive advantage or what we call uniqueness, and then, hopefully, buying companies at prices where we believe the return profiles are much more significant or beneficial than that of the average stock or the average company. So, really, a lot of the outperformance I think is in understanding the duration of the company's competitive advantage, but then also and probably as importantly, the size of the potential markets that it's tackling.
Ptak: So, before we get into a specific name, maybe I wanted to again widen out, I think that you've talked about some broad reasons for mispricing, for instance, a lack of Street coverage, maybe people misinterpreting or putting too much faith in the multiple, not understanding new or unique business models, and then sort of good old-fashioned recency bias. And so, I wonder maybe to frame the conversation, you could expand on that a little bit and maybe talk about how the mix of these different root causes has shifted over time and why that might be.
Lynch: Yeah, I think one of the hardest things--I mean, it's such a tough task to try to beat the market and I think it hasn't gotten easier. And I think over time there have been some areas where we think there are probably good pools to be fishing in, which include a few that you mentioned, and a few others I might put out there as examples would be classification or expert bias, maybe cases where companies don't fit quite easily into a bucket and so, analysts or investors have trouble finding the right context for doing their analysis properly. For instance, when Google went public, a big question that was asked at the time was, Are you a technology company or are you a media company? And I think that there's so much angst around that. And it's really kind of unclear. If you think about what Google is, it's sort of was something new and different. I think it's those kinds of opportunities that don't fit neatly into one sector or industry that often are the ones that we gravitate to, because they're not necessarily so easy to evaluate.
Ptak: Is animal health another example?
Lynch: Right. There's a case where you have, I would say, it's healthcare, but it's not healthcare in the sense that healthcare is a very tricky area, because typically you have a lot of regulatory--it can be both a good thing that regulatory barriers, good and bad. You can have shifts in the regulatory landscape very quickly from a political standpoint. So, that's a tail risk. And one of the nice things about that part of healthcare is that a lot of the spending is coming more out of pocket. It's not backed by any sort of reimbursement or any kind of government benefit. So, there are certainly areas like that and even within healthcare as well--that's not a bad example--but you have other cases where you have technology companies, or companies that provide technology as a solution, maybe it would be a genetic sequencing solution or robotic surgery. And these are cases where you don't have necessarily direct--you might have indirect risks related to regulatory or reimbursement, but they're not quite as direct. And often, I think within--at least within healthcare, when I look back over time, and even prospectively, we try hard to make sure that we have some exposure to ideas that might have that regulatory tail risk, but have it in a limited manner and make sure that we're focusing on cases in those categories that hopefully don't have as much of that exposure relative to the companies that generally make up that population.
Benz: So, let's--and I don't want to get too in the weeds on healthcare, but I would be curious to get your take on all the uncertainties swirling around the healthcare space. How do considerations about regulatory changes, changes in how we pay for healthcare in the U.S., influence your approach to investing in that space?
Lynch: Well, like I said, I think historically, we tried to stay away from or favor companies within that area of end-market spending that have really little exposure or less exposure on average when I look at the portfolio holding. We do have some, and the reality is that the healthcare system could go under massive change or it could remain fairly status quo and have incremental change. And so, we don't want to forgo opportunities that might have very large end-game potential that fit into the more conventional regulatory reimbursement paradigm. But when I look at how we're positioned within those areas, we tend to favor more the former types of ideas I mentioned, which have a lot less direct exposure to such things.
So, I think when I think about risk across the portfolio, but particularly within healthcare, that tail risk is something I think you can't forget about. And I do think most people that are part of the healthcare space, whether they're investors or experts, generally you think that there won't be change and it's sort of in their best interest to think that way because when you put a whole career and time and effort into developing expertise around a certain system, it's not fun to think that you have to reimagine how you're going to spend your time and learn a lot of new things in order to sort of catch up to the way the world could change. So, I think there's some great questions there. But it really comes down to thinking about risk management, having some allocation to an area that's growing, but also at the same time recognizing that whenever you can find a healthcare idea that doesn't quite fit the reimbursement paradigm or have that requirement, that those ideas can be a little more interesting.
Ptak: Before I interrupted you, I think that you were going through sort of these different potential sources for mispricing, or lack of understanding of a name. And we talked about like a street coverage, misinterpreting the multiple, not understanding new or unique business models, which I think you sort of lumped into expert bias and then recency bias. And so, I'm just curious, has the mix of those different sources, has that shifted over time in the portfolio where you've seen the market present you greater opportunities, let's say, because they're more prone to one of these types of errors for whatever reason?
Lynch: Yeah, I think that, as you talked about, maybe time horizon arbitrage or kind of longer-term thinking versus shorter-term thinking is always something that's a really significant part of what we do. The idea of classification bias, I think, has been useful over time and something we're always on the lookout for. I think that more recently the portfolio isn't as focused on those areas. I do think some of our ideas are misunderstood but not for those reasons, but more for maybe, as I mentioned earlier, the longevity of their growth opportunity as well as the duration of their competitive advantage. And we still have some, I think, based on how we're set up that we would call relatively unknown. There are cases where small companies eventually become large companies. And we're set up in an interesting way where our investors wake up every day, and they're able to look at small companies, mid-size, large global companies, you know, U.S., international, and I think that's a platform advantage. We're structured differently. And we're not just dedicating 100% of our time and effort to one product. We're trying to think like investors first and category-oriented people last. And I think that that's a benefit of our structure.
But to answer your question, it's more at this point, I think, looking for cases where people are really focused on short-term, let's say, metrics, like multiples as a proxy for valuation, but where those might not tell the whole story. And I think that there is such a thinking from our vantage point that I would call conventional valuation bias, which is that P/Es or price/book or price/sales or whatever metrics that you prefer, is sort of considered valuation. But it's really not. I mean, in and of itself, you said, tell me something that's 10 times earnings or 10 times sales, I don't really know anything yet about whether I should buy it or not. Maybe if you're going to buy thousands of companies across--in each one of these types of buckets that on average it could tell you something, but when you're dealing with case-by-case situations, I think it's less useful. So, I think a lot of our portfolio today is more about being patient and waiting for the long term to play out and monitoring along the way whether we continue to be right or not in terms of our thesis on the company.
Benz: So, you mentioned that other market participants underestimating the size of a company's market has been an area where you found it sort of a profitable thing to think about. Can you give us an example of that, either currently in the portfolio or something you've owned in the past, something that really you felt like the marketplace underestimated the size of the company's market?
Lynch: I mean, when I look back historically, there's a number of examples that I can think of. But let's just pick Facebook as an example. That was a case where it was actually a very uncomfortable period because post the company coming public, we had a very large weighting in Facebook, we had a lot of conviction about its future, and the potential for its addressable end market to be very large. They were tackling, unlike Google, part of the advertising market that was more about generating demand. Typically, the type of thing you see on television, as opposed to the action-based sort of an approach, you know, I want to take action right now, which is what happens when you search for something and Google serves you an ad. They are very good in that segment of the advertising market. And I think for a number of reasons, in that case, people were underestimating how big the company could be. Certainly, the company was having some particular challenges back at that moment in time and did underperform quite dramatically during that period of time. I mean, it was quite a drawdown where I think the stock was down almost 60% from the IPO price, and the market was actually up during that timeframe. So, that's a really huge swing on a relative basis and, of course, absolute basis.
So, that was the case, I think, where people got so focused on the stock price performance in the short term. And then ultimately--and something we hadn't really anticipated, which was the fact that six months later, there'd be a lockup and there would be more supply of stock in the market and which is not necessarily a fundamental issue, but it is a short-term supply and demand issue. During that six-month window it was very uncomfortable to continue to hold the position even though we thought that the end-market potential was so large, maybe even larger than what Google was looking at, at the time. And we also had a lot of confidence because the company was going through a little transition, not a little one, but a significant one from being focused on desktop to then becoming more mobile in nature. But we thought it also had between the network effect of their social network but also the native quality of their advertising, sort of the perfect killer type of advertising unit that we thought prospectively would actually make them the leader in mobile advertising, which is how things played out.
So, that would be a case where I think because of short-term stock price momentum, in addition to supply and demand dynamics that aren't necessarily fundamental, really led to a diversity breakdown of, Geez, you know, why would you buy this stock before the lockup? And I'll never forget when the lockup finally occurred, and the stock was up 25% that day. It, kind of, shows you in the short term, how you never really know--you know, it's really hard to make predictions about what's going to happen, especially when you have so much information. And we're all human. And when you have this knowledge of a supply event, like you did in that case, it's very easy to come up with a negative view until after that moment in time. The problem, however, is that when you get yourself super-negative about something for a short-term tactical reason, it can be very hard to change your mind and become positive. And I think that eventually that played to the benefit of the stock prices. People slowly but surely came around to the fundamental improvement and benefits of the mobile transition.
Ptak: So, I heard that one of the choices that you have to reckon with in a situation like that is, When is a firm leveraging an advantage or a capability and asset that it's built up, versus where it's mission creep, right?
Lynch: When is something wrong?
Ptak: Exactly, exactly. And so, maybe in the context of that particular example, you can talk about what gave you and your team comfort that they actually were leveraging capabilities, assets, advantages that they had, versus just completely going off the reservation?
Lynch: Well, I think, the core to the thesis was the strength of their social network in that they had hit a size that was going to make it very hard for another social network to replace it as sort of the common network that we all tend to gravitate towards. So, the real question was, can that translate, or does that translate, directly to mobile? So, the confidence in our willingness to stay the course was really that the core of the thesis was around the social network and how strong it was. And whether or not you were going to monetize that desktop or via mobile was a secondary execution issue in our mind, as opposed to something that was inherent about the company's uniqueness. So, I think that's the kind of conversations we were having at the time and what we were thinking about.
So, during those moments of duress, you're right, you're sort of coming back to what really is the thesis. In our case, what we tried to do is make it about the company's uniqueness. Also, I will point out, which is, I think, really important that they also had the financial wherewithal to live through a period of time of transition. So, they had a very strong balance sheet, and even in a scenario where things weren't going to work as quickly as they wound up working fundamentally on the mobile side of things, they were also cash flow generative in a meaningful way. And so, this was a case where they were going through a fragile moment in terms of stock price volatility. But from a fundamental standpoint, about the company’s uniqueness but also its ability to see through that tough period, that gave us the confidence to stay the course there.
What I was going to say--and it's a great question--in hindsight, looking back, you know, it's not that every time a company goes down significantly or underperforms dramatically that we always stay the course. Sometimes something has changed enough fundamentally that we're not willing to do so. And another variable there, I think, that's important is financial leverage. And I brought it up with the strength of Facebook's balance sheet. We had another mistake that we had made where I think, fortunately, we were able to minimize losses when the thesis changed, which was in the case of Valeant Pharmaceuticals where more information came to light regarding their distribution practices. And as we kind of interpreted and analyzed that situation, a lot of the discussion moved away from the company's positioning and competitive advantages in their different product lines and more towards their ability to see through that period, whether or not some of the new information was accurate. And that was a balance sheet question. So, that was a case where we wound up taking very quick action and learned a lesson and reinforced the lesson that we've learned a few times over time, which is always understand balance sheet and the ability for companies to see through their business plans, and making sure--and we advise our companies to this--that they have the cash to see through their business plans with a lot of redundancy.
Benz: So, what systems do you have in place to ensure that you're not overreacting to new news, but that you are revisiting your thesis and factoring in new information and staying flexible and frankly, being able to admit that we got something wrong? What sort of systems do you have to ensure that that sort of critical self-analysis happens on an ongoing basis?
Lynch: Well, the way we make decisions, typically I'm involved on our platform, Counterpoint Global's platform, we have products managed out of New York and we have products managed by Kristian Heugh in Asia. And both of us--and he's done an absolutely outstanding job taking generally our philosophy and process and really implementing it in a really strong manner for global international investment. And so, the way we're set up on the platform is, for the New York-based products I act as the lead investor, and I'm involved in all the final decisions for our buying and selling of companies. But we have a lead investor as well on each individual name. And the same is true in Asia. So, we have a constant back and forth and a constant balance between someone who acts more as a generalist with maybe broader perspective, but less individual expertise on ideas, which would be myself or Kristian, and then someone who's really knee-deep in the weeds and knows all the details and is constantly meeting with the managements.
And I think that's a good balance because there's benefits to both. If you get too close to something, it can make decision-making hard. And if you are too removed, you might not have enough information to make a good decision. So, I think we have a good balance. And as companies, by the way, report earnings, or we're meeting with them and anything meaningful coming out of that ongoing due-diligence, we're constantly as a team broadcasting to the rest of the team, usually via voicemail actually, that, “Hey, here's what's happening. The company just reported earnings, let me reiterate why I think it's unique and here's some new information. Here's an update.” And that promotes a few things. One is, we have a dynamic--I talked about myself or Kristian and an expert, but we also have everyone on the team listening. And I will have times when people come to me and say, “You know, this isn't my idea, and it's outside of my area of expertise, but it seemed to me like something's changing there.” And that will cause some great dialogue. And I think the important thing there, why that occurs is, A, we try to be transparent and open as a team in terms of sharing our ideas and how they might be changing. But also, we incentivize people not just to do well--50% of our compensation is around how the products do, not necessarily how you do in your area. That's only 25% of how you're evaluated over a three-year basis. So, we want people to think portfolio and product performance first, and their segment or sliver last or second, even though—it’s got to have some meaningful impact, but we'd rather overrepresent total client experience than the individual investor.
Ptak: So, I'd imagine another sort of precept that you try to drive through your team is sort of this notion of inverting, and understanding what the bear case is in a name, and just in scanning the top holdings in one of the funds that you manage, I mean, there's lots of what people I think would describe as “platform firms” of various kinds. Your top holding is--I'm looking at Institutional Advantage right now--Amazon, run down the list, Ecolab, Walt Disney, Intuitive Surgical, ServiceNow, Workday, Twitter, Constellation. Different types of businesses, different lines of business, but a number of them are endowed with platforms. And so, as you go through realizing that not every platform is going to be the same, Is the bear case presented on sort of the platform model and what could come in and threaten it are the sorts of trade-offs that you're having to make as an investor in committing capital to that type of business model?
Lynch: Yeah. So, we don't have official like pre-mortems, because sometimes I think that would focus you too much on like one thing that can go wrong. And usually, when something goes really wrong, it's something you didn't anticipate. So, you don't want to be too focused on disproving the one thing and feeling good about it. But you're right. So, when it comes to all these ideas, part of my job--and by the way, it's a balance. We don't have analysts. Everyone's an investor, and I just happen to be the lead investor on the product. But we're all trying to make the right decision together. And along the way, sometimes it's me bringing up, “Hey, shouldn't we be a little worried about regulatory risk as these companies get bigger?” Or might be in the case of Internet, because you're mentioning platform, and often companies in that area sort of fit the bill, Sam Chainani might be bringing that up to me and we might be having that discussion.
So, I think we're constantly thinking in those ways. I think one way the portfolios have evolved, if you looked at them a few years ago, you'd see even more the today obvious platform-type companies that make up large parts of the large-cap benchmarks, which would include what people call FAANG, which I don't love, it's sort of a weird classification. But the point is that we are having those discussions and a big evolution of what we've done in the last few years is that we no longer own some of those companies that are among the largest in the world, in the degree we did. In fact, if you probably compared us to a benchmark, we'd be pretty significantly underweight many of those companies, not because they're not great companies and not because they don't have a lot of great qualities. But as you get to be, 500 million to a billion to a trillion dollars in size, it doesn't mean you can't double and maybe more, but compounding becomes more challenging for reasons such as regulatory. And we started making that transition before all the sort of more recent regulatory news has hit.
We'll see how that all shakes out. But I do think that we're seeing more opportunity in the smaller, less mega-cap today in the U.S. at least, and more towards some of the younger companies that we think have very high growth potential and large end games that might appear expensive in the short term to the average investor. But when you look at the business characteristics and you look further out, there's very exciting futures.
Benz: So, one thing I wanted to ask about is some of the reading that goes on within your team. I think the idea is to encourage intellectual rigor, but maybe you can talk about what you're going for in terms of encouraging your team to read expansively. And I'd also like you to address whether you think this is especially important for people investing within the growth space that you want them to be thinking expansively about how the world might change in the coming decades.
Lynch: Right. So, we've talked over time about having a lot of shared reading. We have a reading network that’s sort of grassroots that occurs here at Morgan Stanley. The value that I'd say was very high a decade ago and it still has value, probably is less valuable today than it was, because of all these other alternatives external to the team, including things like Twitter, where people share all sorts of ideas. And that's great. We're going to constantly be looking for any source where we can learn about things that we were previously unaware of. So, it's a big part of what we do, though, however, whether it's sourced with our internal reading network, or whether it's something external, like I mentioned. At our Tuesday meetings, we really try to focus on what are people reading outside of their areas of expertise when we get together as a team, and emphasize and look for things that might not be what everyone else is paying attention to right now.
And as an example, how that can benefit you--it's not necessarily going to benefit you today. It's not going to lead us to go out and make a certain decision in the moment, but it tends to be cumulative. And as an example, I think it was Dave Cohen, who follows consumer for us, he--and I believe it was Scientific American put out a piece around plastics a few years ago, and it was before it's become a little more in the mainstream in terms of something people are concerned about. And we had a pretty robust discussion around that, which led to another member of our team, Thomas Kamei, who is very passionate and has become very passionate in sort of the ESG side of the investing equation, to put together an event. And we hosted at Morgan Stanley a company called The Aspen Institute, which is a nonprofit focused on ESG. And out of the concern we were having around this topic, it led to us interacting with one of our companies that had a pretty significant exposure to this, in terms of the company sells beverages. So, it led us to actually reaching out, trying to help one of our portfolio holdings get perspective on something before maybe it became a little more mainstream, which I think is a good thing for our shareholders, but also of course, for the company. And it also led to us becoming a little more formalized in our approach there, and Thomas is now spending more and more of his time on those kinds of topics and issues that we think help us understand the competitive advantage better. And so we have a dedicated effort via his leadership to try to continue to have that extra vantage point of ESG when we think about competitive advantage, but then also along the way, reach out to our companies and make sure that they're thinking about a lot of these topics as we move forward.
And the reason I think that's important is, you know, when I think back over my career 20 years ago, my first investment I was excited about was a company called Nielsen Media Research. And it was a classic kind of monopoly. And back then it was like--the mindset, I think, of investors were seeking companies that had pricing power, and it can be monopolistic. And it was actually almost a good thing that their customers didn't like them. They were so entrenched that it was that kind of business. There was significant longevity because they could do what they wanted. And you kind of look over time at where we are today and obviously, things have changed quite a bit. I think today we're a lot more hesitant, certainly, in those kinds of situations and much more focused on looking for cases where people in an ecosystem are all thriving. And the fact that that might lead to more longevity and durability of advantage, given that there's so much technology disruption out there, that companies that are total rent-seekers are more likely to be targets as opposed to maybe investment opportunities.
Ptak: So, do you feel like given the fact that you tend to stress competitive advantage in the work that you do and focus on those types of businesses, do you feel like it makes it even more important to focus on some of these other issues that an ESG lens would force you to focus on? I guess maybe that's an obtuse way of asking whether when you go through and do sort of the traditional kind of company work, industry work, that would lead you to conclude that this is a fantastic business that could dominate, you have to ask extra questions? Like, if they do dominate, what sort of other issues could crop up that would threaten the value of this investment that we would need to take into account of our sort-of traditional analysis, if that makes sense?
Lynch: Yeah, I think that's the evolution that we're talking about. And I think that that leads to try to understand how managements are thinking about those kinds of issues as well. It's a big factor in the world today. The access to information is suddenly so ubiquitous and transparency has risen so dramatically. And it means consumers and end companies really want to understand all these issues as a part of who they choose to do business with and how they go about their day-to-day. So, I think it's an evolution of understanding competitive advantage and I think it's absolutely necessary.
So, one thing we've done there is try to formally create a vantage point where there's someone on the team is championing those ideas, to make sure that we're not only not forgetting, but also emphasizing them in our work. Another thing along the lines we've done there is create a vantage point through Stan Delaney, who 15 years has been our disruptive change researcher. So, he doesn't follow one company. He doesn't follow industries. We come up with topics. Both he and the team, collaboratively, have themes or big ideas that could impact many sectors or where experts might be less useful in the equation because the world is changing so quickly.
So, for example, the first project he was involved with was Internet media. And this was 15, 16 years ago. So, it seems obvious today, but it wasn't back then. And based on a lot of the grassroots work he did, and the nonexpert but in-depth research he performed there, it helped us start to get interested really in some of the companies that now have become platforms, as you mentioned today, but also helped us exit some more conventional media businesses like radio stations where we had had a significant exposure, and where there was a lot to be excited about when you look backward, and looked at the current state. But suddenly, the alternative of that new ad unit and its return on investment just shifted the equation dramatically. And because those companies had historically backward-looking great business models--those companies meaning radio stations--regulatory, local regulatory barriers, they had good power ratios suggesting more advertising would flow to them based on listenership. They also had a lot of financial debt because it seemed appropriate that those businesses were so durable.
So, we do like to think about evolving the team, building peoples' roles around their passions and interests. So, in the case of Thomas, I talked about ESG earlier, Hey, this is great. He's found something that he really wants to own and that's going to be a big contributor for us. And similarly, Stan has been doing that with disruptive change for 15 years. And I think these in and of themselves don't differentiate us one or two, but I think cumulatively a culture and having a platform that has multi-cap and global qualities, and also having a culture that's really about continued learning, I think these cumulatively can add up to hopefully help differentiate us and are now.
Benz: I'm curious if you can talk about a disruptive change that you have your eye on today, something that you think other market participants are underappreciating its ability to transform something within its industry.
Lynch: Stan is about to put out a piece on robotics. But generally speaking, robotics, what's happening there, things are moving fast in terms of the efficiencies and sensors and software, and that's leading to, I think, the addressable market changing from what has historically been kind of manufacturing autos to much more broader applications, it also might have impacts as to where you might locate manufacturing. So, there's pretty big implications there. And I think that if you look at our portfolios, we have a few holdings across the platform that benefit from some of these trends in that area. But I certainly think that's a big one to focus on.
I think others that are kind of early in stage where we don't have direct current impact would probably include quantum computing, and staying on top of what we're seeing there out of Google making some recent announcements in that field; and also artificial intelligence. So, he has a number of topics that he's researching at any given point in time. We are actually adding more resources there because we think it is something different. Again, the system is set up around experts and investors with specific industry and sector expertise, and that can be very useful in a stationary environment. And when the world is dynamic, and I think it does appear to be increasingly so from a disruption standpoint, having inputs, dedicated inputs, on your team, make sure they're broadcasting, helping you and your experts keep in mind how these things are changing, I think is a really good allocation of resource. And it's not one that's typical or common in the industry.
Ptak: I think you'd used the phrase durability of competitive advantage earlier in the conversation. I'm curious how you're thinking about durability of competitive advantage has evolved through the years. You just mentioned how the world is a much more dynamic place. And so, one would think that that expresses itself in the way one thinks about duration of competitive advantages. If anything, the duration would become shorter. Is that fair?
Lynch: I'm just thinking. It's a good question. I think it means the likelihood of disruption is higher and I think we need to always be considering that when we look at our individual companies. Just because there's some theoretical chance of that occurring doesn't mean it will occur. But it's important to have it top-of-mind as you continue to own or take a longer-term ownership position in a company, be open to the fact that there are new variables that just weren't there previously when you made your initial decision.
So, I think you're right. Generally speaking, on average--and I think you're talking more as a population, competitive advantages probably are shrinking. Doesn't mean there aren't some that are still very strong. And while we can't imagine some of the things that can go wrong with them today, it's our job to be open and mindful that those can occur. But ultimately, I still think you can benefit from owning companies with a longer horizon than your average investor, as long as you're willing to look out a little further and keep an eye on these big changes.
Ptak: That's another of the vexing decisions, I would imagine, you face as a portfolio manager when to let go, especially to a name that's been pretty good to you over time. And so, as you reflect on your career, the things that you've learned about that aspect of portfolio management, What have you learned and how was your thinking in that specific facet, how has it evolved?
Lynch: I think, first of all, great investing is opportunity-set-driven. And I think it makes sense or has made sense historically, tends to organize its analysis or efforts around terms like growth and value, and other classifications. And I think that some of those can be misleading and sort of lead to traps in your mind about how you think about the opportunity set. So, I think we should be investors first, and whether or not we wind up in a growth bucket should come last. And growth buckets tend to be defined by things like multiples as opposed to other variables. So, I think opportunity-set-driven investing is the way to be ultimately. And I think along the way, you can have a great idea that you own for many, many years, but at some point, there is a price where you're going to let go, and that price could look like a short-term high multiple or it could look like a very high market cap. And when we talked earlier about how we've repositioned at least in the New York products, more recently some of our U.S. holdings, it's a reflection that some of the largest companies in the world have great advantages. But at the same time, there are things that occur at that level of value that create fragility, things like regulation. So, that's a very long-winded answer. I'm sorry.
But coming back to the question, we're mindful of valuation. We like to buy things when we think they're underappreciated. We're happy to let our winners run using the sort of normal language. But at some point, we are willing to sell, too, for valuation purposes. And that includes both conventional, like, or what someone else might think, “Okay, well, this looks expensive on a short-term basis.” That's not how we're making the decision, but that would include smaller companies that just have gone too far too fast. But I think it also includes some of these larger companies, which again, we don't dislike, and I can't say that they don't have very strong positions, but there is more downside and it is hard to compound at a high rate from such a high starting point.
Benz: We wanted to talk about your allocation to private equity in the portfolios that you run. Can you talk about how that has evolved over your career? I would imagine, earlier in your career, you were focused primarily, if not exclusively, on publicly traded companies. When and why did you decide to expand to private equity, let alone invest in such companies?
Lynch: Sure. Well, after we've been doing this for a while, we certainly meet with companies that are not public as a part of our understanding of industries and sectors. We’d gotten to the point where we were a fairly big team from an assets standpoint, and we thought that taking advantage when we could of opportunities that maybe other people couldn't get because we had a reputation within some of those industries, whether they were Internet or software or healthcare, technology, and relative to the mandates we've managed, we had that capability or had some capacity to do that. So, that's why we made the decision. It was an attempt to take advantage of the research we were already doing, but hopefully in a way that would be on the margin as opposed to something overly significant.
We haven't been doing that for quite some time. I think if you look at the exposures, it's very small, and probably by next year will be de minimis depending on how markets and IPO markets function. And from here on out we're not pursuing that strategy, simply because when you look at the changes in the landscape, the SEC has come out and raised the bar in terms of how people think about portfolio liquidity. And so, when we look at things in that context, we think we're happy with the holdings that we've had historically. We still have a very small amount, but we're no longer looking to pursue that activity given the new environment.
Ptak: How important do you think it is for a growth investor like yourself to be cognizant of what's going on in private markets? Just to basically be tuned in to understand within the different verticals that they're analyzing? You used the term opportunity set before and so, I would think of those private firms as being part of that opportunity set or at least competitive set. So, it seemed like it would behoove that investor to know what's happening in public and private markets alike. Do you think that's fair?
Lynch: Yes. And that's really the genesis of our activities there and why we think it's important. The smallest companies can impact the largest and vice versa. And if you look at how we're set up, we're trying to take advantage of that. And having that additional perspective, whether it's international, global, U.S., or small to large, but of course, that can also extend to non-public. And there's certainly a little risk when you follow public securities, that you mostly focus on those because they're the ones right in front of you. And it's very possible, particularly in today's world, where companies are formed more quickly, and sometimes, depending on the situation grow very quickly, that you need to have an awareness of them as a part of how you think about the competitive landscape for the public companies you're investing in.
Ptak: So, just I'm curious from an analytical perspective, let's imagine that we put you back at Columbia and you're teaching a class on investing in private, so to speak. And you're trying to impart to the students there some of the most critical things to be evaluating when it comes to private firms that perhaps you wouldn't be as attuned to when you're looking at public market equities. There's obviously the balance sheet. There's sort of the nascent state of the business, right? Those are obvious ones. What are other things that you would try to impress upon them that are important to focus on when you're assessing these types of enterprises?
Lynch: Well, look, I think, a few things. Management is always important, whether you're small or large, but I think probably the smaller you get, it can be really critical. And the second variable, I think, that's really important is incentives. How are the key people incentivized or not? So, I think the smaller the business, or the more nascent the business, I think these types of things are magnified. But certainly, there are also variables that matter throughout a company's life cycle. So, in addition to looking at what the company has from a competitive advantage standpoint, how big it can be over time, execution is always important, but I think it's particularly important at that level. So, you really need to have a strong comfort in the incentive system and the people.
Ptak: When you're dealing with companies, I'm curious how the conversations with firm management--I realize, again, just going back to your earlier comments, this is going to vary quite a bit just given the maturity and state of the firm that you're talking to--but how have those conversations through the years evolved? I would imagine that there was a time, right, where there was a hyperfocus on short-term results, and sort of business deliverables. Do you find that the management teams that you speak to, that your team is afforded access to, are a bit more strategically focused than perhaps they used to be?
Lynch: Well, I think, we try to see great businesses where you have a great allocator or a great leader that's also thinking about the long term as opposed to the short term; obviously, there are degrees in between. So, I'd say that we always try to encourage the companies to think long-term. I think most of our companies already do and they appreciate that input. But we're generally attracted to companies that are already--and management teams that are already--hardwired to be that way. It depends on the sectors a little, too. I think the success of Amazon and Jeff Bezos is sort of now more of a given in today's society. And the way he went about growing Amazon was certainly unconventional from an earnings standpoint and how people historically thought about building a company that was public. So, I think that there's a little more success stories. If you follow a long-term vision, that there will be longer-term rewards.
Having said that, unfortunately, along the way, not every situation is quite as good as Amazon's turned out to be. And companies sometimes have to make decisions about shorter-term trade-offs versus longer-term trade-offs. We try to make our influence such that we're emphasizing and promoting the longer-term view. And I think for the most part, the cultures and the styles of the people that we're dealing with tend to fit that already.
Benz: What are some of the biggest portfolio management mistakes that you've made in your career and what have you learned from them? And how did they inform the way that you run money today?
Lynch: We've made a lot. It's a business where you make a lot of mistakes. And I think one of the things before I get into maybe a couple of specifics is, you know, in this business, you have to be really self-aware and try to determine when things go wrong. Number one, as we talked about earlier, sometimes things go wrong from a stock price standpoint, but they haven't necessarily gone wrong on a fundamental level, and trying to figure out if that's what's happening, and that's what the market signal is telling you. And then, you have cases where, no, there's certainly been some change in the fundamentals and whether or not that’s thesis changing or not, it can be challenging. But what I was going to say is that, you know, I do know a lot of people and this is probably not just about investing, but life, where you sort of have a situation where an investment goes badly. And it's really important when that happens to try to learn the right lesson and not the wrong lesson. And it's very easy to say, well, I felt like that management team lied to me, or nobody could have seen something coming, or I'll never going to invest in a certain technology company again because I lived through 1999. So, I'm not sure those are the right reactions to when things go wrong.
And so, I think one big thing is not just about, you know, okay, give me examples of what went wrong, but just always remembering that we want to be careful about making the learning process something where we're doing a process of elimination. Because I think in order to be successful in life, you've got to continuously remain open to things. And if you're constantly winnowing down your opportunity set because of things that have gone wrong, you can really miss some big, big things such as--and I alluded to it--wow, there was an Internet bubble, and there was a technology bubble in 1999; I'm never doing that again. Well, you know, unfortunately, in the last 10, 15 years, you would have probably forgone a lot of the big kind of opportunities that wound up being presented by the market because of that mindset.
And by the way--so, back to that concept of just crossing things off the list, I also think there's this concept of the circle of competence, which is generally a good one, which is, I think, a Warren Buffett, Charlie Munger thing, which is, "Know what you know and stick with it, because you don't want to get outside your comfort zone." "If you don't know who you are, the market is an expensive place to find out," opening line in The Money Game by Adam Smith. So, I get that. But at the same time, I think that it's really important to also have a growth mindset and to be willing to learn new things and not use that as an excuse to sort of stop learning and to not want to learn about a new industry. Because often, what's new is harder to--that's where you can have efficiencies. I think we talked about classification problems earlier. So, there's a fine line there. It's a great thought, but there are downsides to taking it too seriously or being too dogmatic about it.
So, in our case, I think when I look at some of the mistakes, particularly a few years back, again, I'm never going to cross anything off the list. But I think in the area we made a very big mistake in a commodity-driven area, the commodity-price-driven area around rare earth elements and companies that were exposed to them and the concept that there could be a shortage there. And the bottom line is, there may or may not be over time and some of those dynamics might still exist that make it interesting. But these are very capital-intensive businesses where one variable can swing so quickly that you don't have that balance sheet ability to see through your business plan, which we talked about kind of earlier. So, I think that one huge lesson I learned--and that was also something back in the 1999 timeframe--which was that whole balance sheet thing. So, I think that avoiding cases or being willing to sell cases where the capital intensity relative to the balance sheet situation is just not--there's just not enough redundancy, and being really mindful and careful. So, we've had some of those, I think, in the more recent past or so. We've incorporated that and gotten better. So, we haven't seen cases like that. But that is probably my biggest one, which I think is the right lesson, as opposed to maybe saying I'm never going to own a certain industry or sector again, or never going to trust certain analyst again or something of that nature.
Ptak: You've mentioned some of the ways that you try to encourage your analysts to be omnivorous, I guess, you would say--sort of the reading that they do, the disruptive change research that it sounds like you dedicate a few of your analysts to. What are some of the other ways that you try to ensure that you are inculcating the analysts in such a way that they're striking an appropriate balance between being focused and disciplined researchers, staying in their circle of competence, so to speak, but not being entrapped by it in the way that you described before? How do you try to sort of encourage and manage that balance with them?
Lynch: Most of our analysts, or our investors rather, focus on usually two industries or two sectors. So, they have a couple of areas they're looking at. So that way they have expertise, and they can drill down and we can leverage that. But at the same time, they have at least a little perspective on a day-to-day basis about what's happening beyond them. Or the area they follow is diverse enough, like in the case of Jason Yeung, who is outstanding for us in healthcare, there's enough diversity in his area that it's not just about one business model or one spending trend. So, we try to make sure everyone, depending on what they're following, has more than one sort of general business model/spending end market. So, there's not the potential risk of getting too stuck in the weeds of the one thing that you do. I think that's the first thing.
Second thing, I mentioned earlier, when we do have events for the companies' quarterly earnings, of course, a big part of that, just “Is there new information?” being the question, we'd like to broadcast that to everyone on the platform. So, people are listening to what's happening outside their area. We certainly encourage anybody's input about what they think might be changing beyond my own, Kristian's, or the individual lead investor that is on that particular idea. Those are some of the good things we do there, kind of more research-oriented, to try to make sure there's a little extra perspective and not just expertise only. Of course, we mentioned the other DCR, disruptive change research, earlier.
Last thing I'll say we try to do just more from a larger perspective is, we do personality assessments as a team every couple of years. And you know worst-case scenario downside is like we have a little fun, spend the day together and make fun of each other for being different. Or being--so that--you know, I'm such an INTJ or whatever, Myers-Briggs, you know, that’s my personality type, or whatever you are. At worst-case it’s kind of a team-building event, and you don't have to like it or you can think it's hocus pocus--fine. But you know, for some people, and I think, certainly I felt the benefit to doing some of these things, it does remind you how you're hardwired, and it reminds each other that we all have some of that hardwiring going on. And so, it can help you communicate better but also build some of that self-awareness that I think can be useful in coming up with insights and not just being so pigeonholed into one bit of expertise within a larger team context.
Ptak: Maybe my closing question, I don't think that we've asked any of our guests yet for a book recommendation. But since it seems like you're a team of voracious readers, I wonder if we can impose upon you and ask if there's a book that you've read recently that was especially interesting, enlightening that you think the broader world should know about? Anything come to mind?
Lynch: Yeah, I'm going reset expectations, too, because everyone always asks me for books now, and I don't read books much anymore, because I'm so busy reading all the other stuff, which is great, because--and unfortunately, a lot of cool books these days are business books. You can sort of get the gist of it in a 20-page piece and the rest of it is, sort of, “Hey, I wrote a book and I had to make it longer.” So, we have so much reading flowing through here that I've gotten a little bit away from specific book recommendations. I will say, when I think about recent reading and things that are on my mind, I mean, even in the last week, I think Morgan Housel is somebody whose writing tends to be very crisp, very useful. He wrote a piece just recently called “Three Big Things,” big forces changing the world, something of that nature. I think that was really interesting. And he's interesting to follow generally. There's a really high hit rate there with what he produces.
Another source of reading that I think is really great, particularly if you're focused on what people call technology companies, that would be Ben Thompson's Stratechery. He just wrote a piece called, I think, What is a Tech Company? And it's kind of funny, because it's almost like, What is a great business model? But, you know, he's focused on tech and presenting the ideas under that guise. But I wish I had a book recommendation. I really don't. We have so much flowing through here that's, I think, more relevant to the job that I haven't been focused as much on longform reading. I hope I haven't been disappointing in that regard.
Ptak: Not at all. No, those are excellent reading recommendations in their own right, which we we’ll include in our show notes. And I think, at this point, we’ll thank you for your time and insights. We've really enjoyed having you on The Long View. Thank you so much, Dennis.
Benz: Thanks, Dennis.
Lynch: Thank you so much. I appreciate it.
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 podcasts.
Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And @syouth1, which is S-Y-O-U-T-H and the number 1.
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.
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