Whether it is bottom-up stock picking or growth versus value, most portfolio managers are looking for that well-managed company that produces good returns over a long period of time. During the Morningstar Investment Conference in Chicago, two sessions featured some of the best and brightest equity portfolio managers who had different selections and reasons for various stock investments, but also had similar ideas on what made them invest in various stocks or companies.
Three portfolio managers who use bottom-up methods in selecting stocks were Dan O’Keefe, a lead portfolio manager at Artisan Partners; Meggan Walsh, a senior portfolio manager at Invesco; and Keith L. Lee, who is president and chief operating officer of Brown Capital Management. Moderator Janet Yang of Morningstar began by asking the panelists what importance macroeconomics plays in their stock-picking decisions.
O’Keefe led off, stating that macroeconomics is a “false model investors live with.” He said if he could have told people on Dec. 5, 1941, that in two days Pearl Harbor would be bombed and there would be a global war with 60 million people dying, would they buy or sell? He said most would sell, but in reality, the market kept surging throughout the war. “You can’t predict how the macro economy will affect the market," he said. "But you can have insight on businesses, valuation, management teams and business quality. That’s what we focus on. Valuation is the most important driver of investment return.”
He suggested investors “put their head in an annual report, study the business and think long term” for the best results.
Walsh agreed that “valuation framework is the most important part of our process,” although having been a former bond manager, she still watched macroeconomic statistics. She did say it was “pointless to predict what the economic outlook will do to the market because the economic cycle is not tied to the profit cycle. The profit cycle typically moves in advance. We think it would be a fool’s game to tie our fundamental bottom-up analysis to an economic cycle.”
Lee set himself apart from the other managers stating he was a growth manager specifically focused on small companies defined in terms of revenues as opposed to market capitalization, but like the others, his is a long-term investor.
Yin and Yang of Joy Global
In reviewing portfolios, Yang asked Walsh and O’Keefe about Joy Global, which both managers owned but with different outcomes. Joy Global (JOY) is a mining and equipment manufacturer whose fortunes and share price have risen and collapsed with the Chinese stock market. Walsh agreed it might be a “value trap” but noted that they are long-term investors and are “paid to wait.” She pointed out the stock was up 71% year to date. She said it was a great franchise that had only one other firm in its space: Caterpillar (CAT). She said the firm continues to grow and has cash flow generation of $150 million per year just off the service business.
O’Keefe saw the same positives. That said, although the side of the business that sells spare parts and keeps equipment running is doing well, the other side, which is original orders on equipment, is down close to 70%. And though the company stock is up this year, “it has another 50% more to go before we make money back; we lost lots of money.”
O’Keefe says his firm looks at levers that drive business value, both externally, such as the environment, and internally, including the management team and industry characteristics. Although the team had reviewed external factors, such as the drop in commodity prices, they thought that was cyclical. But it continued to get worse. And O’Keefe said they hadn’t gauged the influence the external had on the business.
He wasn’t alone in his misery, as Lee discussed his firm’s investment in Carbo Ceramics (CRR), and wished they had done a top-down view before purchasing the stock. Carbo Ceramics is a hydraulic fracturing firm that uses ceramics in its method. However, in 2014 with the drop in gas and oil prices, the share price started falling as well. Lee didn’t know if it was fundamentals or an experimental change affecting the company’s share price. It turned out the firm was using some experimental drilling methods, but Lee’s team did more research and realized it was a fundamental difference, thus they sold the stock. “I wish we would have had better fundamental research” to allow a better decision, he said.
Walsh pointed out her fund’s mistakes largely were in secularly challenged businesses, such as Western Union, Gannett and Motorola, in which they believed the firms could overcome some of the external pressures, which they could not.
O’Keefe wondered if Apple was broken, and noted his firm had stayed out of investing with it because of “anormalized earnings.” Walsh said her fund didn’t own Apple, either.
Lee asked O’Keefe when the transition happens for him when one of his companies goes from growth to value.
“I don’t see value and growth as being exclusive,” O’Keefe replied. “I just see growth as a characteristic that has to be valued appropriately.” He says his job is to buy something at a discount to its underlying worth. “We own Google, we own companies growing at reasonable rates, but we bought them at reasonable prices.”
Other topics touched on included bank stocks, which have been political hot potatoes. O’Keefe says bank stocks make up 15% of his portfolio and he thought the government needed to step back and let the banks go back to lending money and helping build companies.
One attendee asked about fees, which all managers defended. Lee responded — with humor — that fees should be “as much as we can get.”
Beating the Market With Active Management
The final stock picker panel had a slightly different tone, but started out with Dennis P. Lynch, head of growth investing for Morgan Stanley Investment Management, noting that active managers can add value over time “but also can have a bad spell as all managers can and unfortunately an investor may jump ship at the wrong time.”
He says it’s been found only 15% of managers outperform the market, so investors should determine what common attributes these managers have. Typically, he says, those managers are longer term in nature, not traders per se; they run active portfolios that are different than benchmarks; and “most importantly, they have lots of skin in the game.”
The panel of active and successful managers also included Michael Keller, co-manager of BBH Core Select Fund and Stephen Yacktman, CIO, partner and portfolio manager of Yacktman Asset Management.
Fear, Loathing and Microsoft
Moderator Greg Warren of Morningstar, asked about some stocks they had in common, including Oracle (ORCL), a favorite of Keller because it provides infrastructure on which customers build businesses. “When you are the foundation of other people’s business, it is hard to be displaced," Keller said.
Yacktman said, “We’ve owned Microsoft since 2008, and reduced stake in half last year as we’ve shifted to Oracle. We’ve looked at Samsung, which is very cheap.” He said as a portfolio manager, position sizing is as important as the stock picking. “We never sell (or buy) completely; we gradually move out and in.”
Keller said his fund has owned Microsoft for 10 years, “a remarkable cycle of fear and loathing anytime something happened anew to destroy MS or part of it, but underlying intrinsic value is still there despite bad omens. We bought stock in the 20s, sold some at 58, it’s 50 now. But it’s a stock that sees core, incumbent value and an enterprise that is productivity software … it has a growing, vibrant database business, apps business, and now the cloud business, which is unique, and is growing at 120%.”
Lynch’s group didn’t own Oracle, and again largely because they owned Microsoft stock, which he said “speaks more to growth investment.” He pointed out another stock they owned, Zoetis (ZTS). He said health care is good for investment as it’s a growing part of GDP, but it comes with hassles. Zoetis is an animal drug company and doesn’t have the same political, insurance reimbursement or expensive-drug issues as human health care. Keller agreed it was a good business, and the “secular overwhelms cyclical in this case” for several reasons including the need for humans to care for their pets. “If your animal is sick, you get the right treatment,” he said.
Lynch and Keller were high on Alphabet (GOOGL), with Keller stating it had “the best advertising business model that has ever existed.“
Other stocks favored by the managers included Illumina (ILMN) and Amazon (AMZN) (Lynch), Samsung, Twenty-First Century Fox (FOX) (Yacktman) and PayPal (PYPL), Henry Schein (HSIC), Discovery Communications (DISCA) and Novartis (NVS) (Keller).
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