Lawrence Hamtil: The Virtues of Sin (Stocks)
A contrarian financial advisor delves into his provocative research on the influence of sector weightings on stock returns, value's slump, equal-weighting, and the low-volatility phenomenon.
Our guest this week is Lawrence Hamtil. Lawrence is a principal at Fortune Financial Advisors, an independent Registered Investment Advisor firm he co-founded in 2008. He provides financial advice and investment management services to the firm’s high-net-worth clients. Lawrence came to our attention on social media, where he can be found on twitter at @lhamtil. A prolific researcher and excellent writer, Lawrence frequently publishes investments research and commentary on Fortune Financial’s blog. His research has covered a lot of ground, but a few topics have gained him a following, including his work on the role of sectors and industries in explaining stocks returns; the low-volatility phenomenon; sin stocks; equal-weighted portfolios; and more. Lawrence is a graduate of Rockhurst University..
Background and Influences
Value Investing and Inflation
Equal-Weighting and Inflation
Sectors and Industries: Importance to Stock Returns
Christine Benz: Hi, and welcome to The Long View. I’m Christine Benz, director of personal finance for Morningstar Inc.
Jeff Ptak: And I’m Jeff Ptak, global director of manager research for Morningstar Research Services.
Benz: Our guest this week is Lawrence Hamtil. Lawrence is a principal at Fortune Financial Advisors, an independent registered investment-advisor firm he cofounded in 2008. He provides financial advice and investment-management services to the firm’s high-net-worth clients. Lawrence came to our attention on social media, where he can be found on Twitter at @lhamtil. A prolific researcher and excellent writer, Lawrence frequently publishes investment research and commentary on Fortune Financial’s blog. His research has covered a lot of ground, but a few topics in particular have gained him a following, including his work on the role of sectors and industries in explaining stock returns; the low-volatility phenomenon; sin stocks; equal-weighted portfolios; and more. Lawrence is a graduate of Rockhurst University.
Lawrence, welcome to The Long View.
Lawrence Hamtil: Hey, thanks for having me.
Benz: It's great to have you here. So, to introduce you to our listeners, let's talk about how you got into the financial advice business. What's your background and what drew you to financial advice?
Hamtil: Well, actually, it was somewhat by accident. I had gone away, thinking I was going to go to university in Dallas and I didn't quite like that arrangement. And so, when I came back to Kansas City in 2002, I needed to finish my university studies and, in the meanwhile, I needed a way to pay for it. And so, I had an interest in finance and I got hired on with a small financial-planning firm, and they needed somebody to help with their models, do some of the back-office work, a lot of the research. And so, I signed on to do that. And I never thought I would make a career out of it. But after I graduated from Rockhurst University, which is a local Jesuit school here in Kansas City, that practice was acquired by my colleague now, Dennis Wallace. And so, he wanted me to stay on and help with that transition. And so, in 2005, I took the Series 7 and the various securities exams and started to have my own clients. And a few years later, in 2008, Dennis and I started Fortune Financial Advisors, which was an RIA. So, we transitioned from a broker/dealer model to RIA, and it just kind of grew from there. And it turned out to be something that I liked and enjoyed, and sort of overlapped with my interests. And, of course, I enjoy working with the various clients and so forth. So, here we are almost 18 years later and come a long way.
Benz: What were you studying in school that made you a good fit for that position?
Hamtil: It was a combined economics-finance degree. And so, these gentlemen I was working with, they were more focused on the planning side, but not so much on the asset-management side. And that was more my interest in school, was portfolio modeling and optimization and things like that. And so, that was a void that they needed to fill. And so, that's what I came on board to do and we evolved from there.
Benz: Were there books that were pivotal to you in getting you interested in investments or in the types of investing that you do?
Hamtil: There are a few. David Dreman's Contrarian Investment books had a big role in how I came to see the investment universe. Phil Fisher's books on growth stocks. A few of the classics, I guess. But by and large, I think some of the professors I had in school, they were more of a direct influence. One gentleman whose name escapes me at the moment, he was a retired stockbroker and transitioned into the academic universe and had a fairly significant influence on how I viewed the markets and long-term investing. And it just sort of went from there once I left the university. But there have always been a few things I've gone back to and looked at. And like I said, David Dreman's book was probably the most significant as far as contrarian investing. And I wouldn't consider myself a true contrarian, but I certainly tend to think a little bit more outside the box, I would think, compared to most of my contemporaries.
Ptak: We want to talk about your contrarian streak some more, but before we do that, maybe to build on some of your earlier comments, I wondered if you could tell us a bit more about your advice practice, what services you offer and what's the makeup of your client base?
Hamtil: Sure. So, we have--when we started Fortune Financial Advisors in 2008, there were two advisors and an admin. And I think we were managing just a few households that we maintained from our broker/dealer relationships. Now, we have a total of four advisors, one of whom is primarily an accountant. And we have several hundred households as clients mostly by referral only. We don't do a great deal of marketing, if at all. And most of our clients tend to be high-net-worth individuals, some small-business owners, very little 401(k) plans, but the majority of the people I work with are retirees. So, I spend most of my time managing their cash flow needs, managing their portfolios, and any additional tax planning from their withdrawal strategies, things like that. Some of my colleagues tackle different aspects of the planning process. Their clients tend to be a little bit younger than mine, so they spend some time on college planning, those sorts of things. So, we try to cover all the bases in our practice. But we have it sort of carved up into our little niches based on what our core group of clients need most.
Ptak: How familiar are your clients with the research you conduct in sort of your alter ego as blogger extraordinaire?
Hamtil: Well, I think the feedback that I get is that a lot of them read it, but they also admit to either not paying much attention to it or that it's over their head. So, I don't think that they care all too much about the majority of the research, but they understand that it is kind of the justifications behind how their portfolios are situated. I think the majority of our readers of the blog are fellow advisors, professional investors, and researchers. I think that's kind of the core block who reads it and enjoys the content.
As far as the clients go, they do appreciate that the research is useful in terms of why they have an allocation to something that might be out of favor and why they should maintain that even though it is out of favor, that sort of thing. And so, from that standpoint, I do think that they see value in it even if it's not particularly interesting to them, if that's a fair thing to say.
Benz: Before we leave the topic of your practice, hoping we can just talk about your firm and how you see the investment-management piece fitting alongside planning and some other things that advisors consume themselves with these days. Because in a lot of ways, the focus on investment management makes you a little bit of a throwback. Let's talk about that. Talk about where the research you conduct on investments fits into what you're offering your clients.
Hamtil: Well, I guess, when I look at it, the plan is crucial as far as you're making your resources last the length of your retirement. And when I came into the business in 2002, it was sort of at the back end of the dot-com bust. And that was a very different bear market from the sort of one we experienced in 2007-2009. And I realized that a lot of the individuals who were coming to us at that point for help in 2002, their plans were not working even though they had retired in ‘99, 2000 at the top of that bull market cycle. And so, we're trying to figure out what's the best way to build a portfolio to last through such a downturn and when they're taking portfolio withdrawals and so forth, how they're not cannibalizing their future returns, because they're being forced to liquidate it at an opportune time. And so, that sort of became our core interest was how to build portfolios that were more durable and more robust and yet also, were not laden with extra fees and expenses and so forth for the client. And that's kind of where we got started building custom portfolios, and like you said, being a little bit of a throwback, whether that's investing in individual equities in some cases. But we try to make everything custom for each client, because we know that no two clients have the same amount of resources, goals, and so forth. And so, we really try to be unique in that sense.
Ptak: Do you use index funds or ETFs at all in implementing for clients?
Hamtil: Yes, we do. It depends on the size of the client account. So, it makes it a little bit easier to scale. But if we do, it's generally because it's just easier to manage a few positions than, say, 30 or so which would be the case in a much larger account that's generally individual equity positions.
Ptak: But it sounds like, on the whole, you're expressing an active investing view in most of these engagements for clients. Is that sort of a fair characterization of what we would see if we were to look across your client base?
Hamtil: Yeah, that's a fair thing to say.
Ptak: So, I wanted to ask you about that. We've talked about, sort of, contrarianism in reading through your research. You're a value-investing maven. You've enthused about things like sin stocks. I think that you tend to be a little leery of high-flying growth names and so forth. And so, my question is, how do you make that work with clients who might not be willing to go against the grain like you do, or at least as you've expressed in your research? How do you make sure that you can work well together?
Hamtil: I like to tell people that when they come in as a new potential client that they're interviewing me, but we're also interviewing them. And it's really kind of like we are their employees. So, they maintain us as their advisor as long as we perform the duty that they pay us to do. And we tell them in advance that this is how we do things and this is how we think they should position themselves. And sometimes that's not a fit. And of course, we encourage them to shop around and make sure that they feel comfortable with their advisor relationship before going into the nuts and bolts of the portfolio. Clients obviously have the opportunity to opt out of certain positions if they feel uncomfortable with it. But by and large, after kind of a rigorous dating process, for lack of a better term, we start to work pretty well together, and they understand. And so, the majority of our clients, I think, go back at least 10 years, in some cases longer than that. So, it kind of pays off to go through a long engagement period, if that makes sense.
Benz: What kind of conversation would you have with a client to determine whether they're a fit? What are some of the things that you would hit on?
Hamtil: We explain our business, how we get paid. The majority of it is fee-based. We tell them how we run our practice, how often we like to communicate with clients. We're a relatively low-turnover firm. So, even though we consider ourselves active managers, that doesn't mean that we're going to be doing a lot of trading. For example, a lot of the positions that we own and accounts--we've owned for more than a decade. So, if clients are expecting us to do a lot of trading just to try and surpass the benchmark on a quarterly basis, then we're not going to be a good fit for them. We're upfront about that. And some people do come in with what I think are unrealistic expectations as far as the services that they expect from us. And so, we're upfront about that. And when possible, we say to these people, "You know, so and so might be a better fit down the road if that's what you're looking for." But we understand that that's not going to work out longer term if we don't see eye to eye going into this process on how it's going to be and what needs to happen for it to work out.
Ptak: Let's shift gears and talk more specifically about your research. But I wanted to start at a high level. And I think we should point out that, unless I'm mistaken, the repository for your research has been the blog that you maintain on your firm's website. Is that correct?
Hamtil: That's correct. Yeah.
Ptak: So, maybe to start there, can you give a sense of how you've arrived at some of the research topics you've tackled, which have included value investing, inflation, low volatility, sin stocks, and the role of sectors and industries on stock returns? Like, how'd you pick those things?
Hamtil: Well, the majority of it, I think, I just came across being an interested observer over almost the 20-year career, witnessing a couple of different cycles over that long period of time and understanding that maybe sometimes these things, how we understand them, why certain things work and other things are out of favor--maybe it's not as simple as we might think. And in the period starting from 2000 to 2007, for example, a lot of things were in favor like commodities and energy and value stocks. And of course, the inverse has been true over the last cycle. And so, my interest lies in trying to figure out why exactly that has been the case. Is it investor behavior? Is it performance-driven? Is it macro-related? What's really making all of this happen? And I found myself sort of dissatisfied with a lot of the popular explanations that I saw. So, I decided to dig in myself and offer my own opinions on that. And that's where the research came about for the most part. And we keep trying to find the Rosetta Stone to interpret why all these things have happened, and we're still looking, but we've offered quite a few on various topics. And it makes for a good tool for clients to see, "OK, here's why you own this and not that," or "here's why we adopt this strategy and not the other one." Because these prevailing factors that at one time supported the value strategy no longer do. So, that's kind of the genesis of it all.
Benz: Let's take a look at a big-picture topic. You recently took up the relationship between inflation and value stocks. You picked up where advisor Bill Bernstein left off. He said that there was a strong correlation between inflationary expectations and value investing success, and you rift on that idea. So, let's talk about the connection between inflation and value stocks.
Hamtil: The connection in my mind--I always think of factors like value as kind of a derivative of what's going on in the underlying portfolio, which of course, is going to represent companies from different economic sectors and industries. And so, the classic value factor is a price/book based. And so, historically, price/book has picked up when it's unconstrained as far as sector exposure is concerned. A lot of financials and energy stocks, for example, and a lot of those sectors would do well in an inflationary period; energy, obviously, because of the price of oil and so forth, financials because of interest-rate spreads and things like that. And so, it just makes sense in my mind to view it through that lens that maybe a lot of what the value factor was picking up was just excess performance from these cheap stocks and these sectors during different periods of time, and of course, that covers various cycles over the last hundred years or so. And looking back over the last decade when value has been out of favor, well, financials and energy stocks have been anything but the best performers.
The inflation factor certainly plays an important part in my mind as far as making the classic value factor do well. And I think that that's something that--I don't want to say that it's well known, but maybe not understood in the sense that I would present it, which is that a lot of it is related to the companies that you're picking up and the industries that they're in and how they're affected by the macro environment.
Ptak: Right. So, maybe you can elaborate a bit on that. I think the notion is that firms that have maybe more distant cash flows, they are advantaged when inflationary expectations are subdued because those cash flows are discounted at a lesser rate, whereas firms like some of the type that you described, where the cash flows aren't quite as distant, they would be more valuable in a situation where inflationary expectations are ratcheting up. Does that seem like a reasonable way to describe why inflationary expectations and value investing success would be related to one another?
Hamtil: Yeah, I think that's true. And we doubt that there's a little bit of a duration issue here. And so, growth stocks tend to be higher duration. And so, of course, they would seem to benefit more when the discount rate drops. And the reverse would be true for value where the earnings are a little bit less extrapolated into the future. And so, I think that that's definitely a component as well. So, I don't want to oversimplify it and say it's just one thing or another, but they all sort of play into that theme of inflation, the impact on interest rates, and so forth. And I think it does have a pretty big effect on the spread between growth and value stocks over cycles.
Benz: Inflation is not a hot topic at the moment. What does that lead you to conclude about the prospects for value stocks? Does it seem like their long, dark night will continue?
Hamtil: I think that value is something that does work when it's defined differently and when it allows for sector constraints. So much of investing success is tied to the price that you pay. So, I don't think value is going anywhere. But I do think how people view it needs to be a little bit more flexible than maybe some of the classic definitions. And certainly, when we look at investments, we understand that a good company can be a bad investment if you overpay for it. So, in that sense, I think value investing is always going to be around. I just think people need to be a little bit less dogmatic in terms of how they define it and how they implement it into their strategies.
Ptak: How do you do that?
Hamtil: First of all, when we build a portfolio, we strive to be sector-neutral. So, if we're benchmarking against, let's say, the S&P 500, we look for industries within those sectors that we think are going to do well. But we also look for what we think are the best opportunities, we screen for them, and then we look at their prospects, their earnings growth, and then the multiples that they're trading at whether those are reasonable or not. And so, when we talk with clients about implementing their portfolios, we say, "Here's what we think are going to be the best opportunities and they're valued at such a multiple here and we think that this is a better opportunity than that one over there—that's a little bit excessively valued." Then, of course, we implement the portfolio. So, it's fairly standard as far as modeling goes and trying to buy good-quality companies but not at an excessive valuation.
Ptak: I want to come back to how you build portfolios for clients. Before we do that though, since we're on the topic of inflation, I think one of the more provocative views I've read of yours is on equal weighting. And I think your research has found that equal-weighting stocks is superior to cap-weighting stocks when inflation is higher. Can you explain what leads you to conclude that?
Hamtil: Well, I think, when you look at the value of equal weighting, it's not necessarily tied to--well there’s the classic reasons are that you have more exposure to size and value. I think in other instances it's because you have more exposure to smaller industries within each sector. So, for example, if you look at the industrial sector--that's going to be dominated by a lot of the big blue-chip industrial stocks and you're going to have less exposure to, for example, railroads and things like that. And when inflation picks up, a lot of these sectors, like railroads, they should benefit because they're probably going to be doing a little bit more transportation of commodities, which are going to be in higher demand as the price picks up and more production and so forth. So, I think a lot of it is simply exposure to these smaller industries within each sector. And it's not true I've found for every sector, but it is true for a lot of the more cyclical ones. And it makes sense probably most obviously in energy where equal weighting is going to give you more exposure to E&Ps versus, say, the integrated oil firms that dominate on a cap-weighted basis. So, when inflation picks up and oil prices spike, E&Ps and so forth should do a lot better because they're so cyclical and tied to the price of oil. So, I think that explains a good chunk of it. I don't know that that's all of it. But that's certainly consistent with what I found in my research.
Ptak: What is it about the equal-weighting mechanism itself that would confer that inflation protection? I guess the part I have trouble intuiting is, if some of these industries have properties that make them better inflation hedges, that would seem to make them more valuable to investors, which in turn, would make them a bigger part of the cap-weighted indexes, which in turn, would make the cap-weighted index better at warding off inflation, and then the advantage that equal weighting would boast over cap-weighting would seem to come out in the wash. Does your research find that there's some other mechanism we haven't discussed that makes equal weighting preferable in those situations?
Hamtil: You know, I haven't looked into it that much in depth, but I do think that a lot of it is cyclical, and so perhaps the periodic rebalancing of equal weight, it sort of tends to wash that out. So, when inflation is running hot, the equal weighting will give you that exposure to those smaller industries. But then, the rebalancing effectively washes that out a little bit. So, I think in a cap-weighted structure, the longer that the inflationary cycle runs, like you said, it would be sustained a little bit more. But I think it's something that I need to dig a little bit more into, because I haven't quite put it all together. But I do think that it's something that's there in the data. And I haven't quite figured out exactly why it's the case, but it has held true in most of those subsectors that we've investigated.
Benz: Do you have a go-to product that expresses this equal-weighted view?
Hamtil: You know, you can use the ETFs that are available. But, generally speaking, for our larger portfolios that are individual-equity based, we just try to keep all of our positions equal weighted. So, the theory is the same, although the implementation is a little bit different. But the difference is, of course, in a custom portfolio that we've built, we're probably going to have a lot more subindustries and sectors excluded versus say an ETF that's going to own everything. So, it's not a perfect set, but the logic there is still the same.
Ptak: I wanted to turn the conversation to a topic that you've written at some length about, which is: sectors and industries. It's already come up during our conversation. So, it's appropriate that we turn to that. You've done a lot of work on the role of sectors and industries in driving stock returns. You wrote recently that data support the argument that there are really just a few exceptional industries in which to invest one's capital if, as you put it, deviating from the index portfolio. So, let's start by discussing why you think it's important to focus on aggregate measures, like sector or industry? I mean, when I read your work, I almost get the sense that you feel like some of the other more widely cited factors like, for instance, size and value that those should subordinate to sector and industry. Do you think that's a misreading of your work?
Hamtil: Well, I think that's fair. And I know that there have been a few studies that show that it's better to be a mediocre or a good company in a great industry than a great company in a poor industry. For example, you can be the best energy company over the last 10 years, and you probably still did very poorly compared to, say, a mediocre software company. So, to that extent, I think it does matter very much where you find yourself doing business. But that being said, I think aggregate measures are often skewed by the underlying composition. And it's something that people--investors--need to be aware of when they make their investment decisions is: What are they actually betting on and those allocations? So, from that standpoint, that's kind of where I come at with the majority of my research on that topic is: What bets are we really making with these decisions when we invest our capital? What is required to happen for that to be profitable?
Ptak: Let's talk about that in the context of an actual example that I think you've examined before. So, like cap weight. I know that you have a great fondness for mid-cap stocks. But let's talk about it in the context of small caps, because that's a more established part of the literature that there's this premium that one enjoys if you tilt the portfolio towards smaller companies. And so, you put your own spin on that by looking at the sector composition of these different cap strata. Talk about that and talk about what your key findings were and maybe how that expresses itself in the way you allocate capital for your clients.
Hamtil: What I found is that the majority of the small-cap outperformance over time, I think, can be tied to a handful of sectors, depending on how you measure it. It's not completely clear, because with a lot of the index measurements that we use, there's a lot of migration up and down between large and small. So, we have to be careful what we're really trying to measure. But what I have found is companies in similar industries are going to perform similarly regardless of size in most cases. So, small consumer staples will be somewhat less cyclical, of course, than other small-cap companies just like large-cap consumer staples are. So, in my mind, when we look at it, we don't necessarily think that small caps necessarily are going to be riskier, or so forth, than large-cap stocks. A lot of it is tied to their economic situation and the sectors that they are in and their industries and so forth. So, I guess from that standpoint, again, we look at the aggregate measure, whether it's the S&P 600, or the Russell 2000, or whatever--we break it down and look and see what's actually driving the outperformance. And we found that a lot of it is sector related more than it is related to the universe of size for these companies.
Ptak: And so, if we were to reduce that to outperformance maybe equals sector outperformance--so, if we're talking about small-cap outperformance, as you point out, it probably emanates from a sector concentration that's worked to the benefit of smaller companies. Maybe if we drill down further-What would be the risk or behavioral explanation for why those sectors or industries confer that outperformance? What was it about those that delivered the extra return to investors in, say, smaller companies?
Hamtil: I think it's going to be a multifaceted answer. If you're looking at small-value stocks, which I think is where a good case can be made--that a lot of the small-value premium is tied to smaller financials; it coincided with a big explosion and small banks and the regional banks, and so forth, over a period of time when that factor was really doing well and whether or not that was just picking up that explosion in these smaller banks--I can't really say, but it seems to be consistent. On the other hand, you can look and say, OK, well, small-cap energy stocks have dramatically underperformed large-cap ones, and a lot of that I think can be tied to the boom-and-bust cycles in energy. So, from that standpoint, those smaller-cap energy stocks, which are a lot more exploratory, and so forth, related to oil, they've had a much tougher go of it. So, it's not to say small-cap telecom, which has done extremely poorly after the bubble burst in the late '90s. I think it kind of depends on the cycle and the period of time that we're looking at. But I've seen for the most part that more stable industries, like consumer staples, they have tended to do better and those smaller companies have grown and done much better versus more cyclical industries where there's a lot of catastrophic failures over time in these highly cyclical industries.
Ptak: Maybe if you were to stick with the example of small-cap banks, and we were to assert that these have conferred excess returns over time, and perhaps we'd further assert that the reason they've done so is because they're really cheap. I guess the logical question then is, What is it about these small-cap banks has made them as cheap? I mean, if we continue to telescope down to that level, is there a behavioral or risk-based explanation for why those types of names got as cheap as they did conferring the kind of excess return that, say, small value did over some period of time we measured?
Hamtil: I actually don't have a lot of data on this particular topic, but I can venture a guess, which is that the evolution of these banks making--just speaking from example here in Kansas, with a lot of small banks from smaller cities, they've grown with the communities. And so, I don't know if there's a demographic explanation where these banks were profiting from the growth of these smaller communities, whether or not maybe the cheapness was tied simply to being under the radar. And they're not nearly as analyzed and picked over as the large-cap peers would be probably plays some role in that. There are only so many stocks that people can cover, I guess. And so, a lot of this I would think has to be tied to them just being under the radar. Although I really have no data to support that. It's just a conjecture on my part.
Ptak: We've talked quite a bit about market cap, but maybe we'll shift a bit and talk about geography. You've talked about the importance of sector and industry concentrations in explaining the relative riskiness of developed- versus emerging-markets stocks. For instance, the Emerging Markets Index might see a bigger drawdown than a developed-markets index. But when you compare the drawdowns of stocks of the same sector or industry, between those two indexes, you find--or I should say--you found that they're similar, meaning it's the difference in the sector weightings between the indexes that matters. So, what should an investor do with this information? Or maybe more precisely, what do you do with this information on your client's behalf?
Hamtil: When we build a portfolio for the most part, we have a global exposure looking around the world for the best opportunities, and as I mentioned earlier, we try to be sector-neutral. So, we know we're going to have X amount in information technology, X amount in energy, X amount in consumer staples, and so on. So, when we look around the world and we have our shopping list as far as our allocation decisions, we understand that a lot of the emerging-markets indices, for example, are now heavily loaded in information technology stocks and a lot of Chinese stocks. Ten years ago, of course, it was a lot of financials and energy and materials. So, when we look at a global portfolio, we want to figure out what's going to be the best whether it's American, European, or an emerging markets for our client portfolios. So, that's one reason why we sort of justify moving away from the cap-weighted indices for a lot of the ex-U.S. markets because if we have a lot of domestic energy exposure, we don't want to have it duplicated simply by having the cap-weighted EM index, which, at one point, like I said, was heavily weighted in energy. So, we understand that a lot of these global industries are going to trade alongside each other. Energy stocks are going to be heavily correlated, whether they're American or European, and so forth, IT is the same. They're really just a few that are domestically oriented that are sort of unique in the sense of where they derive their revenues. So, when we put it all together, we're using that to show that a global portfolio should try to pick and choose from the best opportunities and the global opportunity set. But then, also, why we deviate from some of the regional cap-weighted indices like an emerging-markets index, because we find it to be a little bit of overlap with what we have elsewhere.
Benz: You're a strong proponent of investing in low-volatility stocks. For starters, let's define what that means. And then let's talk about how important is the precision of the definition of low volatility for one's success in that space?
Hamtil: Well, the minimum volatility or low volatility, it's been around for, I believe, longer than most other factors. I think it's been studied or observed at least longer than momentum and value, for example. Different people--different researchers--define it somewhat differently. You have low volatility, which in broad terms is going to pick up, for example, in the S&P, the 100 or so least volatile stocks over a period of time, regardless of sectors. So, you'll tend to find a lot of sector concentration in that concept of the portfolio. You have minimum variance, which is kind of an idea that I favor, which is a little bit sector-neutral. So, you're going to have a more broader base portfolio as far as industry exposure is concerned. But different fund managers, different index providers, and so forth, measure it differently. I don't know that there's a best way to try to capture this anomaly. But I do think that it's something that is sort of a fascinating behavioral reality. And if I'm not mistaken, I think it's the one factor that has actually had better live performance than what the performance was in academic research. My friend Andrew Miller likes to point that out. So, that's not necessarily a perfect thing to or easily defined, I should say. But I have seen in most studies that it has been a value add in pretty much every investable universe whether it's the U.S., Europe, emerging markets, and so forth over a very long period of time.
Benz: Why do you think it's worked, the low-volatility strategy? And do you think it will be persistent going forward?
Hamtil: I tend to think of my factor bets as there's kind of a behavioral group of factors, like, momentum and low volatility and then there's may be what I would call the macro type factor bets like value. And we just spent a good deal of time talking about how value probably requires macro things like inflation to do well, whereas low volatility is more trying to capture behavioral anomalies and there are different explanations for why the low-volatility phenomenon has persisted. And a lot of it might be preference for lottery type stocks. Investors will overlook the slow compounder trying to find a next 10-bagger stock even though it has a very, very little chance of paying off. There's the theory of leverage aversion where individuals are shut off from adding to leverage their portfolios. So, the next best thing is to buy high-beta stocks. Regardless, the underlying effect seems to be the same, which is that low-volatility stocks tend to perform higher-volatility stocks, not just risk-adjusted terms but often in absolute terms.
And because it is a behavioral phenomenon that you're trying to capitalize on, I tend to think human behavior is fairly consistent and won't change. And that's why I think the factor, which is, if I'm not mistaken, it's the one factor also that has never had a negative decade of performance. I do think that it will persist going forward simply because I don't think that human beings are going to change all too much. And that's really what you're trying to capture when you put those portfolios together.
Ptak: So, we'd be remiss if we didn't talk about sin stocks, which is another topic that you've written about at some length. In your research, you've drawn a line between different types of sin stocks. There are those that are endowed with competitive advantages, steady demand, and that largely self-fund. Tobacco, I think, is probably a prime example. And then, there are others like casino stocks, which are more boom-bust in nature. Explain that distinction and why you think it's important.
Hamtil: Well, the sin stock anomaly is kind of a fun, entertaining thing, and the explanation for their outperformance is that a lot of people don't want to own these stocks for moral reasons. And so, as Cliff Asness likes to say, you have to pay somebody to own them because somebody has to own them. And so, the way that you pay them to do it is by offering them a higher return, which stems from a lower valuation and so forth. But historically, it shows that not all sin stocks are created equal and a lot of these industries--like tobacco, like defense stocks--they also tend to exhibit a high degree of profitability, consistency in their earnings streams, their wide moat practices, so they're relatively insulated from new competition. So, in other words, the sin stock anomaly could also just be another way to describe quality and low volatility as factors. Casino stocks, for example, we did a fun piece on that, and they are anything but low volatility and very cyclical. So, they don't really check the boxes as far as quality and low vol factors are concerned. And historically, they have been one of the "sin" sectors that have underperformed over time, certainly relative to their peers in that universe. So, I think when investors are looking at this, they want to make sure that if they're just trying to capitalize on other people's moral objections to these stocks that they understand that expected performance may not necessarily be evenly distributed across the spectrum of those industries.
Ptak: Do you envision betting against ESG being a great opportunity for active investors like yourself going forward?
Hamtil: It seems to have a lot of momentum behind it. I don't know. It doesn't necessarily apply to the way I run my practice. Certainly, our clients, if they're interested in it, they're more than welcome to implement it. I tend to think though that a lot of ESG's current run of success might be tied to some of the investments that are currently in favor. And so, perhaps, when the cycle changes, it might fall out of favor alongside, say, technology stocks. But I think that there's sort of like the sin anomaly. I think that there will always be a behavioral aspect to it and people who are wanting to feel good about their investments, and there will certainly be fund managers and so forth looking to capitalize on that as well. So, I wouldn't bet against it. I'm just not sure how pervasive it's going to be in the long run.
Ptak: Why don't we talk about how you incorporate these types of stocks into your practice? Part of the reason why they have the attractive, I suppose, investing attributes that they do--relatively low volatility, outsize returns--is because there's a stigma that's associated with them. And I would imagine that doesn't go down easily with every client or prospect that you're talking to. So, do you have clients that are actively investing in these names, and to what extent have you marketed yourselves based on your willingness to go the other way and consider stocks like these? I know that you've mentioned that it's part of your conversations, but does it tend to be a pretty prevalent part of your practice and show up in a lot of different client portfolios?
Hamtil: When the clients come in, they go through the investment policy statement. Part of that is a section where they can choose to omit certain things from their portfolios. And what we'll do is--tobacco is a classic example. It's an industry that we've invested in for probably 15 years now and owned for a long time. And so, if a client says "I object to owning tobacco," I'll say "that's fine, but here are some things that you might want to consider." And I'll give them the rationale for why we think it might be an attractive investment and of course, it's up to them to say yes or no. And if they say no, then we work around it and find another way to fill that void in the portfolio. But it's fairly open discussion as far as how the clients want it handled and if they're comfortable with it, and if not, we can certainly find a way to be flexible there. So, it's not--we don't necessarily market ourselves as people who are willing to do what others are not. We simply market ourselves as people who build custom portfolios and part of that is building a portfolio with an acceptable expected rate of return based on the valuation of the underlying holdings and that's why we consider those things. Otherwise, we wouldn't own them, right. So, that's how we kind of position ourselves with the clients when we talk about the portfolio composition.
Benz: How does tax management figure into some of these more active strategies? It seems like equal weighting, for example, would be sort of inherently disadvantaged relative to a cap-weighted strategy from a tax perspective. So, do you emphasize the more active strategies in tax-sheltered account types? Or how do you kind of navigate the role of taxes in all of this?
Hamtil: Exactly. We pride ourselves on tax efficiency. And so, if a client has a taxable portfolio and a nontaxable portfolio, we try to maximize that flexibility as much as possible. So, you'll find that we have in the taxable account, for example, a lot of the non-dividend-paying issues. So, they're not kicking off unnecessary taxable income that the client has to report on each year. A lot of the higher-yielding industries are going to be found in the tax-sheltered account. You obviously can't avoid all of the tax consequences when you come into rebalancing and so forth, but we try to be not OCD, so to speak, as far as maintaining strict balances, but we try to do all of those normal portfolio activities in a very tax-efficient manner. And of course, it varies from year to year. So, part of the nice thing about having that integrated with our practice, the ability to show the clients especially when they go over their taxes each year, this is the income generated by your portfolio, but this is actually how much you have to report and you can ballpark the savings there. It's something that is not necessarily an issue for the majority of clients who typically just have an IRA rollover and very little in taxable assets. But for the handful that do, I think it's a pretty big value-add to have those sort of-I kind of liken it to building a portfolio with very strict specifications versus just trying to paint with a very broad brush.
Ptak: I also wanted to ask you in closing, you know, when you're expectation-setting with your clients, we've talked about the various types of research you've conducted and how it expresses itself and the way you implement for clients, how do you expectation set with them? Do you say to them, you know, our goal here is to add some alpha for you, or do you contextualize it differently and say that these are things that we can do because we think that they will help to advance your objectives towards your ultimate goals, for instance, smoothing out the ride, minimizing drawdowns ...?
Hamtil: We try have an honest conversation with what the expectations are, and a lot of it is valuation-based. So, after a big year last year, we told our clients, "The market is a little expensive here. You probably need to reset your expectations accordingly--simply because, the market went from 14 times forward earnings to 18 times and so, historically returns have dropped accordingly." And so, we look at the portfolios and think, "OK, what are some opportunities now that didn't exist a year or so ago that you might be able to capitalize on to increase your return incrementally and how that will add value to the portfolio?" But yeah, we do try to maintain that with the clients, especially in their distribution phases, where they have a much smaller tolerance for volatility and drawdowns, like you said. But it's not something that you can control directly, obviously, especially when it seems like a lot of the investment opportunities are unattractive. But part of that is, it can be mitigated to some extent by implementing some things into the portfolio that might add a little bit over time.
Benz: Well, Lawrence, this has been a super-interesting conversation. You've been most generous with your time. Thank you so much for being here today.
Hamtil: Thank you. I appreciate it. Thanks for having me.
Ptak: Thanks again, Lawrence.
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