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The Best of The Long View Podcast: Conversations With Portfolio Managers

We highlight some of the most indelible moments from our newest podcast.

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On this week’s episode of The Long View, we recap some of our favorite moments from the podcast so far.

Since the podcast’s launch in May 2019, we’ve had the chance to talk to some of the best portfolio managers, retirement researchers, and financial planners and advisors in the business. It’s been a treat to spend an hour each week chatting with them, and we’ve learned a great deal from each of the interviews. 

This week’s episode includes highlights from our interviews with portfolio managers and investment strategists. Next week, we’ll feature some of our favorite clips from interviews with financial planners, advisors, and retirement researchers.

Bill Nygren: 'A Stock That Doesn't Look Cheap on the Surface Might Be One of the Cheapest'

Rob Arnott: Don't Sleep on Value Investing (Especially Emerging-Markets Value)

Rupal Bhansali: FAANG Stocks Are 'Extremely Risky'

Dan Ivascyn: Building a Portfolio to Bend but Not Break

Ben Johnson: Index Funds Are Not 'Zombie Investors'

Dana Emery: You're Not Getting a Valuation Discount for Free

Dennis Lynch: 'Have a Growth Mindset and Be Willing to Learn New Things'

Charles de Vaulx: Why Value Investing Has Slumped but Will Rebound

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services. It's been about seven months since my colleague Christine Benz and I launched The Long View. We've recorded over 30 episodes in that time, interviewing acclaimed authors, leading financial planners, successful entrepreneurs, business executives, and other subject-matter experts. We've had a lot of fun doing it and learned a ton. We owe that to the star-studded roster of guests we've been lucky enough to assemble. They've been as articulate and generous in sharing their perspectives as they are learned and accomplished in their different fields. In that spirit of sharing, we thought we'd look back and highlight some of the most indelible moments from the conversations we've had thus far. In this episode, I'll focus on the interviews we've conducted with the portfolio managers and investment strategists we've spoken with. In the next episode, Christine will pick out her favorite moments among the conversations we've had with leaders in the financial advice, planning, and behavioral finance fields. We hope you enjoy it.

We'll kick things off by rewinding to our conversation with GMO strategist James Montier. Here, Christine asked James how GMO fosters an investment culture of constructive dialogue in disagreement, where more-junior members of the team can feel free to challenge views or interject their own.

Christine Benz: So, how do you try to foster that sort of culture where people, maybe even junior people, feel comfortable speaking up and asserting a viewpoint that's different from yours or another of the firm's principles?

James Montier: It is incredibly hard, and the psychological literature cannot always be terribly helpful. This usually comes down to the fact that you have to have mutual respect, but I think that is easily said and much harder to actually enforce. And I think it has to be almost organic. It has to come from everybody being willing to accept that they could be wrong. And I think investing is one of those fields where there is almost constant evidence that we are all wrong on a regular basis. And that I think fosters a sense of humility. With younger, more-junior colleagues, I think the approach is one that the Royal Engineers in the British Army actually adopted, which is, when they come and try and solve the problem, they start with the most-junior person present and ask for his or her solution. The idea being that that person is then unencumbered by fear of speaking or disagreeing with the superior because they have no idea what the superior will say. This is one of the advantages. The other advantage, of course, is the superior generally doesn't have to make that many decisions because most of the problems get solved long before they reach him or her.

So, I think a lot of it is how you structure your interaction with your colleagues. And we try to encourage the views that everybody has insight and there is no monopoly on truth here. We want to encourage people to have that debate, to make it collegiate conflicts. We don't want somebody to come in and think they know all the answers because experience shows that none of us do. It's really about that desire to grow as a group together that I think we're trying to draw out. But it's hard to encode that in a lot of organizations. And so, we spend a lot of time trying to think about formats, think about ways of getting people to interact. So, I generally choose to communicate via writing while I'm doing internal work. And I think that gives a discipline both on me and for my colleagues. It's a discipline on me because it forces me to try and have a logical chain of thought that somebody who isn't talking to me can actually follow and I think there is a clarity and almost a therapeutic benefit to writing one's ideas down. The other advantage of it from my colleagues' point of view is, they can review that output at their leisure, and then respond. And I think that is very much the way that it used to work when I was in academic and I've seen prospering in academic circles is that kind of interaction and iteration between individuals, but with a kind of – somebody has to stop the ball rolling, if you will. And having something written down is a good – it provides – if nothing else, a strawman for others to kind of bat against.

Ptak: We also had the chance to speak with one of the last star equity managers standing, Bill Nygren of Harris Associates. Bill runs the Oakmark and Oakmark Select funds, among others, and has posted very impressive results over his long career. What's more, he's done it in an interesting fashion, using a flexible value investing approach. Here, Bill explains some of the shortcomings of traditional accounting measures and valuation metrics and how his team attempts to surmount those issues in spotting bargains.

It seems like in some of those situations where maybe GAAP can be more obscuring than illuminating, I guess why would the mispricing persist in situations like those just given the amount of firepower that the institutional investing community is bringing to try and unearth situations like those? I mean, I think that in your letters, you've described some of the types of adjustments that you might make, where there's an expense that's running through the P&L. Instead, you'll capitalize and amortize and adjust earnings accordingly to get a better sense of what the earnings power of the business is. To me, easy for me to say, it seems like a couple of taps, keystrokes, right, where somebody could program that in and the opportunity ceases to be. And so, what's been your observation for why these misunderstandings persist and there's an opportunity for you to exploit?

Bill Nygren: I mean, I'd be really disappointed if you can replicate our research process with a couple of keystrokes. But I think there is still so much capital that depends, at least to some extent, on the primary metrics that have historically been so useful--price to earnings, price to free cash flow, price to book--that when names get outside of normal bounds on those metrics, you're taking that capital away from the potential buyer pool. And we have consistently found that if we can identify those companies, when the GAAP accounting is obscuring the true value, and hold them during a time period where that value becomes apparent, that those tend to be successful investments. It is a very research-intensive process. And I think there are just a lot of players, both individuals and in the institutional community, that are looking for shortcuts that can make the research process faster.

Ptak: Rob Arnott has long been a leading researcher and helped pioneer what ultimately became known as smart beta at the firm he founded, Research Affiliates. Christine kicked off our conversation with Rob at the most logical starting place--the slump in value investing. Here, Rob makes the fundamental case for why we should feel confident that value investing will, after lagging growth for so many years, resurge anew.

Benz: Let's get right into the first question. I'd like to talk about value investing. Though you probably wouldn't identify yourself as a value investor through and through, value is an important input to your approach, and value has really struggled. So, let's talk about its impact on the performance of some of your better-known strategies like Pimco All Asset. What has the experience of the past decade with value's travails taught you, and how is that reflected in the way that you manage portfolios today?

Robert Arnott: Well, firstly, I'd cheerfully acknowledge that we have a pretty strong value bias. We recognize that historically growth has tended to trade at a premium that is actually larger than subsequent growth would justify. There are exceptions, though. The cycle for growth versus value can be a long one. From 1984 to 2000, value underperformed, with almost all of that underperformance in the last 12 years and about half of it in the last two years.

So, what we find is that you can have protracted periods of time when value underperforms. This most recent span is, so far, 12 years and rivals the experience of the tech bubble, both in terms of magnitude of underperformance and in terms of duration. But the market does go in cycles; even if they're long cycles, it does go in cycles. And the important thing to note is--did value underperform because the value stocks themselves performed really badly as companies, as businesses, or because growth itself structurally performed better than it normally does as businesses? In other words, was their underlying growth faster than normal? And the short answer to that is no.

The short answer to that is, if you look at the relative valuation of growth versus value, value has grown cheaper by more than it underperformed. And that's really important. If a style underperforms by 1,000 basis points while getting cheaper by 2,000 basis points, that's a buy, not a sell. And that's sort of the picture of value investing today. It's trading in its cheapest quintile historically. In emerging markets, it's trading in its cheapest decile, cheapest 10% of all of history. And the spread between growth and value is wide enough that just coming back to historic norms, just getting repriced to the normal growth value, valuation spread, would deliver over 2,500 basis points of incremental performance in the U.S. and over 4,000 basis points of incremental performance in emerging markets. So, to me, this looks like a classic long value cycle that has been painful. In terms of our strategies, we've performed below expectations but way above the medians for value managers.

Ptak: Some managers continue to see value in the so-called FAANG stocks. Not Rupal Bhansali, who manages the Ariel International Fund. Here, Rupal explains the risk she sees in one of those stocks, Apple, and how her team attempts to systematically screen out such risks as part of its research process with a particular focus on how to separate the wheat from the chaff in the tech sector.

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?

Rupal 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. 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. 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, etc. 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 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, 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.

Ptak: Pimco group chief investment officer, Dan Ivascyn, has become a giant in the bond investing world and the strength of the standout record he's amassed at funds like Pimco Income. Dan and his team have enjoyed particular success in one pocket of the fixed-income universe, nonagency mortgage securities. Here, Dan explains the role these securities have played in Pimco Income's success and, more generally, in exploiting what he calls frictions associated with the global financial crisis.

Benz: Delving into the portfolio a little bit more, one key ingredient to the fund's historical success have been nonagency mortgage securities. Can we talk about what role these securities have played in Pimco Income's success and also the way that market has evolved through the years? Why is it shrinking?

Dan Ivascyn: Sure. And I'd maybe step back a little bit. I think one of the key themes across the Pimco Income fund as well as other Pimco portfolios was to take advantage of frictions associated with the last financial crisis. Typically, when you have a crisis, like we saw a little over a decade ago, you get a very aggressive reaction. You get an aggressive reaction from regulators, you get an aggressive reaction from rating agencies, you get an aggressive reaction from market participants in the form of pretty extreme risk aversion. And you've seen that in the sectors that caused the most harm during that highly volatile period. The mortgage or the housing markets are a great example of where that dynamic has existed. You've also seen it within the banking sector or the financial sector as well, where you've had massive regulation requirements that these banks and other financial institutions hold a lot more capital than they've been required to hold historically. And they've been limited in their ability to take risk like they have in the past. Those are all great characteristics from the perspective of institutions or funds lending into those companies.

So, what you've seen in the housing market is this postcrisis regulation still having a big impact on credit extension within this space. This is certainly true in the United States. It's true in areas across Europe as well. So, you have a very unique environment where you haven't seen a significant return of securitization. You have legacy assets, either securities that were created before the financial crisis or loans that were originated before the financial crisis that could be turned into new securities that have very, very attractive credit and collateral characteristics. So, we've had a decade of generally positive job growth, we've had a decade of steadily rising home prices, we've had a decade of borrowers that ran into challenges during the financial crisis improving their overall credit profile. And then there's something called burnout in these markets. When you have borrowers that have gone through a tough time but have been staying in their property for now over a decade, even if they get into a more challenging environment from a household budget perspective, there typically is a strong tendency to want to stay within that property, and then of course, equity levels now have increased significantly.

So, the bottom line in these sectors of the market is that, despite almost 10 years passing since the last financial crisis, you have a situation where you have a very, very resilient, very, very defensive profile. And that continues to be a key theme across the Income strategy, where what we're looking for is a responsible steady income stream with material downside protection if we were to get into a much weaker economic environment. And that's in contrast to what we've seen in other segments of the market, like the nonfinancial corporate sector, which bounced back relatively quickly after the financial crisis, where – and you folks have reported on this significantly – where we've seen very high issuance relative to historical patterns, very weak covenants relative to historical covenants and deteriorating credit fundamentals. So, we think that this is a great place to be on a go-forward basis and somewhat unique in terms of this focus relative to other products that are out there in the marketplace.

Ptak: We were also fortunate to be able to confer with one of our internal experts, Ben Johnson, who heads up research of ETFs and index funds here at Morningstar Research Services. We began our conversation with Ben asking why indexing, which was once seen as a small quirky corner of the investing world, has burst into prominence the way it has.

So, maybe we'll start with the big-picture question. Indexing used to be viewed as--it was a bit of a backwater, viewed as sort of a quirky approach, enthusiasts maybe would engage in it, but not the wider market. Now, it's huge by some measures. And so, I think that one of the basic questions that one would have observing that trend is, Why has indexing taken off the way it has?

Ben Johnson: Well, it's a great question. I think there are a lot of different reasons that explain the growth in indexing, and especially, I would say, the growth we've seen in the past decade or so. I think, early on, it was just a tough sell, right? I mean, from the very beginning, index was labeled as being un-American. And that, I think, is a brand that stuck with it for quite some time. It was effectively the ultimate freeloading strategy. You're aspiring to do nothing more than just owning the market. You're sufficing. You're sitting tight. You're just letting the market do the heavy lifting for you and not setting out and being enterprising and cunning and intelligent and wielding all of the many talents that God gave you to try to do better than the market.

In no other field does it apply that just kind of sitting tight and being happy with doing nothing yields good results, right? I mean, you don't get to the top of Mount Everest by failing to train; you don't win a marathon by failing to train; you don't win a spelling bee by failing to train; by failing to try.

Whereas in indexing, it just fundamentally breaks that logic. You can let the market do the heavy lifting and have a perfectly good result if not a far better result than you might get through a variety of different approaches. And part of that just (goes) to costs, right, which I think explains a lot of this most recent leg of the growth that we've seen in indexing--is a growing awareness around the importance of costs that also counterintuitively in investing – to channel the late Jack Bogle – the less you pay, the more you're likely to get.

So, if you pay Ferrari prices, you're going to find yourself in all likelihood behind the wheel of a lemon. If you pay lemon prices, you pony up for a Honda Civic, you're going to get long-term Ferrari-like performance, which is very counterintuitive.

And I think that growing awareness, coupled with shift in the economics of advice – not just in the U.S., but this is a phenomenon we see globally – where many advisors are moving away from transaction-driven models of doing business towards fee-based ones. There's a real incentive there for them, if they want to retain the rents that they're keeping, to maintain the economics of their practice at a level that allows them to live comfortably, that they're going to squeeze the fees out of the asset-management products that they use on behalf of their clients, so that more of that accrues to them in the form of a fee that oftentimes they're charging as a percentage of assets under management.

So, that's going to ultimately favor indexed products as well, be it index mutual funds, be it exchange-traded funds. So that, I think, is a huge leg of growth, a huge factor driving the growth of indexing more recently, as is that same awareness within defined-contribution channels, and you see that as manifest either in the growth of target-date funds that are made up of index funds, or the increasing prevalence of a la carte index mutual fund options on 401(k) menus. And the 401(k) for most young investors, for most small investors, is their retirement vehicle of choice. It might be their only retirement vehicle. So, it's really a confluence of all of these different factors, be it psychological, be it economic, be it sort of these structural trends that we see in place that have driven the growth of indexing to levels that we see today.

Ptak: Dodge & Cox CEO and Portfolio Manager, Dana Emery, touched on a range of topics during our interview, including firm stewardship, how to build a cohesive team, and the intricacies of managing a bond portfolio. But we were especially struck by her perspectives on what it's like being a prominent female leader in a business not known for its diversity. In this excerpt, Dana offers her thoughts on what it takes to foster a diverse culture that supports advancement in growth regardless of background and some of the initiatives they pursued at Dodge & Cox to promote diversity.

Benz: So, I want to switch gears yet again and just get your perspective on what it's like to be a prominent woman in the asset-management industry. Does it affect your view on hiring people? Does it affect your thoughts on managing people? Talk about that.

Dana Emery: Yeah, I mean, I guess, I don't spend a lot of time thinking about myself as sort of prominent in the industry. I focus a lot on managing our own firm. But I think to the extent that I'm in a role, a leadership role, and that can be a role model for others in the industry, I embrace that. I've had a lot of young people in our industry say that, you know, seeing a woman leader is something that attracted them to the firm. And so, I think that's wonderful. I think, our industry, as you know, is still not diverse.

Benz: No.

Emery: And last Morningstar study, I saw that Dodge & Cox had the highest percentage of women in investment decision-making roles in the industry at 30%. So, I wouldn't call that a victory. But I would say that it's just parser through our culture. We have a culture that, regardless of background, we're all trying to grow together and get the best investment outcomes, and we've always operated with lean teams. And I think that one of the things you hear about big firms is just being able to get that visibility and get those prime projects or things where you can shine. And our firm is small. And we do everything in teams. So, there's a lot of opportunity for people to show their work ethic, their preparedness, and advocate for different investment ideas. And that's noticed. When people really roll up their sleeves and help the firm get better, that is noticed. When I started at the firm, it was only 35 people and three people in the fixed-income group. So, there was really no choice. I had to roll up my sleeves, and I had to raise my hand for opportunities. And we try to keep that culture now and encourage people.

So, we know that the industry and ourselves need to be deliberate in attracting diverse talent because I think that people don't really understand our industry. I think we had Wall Street-type of bad behaviors--I think tainted the industry a little bit post the financial crisis. And I think a lot of times we found when we were talking with students out on campuses, they don't totally understand the ecosystem of what an asset manager is, what an investment bank is. And so, we try to do a lot of education there. And then, we've also tried to support organizations that are attracting women and minorities to the business. There's a great nonprofit called Girls Who Invest that is doing kind of like a boot camp on college campuses where they'll go in for six weeks and get intensive training in financial analysis. And then, they'll get placed out into a whole variety of asset managers. And I think that those types of initiatives as you try to bring in young people to our industry and make them understand the important social purpose of our industry, and that it's a great place to make a career regardless of your background, we want that diverse talent attracted to our industry and our firm. So, we've made a lot of our own efforts, but we see the firm, the industry, and various firms in the industry making various degrees of effort in that regard.

Ptak: Dennis Lynch heads up the Counterpoint Global team at Morgan Stanley, where he and his colleagues manage a number of growth equity strategies, including Morgan Stanley Institutional Growth. In this segment, Dennis talks about one of the paradoxes of growth investing, the tension between innovation and mission creep, and how to distinguish between the two. Dennis addresses that question within the context of one of the team's more successful and controversial holdings, Facebook, and how they assess that firm's transition to mobile advertising.

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?

Dennis 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 displace it as sort of the common network that we all tend to gravitate toward. 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 plan with a lot of redundancy.

Ptak: We've also asked a number of our guests to reflect on what it's like to run money and whether it's gotten tougher through the years. Christine put that very question to Charles de Vaulx, the value maven who comanages the IVA Worldwide and IVA International funds. It's not every day that a committed and successful active manager like Charles sings indexing's praises, but praise it he did in this interesting snippet from our conversation.

Benz: I'd like to talk about active versus passive investing. There's a lot of research out there, including some that we do here at Morningstar, suggesting that it's getting tougher for active managers to add value, even before fees come into play. So, reflecting on your own experience over the years, do you find this to be true? Is it getting tougher for active managers? And talk about the extent to which investor flows into passively managed products have created opportunities for you or have resulted in headwinds.

Charles de Vaulx: Well, thank God, Christine, that the passive wave has happened. For 20, 30, 40 years, I have, before that, Jean-Marie Eveillard, whom I've worked with for a long time, was saddened by the fact that there was so many, you know, closet indexers and index-huggers, and they were charging a fee but yet never truly wanted to deviate that much from the benchmark. And we conversely said that we were--on one hand--we were different because we were diversified. Many people wrongly tend to equate active management with the running of concentrated portfolios. But our way of doing it, the Jean-Marie Eveillard way, was to have diversified portfolios, 100, 150, 200, 250 names, but yet names that had nothing to do with the benchmark. And even more than that, we were willing to make what we called negative bets. Now, being along only to make a negative bet means basically owning little or nothing of what may have become the biggest part of the benchmark.

In the late '80s, we had no Japanese security. In '89, late '89 with the Japanese bubble burst, Japan was 40%, 45% of the MSCI World. I think it was 55% of the MSCI World ex-U.S. Ten years later, the tech bubble, TMT stocks, both here, in Germany, in France to some extent, Japan, tech stocks were 30%, 35% of most benchmarks. We owned none of them. In '06-'07 around the world, the biggest part of the benchmarks were these financials. And I think they did not do too well in '08-'09. So, yes, good riddance to all these fake active guys. The active guys that deserve to survive are those that are truly active, again either in a concentrated way or our way, and active funds that have shown a willingness to be attentive to their size, make sure they don't get too big and as a result cannot deliver the goods, cannot perform. We have had our funds closed for a long time. We reopened a year ago because after having suffered some redemptions. And then, I think, some of the institutional investors, I think, are right to understand that some areas of the marketplace are probably a lot more efficient than others. I don't know, say, large-cap U.S. stocks. So, just maybe if you want your beta, buy an ETF or a passive fund, and for less-efficient areas, which I believe international investing, still international markets, especially small- and mid-cap markets, maybe high yield, maybe distressed--I think those are areas where some active managers should be able to keep adding value.

Now, of course, people who start putting more and more of their money in passive funds should understand that there's no downside protection. And so, they have to make sure that characteristic is in line, one, with the investment objectives and also the temperament. I'm obviously a huge fan of Warren Buffett, we own Berkshire Hathaway. But I am puzzled by the fact that he is urging... Now he, by the way, who made the seminal speech at Columbia University showcasing, proving to the world why value investing was a superior strategy. Warren Buffett doesn't seem to bother defending value investing anymore. But he's urging everybody to buy a low-cost index fund, S&P 500, and he's advised that his wife should have 90% of her money in that upon his death.

Now, Warren Buffett always has said that he does not equate volatility and risk. That's fine. But that's him. I don't think Warren Buffett truly acknowledges the fact that most individuals, most are not able to cope with the volatility that indices entail. It was not too long ago--what was it, from September '07 to March of '09--the S&P dropped 47%, 48%. I don't know many people who, if they had 90% of their wealth invested in that, would have had the fortitude to stay the road. The only reason why Jean-Marie Eveillard invented our way of investing, the SoGen way, which became the First Eagle way and hopefully now the IVA way is, our awareness that most clients do not tolerate volatility, downside volatility, well. And so, we've created vehicles that put a lot of emphasis on limiting that downside volatility. But the other part of the equation is also our belief, and that's a mathematical belief, that one of the best ways to compound wealth over time is to minimize drawdowns. So, I don't know if I've answered your question, but ...

Benz: Yeah. No, you have. What about the thought that somehow indexing is mutating markets or causing markets to behave differently?

de Vaulx: I want to believe that it probably exacerbates at the margin some trends. If people pull out of an active fund so that that active fund has to sell some maybe, you know, decent stocks, and then the money then goes into an index fund that has to, by definition, buy more Google and Apple and so forth. So, I think, at the margin, it exacerbates things. But I really want to believe that... I think closet indexing, I think, had the same perverse impact. Even during the tech bubble, many active guys felt that many of these tech stocks were outrageously priced, but they still wanted to own some because they felt they had to. I think the true reason why value has not done well, and why growth stocks--it has to do with what I discussed earlier, these very low interest rates, the buybacks, the M&A, the lack of reversion to the mean. I think these are the true ultimate drivers. The rest is noise.

Now, I think, yeah, there's a lot of questions about the structure of the markets or is the market as liquid as it used to be and what happens when ETFs have to face redemptions? So, I think these are real worries and questions, but not the ultimate drivers.

Ptak: Thanks for joining us on The Long View. We hope you enjoyed these moments from our conversations as much as we did. On behalf of Christine and the whole team at Morningstar: Wishing you a happy and healthy holiday season. 

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