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STEVEN ROMICK: CONTRARIAN CASH TRANSCRIPT

May 23, 2014

Steven Romick, Morningstar’s 2013 Allocation Fund Manager of the Year on why he is holding large sums of cash in his FPA Crescent Fund.

Consuelo Mack: This week on WealthTrack, Why is Great Investor Steven Romick hording mounds of cash and other safe, money type securities in his award winning FPA Crescent Fund? Contrarian Romick explains why he isn’t putting his cash to work in the market, next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Holding cash is considered by most professional investors to be one of the worst investment choices you can make right now. It yields next to nothing, as it has for the last five years largely because of Federal Reserve and other central bank policies that have kept short term interest rates at record lows. And when inflation is taken into account cash is actually a money losing proposition. There is however a small minority of investors who value cash and are not afraid to hold large amounts of it and its equivalents when conditions warrant. Warren Buffett is probably the most famous among them.

This week’s Great Investor guest is also one. He is Steven Romick, lead portfolio manager of the five star rated FPA Crescent Fund which he launched more than 20 years ago. Romick and his team were named Morningstar’s Allocation Fund Manager of the Year in 2013 because of their “capital preservation and strong stewardship which helped the fund achieve its goal of delivering equity like returns with less equity risk over the long haul.” Since its inception this go anywhere, invest in anything fund has delivered better than 11% annualized returns besting the stock market and its balanced portfolio benchmarks by substantial margins. Romick, a proud, self professed contrarian value investor has been a vocal critic of the Federal Reserve’s unprecedented monetary expansion and has become increasingly wary of the rich levels of prices in markets around the world. In quarterly letters to clients he has pointed out several indicators of just how expensive markets have become. One of the most dramatic is this chart sent to clients in his last annual letter showing stock prices as a percent of GDP. As you can see the value of stocks was worth more than 200% of the economy’s total output of goods and services rivaling the market peaks of the dot com bubble. As the markets have appreciated in recent years Romick has been reducing his stock and bond exposure and raising his cash positions to the second highest point in the FPA Crescent fund’s history. I asked him why.

Steven Romick: We’re not that optimistic. It’s not that we’re pessimistic. I don’t want to confuse the two. It’s not a target rich environment, and multiples in the market are higher than average, and there’s real risk out there from central bank action. How it all ends, we don’t know. We don’t know with all the trillions of dollars that have been used in some type of academic arguments, but hopes that it alchemizes into reality has yet to be seen. So we don’t know we’re going to have inflation, if so, how much, when? We don’t know if we’re going to have deflation. If so, you know, when that might occur. And so we have a portfolio today that’s kind of betwixt in between and we’re trying to create it in such a way that it’s robust in more than one scenario, because we have the ability to do more than most. One might say we have more than one way to lose money because of that, but nevertheless, we like to look at it as opportunistically as we can and say we can buy common stocks, preferred stocks, junior debt, senior debt. We can buy containerships, we can invest in different parts of the world, and it gives us a lot of opportunity to lift different kinds of things. When we look across the world today where we have zero interest rate policy in so many of these developed economies, it pretends to convert capital allocation decisions, and as a result asset prices get lifted and we find less opportunity than we have historically found. So at the end of the day, price is going to be our guide. And so you can have a terrible outlook, but as long as the assets you are considering purchasing have that bad outlook priced into them, then it’s fine. So the problem we have today is we have concern about the future for some of the reasons I mentioned, and yet the assets aren’t really taking that into account. So the risk reward for individual investments on a micro basis are not terribly attractive. So cash builds for us as a byproduct of what it is that we do, not as a top-down. “Oh, the world’s expensive so let’s go have a lot of cash.” One thing I’m confident in today is that there will be greater volatility in the future than there has been most recently.

Consuelo Mack: Right. Because we’ve had very low volatility. Why do you think there’s going to be more volatility?

Steven Romick: Well, there’s never been a point in time in history where governments have been able to really get together and say, “Hey! Let’s go and manage the economy by doing all of these things.” We’ve got a four trillion dollar, you know, fed balance sheet that has to contract at some point in time.

Consuelo Mack: So we’re seeing a gradual pullback, at least in this country, and yet volatility has not increased. So is it possible that we could have kind of a soft landing of the withdrawal of central bank easing?

Steven Romick: Sure, everything’s possible. I mean, Kermit the Frog married Ms. Piggy. Nobody thought that would happen. (Laughter) So yeah, anything could happen, although I think it’s unlikely. I think that, you know, we’re challenged by the idea that the government can really manage this in such a way. And you spoke to contraction and quantitative easing, and we haven’t had any great effect yet. However, it’s really a three part process, because we built up the balance sheet, so now what we have to do is A, they’re going to start by reducing asset purchases. Then second, they will stop asset purchases, and then third, they’re going to have to find somebody else to re-fly out the balance sheet as the balance sheet unwinds as those loans that they purchase, or whatever it is they purchase, you know, come due. So there’s a lot that still is yet to come, and we know with quantitative easing is something none of us even heard of a decade ago or ever thought about, and now we’re depending on it. It’s a little bit like we know we’re addicts. I mean, my partner Bob Rodriguez calls it Red Bull Economics. You get all jacked up on the Red Bull and then anything can happen.

Consuelo Mack: How are you managing your cash now versus what you would have done traditionally?

Steven Romick: Well, in the past we were more commercial paper with a little bit of US treasuries, and then as we got into 2008 we started backing away from treasury securities. And we really focused more on US treasuries, just because we weren’t getting paid to play, we weren’t getting paid in the risk, there were too many questions out there, and we questioned the treasury function in some of these companies. It wasn’t an analysis we wanted to make at the end of the day. We wanted to analyze businesses and know that we were buying those businesses or assets at good discounts to what the underlying value was to give us the margin safety, if you will. And we didn’t want to have to make that analysis in the case of commercial paper, so it was a why bother? They’re not getting paid for an equity rate of return so let’s just not worry about it, so we owned US treasuries. So since then we have less of that concern, so commercial paper has come back into the portfolio, and we’ve also gone overseas into certain other …

Consuelo Mack: Some sovereign debt, right?

Steven Romick: Some sovereign debt, and we’ve actually hedged out some of their currency risk, but we still have the sovereign risk, but we’ve actually been able to, in the one case we’ve really done it, in any kind of size been able to actually get higher rates of return than we could even after hedging out the US dollar.

Consuelo Mack: Which is in Australia?

Steven Romick: Singapore. Nearby.

Consuelo Mack: So why are US treasuries no longer the most prudent course?

Steven Romick: Well, for us it was just a question of we think that there’s other places you can do just to protect your capital. I mean, the US treasury market, we didn’t think anything was likely to happen, but you know, in this case diversify is a good thing.

Consuelo Mack: You’re a contrarian investor and you’re very proud of that fact. So are there any contrarian investments out there now that are catching your eye? You know, where else is there to go but cash?

Steven Romick: There have been a few places we’ve been finding to invest in. The problem has been, the reason why cash is built, there hasn’t been enough to create a whole fully invested portfolio. So in the last six, nine months we built a position in the aluminum industry. Aluminum is trading at an historic low, inflation adjusted low, particularly since such a large percentage of the cost of aluminum … aluminum production or energy, and energy costs are a lot higher today than they were a decade ago.

Consuelo Mack: So I know Alcoa, for instance, is one of the …

Steven Romick: And Alcoa is an interesting one because everybody who follows Alcoa, the Wall Street analysts, are metals and mining analysts, and what tended to get lost in looking at Alcoa was that the largest portion of its value was not the stinky, smelly, polluting aluminum business, but was the engineer product solutions business where they are really one of only two people in the world to manufacture these aerospace suppliers, you know, with these highly engineered products that really don’t use much aluminum at all. I mean, more than 90 percent of it are specialty alloys and titanium, so Alcoa, you know, as an aluminum company, it’s most valuable division does very little in aluminum. And people weren’t valuing that correctly, because the wrong people were looking at it. And so that gave us an opportunity to invest in Alcoa back last fall, and we were able to … what we viewed at the time, given the terrific value for the engineering product solutions business whose largest competitor is Precision Castparts … you know, Precision Castparts at the time traded 14 times EBITDA, and we weren’t going to even apply multiples like that to this business, even though we would argue it was as good or is as good as Precision Castparts business. Even at a discounted value, we had a huge option on the turn of aluminum. You know, we didn’t know what aluminum would turn. Will it turn? Will it turn? But we do know that half of the capacity in the world is losing money, so only half of the aluminum in the world actually makes money today, so you either need to see supply, contract, which is happening, Alcoa is closing its melting capacity today as well, or you need to see terrific demand growth, and we are seeing demand growth as well. If you look at the back log for airplanes, for example, it’s an eight year back log, about as high as it’s ever been, and they’re big users of aluminum for skin and other parts of the airplane, as well as you see it really at the margin move in the automotive industry. So you can think of examples in GM or Ford where you see increasing amounts of aluminum use. They’re putting 300 pounds more of aluminum in a Ford F150, which will save 1000 pounds of steel, which makes these cars lighter, easier to handle, and also makes these cars more apt to meet EPA requirements.

Consuelo Mack: How does Alcoa Aluminum get on FPA Crescent’s screen?

Steven Romick: Well, we can thank Brandon Stranzl for Alcoa specifically, who’s on our team.

Consuelo Mack: One of your research analysts?

Steven Romick: One of our research analysts. And, you know, the way he got to it … look, we’re in the business of looking for bad news, in very simple terms. So whenever you see stocks that are making new lows or you see headlines that say, “Well, you know, aluminum is dead. Aluminum pollutes. You know, aluminum capacity closing. Alcoa in trouble. Versall(?) in trouble.” I mean, you see those kinds of headlines, we say, “Hmm, there’s lots of bad news. There’s probably natural sellers, so maybe we can go and take advantage of that.” One of the things that we bring to the table, we believe anyway, is time arbitrage. We’re very patient as investors. We patiently wait for the opportunities that we’ve patiently researched, and we patiently wait for those opportunities to work out. So the bad news today is not unrealistic. It’s fair. I mean, the aluminum business is challenged today. However, we’re comfortable looking out a number of year, and it won’t be as challenged in the future. And so if we’re patient and we can wait for that opportunity or the valuation to reset, you know, down the road, and as long as we can get what we feel is a good IRR between now and then, we’ll look to go in and invest in those kinds of businesses.

Consuelo Mack: So do you tiptoe in? Do you gradually build positions?

Steven Romick: Sometimes.

Consuelo Mack: Or it just depends?

Steven Romick: Sometimes we have to get to know the business better over time. It takes time to get to know these businesses. Sometimes we have a very strong understanding at the get go, or we’ve invested in that business before. At the end of the day it’s a combination of understanding and price. Understanding, conviction and price, I should say.

Consuelo Mack: Looking around the world, where else is everyone running from?

Steven Romick: I don’t know they’re running from a lot of places. I mean, there’s not a whole swath of businesses that are out of favor.

Consuelo Mack: Well, they’re running from the emerging markets, for instance.

Steven Romick: Right, but emerging markets are …

Consuelo Mack: Russia.

Steven Romick: Yeah, emerging markets in general are areas that the multiples have contracted a bit and stock markets have declined in emerging markets. However, more of that decline has really been the result of commodity based companies, more cyclical companies and finance companies. And these are businesses that we aren’t as interested in in many of these markets.

Consuelo Mack: Because they’re just too cyclical?

Steven Romick: We prefer on average doing a higher quality business. And in the case of Alcoa, the aluminum smelting business wouldn’t be as high quality. The EPS business, that engineering product solutions business is very, very high quality. So we want to own these higher quality businesses, and the higher quality businesses in emerging markets aren’t trading at big discounts. You mentioned Russia. We have a small stake in Russia. I mean, Russia’s interesting, because it’s obviously quite combustible over there right now, and it’s unusual because people are running in fear, and when looking at Russia, you can look at a lot of companies that are actually of strategic importance to the state as well as to the globe. So something you couldn’t say about Venezuela, for example. There might be businesses that are important to the state, but not as important to other countries around the world.

Consuelo Mack: Right. I mean, they’ve got these giant energy producers, for instance.

Steven Romick: Exactly. They’re the largest, the largest hydrocarbon producer in the world, and as far as public companies are concerned, they have the largest reserves in oil in Rosneft and the largest reserves, as you mentioned, in Gazprom in gas. And it’s of strategic importance to the state because energy accounts for 25 percent of Russian GDP. It’s 50 percent in Russia of their annual revenues, and representing its strategic importance to the state and how important it is to their neighbors, it counts for 60 percent of their exports. So we understand that there’s risk there. However, these companies are trading at very large discounts to other companies of their ilk. You know, in Exxon, for example. So these large discounts, you know, justify the risk of owning some of these companies in Russia, which has an uncertain future. Not that Russia’s future is so uncertain over the long term, but shorter term those correlate some questions, but that’s what created again these natural sellers which allows us to come in and do some buying. But what’s interesting about looking at Russia is that people there seem to be less concerned. There’s massive insider buying in some of these companies. In the last 12 months in Lukoil, for example, there’s been a billion dollars purchased from insiders. One may question where they got a billion dollars, you know, but we look at these Russian companies, you know, there’s a fair amount of taxation that goes on by the Russian government, and there’s probably another … call it less official means of taxation in the from of, you know, more nefarious activities occurring within the companies. However, the earnings we see are audited by legitimate companies and these earnings that we’re seeing today are already met of both forms of taxation, and they’re cheap on that basis. So as long as things don’t get worse in that regard, we can be pretty comfortable with these companies that we’re buying at these prices today.

Consuelo Mack: So it really is because of the prices? Because I mean, it would make me nervous as an investor to know that you are in basically a thugocracy, as someone told me, with Putin running Russia, and you know, heads of companies get thrown in jail at any given moment if they get too powerful. So for someone who’s most concerned about avoiding the permanent loss of capital, and you always say that your defense is more important than your offense …

Steven Romick: There’s no argument that this is a complex country with an authoritarian regime. There’s no argument there. However, again, we feel that price is the guide, and we argue we do play defense first. We think about it in terms of the whole portfolio, so it’s a defensive portfolio. If you’re not willing to lose a little money along the way in certain investments, you’re not going to make money either. So there’s no chance you’re going to go through life and not lose money. So if you size positions correctly, and we believe that our investments in Russia are sized appropriately. Not to say they won’t increase somewhat, but it’s never going to be the largest part of our portfolio for sure for some of the reasons you’ve mentioned, but we certainly are willing to accept some risk attached to that. And don’t forget, you can’t steal from something that’s insolvent, the country needs these companies to continue to spew off cash. Again, 25 percent of GDP, 50 percent of Russian government revenues, so you need these companies to continue to renew throw off cash flow to fund whatever the regime wants to do.

Consuelo Mack: One of the things that you and I have talked about in the past is that you look for companies that you call compounders, and these are companies that you know you’re definitely going to make money. The question is not if you’re going to make money, but it is how much money you’re going to make, and in five to ten years they’ll be worth a lot more than they were today. So what are your favorite compounders in the FPA Crescent portfolio right now?

Steven Romick: Well, one example of a compounder would be a company called Meggitt PLC. Meggitt is an aerospace supplier, and we actually like the aerospace industry. I mean, you’ll have growth in passenger traffic. You know, 3 to 6 percent over the next 10, 20 years. That’s a nice place to start from. Airline traffic is going to increase around the globe for a number of reasons, not the least of which is growth in emerging markets, growth in population, as well as growth and increase in wealth. More people will fly, more airports are built, you know, and it all feeds upon itself and you’re going to see a lot of that over the next ten, 20 years. So to find a company like a Meggitt, which is dominant in the wheel and brake business, and they have a number of other businesses, but the biggest portion of the profits comes from wheels and brakes. They have more than 50 percent share in the regional jet market as well as the business jet market, where in those two markets they are single source. So a company, an OE, an original equipment manufacturer, will go and contract with a Meggitt or somebody else, and hopefully Meggitt in our case since we own Meggitt, and will contract with a Meggitt, and Meggitt basically gives them the wheels and brakes for free, because they make all their money in the after market, and there’s huge margins on that. And these products get priced as the wheels wear out and parts break, and you know, they get price in this over time, you know, ahead of inflation. So it ends up being a terrific thing, and you’d have terrific confidence that you can get a vision for what the earnings will look like in the future.

Again, to your earlier point as we think about compounders, we can’t know exactly what they are, but this is a company that we felt was going to grow at a very healthy clip that generates a lot of free cash flow. We hope that management makes intelligent acquisitions and uses of that capital, which there’s no guarantee of that, and the risk out there for Meggitt would be how they spend their capital, because they’re an inquisitive company. They’ve done a reasonably good job historically, but the fact is the returns on capital for their core organization, you know, and for the business are very, very, very high, and that’s what we want them to focus on and buy shares back intelligently as prices permit. So as we think of the future as we look at Meggitt, we think that five to ten years from now this is going to be a better business than it is today, and as long as the multiples at least maintain we’ll do very well, and given the fact we bought a company at a discount to the market, there is some option out in the multiple. That’s not something we’re counting on.

Consuelo Mack: We always ask all of our guests at the end of the interview is if there were one investment we should all make in a long term diversified portfolio, and you can never recommend your own fund, what would it be?

Steven Romick: You know, it’s interesting today. I actually see today as being more opportunities in the private sector than there are in public. I mean, where there’s more inefficiency, relatively speaking, is in the private sector, which is why in our fund we also invest in certain illiquids, and we’re able to make certain real estate loans and get low … (Overlapping Voices)

Consuelo Mack: Real estate loans.

Steven Romick: First lien real estate loans. We partner with a AAA real estate investor to make first lien real estate loans. And we’re getting low teens, you know, IRRs … expected IRRs, I should say … on these loans, and we’re very excited about it, given the good loan to values that we have. And I think that for an individual investor, I think at this point in time, one needs to be wary.

Consuelo Mack: One of the things that you and I had talked about the last time you were was you were also investing in farmland, in private partnerships that had invested in farmland. So these are in liquid, they’re long term investments, they’re a very small part of your FPA Crescent portfolio, but that’s the kind of things that you are having to get involved in because there are so few other opportunities out there.

Steven Romick: Yes, but I would also say it’s more than that, because in the case of farmland, which we first invested in a number of years ago, and it’s not as inexpensive as it was.

Consuelo Mack: It’s definitely appreciated.

Steven Romick: So it certainly is work … it’s not just a question of so few opportunities out there, but we like the way that investment would behave in a number of different scenarios, not the least would be inflation, decline in fiat currencies, so we felt it made sense within the portfolio. But it wasn’t just because we couldn’t find investments elsewhere. Same thing with the real estate loans. I wouldn’t say that we wouldn’t own these real estate loans in a different environment where there was more opportunity, because we very well might, depending upon what was there, what was available elsewhere. Because these real estate loans, I mean, our goal is to provide equity rates of return to our clients, and to do so in the void of permanent capital along the way. And if you can go and get low teens IRRs, as we think we’re getting on these real estate loans, then why not? And we’ll take that all day long. And it’s not going to have the same kind of volatility as other investments might, won’t get the same market to market risk, you know, in the portfolio day to day, and we miss clip coupons for a few years.

Consuelo Mack: And last question: What would get you more interested in investing some of your cash?

Steven Romick: Again, it’s bottoms up, and we talked about a couple of themes. Aluminum was one. You know, Russia was an example that you brought up. And so it could be thematically driven, where we see areas of the world or asset classes or industry groups that fall out of favor or individual companies having a little stumble along the way.

Consuelo Mack: So Steven Romick, it’s always a pleasure to have you here on WealthTrack, so thanks very much for joining us.

Steven Romick: Thank you.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point: keep a stash of cash in your portfolio. Cash has become a dirty word in most investment circles because it yields close to nothing right now, but it has other redeeming virtues that make it a must have asset. Cash adds ballast to a portfolio in choppy markets. While other investments rise and fall, it provides stability and protection. It adds liquidity and opportunity. Cash can be put to use in a moments notice, especially to buy when others are selling. And it provides a psychological advantage: Fairholme Fund’s Bruce Berkowitz calls cash “financial valium.” It keeps him calm when others are panicking. Next week is the start of one of public television’s fund raising drives so WealthTrack might be pre-empted in some markets. We are therefore revisiting an interview with another Great Investor and Morningstar fund manager of the year, the Royce Funds’ Charlie Dreifus will explain why a small-cap manager is also investing in large cap stocks. Please go to our website to hear our extra interview with Steven Romick. Also visit our new WealthTrack women section. We will have updated financial advice specifically for women from our panel of award winning women financial advisors. In the meantime as you enjoy your Memorial Day holiday take a moment to remember all of the soldiers who sacrificed throughout our country’s history to make our precious freedoms possible. We owe them our undying gratitude. Have a lovely weekend and make the week ahead a profitable and a productive one.

CHUCK AKRE: COMPOUNDING MACHINES TRANSCRIPT

May 16, 2014

CEO and chief investment officer of Akre Capital Management, Great Investor Chuck Akre, explains how he finds “compounding machines” and why he invests for the long haul.

Consuelo Mack: This week on WealthTrack, the search for “compounding machines”, companies able to reinvest their free cash flow to deliver above average returns. Great Investor Chuck Akre says they are few and far between but once he finds them he holds on to them in his five- star rated Akre Focus Fund. A rare interview with Chuck Akre is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. What are the most shareholder friendly actions companies can take to enhance the value of their shares? Well talk to any investor and one of the first suggestions that comes to mind is increase their dividends, which are especially valuable in this income starved world.

Historically dividends have really counted. At least 40% of the 12% annualized stock returns over the last 50 years have come from reinvested dividends. What’s the outlook for dividends today? According to research from S&P Dow Jones indices, the trends are very positive. After setting records last year dividends are off to the races again. In the first quarter, dividend net increases, that’s dividend increases less decreases, rose $17.8 billion for U.S. domestic common stocks. And S&P’s senior index analyst Howard Silverblatt predicts at current declared dividend rates, companies could easily set new peak payments for this year. But Silverblatt also noted there is a risk- reward trade-off to all of these dividend payments particularly among the largest companies. All 30 Dow Jones industrial average stocks and 84%, or 421 of the large-cap S&P 500 companies pay dividends, the most since 1998. According to Silverblatt, “that security of income has come at a cost of capital appreciation, with the small-and mid-caps having returned significantly more in stock price”. Which is where this week’s Great Investor guest comes in; he says that dividends are a “less efficient use of capital”.

He is Chuck Akre, CEO and chief investment officer of Akre Capital Management which he founded in 1989 and portfolio manager of the Akre Focus Fund which he launched in 2009. The fund which is rated five-star by Morningstar has delivered nearly 19% annualized returns since its inception. Although Akre is new to us he has a long and distinguished investment track record including a 12 year stint as the sole portfolio manager of the once top performing FBR Focus Fund. Akre is known for running tightly focused portfolios with very low turnover. Two thirds of the fund’s more than $3 billion in assets is concentrated in its top ten holdings. As he puts it, he looks for compounding machines to hold for years. I asked him to define a “compounding machine.”

Chuck Akre: One example I use for compounding often is the issue of a penny doubled every day for a month for 30 periods, and that turns into $10.8 million. One penny turns into 10.7, 10.8 million in 30 periods, 31 days. That’s the effect of compounding, and so when we’re looking for businesses to do this, we want businesses that can reinvest their free cash flow back in the business to continue to earn the above average rates of return on that capital and, therefore, compound the owners’ capital.

Consuelo Mack: Above average rates of return. What does that mean these days?

Chuck Akre: So, sure. It’s important. The average return in common stocks for nearly 100 years in this country is around 10 percent. Whether it’s nine or eleven is of no consequence to us.

Consuelo Mack: And that’s dividends reinvested.

Chuck Akre: That’s total return, absolutely. So in our case we look to be able to return above average returns, and we’ve done so for a very long time, and depending on which vehicle we’re talking about, it’s a different level but substantially above that average return.

Consuelo Mack: Chuck, why don’t you favor dividends as much as many of the other Great Investors that I talk to do?

Chuck Akre: Well, we said at the outset that our goal is to compound our capital, and there is no free lunch. A management has three or four choices to do with all the free cash they generate. They can pay dividends. They can buy back stock. They can invest in their own business, or they can acquire other businesses, and so in order to compound our capital the most efficient way to do that is to invest in their own business or another business where they earn above average rates of return. If they pay a dividend, they no longer have that capital to do that, and so it’s a marginally less efficient way for us to compound our capital.

Consuelo Mack: And you also not only wanted to deliver above average returns. You also want to deliver above average returns with less than market risk.

Chuck Akre: Correct.

Consuelo Mack: Which you have done over time.

Chuck Akre: Correct.

Consuelo Mack: So what’s the secret to delivering below market risk?

Chuck Akre: So it’s not a secret. It’s really quite intuitive and straightforward, and that is the businesses which we own in the portfolio have more growth, higher returns on capital, stronger balance sheets and frequently valuations which are below market. So just on the face they have a below market average risk.

Consuelo Mack: And yet when I look at the Akre Focused Fund, for instance, it’s very focused. That is not a misnomer. In fact, you have about 30 holdings.

Chuck Akre: Correct.

Consuelo Mack: And the top 10 are about two thirds of the portfolio.

Chuck Akre: Correct, and the bottom 10 are less than 10 percent.

Consuelo Mack: And some of them you’ve held for 20 some-odd years through great markets and terrible markets. As stock prices go up and the valuations are not as attractive, isn’t that a high-risk proposition?

Chuck Akre: Not necessarily. The requirements for a great business for us have really three components. The first is we spend a lot of time trying to understand what’s causing this above average return to occur. Is it getting better or worse? The second thing we look for are the people who run the business, and not only do we want to have great business managers, but we want to see to it that they treat public shareholders as partners even as they don’t know them, and then lastly we look to see if there’s a great history of reinvestment of the free cash flow as well as a significant opportunity to reinvest free cash flow and earn above average rates of return. Those are the characteristics of the businesses. None of those things ever behave in a constant fashion. Business models get better, they get worse with time. People’s behavior sometimes changes modestly. The ability to reinvest or the results from an reinvestment will vary from time to time, and so we make a judgment about which ones are real keepers.

Consuelo Mack: So given the fact that there are thousands of companies to choose from, so why is it so hard to find companies that have those three characteristics?

Chuck Akre: Well, the first two things, the business model and the people, business models change over a period of time and so they will behave differently in different environments, and you watch that. People’s behavior will change over a period of time. Sometimes in my business I keep saying to myself actually I’m getting better with age, and I hope that’s true, the outcomes would reflect that.

Consuelo Mack: Let’s use an example, Markel, a property casualty insurer. You’ve owned it for over 20 years.

Chuck Akre: Over 20 years, right.

Consuelo Mack: And you’ve stuck with it throughout those 20 years?

Chuck Akre: I have, and in 2013 the growth in book value per share was 17 or 18 percent. It’s 18 percent I think, and over the last five years, 17 percent. Over the last 20 years it’s probably about 14 percent, and if you went back 10 years ago it might have been above 20 percent, and so it will go up and down with all kinds of issues. The level of interest rates in our country are at a 30-year low, and so with a business that’s leveraged in their investment portfolio, that makes a difference. Pricing in the property casualty insurance business was negative for seven years, or eight years, and only began to get better about a year and a half ago. So during that last 10 years there has been one period where the growth in book value per share fell below 10 percent; but it did not cause us to sell the security because, as I say, in 2013 it was back at 18 percent. To have that kind of economic growth in real economic value per share in what I’d call a zero percent interest rate market is a Herculean experience. I mean, it’s wonderful.

Consuelo Mack: So the returns of the company are phenomenal as far as their business is concerned. What about the stock price?

Chuck Akre: Well, the stock price has kind of reflected what’s going on with the growth in book value per share. Today we look at these things differently than much of Wall Street and much of the sell side. In 2013 the growth in book value per share was over $70 a share. I don’t recall right off hand but maybe mid 70s, and certainly all of 2013 the stock price was in the $500 range. Today it’s in the $620 range, something like that. That is still less than 10 times the real economic earnings of last year. The change in book value per share is in fact the real economic earnings. So it’s still selling for less than 10 times in our judgment, the way we look at it.

Consuelo Mack: Tell me what you look for in an underlying business.

Chuck Akre: Well, American businesses probably have single-digit net margins on average, and the returns on equity, returns in the owner’s capital as I suggested are probably in the low teens. So if we find a business as we’re looking around that has returns which are significantly greater than that, that causes us to get curious about, well, why is that occurring? And so the simple reasons would be they have patent or they have the absence of competition for one reason or another.

Consuelo Mack: That’s the moat.

Chuck Akre: Right, that’s the moat, the frequent phrase that’s used.

Consuelo Mack: That Warren Buffett and Ben Graham …

Chuck Akre: Right, and sometimes in a business we say, well, we don’t know precisely why they’re able to do it. This is what we think, and that’s okay, too. We’ve learned to get comfortable with that.

Consuelo Mack: Not being quite sure, but you just know they’re doing it.

Chuck Akre: Right, not being quite sure. This is what our hunch is. Managements…if it’s something that’s really a secret sauce, the managements are unlikely to share it directly with us because it invites competition, and if you have a business with very high returns, it will naturally invite competition. Everybody wants to get something that’s got better returns than they have. So that’s how we go about it, and we spend a lot of time trying to study other companies in that line of business or other businesses that are related and make our judgments that way.

Consuelo Mack: Can you give me another example? I’m looking at your top 10 holdings. Colfax, I mean, Moody’s, MasterCard, American Tower, Dollar Tree, Visa.

Chuck Akre: So some of them are quite easy to talk about, American Tower, for example. You know they are essentially the largest worldwide in the business of erecting towers which support antennae for wireless communications.

Consuelo Mack: Big growing business globally.

Chuck Akre: Right, and so it’s a vertical business. The model is more towers, more tenants per tower and more rent per tenant, and on the last item their contracts with the carriers typically have annual escalators built into the contract. So every year they’re going to get three or four percent more for that same service. In addition to that, as we’ve gone from what they call 1G to 2G to 3G to 4G and so on in our handheld sets and stuff, each of those requires actually a dense tower network because they require a greater level of complication as it were in the antenna, that sort of stuff. So each of those greater density requirements requires more towers and sometimes alterations of the antennas on the towers and that sort of stuff, and each is a profit opportunity for American Tower. So it’s a very protected business. And then in the last half a dozen or more years, they’ve been growing extensively outside the U.S. and are in 11 different countries as well as the U.S., and so, very protected. You can see why they get high returns on their assets. On the other hand, if you take a business like MasterCard or Visa, it’s much more difficult to figure out exactly why they have such high returns on the capital, and the returns are enormous. They are unable to invest in other businesses that have returns that are as high as theirs.

Consuelo Mack: What a problem to have.

Chuck Akre: What a problem to have, and so they still have to do something with the enormous amount of cash they generate, and what they’ve done is they’ve instituted a small dividend that they grow. They’ve instituted some share buybacks over the last couple of years where they’re buying back billions of dollars of stock, but they still end up with lots of extra cash, and that’s a little bit of a dilemma. It makes the compounding a little bit more difficult because they’re not reinvesting. So they buy small businesses that help them with advances in mobile technology or whatever else, that’s the mobile payments, all of those things, but they cannot make large investments in businesses which have those high returns.

Consuelo Mack: It sounds like, therefore, their sustainable model years in the future might be more difficult than it is than for an American Tower.

Chuck Akre: It might be, but there’s ubiquity of acceptance of a MasterCard or a Visa card around the world. It continues to grow, and their business model is such that they get paid not only on each transaction but they get paid on the amount of currency in each transaction. So it’s really a wonderful inflation hedge; that is, if currencies get devalued and the dollars involved in a transaction go up, they get more money out of it, that sort of stuff, so it’s a really fascinating business model. Consuelo Mack: You also have I think what you call your workbench companies. They are almost like workouts as far as you’re concerned. Could you share one of those companies with us?

Chuck Akre: Colfax was one of those, and it’s our largest holding these days, but we started with it in a very small piece, and we were attracted to it for a number of reasons including what their business plan and model was.

Chuck Akre: They acquire other industrial companies and through a technique of their own that is based on a Japanese Toyota manufacturing model of continuous improvement. They improve, rationalize these businesses dramatically. So they source and buy underperforming companies and buy them and improve them and dramatically increase the rates of return.

Consuelo Mack: Do they then sell them, spin them off or … ?

Chuck Akre: No, they don’t.

Consuelo Mack: They keep them.

Chuck Akre: They keep them going for the most part. The company was founded by Mitch and Steven Rales who had also founded over 30 years ago a company called Danaher, where, in Danaher they compounded the shareholders’ capital 20 percent a year for 30 years. I mean, and so we’re attracted to that. We’re attracted to that way of thinking. They’re both significant shareholders and are behind this business. So in one sense it’s sort of we thought maybe it’s a Danaher redux, and we got started as a small company. Then we went to visit them, and we’ve been to visit them again and so on, and watched how they performed with their acquisitions and see how things are going. So that’s an example.

Consuelo Mack: Tell me what you look for in management.

Chuck Akre: You want to find management that of course is terrific at managing the business, and presumably they’ve demonstrated that by the time we get involved. We’re very interested in how they think about lots of things. We ask them often, how do you measure your success at this company? By what means? By what? And so we listen to what they have to say and make our own judgments about that.

Consuelo Mack: What are the kinds of answers that you like?

Chuck Akre: Well, sometimes you get answers such as, well, if the stock price goes up; and sometimes you find CEOs that have screens on their desk. They’re watching the stock price all day long. And that’s not a characteristic that we find particularly attractive.

Consuelo Mack: Because you don’t care about the short-term stock performance?

Chuck Akre: Right, and I would say our quick judgment would be their eye is on the wrong thing. That’s our own parochial view. We’re interested in hearing how they discuss the reinvestment of the free cash flow they generated, how they discuss the arrangement of their balance sheet and whether they use debt capital, and so on, and how much they use. I mean, all of these kinds of issues are very important in helping us with our judgment. You know, at the end of the day, if this business could be quantified, I wouldn’t have a job. People would just punch a button on a computer and it would do all the investing for them.

Consuelo Mack: Lots of people are doing that.

Chuck Akre: Indeed. And in fact, some of them do it very well using very sophisticated mathematics, but that’s not what we do. They’re trading against prices in the market and using information that comes to them in their models to do that. What we are is we’re investors in businesses, and we’re trying to identify those unique businesses with very high returns because at the end of the day the core of our thought process says that our return in an asset will approximate that return on the owner’s capital that the business generates.

Consuelo Mack: How many managers are there out there that can afford to think the way you think, to think long term?

Chuck Akre: I don’t think any of them are striving to think the way we think. They’ll get to their own conclusion about how to operate the business, and many of our businesses have shareholder support in the way they go about it. They’ve attracted the kinds of shareholders that they deserve, a line that Warren Buffett has used for many years, you know. So the way they discuss their business and the way they discuss their outlook and their operations helps lead certain kinds of investors to them. So many of the businesses we own have attracted shareholders that are sympathetic with the way they run the business at least.

Consuelo Mack: Why is it so difficult to identify a good investor, and what’s your definition of a good investor?

Chuck Akre: Well, at the end of the day it ends up having to do with outcomes and outcomes relative to goals. So the issue then comes down to, is there anything that you can do or understand that will help you predict whether this manager or that manager is going to have an outcome that’s coincident with what your goal was? Sometimes they’ll do that even when the results might have made you uncomfortable, but nonetheless they still met your goal. For example, we went through that period in 2008 and early 2009 which felt terrible. The stock market had very negative returns as you remember, and people who understood for example what we were about and were able to not worry about the balance of their account at a period in time have done wonderfully as a result of sticking with the program. We struggle with trying to make sure that our clients understand what our approach is, and we work very hard to try to get them to understand it.

Consuelo Mack: One investment for a long-term diversified portfolio, we ask every guest, what would it be? What would you have us own in a long-term diversified portfolio?

Chuck Akre: Well I think we talked about Markel earlier. Sort of everything about the business is terrific. Today they have a $17.5 billion investment portfolio on just less than 14 million shares outstanding. So they have enormous leverage to the opportunity of rising rates. You know, rates have been declining for 32 or 33 years. Some day they won’t decline and so that kind of leverage on rising rates will be very important. Number two, pricing in the property casualty business began to strengthen about a year and a half ago after seven ugly years; and maybe it’s stable or improves a little bit. Three, they made an acquisition last year that doubled the size of their gross written premium. Four, they have taken an attitude that is slightly more opportunistic about managing their balance sheet, and then five, they have a division in the company called Markel Ventures that is growing a stream of income away from the insurance business a la Berkshire Hathaway. So you can buy it at less than 10 times our notion of economic earnings today and have a good shot that it can compound our capital on average probably in the mid teens for the duration.

Consuelo Mack: Chuck Akre, thank you so much for joining us on WealthTrack for the first time.

Chuck Akre: Thank you, Consuelo.

Consuelo Mack: We’re delighted to have you.

Chuck Akre: I enjoyed it. Thank you.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is one we have recommended several times over the years. It is: put the power of compounding to work for you. As Chuck Akre said this week and Chris Davis said last week, there are companies that are compounding machines and as we have identified several times, there are also mutual fund managers that invest in them and are proven compounders themselves. It just so happens that we have had several of them on WealthTrack recently. In addition to Akre And Davis they are: investment legends, Chuck Royce And Charlie Dreifus whose Royce Funds invest in high quality multi-cap businesses around the world, Franklin Income Fund’s Edward Perks who looks for both capital appreciation and reliable income streams, and Wintergreen Fund’s David Winters who seeks out value among leading global brands. All of these portfolio managers invest in top quality businesses and managements for the long haul to benefit from the power of compounding earnings, cash flow and in many cases dividends.

Next week we will sit down for a rare interview with Morningstar’s 2013 allocation fund manager of the year, FPA Crescent Fund’s Steven Romick who invests in what he calls compounders, in his words, companies whose businesses will be better off in ten years than they are today.

To see more of our interview with Chuck Akre, including his motto for life, visit the extra feature on our website.

Also in our new WealthTrack Women section, our panel of award winning financial advisors will offer specific advice for younger, older, single, widowed and divorced women on creating a financial plan that is right for their particular stage in life. In the meantime, have a great weekend and make the week ahead a profitable and a productive one.

ANDREW LO: FINANCIAL INNOVATION

May 9, 2014

Consuelo Mack: This week on WealthTrack, How do you prevent investors from constantly shooting themselves in the foot by chasing hot performance and selling at market lows? Professor Andrew Lo and his team at MIT’s laboratory for financial engineering are working on solutions to protect investors. That’s next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Investors are notorious for making bad market timing decisions. They tend to chase hot performance and sell at or near market lows. The latest research from the Bogle Financial Markets Research Center and Morningstar shows an all too familiar pattern. No matter what the mutual fund category investors underperform the very funds they invest in. Over the last 15 years for instance investors underperformed large cap growth funds by an average of 2 and a half per year… the gap with large cap value funds was almost 2 percent annually. For international stock funds the annual underperformance was nearly the same amount. And even bond fund investors lagged by 1.8% a year. But it’s not just individuals who make terrible timing decisions. It turns out corporations do too. According to some fascinating research covered by WealthTrack guest James Grant, in a recent Grant’s Interest Rate Observer, “we humans seem genetically incapable of buying low and selling high”. Grant’s went on to say “according to Factset, the average price at which the companies of the S&P 500 repurchased stock between the fourth quarter of 2012 and the third quarter of 2013 was 99.8% of the average price of the preceding 12 months. In other words, managements bought in shares, not because the price was low, or the value commanding. They bought in shares, as we read the managerial mind, because everyone else was buying them in.

This week’s WealthTrack guest is on a mission to help investors avoid their poor market timing and chronic underperformance. He is financial thought leader Andrew Lo, professor of finance at the MIT Sloan School of Management and head of its laboratory for financial engineering. Lo is a prolific writer for finance and economic journals and applies his research in the real world as founder, chairman and chief investment strategist at Alpha Simplex which runs a series of hedge fund like mutual funds under the Natixis name, including his flagship Natixis ASG Global Alternatives Fund. I began the interview by asking Professor Lo to describe his latest project at MIT which they have dubbed Artificial Stupidity!
Andrew Lo: Well, in a nutshell it’s trying to simulate realistic investor behavior. So often we think about investors as maximizing their self-interest and engaging in the right kind of investment activities, but in fact it’s very difficult for investors to follow what economists tell them they should be doing, and so what we wanted to do was to simulate actual investor behavior and ask the question, are investors able to earn a decent rate of return if they simply act the way they feel? And that’s the hope is to try to understand where they actually break down in terms of the decision-making processes.

Consuelo Mack: So let’s talk about, number one, there’s artificial intelligence and now you’re doing artificial stupidity. So where did that title come from?

Andrew Lo: Well, yeah, it’s a little bit of a …

Consuelo Mack: Tongue-in-cheek?

Andrew Lo: Tongue-in-cheek, yes, absolutely. Artificial intelligence obviously is a big part now of the financial industry. We have all sorts of algorithms that help us act smarter, but the problem is that what we need to understand is first where are we making the systematic mistakes, and so maybe artificial stupidity is a little bit too strong. Maybe we should say artificial irrationality. We want to understand how investors ultimately make the mistakes that we all do. Once we can identify and then replicate the mistakes, we can then simulate how an investor’s portfolio is going to be subject to those mistakes and then start beginning to think how to correct them.

Consuelo Mack: Supposedly we buy high and we sell low. So we chase performance, and we hate pain and losses so the minute our investments go down, we get out of them. So that’s wrong?

Andrew Lo: Well, it’s wrong to pull your hand out of the fire and leave it out for years and years. So when we lose money, and all of us will lose money at some point if we haven’t already, once we lose money, investors often go to cash and stay in cash way too long. By the time they realize it, they’ve missed out on some pretty attractive returns. For example the last couple of years the S&P’s done great. By the time they realize that it’s often too late. They’ve missed a pretty big rebound, and so the idea of understanding what drives us, what causes us to make these mistakes can actually tell us how to fix them or at least construct algorithms that will help us to act smarter.

Consuelo Mack: But you think that the buy and hold idea of investing is wrong. Correct?

Andrew Lo: Well, I would say that buy and hold is not wrong, but it’s incomplete, and it’s incomplete in the following ways. During normal times when the stock market is moving in reasonably acceptable levels of volatility where we don’t have huge crashes or huge run-ups, it’s actually pretty reasonable to buy and hold equities. For example, through the 1930s all the way up to the early 2000s, if you bought and held you would have done pretty well. The problem is that over the last decade the stock market has been much more of a roller coaster ride. Volatility shoots up and then it calms down, and it spikes up yet again, and so for the typical investors it’s not realistic to expect them to buy and hold over the last 10 years when you have peak-to-trough declines of up to 51 percent which is what we saw in 2008 and 2009. Nobody is going to sit idly by and watch half of their portfolio evaporate. They’re going to pull out much sooner than that, maybe after they lose 20 percent or 30 percent or 40 percent. At some point you’ve got to say it’s enough, and the problem is that in this kind of a market buy and hold can be deadly. If you aren’t really aware of the risks, you won’t be properly prepared for them.

Consuelo Mack: You mentioned pulling your hand out of the fire. Obviously when you start feeling pain, you should pull your hand out of the fire perhaps, and perhaps you should pull or at least reduce your exposure to the most risky assets which frequently are stocks. Therefore, what is it that you would have us do differently?

Andrew Lo: Well see, this is where the analogy may break down, and we have to be very careful about how we use it. So the reason that people pull their hand out of the fire is because if you don’t your flesh is going to start burning.

Consuelo Mack: You’ll get burned, yes.

Andrew Lo: So the question you have to ask is when you lose money in the stock market, are you likely to lose more money if you keep it in there? Or is it just a temporary blip, and that’s really the question that investors have to focus on. Over the course of a 70-year period, most of the time when you lose money it was a temporary blip. In fact, during the Internet bubble years, the only lesson that investors learned is to buy on dips. The problem is that over the last decade that lesson is not going to serve us as well as it did before, and so the key is to try to identify periods where you need to pull your hand out of the fire because it’s going to continue burning and other periods where it is a temporary blip and you can let it go and see what happens over the course of the long term.

Consuelo Mack: Is it possible to predict that?

Andrew Lo: Well, it may not be possible to predict it, but it’s possible to identify it, and that’s actually a very important distinction. We can’t predict the next crisis, but if we understand that we are in the midst of a crisis and react, we can close the barn doors after maybe 40 percent of the horses are gone as opposed to all of the horses being gone. So I think that being able to understand your current environment and being in a position to adapt to that environment can actually help you stave off some of these serious losses.

Consuelo Mack: Is this what the project’s attempting to do, is identify when you should cut and run and when you should stay?

Andrew Lo: It is but more importantly it’s trying to identify what individuals’ natural inclinations are and to try to see how that matches against the historical data and ask the question, under what periods is our natural inclination going to be beneficial and what other conditions will it actually be detrimental? If you can identify those two different kinds of environments, you can begin to start adapting more intelligently, and so the idea about artificial intelligence is first let’s figure out what artificial stupidity is, and then we’ll try to do the opposite.
Consuelo Mack: How far along are you in the process? Do you have any indications yet?

Andrew Lo: Well, you know, we’ve done the beginning scaffolding of understanding what all of the various different biases are, so I would say that there are probably 11 different features of human cognition that are particularly detrimental for financial investing, and so what we’re trying to do is to simulate those behaviors and to make sure that we’re actually replicating those behaviors in actual investors. Once we’re sure that we’ve got those behaviors properly replicated, we can then start doing the simulation of looking at various different environmental conditions that lead to good or bad outcomes.

Consuelo Mack: Are there behaviors that are more damaging than others? Are there like the top two worse behaviors that you can identify or have identified?

Andrew Lo: So the top behavior that’s damaging is actually not what most people think. Pulling your hand out of the fire, taking money and moving it into cash after big losses is actually not a bad thing. The really bad thing is leaving it in there way too long, so not going back in when you need to, and that’s the problem. It takes a while for investors to get comfortable again with the market after being burned, and that process can be deadly. We can lose out on huge returns if we wait too long to get back in. So we need more discipline in thinking about moving into and out of cash.

Consuelo Mack: Right now one of the major fears of many individual investors is market volatility, and my understanding is in some of the research that I’ve seen is that in fact individual investors and some institutions are underinvested in the stock market. Are we making the same mistake now?

Andrew Lo: I think it really depends on the horizon, and that’s another aspect of artificial stupidity. We don’t take into account enough the various different life stages that we might be in. So for example, a 60-year-old who’s thinking about retiring in another 10 or 15 years might look at things very differently from a 35-year-old who’s really just beginning to get into the most important parts of his or her career. So I think that horizon matters more than most people think but also risk tolerance. I think we have to go through the internal calculus of if I lose 20 percent, am I going to freak out? Or can I withstand up to 30 percent loss and still move on? Once you factor all of these considerations, you can actually construct the appropriate portfolio that’s going to be right for you. So I would argue that individuals have to start thinking about personal benchmarking. You know, we have personalized medicine now. Not surprisingly I think it’s because of the sophistication of the healthcare industry that we do that. I think we need to have personalized benchmarking so that we can understand exactly what would be appropriate for you which may be different from what’s appropriate for me.

Consuelo Mack: How close are we to having that kind of personalized approach to investing?

Andrew Lo: Well, I think the science is already there. What’s lacking is the engineering. So in other words, we have the theory. We know how to construct personal benchmarks to be specifically designed to fit your goals, needs and circumstances. We don’t yet have an easy way to implement that, and so what we need are more financial products that will allow us to take these personal benchmarks and put them into practice.

Consuelo Mack: The last time you were on, you said how much the markets have changed, that it’s not your mother or my mother’s market. It’s not even my market when I was younger, and a couple of things have happened. Government intervention in the markets is one thing. Technological advances, the fact that there are so many more players in the market. It’s a global market now, and that it requires a new attitude on the part of investors. So number one, are there any other seismic changes that you’ve identified since you and I last talked a year or so ago? And number two is, what are the kinds of adaptive behaviors that we should be following as individual investors?

Andrew Lo: Well, in terms of the seismic changes, there’s definitely big factors at work in driving markets, much more so than ever before. You know, certainly we’ve identified what those factors have been for the last several years. The Fed is probably one of the biggest, but we also have the European debt crisis that’s still outstanding, the Chinese real estate market that’s cooling down. There are a number of very, very big issues that are hanging over our head. Over the next 10 years I think we’re going to end up into a much better place for financial markets, but in order for us to get to those really 10 good years, we’re going to have to go through some pretty serious financial dislocation and reform. So within the next two or three, I wouldn’t be surprised if we run into another significant crisis, and there’s going to be a lot of new developments on the regulatory front that will have to be worked through before we get to that period of time. But I’m actually optimistic that after we work through those issues, and it may take another two years, another five years, there’s going to be a period of great prosperity. Once the financial system becomes reengineered, we’re going to see some tremendous growth.

Consuelo Mack: What is your view of the U.S. market now, and how risky is it for investors?

Andrew Lo: Well, I guess I would say it’s probably partly cloudy with some threat of showers in the sense that we have had a very good run over the last couple of years. The economy looks like it’s recovering, but the recovery is not without its issues, and so I think we’re in a transition period where it’s very easy for the market to turn. I expect that this year will be somewhat less rosy than last year. The growth will be somewhat more muted, but ultimately I think we’re actually transitioning to a pretty decent equilibrium. That equilibrium is going to be potentially threatened if we have some problems in other countries because now the economy is so globally interrelated, but barring that kind of a disaster I think that we’ll be able to get to a reasonable level of growth and employment.

Consuelo Mack: Let me read you something from AlphaSimplex, the company that you founded, and you’re now the chief investment strategist for and the chairman. “It is to help investors achieve greater diversification than traditional stocks and bond funds while actively controlling risk and liquidity.” How can I as an individual control risk for starters? What are some of the tools that I can use?

Andrew Lo: Well, to start with, you have to know what risks are. Someone said that you can’t manage what you don’t measure. So the first question is, how much risk have you got in your portfolio? You have to go through the various prospectuses, talk to a financial advisor, or some of the funds have quarterly calls. Participate on those to try to learn what risks are embedded in funds, and by risk I don’t just mean volatility which is what usually people mean when they think about risk. There are all sorts of risks, different dimensions of risk. For example, liquidity risk. If you’ve got your money in a real estate fund, there may be some liquidity issues so that when there’s a flight to quality because of some type of financial distress, those kinds of funds may be hit more than others. So try to understand what the different dimensions of your risk are, and then ask whether during certain periods of financial dislocation that’s going to hit your portfolio more than others or more than you would like. Once you understand what the risks are, you can then start to make changes in your investment decisions to try to manage those risks.

Consuelo Mack: Most Americans I would imagine have a fairly traditional portfolio of heavily invested in U.S. stocks, probably heavily invested in large cap U.S. stocks, and perhaps a sizable portion of their portfolio may be in corporate bonds, for instance. Again, very U.S.-centric. How risky is that kind of a portfolio.

Andrew Lo: So I think that’s a huge risk.

Consuelo Mack: Really.

Andrew Lo: And I think it’s really changed a lot over the course of the last couple of decades. So I think that nowadays investors also suffer from this diversification deficit disorder problem that we’ve spoken about before. The fact is that if you think you’ve got diversification from 500 securities, if those 500 securities are part of the S&P 500, you are not diversified. You have one big bet on U.S. equities, and it’s turned out over the course of the last several years that those bets may have done well in certain periods, but they’ve been disastrous in other periods. So the kind of diversification that I’m talking about is diversification across stocks, bonds, currencies, commodities, long and short but all in a portfolio that can be managed somewhat more actively for the risk if not for the alpha.

Consuelo Mack: And controlling the liquidity which again is an AlphaSimplex mission, you just described some of the ways that you can control liquidity. It depends on what you’re invested it, but aside from avoiding illiquid securities, is there another way to control liquidity?

Andrew Lo: Get a sense of how illiquid or liquid your assets are and then ask, what kind of illiquidity can you afford? Now, I would first suggest that illiquidity is actually a very good way to earn a higher rate of return. A good example is real estate. Most people have homes, and if you live in your own home you’ve got a pretty big illiquid investment, and if you’ve got a mortgage, it’s a leveraged investment. That’s not a bad thing if you’re living in a reasonable area and there’s price appreciation, but it is illiquid. So you have to recognize of your assets what’s liquid, what’s illiquid and how much illiquidity can you tolerate, or rather how much liquidity do you need? For example, to pay for your kids to go off to college or medical expenses, these are the kinds of things that we rarely think about in the context of investing. I think we have to bring it all together and think about them holistically.

Consuelo Mack: Oh, that’s very interesting. So you’re taking a completely holistic approach of all of the assets that you own not just financially liquid assets but real estate. I’m assuming you would put in art, collectibles, whatever, the whole nine yards.

Andrew Lo: Everything.

Consuelo Mack: And try to look and see where you are invested. You’ve launched a new fund at AlphaSimplex called the Natixis ASG Tactical U.S. Market Fund. It is a long-only U.S. equity fund. All right, so here you are. You are a huge proponent of broad diversification, you also run alternative investments. I mean, that’s what hedge funds are, but now you’re running a long-only U.S. equity fund? Explain what that is. It seems to be contrary to what your overall strategy is that you’re recommending for us and that you’ve done your entire professional life.

Andrew Lo: Well, actually it’s pretty consistent with what we’ve been doing, and really we decided to launch it because of requests that we got from existing investors. The basic motivation for this tactical U.S. equity market fund is that it makes use of the insight that during normal times, equity markets do pretty well. During abnormal times, and by abnormal I mean when risk is very high, when the volatility goes up, equities are almost never your friend. And so that insight translates very directly into a very simple strategy where if you’ve got money in equities during periods of high volatility, you should be underinvested in equities, and during periods of normal volatility, you should actually be overinvested in equities in order to compensate for the loss of the equity risk premium during the other periods of time. We’re invested in equities, but we use futures contracts as well as ETFs to provide extra exposure to equities when we see volatility going down and being normal, and when volatility starts to shoot up, we’ll actually go to cash so that we reduce the exposures, but most importantly we get back into equities dynamically as markets begin to recover, and we tend to do it in an automatic fashion so that we’re not relying on human judgment or lack of judgment.

Consuelo Mack: So how is it invested today?

Andrew Lo: Well, today it’s actually invested in equities. It’s completely invested in equities, and the volatility is actually at a pretty reasonable level, and so it’s certainly benefited over the course of the last year from that kind of a position.

Consuelo Mack: So interesting. One investment for a long-term diversified portfolio, what would you have all of us own some of? And I know you are a big proponent of having a very well-diversified portfolio.

Andrew Lo: Well, I would say some kind of managed futures fund mainly because that’s a bit off the beaten trail for the typical investor, so they wouldn’t normally think of it and because managed futures actually provides natural diversification during times of distress. Some people call that crisis alpha, and that’s something that’s hard to come by these days, particularly given the traditional investment products that all seem to point south when the going gets tough. So managed futures, you don’t need a lot of it in order to get the kind of diversification that they provide, but you need to start thinking about it and understanding what the risks and returns are, and that could actually be very beneficial for the typical investor.

Consuelo Mack: Non-correlated. They zig when the rest of the market zags. Five percent, is that enough to have in your investments portfolio to protect you?

Andrew Lo: Well, I think it depends on the level of risk tolerance but somewhere between five and twenty percent depending on age, circumstances, risk tolerance and so on. I think that would be actually a pretty good range to think about.
Consuelo Mack: Andy Lo, it’s so great to have you again on WealthTrack. Thank you so much …

Andrew Lo: Always a pleasure. Thanks for having me.

Consuelo Mack: … for joining us.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point picks up on Andrew Lo’s point that investors biggest mistake is not getting back in the stock market soon enough after a big market decline. The action point is: establish an automatic rebalancing discipline in your portfolio to avoid reacting emotionally to market volatility. As this graph from Vanguard shows semi-annual rebalancing of even a simple balanced portfolio can make a huge difference. Two portfolios, one “drifting” the way many investors have over the last decade and the other rebalanced semi-annually start with 42% U.S. Stocks, 18% international stocks and 40% U.S. Bonds. Both did well in the 2003- 2007 bull market with the drifting one outperforming. Both suffered 32% declines in the 2007-2009 bear market. But the automatically rebalanced portfolio reinvested back up to the targeted 60% stock position from the 2009 market lows whereas the drifting portfolio had gotten out of stocks and stayed out. Staying out of the stock market cost the drifting portfolio mightily with the systematically rebalanced portfolio up 151%, more than twice the gains of the drifting portfolio that failed to get back into stocks after the financial crisis. Vanguard admits this is an extreme example but as Professor Lo said holding cash way too long after a bear market is a common and costly mistake.

On our website’s extra feature this week, Professor Lo will discuss the broad interest he is generating with his mega fund project to battle cancer.

Also in our new WealthTrack Women section we will have updated financial advice specifically for women from our panel of women financial advisors. Have a great weekend and make the week ahead a profitable and a productive one.

CHRIS DAVIS: IT’S ALL IN THE FAMILY TRANSCRIPT

May 9, 2014

Consuelo Mack: This week on WealthTrack, it’s all in the family! Third generation investor Chris Davis shares the investment lessons passed on from his grandfather, to his father, to him at the Davis funds family. The next generation Great Investor, Chris Davis is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. When asked what he expected the market to do legendary financier J.P. Morgan replied: “it will fluctuate”. And so it has, quite a bit! Despite the oft quoted 12% annualized returns of the last fifty plus years, it turns out it is a market of extremes not means. As this chart reveals, which shows the frequency of years the S&P 500 has averaged certain types of annual returns since 1958, the market has never returned its 12% average and has rarely come within even 50 basis points or half a percentage point of it. The most frequent market returns have been at the extremes. In nearly 20 years the market experienced returns of less than 6% a year and in more than 20 years saw better than 18% results. No wonder investors get nervous!

Now the flip side is that despite these extremes the market has climbed inexorably higher over the years, exhibiting some reassuring predictability along the way. Take a look at this chart, courtesy of this week’s guest. Since 1928 there have been ten 10-year periods of poor market performance. Poor is defined as annualized returns of less than five percent. Each poor performance decade was followed by a 10-year stretch of much higher returns. Of interest to all of us, the last 10-years of subpar performance ended in 2011. As we have discussed on recent WealthTracks the biggest mistake investors make is not getting back into the market soon enough, to participate in those strong rebounds after a prolonged bear market.

This week’s guest wants investors to overcome that failing. He is Christopher Davis, a third generation Great Investor who is chairman of Davis Advisors, portfolio manager of the Davis Large Cap Portfolios, as well as co- manager of the firm’s flagship Davis New York Venture Fund among others. New York venture was started by his dad, Shelby M.C. Davis in 1969. Chris took over the reins in 1997. In his youth Davis also worked closely with his late grandfather, Shelby Cullom Davis who made a fortune in insurance and financial stocks. Chris was named Morningstar’s Domestic Stock Fund Manager of the year in 2005 and more recently The Motley Fool named Chris one of its current generation of Superinvestors.

I began the interview by asking Davis how he avoids the classic mistake of mistiming the market.

Chris Davis: Well, I think if you take one sort of generational lesson, it’s that stocks are ownership interest in businesses. And John Train had a wonderful quote, he used to say, “Investing is the art of the specific,” and when you start thinking about owning a business and what sorts of things will make that business more valuable over time, you really stop thinking about what’s going on in the Ukraine or what’s going to be the Fed’s next move. You start thinking about well, can that business open more stores? Can that business get new customers? Can that business enhance its competitive advantages? And once you do that, you stop thinking about all these unpredictable short-term forecasts and you start focusing on what you can have conviction in, which is, what are the competitive dynamics of that business? What will make that business more valuable?

Consuelo Mack: Are there any macro events that you do pay attention to on a regular basis?

Chris Davis: Well, I think you have to invest knowing that the world is an uncertain place; that terrible things and unexpected things will happen. Now of course, very positive unexpected things will happen, too, but nobody should invest with the view that if something happens, a geopolitical event, the formation of oil cartels, world wars, I mean, all of these things have happened during a period of time where the American businesses have still made progress decade after decade after decade. So you have to invest knowing that the world is uncertain, and when you do that you start thinking, well, am I owning a business that can withstand unpleasant, unpredictable events? Does it have too much debt? Does it rely on short-term financing? Is it something that couldn’t survive dislocation for some period of time? Well, when you invest knowing that that’s the world that we live in, then it becomes not about when to invest but what sorts of companies to invest in, and that to me is a much more useful way to think about risk management than trying to predict the unpredictable.

Consuelo Mack: And yet as an investor it’s one thing to say we invest in companies which you do long term. Then there’s the other aspect of that is you’re investing in these stocks as well of companies and stocks do go up and down, and stocks are affected. We just came through a major financial crisis, probably the worst financial crisis that you and I have had in our lifetimes in 2008 and 2009. How do you react to that? I mean, were there any lessons that you learned from that as an investor.

Chris Davis: One of the most powerful lessons of the financial crisis in a way was resiliency. How many businesses continued to generate profits, generate revenues, generate growth through that period. In a funny way, here in New York we can think back to the events of 9/11 and what a dislocation that was, and yet here we are in this lesson of resiliency, you know, this enormous ability to come back to make progress. So what I would say is this is that the price fluctuations are there to serve you. They are not there to instruct you. They’re there so you can take advantage of them.

Consuelo Mack: One of the things that you’ve said in other interviews is that it’s not only your brain that’s important as an investor but your stomach is probably the second more important organ. Talk to me about how you handle your stomach.

Chris Davis: Well, I think there are certain tricks that you can work with as a way of framing the issues that can help. One is always to stretch out time periods, and the time period could be the period at which you look at price returns of stock. If you had taken a vacation in 2005 and came back today, you wouldn’t think there had been a huge dislocation. You would just sort of think the businesses have sort of flopped along, and you’ve earned some dividends along the way, and so the longer your time measurement horizon, the less you see that volatility. It shrinks in terms of noise, so that’s important.

Slowing down the decision making process. One of the things I tell investors all the time is usually it’s the case that when you want to get into the market, prices have already gone up a lot, and when you want to get out, prices have already gone down a lot. That’s usually the … so how do you fight that? Well, it’s easy to say, “Don’t do that”, but that’s like saying buy low, sell high…it sounds easy. But what you can do is average in. Systematic investing is such a powerful tool for minimizing the impact of emotions. I even had a family member who came into some money and was looking at what to do. I said, “I know you’re going to overreact. If you get invested today 100 percent and the market goes down tomorrow, you’re going to be calling me every week saying, “What am I doing? What should I do?” I said, “If instead you get in evenly, maybe over the next three years just do a certain amount every month, every quarter, every year, you’ll take your emotion out, and that way if the prices go down, you feel, well, I’ve only just got started. I don’t need to be nervous. If prices go up, you’re glad you got started.” Systematic investing works so well, and it’s just amazing that more people don’t do it, but of course through their 401(k) plans they are.

Consuelo Mack: Chris, as we said in the introduction to you, you’re the third generation Davis investor, and I know you worked with your grandfather. You worked with your dad. Where did this sensibility of investing in businesses and not stocks come from?

Chris Davis: You know, it really started with my grandfather. It’s an exciting story to us because we’re in the business. It’s not that titillating a story outside because it was really about his insights into the insurance industry. He was an insurance regulator, and one of the things he noticed was that these businesses that were growing as the soldiers came home from World War II and the baby boom was underway and the suburbs were being built, these soldiers were coming back, and they were buying life insurance, but the accounting for life insurance in those days was such that the big commission that the insurance companies paid upfront, the expenses of putting that policy onto the book meant that they reported a loss in the first year for each policy they sold, and so the companies that were growing the fastest looked like they were losing money, and this is where he developed this idea of owner earnings. He said, you know, if you own a business you have a much better understanding of what the true profits are than if you’re just looking at GAAP accounting or random financial statements, and so he really got at this idea of focusing on the business and the economics of the business, trying to look beyond perception, and I think the second big part of his insight was the quality of the people, that businesses are really collections of people, ideas and capital, and that focus of where a great manager can take a company over a generation, that’s something he really, really taught my dad and that my dad constantly reminded me of. Just watching where an entrepreneur can take a company over 30 or 40 years, it’s just fantastic. So those were the big insights I think.

Consuelo Mack: Who are the great managers now? Obviously you’ve been a long-term shareholder of Berkshire Hathaway, so Warren Buffett would be one of them, but everybody knows about Warren Buffett. So who are the other great managers that you’re investing with now at the Davis Funds?

Chris Davis: Well, one of the great books that all of your viewers should read is a book called The Outsiders, and what’s fascinating about it is it’s a profile of nine executives who ran businesses where they understood the capital allocation part of the business, and often that is misunderstood.

Consuelo Mack: And explain the capital allocation part of the business that’s so important.

Chris Davis: Well, what we always say is if you own a business and the business produces earnings, at the end of each year you have some choices of what to do with those earnings. You could pay it out as a dividend. If your shares are under value, you could buy in stock. But of course if you’re running a business you have some other choices too, you could issue debt, you could buy other companies, you could issue shares.

Consuelo Mack: Reinvest in your business.

Chris Davis: You could build factories and so on, and what often happens is managers, when they’re in that role, want to just keep getting bigger, and they don’t think about the return that they’re getting when they buy another company. They just think about the fact that they’ll be bigger, and so a lot of value is destroyed by executives that think about size but not about value and value creation.

Consuelo Mack: Who was your favorite outlier?

Chris Davis: Well, I mean, of course Warren was, but when I think over time you think about companies like Leucadia which was not a household name, incredibly well run, enormous value creation. One of the things we’ve done at our company is we’ve thought of if you were going to write that book 15 years from now, who might be in it? And it’s a very interesting question. I mean, I love the companies we own because I think they combine decent businesses with thoughtful capital allocation, and there are some unusual ones.

Consuelo Mack: So let’s talk about some of the companies that you own that kind of exemplify that next generation of great managers that you want to invest in.

Chris Davis: Well, I’d divide the companies we own into a couple of categories. So we own companies where we think the business is very durable. The cash that they generate is predictable and that management can be trusted to do something sensible with it. Now these aren’t going to be galloping off enormous growth companies but our largest company, Bank of New York for example, would fit that category. And we think …

Consuelo Mack: Predictable earnings, Bank of New York.

Chris Davis: Predictable, durable business, 250 years old and it has the word “bank” in the name so people get nervous.

Consuelo Mack: Yes, it does, but it’s really not.

Chris Davis: It’s a processing company. If you think about the financial markets as if they were a city, what Bank of New York does is maintains the plumbing. It really is simply … it does custody and trust work and bond indentures and ADRs, and but all of these are processing.

Consuelo Mack: Boring but essential.

Chris Davis: Essential and all generate decent returns on capital. So generates this cash. It has enormous amounts of capital. It has very little credit risk and so that would be an example. My father used to call these boring but beautiful.

Consuelo Mack: Because the culture of Bank of New York is such that their successors, their management will have that sort of culture, boring but beautiful. That’s what you’re depending upon.

Chris Davis: Well, and not just that, Consuelo. They did the merger with Mellon and they did some other ill-timed mergers that I think sometimes you learn the lesson by touching the third rail.

Consuelo Mack: So that’s one kind of company. What’s the other kind? What are the other kinds?

Chris Davis: Well, I go from that’s our largest holding, so I should talk about our second largest.

Consuelo Mack: Google.

Chris Davis: And it’s Google. Now there you have the other side of it. You have a young management team. You know, I’m afraid they are younger than me.

Consuelo Mack: Very few are.

Chris Davis: With a fabulous, enormously protected competitive position, and with management that likely will be there for another 20 years or 30 years, and yet the valuation of the business is about 20 times earnings. Now when people talk about a multiple of earnings, what I always say to viewers, invert it. Think about it as an earnings yield. Right? So a 20 times earnings, if you turn that upside down, that means for every dollar …

Consuelo Mack: So not price/earnings but earnings over price.

Chris Davis: Exactly, and so what that means is when you buy the shares, the amount of earnings they generate relative to the price you pay is about five percent as a yield. So you think about that in a sense as your yield, and then the question is, are they doing sensible things with it? Now I think that they do understand competitively their businesses better than almost anybody I’ve seen. People like to say acquisitions are dangerous. We think acquisitions are dangerous, and yet they did a brilliant acquisition of YouTube and, of course, they bought the company that created the operating system, Android, for the vast majority of phones on earth. So they have been incredibly visionary and incredibly thoughtful about how they protect this competitive business, but if you were to say, is that a business that in 10 years from now is almost certain to be more profitable than it is? I would say so, and that’s unusual in technology. That’s one of the big changes in the world is that with the Internet there have been new blue chips created. I’d put Amazon in this category. We own just a little bit of Amazon, but without question Jeff Bezos is one of the great executives of a generation and has built one of the great companies, and I would defy anybody to give me a scenario where Amazon is a smaller company 10 years from now than it is today.

Consuelo Mack: Large does not necessarily mean quality to parrot what you said earlier.

Chris Davis: That’s true, so I would …

Consuelo Mack: And how profitable is Amazon and their business model?

Chris Davis: It’s a great question. I mean, this goes back to what I said about my grandfather and owner earnings. I think one of the very interesting things to think about is how much could Amazon earn if they were not reinvesting for growth? And so right now they earn very little money. Amazon is investing to protect and build their competitive advantage and build the value of the company over time. So we think it’s a very sensible thing to do, and so it is an unusual thing to look at our portfolio and see that we have stalwarts like Bank of New York, American Express, Wells Fargo, Berkshire Hathaway. These are sort of global leaders. They’re blue chip companies. People are comfortable with owning them, but we also have owned companies where we see them in a sense as the future blue chip companies. Some of them have higher growth rates like Google and in this case a little bit of Amazon, and they aren’t as well understood because of that. A lot of value investors won’t look at them, but what we believe is that growth is a component of value. Companies that grow profitably are more valuable than ones that don’t, and we don’t understand why investors try to create this distinction where they say it’s a strange thing for one investor to be simultaneously interested in United Health or American Express and at the same time see value in a company like Google.

Consuelo Mack: So those were two types of companies that you were just talking to. Was there a third type?

Chris Davis: Well, I think there’s always a type that we call “out of the spotlight”. These are companies that aren’t so well known. They aren’t household names but they’re often in dull businesses but with great economics, and there can be smaller companies, so we have this category that we call “out of the spotlight”, and you might have companies in there. Well, in New York like the Loews, the Tisch’s company.

Consuelo Mack: Conglomerate.

Consuelo Mack: Hotels and casinos.

Chris Davis: Hotels and Markel Insurance, companies like that, great records of long-term stewardship but not necessarily household names, and I would even give you one last category which is the category that’s hardest for all, and this is the category that we call “headline risk”. These are companies where your viewer hears that you own them, and they say, “Oh, god, that sounds so terrible. It sounds controversial,” and what we feel is over time investors should have the stomach to look at businesses when they’re under a cloud of controversy. So in the ‘90s it might have been in tobacco, for example.

Consuelo Mack: With all the litigation.

Chris Davis: People didn’t want to look at Philip Morris and yet it was an enormously great time to invest. Well, what about companies like Tyco when it went under its cloud?

Consuelo Mack: Your biggest headline risk company now is … ?

Chris Davis: Well, I would probably say it’s in the health insurance area. I think when you own a company like United Health, I think what happens is people say, “Well, what about Obamacare? What about what’s going on with nationalization of health care and so on?” There’s a lot of controversy. There’s a lot of misunderstanding. There’s a lot of regulatory risk, but I would also put in some of the financials. I mean, we own JPMorgan, and I think I’ve met Jamie Dimon maybe the year I started in this business when he was still the number two guy at a company called Commercial Credit.

Consuelo Mack: Your view of JPMorgan at this point as an investment?

Chris Davis: Oh, I have a very high regard for JPMorgan, very high regard for the management, for the necessity of what they do, for the thoughtfulness, and when you see these things like the London Whale that are very upsetting to people, one of the things that I found very reassuring about that was how well the company reacted. They got the news out as fast as they could. They communicated honestly with shareholders. I would say an interesting thing to recommend is annual reports, because most annual reports have become marketing documents. You know, there’s no sense reading them. They’re just written by an investor relations department, but every year there are a handful that are really worth reading. Well, of course, Berkshire’s is worth reading. I would highly recommend that every viewer read JPMorgan’s annual report, and you could go back and start the year that Jamie Dimon became CEO of Bank One and read his first annual report as a CEO and read every one since. It’s honest, thoughtful communication about the environment, about the businesses, about the strengths and weaknesses. So I’m very comfortable, but I would view that as a company full of headline risk, and so that sort of thing, when you think about annual reports as … and by the way, I would read Amazon’s.

Consuelo Mack: So Jeff is really a creative thinker.

Chris Davis: And one of the interesting things is in every annual report he reprints his first letter to shareholders from 1998. It’s an outstanding pledge of these are the principles of how we will run the company, and he has really stuck by those.

Consuelo Mack: Let’s talk about how you are judged at the Davis Funds from outside investors, and one of the things that you want is returns in excess of the S&P 500, and if you look at your Venture Fund, for instance, which started in 1969, since inception and through many, many periods it has had excess returns to the S&P 500. You’ve just come through a period of time where it has not, for instance, the last ten years and five years. Last year, 2013, you did once again surpass the S&P 500. Why have you underperformed your benchmark, and also how do you handle that?

Chris Davis: Well, of course, when times are good we used to always put in our annual reports, we’d always say periods of underperformance are inevitable. We will go through bad periods, but of course when you’re doing very well, that just sounds modest. When you’re not doing so well, it sounds defensive like you’re making excuses. We don’t want to make excuses. You know, our money is invested alongside our clients, so we eat our own cooking, and so we are aligned. We have complete incentive system to generate the results over time. So when we lag an index, we know we will go through periods of that. It’s part of active management. You have to be willing to look different, and that means sometimes that looking different will lead to periods of underperformance. Now in our case, it was exacerbated by the financial crisis. We’ve always had some …

Consuelo Mack: Because you had heavy investments in financials.

Chris Davis: We did, and amazingly virtually all of them came through not only unscathed but are generating record profits. American Express, Berkshire, Wells Fargo, JPMorgan, but we also had a big holding in AIG, and that was a catastrophic loss.

Consuelo Mack: Right, and that really hurt you. So that legacy is still …

Chris Davis: That legacy is still in the numbers. So we have to grind through that. I mean, that is just the fact of it, but I would say that we do have a high degree of conviction that the performance of the businesses we own has been better than the performance of the stock prices of the businesses we own. So the value of the businesses over the last decade have grown more than the stock prices.

Consuelo Mack: And that’s what matters to you.

Chris Davis: And that gives us a lot of confidence about the future.

Consuelo Mack: Last question, one investment for a long-term diversified portfolio. What would you have us all own some of in a diversified portfolio?

Chris Davis: Well, I’m going to cheat and say the two that we spoke about because, you know, we ….

Consuelo Mack: Bank of New York and Google.

Chris Davis: We have low turnover. We’re going to own these for a long time, and so I feel it would be wrong for me to talk about my tenth largest holding. I should talk about the ones that I own the most of, and I like that as a pairing. I think they’re both wonderful leaders in totally different industries.

Consuelo Mack: Chris Davis, such a treat to have you back on WealthTrack. Thanks so much for joining us.

Chris Davis: Thank you so much, Consuelo.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point follows Chris Davis’ advice to invest systematically. Most of us do it automatically in a 401 k plan where money is deducted from our regular paycheck and invested. But any investing outside of that is subject to market timing and the state of our emotions towards the market. Davis recommends investing equal amounts of money at regular intervals, very month or quarter for instance, which will insure that we are automatically purchasing more shares in down markets and fewer shares in up markets. This kind of disciplined approach can save us from the classic mistake of buying high and selling low.

Next week we will introduce you to a new Great Investor for us. Chuck Akre will explains how he finds “compounding machines,” companies that produce high rates of returns for shareholders in his five- star rated Akre Focus Fund.

In the meantime on our website we will have more of our interview with Chris Davis in our extra feature and in our new WealthTrack Women section our team of award winning women financial advisors will share specific steps they take with their female clients to develop a financial plan.

Have a wonderful Mother’s Day weekend and make the week ahead a profitable and a productive one.

 

CHARLES ROYCE: CHANGING MARKETS

April 25, 2014

Consuelo Mack: This week on WealthTrack, an embarrassment of riches! Legendary value investor Chuck Royce says there are treasures to be found combing the global beach for high quality small company stocks here and abroad. Great Investor Chuck Royce is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. Talk to any financial advisors and they will tell you that many of their clients are just starting to recover psychologically from the beating they took during the financial crisis. Five years from the 2009 market lows individual investors are just now considering getting back into stocks or adding to their stock portfolios. The question they are all asking is: is it too late to get back into the market? What’s luring them in are the super-sized returns of the last five years… The S&P 500 clocked in 20.5% annualized returns. The small cap- oriented Russell 2000 nearly 25%. Look at just about any stock mutual fund category and the five- year annualized returns are spectacular. U.S. Large-cap core funds nearly 20% annualized returns. U.S. Mid-cap core funds over 22%. U.S. Small-cap core nearly 25%. Being a bear was a killer- dedicated short funds, which bet on prices going down had annualized returns of negative 35%. And investors who fled to the safety of cash got just about nothing. Five year annualized returns for money market funds were a miniscule three hundreths of a percent!
This week’s WealthTrack guest warns not to read too much into these outsized stock returns. They are not indicative of future performance. They represent a slice of time off a severe market bottom. He is Great Investor Charles “Chuck” Royce, a pioneer in small company stock investments. He is president, director of investments and portfolio manager at the value and small-cap oriented Royce Funds which he founded in 1972. His flagship Pennsylvania mutual fund has outperformed the Russell 2000 for the last 10, 20, and 30 year periods. The fund has delivered impressive 14.5% annualized returns over the last 40 years. I began the interview by asking Royce about one of his investment truism “that the markets are cyclical”.

Charles Royce: You should expect for markets to have market cycles, i.e., there will be ebb and flow. There will be corrections on the order of certainly maybe once a year, once every year and a half, over a course of five years, maybe a full market cycle or two. So these things are just not in a straight line. We just had a straight line moment, though, from the bottom, and to some extent that’s extremely misleading as to what’s likely to happen.

Consuelo Mack: You’re right. We recently hit the five-year mark exactly from the market bottom, and all of us are looking at our mutual fund portfolios and saying, “Wow, they’re compounding at X percent a year, 20, 30 percent, whatever,” and you’re saying this is a moment in time.

Charles Royce: Well, it’s completely artificial. There is no measurement period that should measure just from the bottom to the top. That would be silly. You want to measure over an adequate period of time. Five years most of the time should be an adequate period of time but in this case not. So from a market peak to a market peak would be the ideal way to measure things, but we measured from the bottom.

Consuelo Mack: Where are we in the market cycle now as far as the overall market?

Charles Royce: We are in a different phase. I believe this run-up phase, the straight line phase is over.

Consuelo Mack: Is the market expensive now? How would you characterize the overall market and the small cap market?

Charles Royce: That’s a really tough question. The issue with valuation is ideally you’re looking out three years, five years and then sort of discounting back. I’m an optimist. I believe this economy is bumping along at a reasonable pace, sometimes a little slow, sometimes just right, and I believe that will continue. I’m optimistic, and I do think that valuations for a decent section of the market, it’s very, very good. Certain sections, the speculative sections are overpriced.

Consuelo Mack: You are optimistic about the U.S. economy specifically.

Charles Royce: Yes, yes.

Consuelo Mack: What are you looking at that is telling you to be optimistic?

Charles Royce: Well, I think we’ve made progress in the sort of important areas. The area that I don’t think is critical is the employment level. I know that’s a focus of the administration and a focus of the Fed, but I think that’s unrealistic to say that should be your primary benchmark. The stock market is a very good indicator often of economic progress, and the stock market of course has responded very favorably. So I’m optimistic for a lot of reasons. Our relative economy is doing well in the world. I’m optimistic about the rates returning to sort of normal, and it’s done that in a little bit. So I’m optimistic for a lot of reasons.

Consuelo Mack: One of the things that you’ve been telling clients is because you are optimistic about the economy that you expect quality stocks, number one, to take over leadership in the market and also that small cap stocks should flourish as well. Why are they linked?

Charles Royce: Well, they’re not necessarily linked, but most people can’t figure out what small stocks are. Are they quality? Are they biotech? Are they this or that? Are they technology? So there is kind of a blur around small stocks. There is a component of small companies that we favor as a theme. We have some specialized funds that do quality only, and we have some broad funds that do a lot of quality. So quality is very important to us. Quality has underperformed dramatically since the bottom. It’s underperformed because this monetary stimulation gave preference to the inferior company. The company losing money, the company with high leverage was able to cure thyself. It was able to use a junk bond offering, was able to refinance debt. Those stocks that let’s call it losing company, inferior company, let’s call it a five dollar stock, went up to 25, went up four or five times.

Consuelo Mack: Big gains.

Charles Royce: A quality company that we typically owned that survived the financial crisis very well did not have the benefit of refinancing because they didn’t need to refinance. So that call it hypothetical $20 stock only went up to 40.

Consuelo Mack: That’s starting to change now in that the value companies and the quality companies are starting to lead. Is this a turning point, and why is it happening?

Charles Royce: It’s absolutely a turning point, and it started about this time last year. Around May 1st the 10-year Treasury bond was at 150, and as there was conversation at the Fed level about maybe they will slow down the purchasing of securities, tapering, there was an immediate reaction in the marketplace. The 10-year bond went from 152. It hit three percent. It’s pulled back a little bit, but there was an immediate reaction which completely shifted the tone in the market. Quality stocks have done better since then. They’ve done a lot better this year. So I truly believe leadership has shifted and that it will persist for a long time.

Consuelo Mack: And when you talk at Royce about quality, what do you mean?

Charles Royce: Quality for us is probably an unleveraged company with high returns on capital. Returns on investment is a wonderful, simple metric to measure quality.

Consuelo Mack: Chuck, one of the take-aways of the financial crisis was that macro matters, and the markets were moved by macro headlines, and it overshadowed what was actually happening at the fundamental level with the kind of companies that you invest in for instance. What headlines do matter? What macro events do you pay attention to and which ones should we not pay attention to?

Charles Royce: Most headlines you shouldn’t pay attention to. Of course there are macro elements that become critical over time. The financial crisis is a great example of that. There was probably more warnings that we all could have paid more attention to, but in general I think headlines actually are distracting. They’re irrelevant. They do not provide you any market information, so I’m actually a skeptic about how important macro really is day to day.

Consuelo Mack: What do you pay attention to? Fed tapering, clearly you pay attention to.

Charles Royce: We get our economic information from our companies. So we see companies every day, and of course we’re asking about what are they seeing. What are they feeling? What are they hearing? What are their own plans? Are they planning to start capital expenditures, et cetera? And that’s our input source. That’s better than an economist.
Consuelo Mack: And is that company by company on a very micro level, or are you getting impressions now from what your companies are telling you about the economy, the outlook, business spending, whatever?

Charles Royce: We certainly ask those questions, and they give us their feedback. In many ways they respond to headlines, too, so of course there’s a sort of feedback loop here, and it’s not all accurate, but ultimately the economy depends on what corporations are doing. Are they hiring? Are they spending money? Are they thinking about M&A? So we have that conversation, and that’s how we incorporate macro into our thinking.

Consuelo Mack: And what are you hearing as far as attitudes from companies and their plans about M&A and capital investment? Is it positive?

Charles Royce: The capital expenditure cycle has not started. I believe it will start momentarily. I think we’re going to see sort of signs of elements of that very shortly, but I have not heard that from the companies we’re talking about. They’re very interested in M&A. They’re certainly dancing in the M&A world. You can see that in lots of different ways. So I think cap ex comes next.

Consuelo Mack: Let’s talk about index funds, passive investments. They now account for about a third of U.S. equity funds for instance. They’re now index funds or ETFs. What’s your view of that competition?

Charles Royce: They are the new kid on the block. They work well in markets of exactly the kind of market we’ve had, a straight up market. A straight up market is ideal for passive investment. There is no corrections to worry about. There is no cash to worry about. You just stay fully invested and you do very well because the market does very well. Now, that market is over. That particular phase of markets are over, and I believe the glamour around ETFs will fade as we move into a more normal volatile market environment.

Consuelo Mack: Your first job you’ve said many times is to protect principal and not lose money. When you look at an index fund or an ETF for instance, there is no one there who is trying to protect your principal from losing money. They’re going to do what the market does. So talk to me about how you protect principal as an active manager.

Charles Royce: Active managers perform a wonderful role. They should be risk managers. They should be taking into consideration at all times the risk/reward of the investments they make. They should think about how much cash position is appropriate for the market cycle. Obviously a passive system doesn’t do that, so I very much believe that active management especially in the small cap universe is the only way to go. There are many, many active managers. We’re one of them. I expect them to do a lot better in a lower return environment.

Consuelo Mack: And why particularly in small cap companies?

Charles Royce: Because small cap companies have such breadth to them. There are thousands of small cap domestic companies, five, six, seven thousand companies, and if you think about globally it’s 30 or 40 thousand companies. So there’s so much to do, and an index will never demonstrate the opportunity set that a full look does.

Consuelo Mack: You are known as a small cap pioneer. You identified initially U.S. small companies as a class of companies that actually deserves to be an asset class of its own that has certain characteristics. So first of all, what are the characteristics of small cap companies that we should know about?

Charles Royce: The domestic class, which is what we’re principally involved with, is in this 5,000 plus universe. It’s a very evergreen universe. There’s always new companies. There are two to five hundred IPOs a year. There are spin-offs all the time. There are big companies that trip and become small companies. So there are at any given year 500 or so new entities. That’s the wonder of it all. That’s what makes it an evergreen universe. That’s what makes it so excellent as an investing set.

Consuelo Mack: And has it become in the 40-some-odd years that you’ve been running the Royce Funds, has it become significantly diversified that it’s not acting as an asset class anymore?

Charles Royce: No, I think the opposite has been true. Actually because we had this financial crisis, because we’ve had a straight up market, it would have the appearance that all the stocks have operated together. It really hasn’t been that way. Active managers have underperformed. We have underperformed in general.

Consuelo Mack: In the last three years.

Charles Royce: In the last three years or so.

Consuelo Mack: Because five years I looked at the Pennsylvania mutual fund, and five-year annualized returns it’s about even with the Russell 1000. Ten-year annualized returns, ten percent versus nine percent annualized returns, and 15 years it’s over eleven percent versus under eight and a half percent. So over time, you as an active manager have definitely outperformed the market by significantly bigger margins.

Charles Royce: Well, I appreciate that, but in fact our goal day to day is to deliver strong absolute returns, and then as this takes place over time, we like to think that strong absolute returns will beat relative returns, but there has been a period where we have underperformed on a relative basis in the last three years or so. I think that’s turning as we speak because quality is doing much better in this year, much better since the peak, much better in the last 11 months.

Consuelo Mack: There is another area of small cap investing that Royce is getting involved in, and that’s investing in international small cap companies which you’ve actually written that it almost could be another asset class.

Charles Royce: I absolutely believe that international small cap investing is exactly where domestic small cap investing was 20 years ago, so I believe this is a wonderful opportunity for most investors to think outside of the U.S. and to think about international small cap as potential source of returns. We believe that. We’re actively doing it.

Consuelo Mack: Is this because we’re just discovering that there are all these small cap publicly traded companies in foreign markets, or have they been there all along, or are they new? Are there more of them now, or what’s going on?

Charles Royce: There are not necessarily more of them now. As a society we’re a pretty provincial society, so we just haven’t thought globally until recently, until the last five or ten years. So it is an opportunity for us, but it’s always been there, and I think it will be a permanent asset class, international small cap, in the same way domestic small cap is.

Consuelo Mack: Well, we recently did a webcast with David Nadel who is your Director of International Research at Royce talking about Royce rediscovers India. He had just returned from his umpteenth trip to India. What are the other areas that you’re finding that are particularly fertile for investment in the small cap area?

Charles Royce: We love Europe. We’ve been very active. That was probably our first adventure into small cap land, so we’ve loved … and they’ve been very successful, these premier industrial often northern European companies that represented just extremely high quality, very global companies that operated around the world but from Europe.

Consuelo Mack: And a lot of them are family owned? Is that correct?

Charles Royce: Many of them are family owned. Many of them are exactly what you would look for, high returns, very good governance, dividends, excellent prospects, sort of niche products, and they’re very active in the emerging markets.

Consuelo Mack: You mentioned dividends. Of course, investors have been looking for dividend- paying stocks. We don’t typically think of small company stocks as paying dividends, but in fact that’s yet another class of small company stocks that you’re also mining and investing in at Royce.

Charles Royce: There’s no question about it. People think small companies are just sort of biotech or fancy or high growth or speculative, et cetera. In fact, there are plenty of stable dividend-paying companies. We have a theme and a few funds, our Total Return Fund and Dividend Value Fund that specialize in dividend-paying companies. We can capture I believe very decent returns, maybe not the tippy-top returns, with far less volatility in using these dividend-paying companies, and there are plenty of them, and we love finding them.

Consuelo Mack: Chuck, do you have a favorite company or two that exemplified the kinds of companies that Royce invests in over time that you’re investing in now that are in one of the many portfolios that you run personally?

Charles Royce: Sure. There would be maybe two good examples. Lincoln Electric. They are in the welding business which sounds like a pretty narrow business.

Consuelo Mack: Woo!

Charles Royce: But it’s a very wonderful business. They are a global company. They are located in the Midwest in this country, but they have a global reach. They understand the right way to allocate capital, and it’s a very typical company for us. It’s in many of our portfolios. Another company in the financial services business that we like which is not a bank … we have not loved banks. We didn’t love them before the financial crisis, and we don’t love them now … is an asset manager called Federated Investing which is located in Pittsburgh, and they specialize in money market funds. Interest rates have been horribly low, and that has impacted them, but I believe interest rates will do fine over time, and they have actually consolidated their position.

Consuelo Mack: Royce Funds runs well over 20 funds, and you’ve just mentioned some of them. I mean, they’re premier. They’re micro-cap. They’re dividend funds. They’re international funds. Is there one particular area of fund, Royce Funds, that you think has exceptional opportunities above the average Royce Fund for instance at this point?

Charles Royce: Sure. Our quality-based fund, Royce 100. Lauren Romeo and myself run that fund. It specializes in superior companies where we have high conviction, and it has underperformed somewhat in the last three years as this whole quality theme has underperformed, and I believe it is an outstanding possibility for the next three to five years.

Consuelo Mack: So quality is going to count.

Charles Royce: Quality has turned around, and quality is going to be the leader.

Consuelo Mack: Final question. One investment for a long-term diversified portfolio, and of course you cannot recommend one of your funds. What would you have all of us own some of in a diversified portfolio?

Charles Royce: You must think active management. So my recommendation on that question is pick an active manager with a great long-term record. Active management will come back into play as markets go through a much more normal volatility period just as we’re having right now.

Consuelo Mack: Chuck Royce, thank you so much for joining us on WealthTrack.

Charles Royce: Thank you.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point borrows some research from Morningstar’s Russell Kinnel which fits into a frequent WealthTrack guest theme. This week’s action point is: buy some unloved sectors of the market. For the past 20 years Morningstar has tracked the annual performance of the most heavily sold mutual funds, which they call the unloved, vs the most bought categories…the loved. Using a 3-year holding period, the unloved funds returned an annualized 10.4% vs 6.4% for the most loved. Kinnel recently looked at what investors fled last year in his monthly fund investor newsletter. What were the unloved categories of 2013? Kinnel says there were large redemptions in large-growth, commodities, and precious metals funds. Among Kinnel’s recommendations in each unloved category are: Primecap Odyssey Growth, which he calls one of the best growth funds around. Harbor Commodity Real Return Strategy run out of PIMCO, because of transaction costs he recommends holding it in tax- sheltered accounts. And in precious metals, Oppenheimer Gold and Special Minerals Fund. With a nearly 48% loss last year, Kinnel says it is the epitome of unloved. Kinnel recommends holding the unloveds for a minimum of three years. Next week we will sit down with MIT professor and hedge fund manager Andrew Lo, a financial thought leader who is working on strategies to make us better investors despite ourselves! His latest MIT project: Artificial Stupidity! You won’t want to miss that conversation.

For more of our interview with Chuck Royce, including his views on high-frequency trading go to WealthTrack.com and click on the extra feature.

Plus in WealthTrack Women, our panel of female financial advisors will discuss how women differ from men as investors.

In the meantime, thank you for joining us. Have a great weekend and make the week ahead a profitable and a productive one.

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