“Investors are asking about stocks, corporate debt and so-called hybrid investment,” Michael Herbst said Thursday morning. “But with volatility, yield and equity returns being what they are, those decisions have been turned on their heads.”
Herbst, Morningstar’s associate director of fund analysis, hosted a panel of high-profile fund managers for the general session at the company’s annual conference in Chicago.
Featuring PIMCO’s Mark Kiesel, Invesco’s Meggan Walsh and Don Yacktman of Yacktman Asset Management, the panel touched on each manager’s investment philosophy and how they identify potential red flags, especially when investing across capital structures.
Herbst began by asking the panel what they look for “across the capital structure fence?”
Yacktman, an equity manager, said he “tends to look at equities in the same way we look at bonds. If we are to hold on to them for a long time, what type of risk and return would we have? It’s almost like holding a bond to maturity.”
Walsh added that Invesco focuses on the potential for capital appreciation, and that she “spends a lot of time on figuring out the potential downside,” which, given that she’s a portfolio manager, was reassuring for the audience to hear.
Kiesel said PIMCO managers take a top-down approach, beginning by asking themselves what areas of the world they feel will perform best.
“Currently, we feel it’s the United States and Asia,” he said, partly agreeing (Asia) and disagreeing (United States) with Franklin Templeton’s Michael Hasenstab from Wednesday. “We then consider a particular company’s enterprise value and where on the risk/reward spectrum we will then perform best. It’s really very simple; it’s the best part of the globe, the best sector in that part of the globe and then where we should invest in the capital structure.”
Herbst then asked about the managers’ red flags.
“We favor businesses with a high return on real assets, so we look to the left side of the balance sheet,” Yacktman said. “We look to avoid low return, low turnover of assets and companies with off-balance sheet issues like pensions. We feel pensions are the wrong way to fund retirement.”
Kiesel noted that most company balance sheets are healthy at the moment, as capital market have “been open” for the past three to four years.
“Credit might not be available for governments, but it sure has for companies,” he said. “So we look at the stress-free cash flow for the company throughout an entire business cycle.”
Herbst then asked the panel about their process for evaluating company management teams, which he said was one of the most frequently asked questions from investors. Kiesel said PIMCO travels frequently to visit companies at their headquarters and specifically asks executive teams about their top three priorities.
“For instance, banks are currently building capital, which means they’re not equity friendly and are running a conservative business because governments are trapping capital inside. This means it’s a good investment for bondholders. So we’ll get on a plane, meet the managers and ask them about it.”
Walsh said it’s important to “watch what managers do, not what they say,” a point to which Yacktman emphatically agreed.
“They’ll give you standard answers to your questions,” she said. “We want to see a proactive method for how they responsibly handle their cash on their balance sheets. Right now, a lot of cash is trapped overseas and managers are looking to make acquisitions in order to grow. But these acquisitions might not be good fits. So we keep their feet on the ground.”
“Behavioral patterns are instructive,” Yacktman added. “I once spoke with a CEO who said, ‘My people are always trying to get me on CNBC. I don’t want to go on CNBC. The people that watch are not our investors, and I don’t want the investors that do watch. It would be a total waste of time.’ That was music to my ears. I said, ‘Wow, this guy is focused.’”
As for where the managers are finding alpha from a valuation perspective, Walsh named the housing and homebuilders, consumer discretionary, transportation and lodging sectors. Kiesel likes energy, which he said is a good area for equity and debt investors. He agreed with Walsh that housing has hit bottom, and as a result like Weyerhaeuser for their timber exposure. Lastly, he pointed to gaming in China.
“If you look at Macau, it’s doing five times the business of Las Vegas. Five years ago they were essentially even. So this is another area that is good for both equity and debt investors.”