What Every Investor Should Know About Valuations ft. David Giroux

[00:00:08] David

Leveraged loans in combination with Treasuries, together, are kind of the peanut butter and jelly sandwich of the fixed income market, if you will. Because think about this. You know, leveraged loans do well when rates are rising. The Treasuries do well when rates are declining. So, they help offset each other a little bit there.

So, if you put loans together in a portfolio with Treasuries, again, you get the combination of those two things, the peanut butter and jelly sandwich, generates really good risk returns.

[00:00:42] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:38] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle. We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:22] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by David Giroux. David is an award winning Portfolio Manager at T. Rowe Price. He’s a six-time nominee and two-time winner of Morningstar’s Fund Manager of the Year award.

He is the Portfolio Manager of the Capital Appreciation Fund and the Capital Appreciation Equity ETF, and Co-portfolio Manager of the Capital Appreciation and Income Fund at T. Rowe Price Investment Management. He’s been with the firm 26 years. He’s head of investment strategy and also CIO for T. Rowe Price Investment Management and he’s also the author of Capital Allocation. So, David, it’s a pleasure to have you with us. How are you?

[00:03:02] David

Good, good. Thank you, looking forward to the discussion today.

[00:03:05] Alan

Good stuff. Well, as I mentioned, you’ve been with T. Rowe Price I think for all your career.

But how did you get interested in markets and investing in the first place?

[00:03:15] David

I became a finance major my sophomore year of college and I started reading a lot of books about investing. Actually, that’s probably how I got a job at T. Rowe Price.

I think I read like 40 books on investing by Ben Graham and Warren Buffett, and really just found my passion in life with regard to investing. And again, I joined T. Rowe Price in ‘98 and became an analyst two years later, covered autos, industrials.

And then in ‘06 I was asked to manage the Cap Appreciation Strategy, or fund, at the time, and have been doing that ever since. And, as you mentioned, we’ve kind of launched a couple other products along the way that are similar in strategy. Maybe just a little bit of slight difference in asset mix. And it’s been an exciting 26 years.

[00:04:15] Alan

Absolutely. It’s always interesting times and markets, but we’ve seen some interesting shifts over those 26 years, I’m sure, which we might get onto in a while. But maybe just to set the scene a little bit, you mentioned the different strategies and funds. Some are, I think bonds and equity, some are equity only. So, maybe if you could give us a sense of the strategy and the kind of the size of the portfolio and any constraints.

[00:04:39] David

Sure. Probably the biggest strategy is the Cap Appreciation Strategy, that strategy is of $95 billion in assets. It’s a traditional balance strategy, although the asset allocation is a little bit different. We tend to have a little more high quality, high yield, high quality leveraged loans, you know, to be a little bit less Treasuries, really not any mortgages on the fixed income side. And we try to run the equity sleeve a little bit less aggressive than that of the average balance strategy.

You know, we’ve had a very good track record over time on that strategy and that kind of led us to launching, in 2023, an equity only strategy that, you know, a couple more names, you know, more like a 100 name portfolio, you know, with it with a goal of basically trying to output the market every year. A goal of having a little bit less risk and having better tax efficiency than an S&P 500 index strategy.

So, we’ve been running that strategy. It’s a little bit more than $4 billion in AUM now. And then we launched a Cap Appreciation Income in partnership with our quant team and Farris Shuggi. And that strategy is a couple hundred million dollars in size, but it’s kind of the inverse, little more conservatively run balance strategy.

That’s a strategy with more like 40% equities, 55% fixed income, and currently about 5% in cash, but a little bit more conservative relative to CAF, the mothership, if you will. But in all, a little bit around $100 billion in assets – three main strategies.

[00:06:11] Alan

Good stuff. And obviously, within the larger Capital Appreciation Strategy, you have the facility to be quite dynamic and responsive to market changes. And in terms of that equity allocation, how high or low could that get over time?

[00:06:25] David

Yeah, it’s a great point. I think what we typically are doing something very, very different than most managers. During COVID we put $9 billion to work when we were only about a $50 billion strategy. We went from 15% cash to 2% cash. We went from 55% equities to 72% equities, basically in a month in 2009, 2011, 2015, 2016, 2018, 2020, 2022. When risk assets are cheap, we will buy those risk assets aggressively. Whether that be equities, whether it be high yield, these leveraged loans. We’re zagging when the market’s zigging, if you will. We are adding to risk assets when risk assets are cheap, and we’re pulling back from risk assets when risk assets are expensive.

[00:07:13] Alan

Okay. And I read somewhere that a quote, I think was attributed to you, that you were probably as negative about the S&P 500 as you’ve been in a long time. Without putting words in your mouth, is that correct?

[00:07:27] David

Yeah, I think that was a comment we made. I think it was coming from the Barron’s roundtable discussion earlier this year. And it’s simply a function of 2 years of 20% market returns at a time where S&P earnings have not been nearly 20% a year at all. I think earnings this year will end up… Earnings in 2024 grew more like 10%, and earnings was less than 10% in the year prior.

So, we just have a lot of multiple expansion, a lot of high expectations in the marketplace. And I think regardless, wherever you look, there’s not really great value, unfortunately. Cyclicals were pricing in a pretty big recovery. The AI trade was, you know, in full throttle, if you will, very, very, maybe a little bit extended, if you will.

And then you had some kind of Nifty 50 stocks. The cost, because of the world, that used to do for 35 times, 57 times early. Walmart used to be 25 times earnings. That rate for 37 times earnings. And so there was very, very few pockets of opportunity in the marketplace.

So not only was the market expensive at 22 times forward, but if you go cyclicals, retail names, these Nifty 50 stocks, AI, there wasn’t much area of good value in the marketplace outside of maybe healthcare and some idiosyncratic names.

Usually, sometimes when you have a situation where one area is really, really in favor, other things are really, really cheap. This time, almost all parts of the market were kind of a rising tide driving all stocks higher.

[00:09:01] Alan

Yeah, interesting. I mean I was surprised to hear that. I heard you mention that on another podcast. And I was kind of surprised because I think the perception among some investors is for sure, you know, the high tech, high growth stocks are being richly valued, but maybe that the rest of the market wasn’t that expensive. But certainly, by the measures you look at, you’re saying that most of the sectors are valued highly relative to their typical averages. Is that right?

[00:09:26] David

Yeah, I think that’s true. Yeah, I think yes. And that’s maybe it’s a little bit different if we had a conversation in 2023 or obviously 2022, where cyclicals were really, really cheap in 2022. If you think about it, if you take a step back, I think just think about financials, think about banks.

Banks historically trade in a range of, let’s call it 8 to 12 times earnings. And a lot of banks today have ranges that move from 8 to 12 times earnings to 12 to 16 times earnings. Goldman Sachs. It wasn’t too long ago we bought Goldman Sachs a little above tangible book value. And there was an expectation that could they ever get to 1.5 times tangible book value. And now they trade for 2 times tangible book value. That usually doesn’t last very long. So, you have financials very, very high valuations.

Industrials, until recent view, that they’d have a big economic recovery. They retrieve for 23, 24, 25, 26 times earnings, well above historical averages. You also had, again, there was, I almost call the Nifty 20 where there was just some kind of companies where their algorithm, their growth rate really hasn’t changed dramatically, but the multiple the market was willing to pay for them expanded dramatically. Costco is probably the poster child for that, a company that used to trade in a range of 28 to 35 times earnings. All of a sudden went to 57 times earnings.

Walmart, best case scenario, Walmart has an 8% EPS growth rate with almost a 2% dividend yield, a 10% algorithm, and used to trade for what’s called a range of the low 20s to mid 20s all of a sudden went to 37 times earnings.

You had a lot of names in that camp of good companies that used to trade in a range and the market is all sudden awarded a much, much higher range than they have historically for those companies. So, when we think about that, outside of healthcare which has been had some issues, we did not see really good value anywhere in the marketplace.

Even utilities, which has been a favorite for ours for a long period of time, has had a really big upswing because of AI and more data center needs. Power consumption going from 0 to maybe 2% or 3% a year. That’s kind of step function change for those kinds. But, again, they’ve been good stocks as well. So, the areas where you see opportunity in the marketplace really, really narrow versus history.

[00:11:44] Alan

And what would you say has driven that step change in valuation? Is that a function of the momentum trade or just generally bullish sentiment or a bit of both?

[00:11:53] David

I think it’s a combination of multiple things. I think there’s a, in some cases a stock that just works over a period of time, especially in an area where other stocks aren’t working, success breeds success, and the multiple goes higher and higher. And yet again, usually, historically speaking, one of the ways you can avoid underperforming is avoid companies that have high multiples – high multiples versus history.

So, I think you’ve kind of got that to extreme in the Costcos of the world, the Walmarts of the world, the Cintas of the world, where again low double digit algorithms that in some cases now trade for 40, 50, 60 times earnings doesn’t make a lot of sense from a long term investor’s perspective. Some of it is just there’s a lot of positive sentiment around what Trump was going to do from a policy perspective.

I think in many respects what we’ve seen that those policy changes are probably more detrimental than positive. So, as we’ve seen this morning and last night, and bigger and bigger terrorists, and retaliation, and higher inflation, that’s not a good thing. A lot of disruption into scientific community with some NIH cuts, just probably more disruption than positivity on the Trump side.

So, it’s a combination of a lot of factors, momentum, sentiment around Trump. But all those things kind of drove that market valuation higher.

What’s interesting is if you look at where S&P 500 earnings expectations were in March of last year, the market thought 2025 earnings would be like 279. And in reality, I think once earnings settle for this year, the expectation for 2025 is down to 269, 268. So again, it’s funny, we had this big market rebound even though earnings expectation of ‘25 actually come down a little bit.

[00:13:49] Alan

Interesting. So obviously, I mean you’re referencing various macro factors there around Trump, et cetera and the outlook for the economy. But at the same time, you’re placing a lot of weight on valuations. And a lot of people will say, well valuations, that’s fine, but they don’t determine stock prices over the next one year.

So, how do you blend that kind of valuation centered approach with being cognizant of the macro developments and then taking it all together to determine how much risk to allocate in the market at any point in time?

[00:14:20] David

Okay, well what I would tell you is, if you just take a step back, let’s just take a step back for a second. If you think with the market returns, let’s call it 10% over time, you know, 10% of the time when there’s kind of blood in the streets, when, when markets are cheap, when sentiment is bad, in that period of time, the risk of loss in a 12 month period of time goes much lower and expected returns are much higher. So obviously we’re not in that period of time right now. Valuations aren’t cheap, markets aren’t down a lot.

So just by that very factor, if you agree with that sentiment, you would say, if the long term return is 10%. We’re not in that situation. So, if you X out those really good periods, we’re more like at 9% returns. But I think valuation by itself, to your point, is not that new evil. And there has been a big shift in the marketplace over the last, let’s call it last 20 years. In 2006, financials, materials, energy, was 45% of the S&P 500. And those are low multiple sectors. Those are 10% multiple sectors.

Today those sectors now only represent, let’s call it 25% of the ESP earnings, down 45%. And what’s a lot bigger? Semiconductor, software, areas that trade for higher multiples, generally speaking. So, there is a mixed impact that drives the valuations of the market higher.

You can’t look at the market today versus ‘06. I completely agree with that mix impact that’s driven multiples higher. But even if you segment the market, like we do, what you would find is what I call traditional growth stocks, let’s call it 44% of the market. They historically trade for about 29 times earnings. They’re at 32 times earnings today.

If you look at heavy cyclicals: insurance companies, financials, banks, some industrials, machinery, these are companies that normally trade about 12 times earnings on average, trading at 17 times earnings, well above where they would normally trade. And then again, we talk about some of these Nifty 50 stocks that collectively would have traded in a, let’s call it, mid to high 20s bucket, now trading collectively at 40 times earnings. So, the valuation is not just a little bit elevated in some of those areas, it’s really elevated.

And so, I think when you have a combination of extended valuation with maybe overly rosy fundamental outlook, which doesn’t appear to be the case. That’s not a good environment. That’s not a good combination, if you will.

And again, what I would tell your listeners is that we are longer term investors. I have no idea what’s going to happen today, tomorrow, next week. It’s not what we’re good at, honestly. But what I can tell you is we model every company in the market through the next five years. And I can tell you that if you look at a reasonable assumption for earnings power in 2030, maybe a little bit more than $400 of SB 500 earnings, and you put a normalized multiple on that, which reflects the mix of the market. You can make an argument to the market in five years and the future should be 7200, 7100. And that kind of spits out a low fives kind of total return from where we are today. And again, that’s just not that attractive.

Now when I did that same analysis in 2022, I was spinning out the next five years, it was kind of spinning out a 1213 kind of return. But that was when the sentiment was not great, valuations were cheap, and a lot’s changed. We’re in the opposite position where fundamentals maybe are plateauing a little bit, at the same time where rates are staying high, and evaluations are extended – just not a great setup.

[00:18:19] Alan

No, I take it. Yeah.

I mean, if I was to take the other side of it and maybe kind of reflect some of the more bullish sentiments you hear, it might be along the lines of, okay, I hear what you’re saying about Trump, but regardless of Trump, we’re in the midst of a productivity boom, the digital revolution, which is going to underpin productivity growth more generally and growth and earnings. Yes, multiples are high, but they might stay high over that five year period.

And we’re into kind of a higher nominal GDP type environment than we were maybe in the last decade. So, all of that together might underpin higher returns for equities. I mean, what would you say to those types of arguments?

[00:18:59] David

What I would say is what we do really well, we are individual micro analyses, and we’re doing 500 micro analyses to come up with that. I know I get 99% of what I do is kind of the micro company analysis. And if you do that at 500 company levels, you can kind of build a bottom up analysis. What I would say is, again, I think we are believers that AI is clearly a positive.

But again, I think when you have companies like Palantir that at one point were traded for 90 times sales, the expectations are so high. What do you have to believe to believe a Palantir is a good stock from its highs?

You have to believe that they’re going to compound revenue at a 25% to 30% rate for next 10 years, that their terminal margins are 40 and you’re going to get a 30 multiple on that. It’s just the odds of that are very, very low. And even if that were to happen, you’re going to get a very, very low return over that period of time.

So, what I would say is that there probably will be some more productivity from AI. But I also would say remember the difference between the next class decade two is 10-year average, probably 2.5% last decade. I don’t think we’re going to average 2 1/2% on the 10-year in the next decade. The decade prior to COVID was a decade where the Fed was doing everything in its power to get inflation to 2% and was struggling.

They were quantitative easing here and there, keeping rates low and they still struggled to keep that. Could earnings growth be a little bit stronger than the last decade? Absolutely. But I think REITs are also a little bit higher. And again, even though the market mix is more positive in the last decade, I don’t think the market mix supports a 22 multiple.

[00:20:42] Alan

Yeah, so, and effectively what yield are you assuming? Or is there one yield for the 10-year over the next five years, is that built into your model?

[00:20:51] David

We assume about a 4% 10-year.

[00:20:53] Alan

Yeah.

[00:20:55] David

I think it’s right around there. I think it’s either 3.95% or 4% applies.

[00:20:58] Alan

So, by the same token, if yields prove to be higher, there would be downside risk to your forecast on that basis as well. Is that right?

[00:21:05] David

There would be. Although I will say it’s a funny dynamic. If you look at the sense of Great Financial Crisis, the correlation between interest rates and The S&P 500 multiple is zero. It’s literally zero. There’s basically no correlation. Now again, part of that is what we talked about before. The market mix.

Yeah, rates have gone up, but the market mix has gone up too. If the market had been constant and there’d be a higher relationship, just like there was a very, very high relation from 1966 to 1998. There was a very high correlation between interest rates and the ten-year, and the earnings yield of the market. Again, the last 27 years that’s kind of gone away.

[00:21:44] Alan

Yeah, I mean I was curious about that point.

Obviously, you know, that is one of the changes that we’ve seen over time since COVID, basically, that the bond equity correlation has shifted, as you say. You know, historically bonds and equities were positively correlated and then became negatively correlated.

And then as we went, you know, 2022, we were positively correlated again. Is that something that is a key input into your portfolio construction when you’re looking at the mix between equities and fixed income or not?

[00:22:13] David

I would say it’s funny. We’ve actually seen it here in the last week or so as the market’s come under pressure. I think if you look, ‘22, I feel like, is a little bit of an aberration. If you look at the last, I don’t know, last 30 years of history, it’s very, very rare to have an environment where, in a period of time, equities are coming down, where Treasuries do not appreciate in value. I think 22 was just a… We went from sub 2% interest rates or inflation to 8%. And the idea is how long it was going to take us to get back to kind of normal? And it’s probably taking us longer than everybody thought to get back to normal. And so, I think, hopefully, that was a one-time event that we won’t have to repeat again. That was a culmination of a lot of things kind of drove inflation to 8%.

That was policy decisions in the Biden administration that was policy decisions, the Federal Reserve, there was a supply chain challenge, there was a pandemic. All those things kind of happened all at the same time. That kind of drove us there.

So, I would say most of the things that would cause a market meltdown, a market of all 5%, 10%, 15%, 20% would probably be accompanied by a decline in interest rates. Most of those things, not all, but most of those things.

[00:23:31] Alan

You did talk about the inflation going to 8% and we mightn’t see it going up that high again. But there is that view in the market that inflation might be a bit stickier, that we might see more of these kind of mini flashes of higher inflation. I mean, given that you’re focused on financials, equities and bonds, what levers do you have to kind of pull? If you really were strongly convicted that inflation was going to be higher, would that push you to certain sectors or would you just have to live with that possible scenario of bonds and equities falling at the same time?

[00:24:04] David

Well, we have a lot of flexibility in this strategy. So, one of the things that we own, about 10% of the portfolio is in leveraged loans. Leveraged loans are a great product, right? They are floating rate in nature. If rates stay higher for longer, you get higher yields.

So, if you think about in a portfolio construct, having that high quality leveraged loans be 10% of the portfolio, that’s an asset class that had positive returns in 2022 when rates were rising. So that helped buffer some of the negative returns in equities, helped buffer some of the negative returns in Treasuries.

Actually, at the time, we didn’t really own much Treasuries at all. So, having leveraged loans in the portfolios is an option. Again, we’ve actually brought that down a little bit. As the rates on Treasuries have risen, the yields on high yield have risen, we’ve raised that exposure.

What I would say is we are constantly making decisions on where is the best risk reward in the marketplace? So, if I go back to 2022, even though rates were rising and inflation was higher, the return we could get in investing in equities was off the charts. Like I said, 12% for the market, which is great. We can obviously do better than the market.

And you were getting kind of, let’s call it 4% treasuries and 6% in loans and high yield, owning a lot of equities made a lot of sense. Now if I think about that analysis today – getting a little bit more than 4% on treasuries, you know, 6% on loans, 6% on high yield.

But again, I just talked about the equity returns over the next five years. We would project, you know, maybe conservatively, but you know, about 5.2%, you know, so you’re getting higher returns in fixed income today on a forward projection basis than you’re likely to get in equities. And so, we are constantly looking at that analysis.

You know, is it better to own a utility that has half the beta of the market or buy a single B bond that has a beta of 25% of the market? We’re constantly doing that kind of that analysis. There are no silos, we all met, we manage the fixing portion of CAF and CAFE together with the combination. So, we’re constantly looking at those decisions all the time.

[00:26:26] Alan

Yeah, and at the moment, what’s the thinking on that? Like obviously, as you say, you get four and a quarter, whatever it is in Treasuries. Now, obviously you pick up a couple of percent if you go with levered loans. But if you get a severe downturn, presumably there are the sectors that are going to get marked down and face stress. And your Treasuries, you’ll get your duration there. So, how much is that driven by, I suppose the total return expectation and how much is it driven by their potential characteristics in an adverse scenario?

[00:26:53] David

It’s both. It’s actually both. We do a multi scenario model around that with probabilities of downturns, all that kind of stuff. What I would tell you is again, you look really good there. But I think one of the things just to keep in mind is, because we don’t know exactly what the future is going to hold, right. So leveraged loans in combination with Treasuries together is kind of the peanut butter and jelly sandwich of the fixed income market, if you will. Because think about this. You know, leveraged loans do well when rates are rising. The Treasuries do well when rates are declining. So, they help offset each other a little bit there.

If you had an environment to your point, you had a big downturn, the rates might come in, which is negative for loans, and spreads might widen, which is negative for loans. But Treasuries actually rally. So, if you put loans together in a portfolio with Treasuries, again, you get the combination of those two things, the peanut butter and jelly sandwich, really generates really good risk returns. That helped in 2022, and so far. Year-to-date, you know, Treasuries are outperforming loans, but the combination of those two really produces really good risk adjusted returns. We try to, you know, have those exposures, in most environments, somewhat similar in size.

And again, what we own in loans, you know, we own things that are very, very safe, the highest quality loans. We’re not speculating in dish. We’re investing in really high quality companies that have very, very little limited cyclicality that tended not declining from a spread basis very much even in their downturn.

[00:28:34] Alan

So obviously you’ve been running the strategy since ‘06 and you’ve been in the markets, you know, 26 years, which spans a long time. There’s a good chunk of history. I mean, how much do you go back and look at periods in the past or not?

I mean, people draw parallels between now and the late ‘90s. Obviously we’re talking about how the portfolio might perform in a severe downturn. I mean, obviously, I guess you might stress it on the data during the financial crisis. Are they all inputs into the decision making?

[00:29:06] David

They are, they are. The future is very difficult to discern it. Every cycle is a little bit different than every other cycle. And again, what I would say is we understand. We studied every market downturn for basically the last 50 years. We thought about how far do markets decline.

We have factors we look at, which I can’t really go to the proprietary, that would tell us when is the time to get really aggressive with the portfolio, when is the time to go from 57% equity exposure, today, to 72%. We know that point. We know at what point does the market return get to double digits. We know all those points. We have a predetermined plan put in place that if the market went to X, we would go, most likely, from 57% equities to 62% equities.

If the market went to X minus 15%, we know we would probably go from 57% equities, to 72% equities. But everybody else who’s really bullish today capitulates at the bottom, we’re going to be all in on equities in that environment. And we will probably be selling Treasuries along the way, during that period of time, and buying high yield, or buying leveraged loans, just like we did in other downgrades. So, we know how spreads expand in downturns. We’ve looked at how 5-year, 10-year, 3-year Treasuries change. Yeah, we have a wall of data that helps us make intelligent investment decisions irrespective of the emotions that most market participants might be going through in a downturn.

[00:30:51] Alan

Okay, good stuff. And just to be clear, are you at 57% equities now, is that right?

[00:30:57] David

Yeah, just to be clear, we do self-calls on portions of our equities. So, we look at it like a delta neutral basis. Okay. So, if you X out the call, if you include the calls, our net equity exposure is at 57% today.

[00:31:10] Alan

And that’s very much on the low side of the range in the track record of history.

[00:31:14] David

We’ve averaged about 61% to 62%. So, you know, you were probably about 500 basis points underweight that exposure. And again, we would be underexposed to the Palantirs, the Teslas, the Grog.coms of the world, some of the companies that may be a little… the Costcos, the Walmarts, some of the more speculative or highly valued stocks in the marketplace too.

[00:31:38] Alan

Yeah. And so, maybe tell us a bit about the process for stock selection. Presumably as you say, you do it bottom up on all the stocks. So, it presumably is heavily valuation driven. I have heard you, elsewhere, speaking a lot about the importance of management and great management.

So, I mean, I guess it’s a mixture of qualitative and quantitative. But in your own words, how do you balance those factors and what does great management look like?

[00:32:03] David

Sure, great questions. So, when we think about the market, we look at the 500 companies in the market and where are we going to spend most of our time?

So, we’ve done a lot of, whether it be qualitative or quantitative studies on this. What we’ve basically found is there are six reasons companies tend to underperform the market over a five-year period of time. Six main reasons we try to avoid those companies. We call it the fatal flaws. You know, bad management team, poor cap allocation, secular challenge.

A company that doesn’t have a business model that supports high single digit EPS plus dividend yields, or a company that could do that but it’s very, very high risk, and then an extreme valuation. Again, we mentioned the companies today that have what I call an extreme valuation.

So, if you go through company by company in the marketplace, and you say I want to avoid all these companies that have one of these six fatal flaws. It kind of leaves you a stock portfolio of you know, a universe of investable ideas of 115 stocks at the low end to maybe 140 stocks at the high end.

I think today is like 122 stocks that are kind of investable for us today. And we’re going to spend all of my team’s time, all my time, focused on those 122 stocks. And for the cash equity sleeve, we’re going to select maybe the 60 best of those names. And for the CAF ETF, we’re going to select the 90 best names of those.

Now to your question about what makes a good management team? It’s the right incentives. What is the management team trying to do? Are they trying to build a big empire? How good are they operationally? How often do they come back with excuses about why they can’t get their algorithm, why they can’t deliver on what they’ve promised? Do they surround themselves with really good people or do they surround themselves with weak people who don’t want to challenge them?

A good management team deploys capital wisely, whether it be buying back stock, doing bolt on acquisitions at high returns. Are they more strategic in my term means poor returns on capital for their deals. So, it’s all those things that are really important to our process.

One of the names I mentioned before, or maybe we haven’t mentioned, but I mentioned the past, is, you know, GE was a company that we didn’t focus any time on because we knew they had a horrible management team, had horrible capital allocation. You know, Jeff Immelt has probably destroyed more shareholder value than any other CEO in the history of mankind. As a CEO, it’s kind of crazy.

And again, it wasn’t our focus, but the day Larry Culp was announced as CEO at GE back in 2018, I literally didn’t do anything else for 14 days but do a deep, deep dive on GE. And as a result of that, it’s like, ah, there’s a lot of upside here. We have a change agent. Capital allocation is going to be better, company’s not going to go bankrupt. And we made a giant bet that worked out really well for us.

But that’s an example of, you know, coming with a lot of fatal flaws going to a company that didn’t have any fatal flaws. I mean, clearly had challenges at the time, but we had a high degree of confidence that the management team could, and capital allocation would get a lot better. And we made a big bet. We want to invest with management teams that we trust them. We have a long term perspective, Capital allocation is good, yeah, that’s really important to us.

[00:35:37] Alan

Okay, you mentioned capital allocation a lot and obviously you’ve written a book on the topic. I mean, we have seen, I suppose, I don’t know if it feels like a growing feature of the markets in the last 10 years of share buybacks and that’s been an important driver. I mean, from your perspective, do you see that as good capital allocation? Obviously, I guess it depends on the stock by stock basis. But generally are you favorable on that?

[00:36:01] David

It really depends. It really depends. I mean, you know, it’s funny the companies who should not be doing share repurchase are companies such as companies that are secular challenged. If your business is in secular decline, your growth rate’s slowing, your margins are under pressure, your margins under pressure, you really shouldn’t be buying back your stock because you’re not getting good returns.

A steady Eddie company that trades for 15, 16 times earnings, that is growing mid single digits, with high single digit kind of EBITA growth, they should be buying the stock all day long. Right. You know, again, Costco should not be buying stock. Walmart should not be buying stock because they are low returns.

An industrial that trades for 25 or 26 times earnings should be doing both on acquisitions at 12 times EBITDA, shouldn’t be buying back their stock at 25 times earnings. So, I would actually argue, in the last 10 years, as valuations in the market have risen in general, you see a lot of companies that are either in secular challenge mode or have very cyclical businesses that are buying back a lot of stock. And that’s not a recipe for value creation.

It’s really firm dependent. You should go, where is the best risk adjusted returns for me to deploy capital? When valuations for acquisitions are low we should be doing acquisitions. When valuations for acquisitions are expensive you should be buy share or even building cash on the balance sheet. It’s really firm specific more than anything else.

[00:37:27] Alan

Good. And I mean for the average investor, what would your advice be or suggestion be in terms of how to think about valuations and capital allocation, management quality, et cetera? Obviously most individual investors don’t have a team like yourselves, maybe don’t have the insight about the quality of the managements. And then you read so much about valuations, different metrics, KPE, you know, you do a bottom up IRR of the market. So, it’s like break it down into simplicity.

If you were teaching a group of undergrads or some novice investors how to think about valuation, what are the key things you have to watch?

[00:38:12] David

You know it’s a really good question. I’m going to give you a really not great answer. I mean the reality is, you know, it’s really hard for an individual investor to do the kind of work that we do. We have the access to management teams, you know, we build models, you know, at five, six years on everything that we invest. It’s really hard to do that in many respects. I mean I guess that the best answer would be just to buy the Cap Appreciation Fund. Then we do that for you.

In CAF we can balance risk/rewards within asset classes and go where the value is. What I would just say though, and then again, this is not going to be a great answer. But, you know, part of our strategy, Allan, is trying to find the best risk adjusted algorithm in the marketplace for the lowest multiple. Costco has a low double digit algorithm, their earnings plus their dividends, low double, maybe 10%, 11%. That’s what they historically are, all right. And they trade for 57 times earnings.

Other companies in the marketplace, Becton, Dickinson has the same algorithm, same risk profile and they trade for 15 times range. So, I would argue, over time, if you have the same risk profile and the same earnings growth and same kind of dividend, over time those two things converge. The multiple of market awards, back to Dickinson, should increase, which increases your total return over a period of time. And the multiple in the market should pay for Costco should decline over time.

And I think, over time, if you think about a lot of the value creation that we’ve created in CAF, over time, it’s finding that company that the market doesn’t appreciate. Buying Therma when it’s 11 times earnings, buying Danner at 14 times earnings, buying Pfiser at 12 times earnings.
Buying Auto Zone at a low double digit multiple and having these great algorithms, great companies and all of a sudden the market figures it out, so you get the combination of really good earnings growth and a lot of multiple expansion as well at the same time. And that is how you produce low double digit algorithms can kind of go to high teens total return. That’s been a really important part of our strategy.

So, ignore what’s exciting in the marketplace and just try to find companies that you think can generate high yield digit returns, little digit returns where their multiple is just too low for that relative to other companies in the marketplace. It’s hard to do for an individual investor, but that’s a lot of what we do at a very, very basic level.

[00:40:47] Alan

Yeah. And I mean, would you ground yourself as traditional value investors? And I guess the reason I ask is we had Aswath Damodaran on previously. He seemed quite downbeat about prospects for traditional value investing. His point was the kind of screens Graham ,Dodd, Buffett type screens. Anybody can do it now, you can download a spreadsheet to do it for you. You’re not going to get rewarded for that type of analysis. But it sounds like you believe that that is the case.

And I suppose the second question is there is a view that you can identify the cheap value stocks, but they could stay undervalued for a lot longer in the current market than they might have in the past.

[00:41:30] David

Yeah, let me make a couple of points. One, the challenge with the value index is you think about ,this is going to be a very simplistic way to think. But 40% of a Russell 1000 index has some degree of secular challenge. The business is under pressure. It’s long term. There’s no mean reversion characteristics to those businesses. And if you put $40 in those stocks, the odds of underperforming are pretty high.

Now, the other 60% of the market in value stocks, JP Morgan, Bank of America, they’re not the Nvidias of the world, but they’re not horrible companies and their cyclicality, again, if you buy them when they trade for 9 times earnings and sell them when they trade for 12 times earnings, you can make a lot of money doing that. But the value universe of stocks will not grow earnings at the same rate as the rest of the market. We think about multiples.

We talked about multiples a lot in this discussion. The reason why growth stocks have destroyed value stocks for the last 15 years, it’s not really multiples. It’s just they’ve grown so much faster. They’ve grown to be much larger companies relative to the value universe which has been left behind.

But going back to your first question with regard to what kind of investor we are, I don’t consider myself a traditional value investor. I consider myself a GARP investor. Growth At a Reasonable Price investing. And I would tell you I think that is the most attractive part of the marketplace.

When we look at the GARPI stock, our proprietary GARP universe, over the last since 2006 it’s after the market by 400 basis points per year. Earnings growth has been about 40% higher than the market over that period of time. And in downturns, earnings don’t go down for those companies for the most part, they’re not that cyclical.

And so, a lot of the alpha we’ve generated, the equity sleeve of CAF over time has really been a function of this 2000, 3000 basis point overweight to these GARPI stocks. And I would tell you that’s the most inefficient part of the market.

Why is that inefficient? Think about the growth investor. A growth investor with these GARPI stocks will say, well, I only want to make companies that are growing organically 10% a year. And so, I’m not going to own these stocks, or I’m going to own too little of these stocks. A value manager might say, hey, I can buy banks at 9, 10, 11 times earnings, maybe not today, but normally 9 to 11 times earnings. I can’t pay 18 times for this GARP stock.

A retail investor probably hasn’t heard of Revvity or Marsh & McLennan or these companies. And a hedge fund, he wants high volatility. He wants to be able to make a call in a quarter that stocks can go up 8% or down 8% in a quarter. These are not the size to do that. So, there’s no natural buyer for these stocks. Which actually sounds bad, but in many respects what it is, is you have these companies that have these really great algorithms that can generate low double digit returns between the earnings growth and the dividend with very low volatility. And they trade for too low valuations relative to where they should be.

And as a result of that, you’re able to, in most cases, a lot of these things, they become a little bit better over time. Their multiples expand and even if they don’t expand, you still grow earnings 30%, 40% faster than the market over time. It’s just a supply demand imbalance for these GARB stocks, which creates just great returns for our shareholders over time.

[00:44:52] Alan

Interesting. Well, I mean, what you’re talking about there maybe reflects some of the market microstructure and curious to get your thoughts on how that has changed over time.

So obviously we’ve had factors like the growth of indexing, the rise of ETFs, or like sector ETFs, easy to invest in sectors, et cetera, and obviously growth of hedge fund strategies, more alternative risk premia, factor bets, etc., So, putting it all together, it sounds like that has thrown up opportunities, to your mind, particularly in GARP stocks. But I mean, in general, have all of those changes made it easier or more difficult for you in your job?

[00:45:33] David

It’s funny, I’m at a traditional asset manager that is under pressure, as all regional asset managers, because of the rise of ETFs and other passive forms of investing. So, as an investor, to your point, that’s been a challenge. But at the same time, as an investor, it’s actually really positive, it’s really great.

If you think about when I joined in1998, there was a lot of investors who were very, very… You know, it’s a large part of the market who were thinking more than one year out. We were a lot of people who were thinking, oh, what’s your earnings power three years out? What’s your earnings power five years out?

Today, a lot of those investors have just gone away. They’ve lost a lot of assets. You look at the kind of questions you get asked at conferences. It’s so short-term in nature. And what’s interesting is, I think what’s happened is all of the intellectual firepower investment in the industry, whether it be hedge funds, or whether it be short-term investors, or passive, everybody’s focused on the really short term they’re trying to solve what’s the stock going to do next week, next month, what’s next quarter going to be. And no one’s asking the longer-term question about what’s the earnings power three, four, five years down the road.

So, I would actually argue that in the short term the market’s getting much more, much more efficient. Your ability to have an edge in the short-term with data points or insights is really, really limited today. I think that’ll even come more true with AI, all that kind of stuff.

But the kind of investing we do, the three to five year investing that we do, that focus on our North Star is that five year internal rate of return. That’s become far less efficient. And again, you see all these very, very strange correlations today with ETFs.

And I’ll give one example, it’s actually probably, it’s a little bit old, but when Hillary Clinton was running for President in 2016, she tweeted, I guess it was a tweet back then. She tweeted about how high drug prices were and it drove down everybody in the, what was the DRG, the pharmaceutical index.

And every Stock was down like 10% from the highs. And you know, it could be called Zoetis, which makes drugs, not for humans, but for horses and pigs and cows and chickens and goats. It was down 10% as well, or 9% as well. Now, I’m pretty sure she was not concerned at the time about the price of drugs for cows and chickens and goats and sheep and all that kind of stuff.

But it was an index and people just shorted the index and it drove that down. Another example, when Donald Trump was elected for the first time, REITs used to be part of the financials index and rates were rising dramatically. And so that drove, right after he got elected, that drove financials up, but it also drove REITs up, which should have gone down because REITs were a part of the index. So, people were just buying the index and it drove…

So, we find all kinds of situations where people are making a tactical decision based on a sector, or a thesis, and it drags something too high on the upside or too high on the downside for no real reason. And we can take advantage of that. So, we like passive as investors, probably not as shareholders necessarily, but we do like it as investors.

It makes the market more inefficient. It makes it far more inefficient on the long end of the curve, the long end of what we do. So, we’re really excited about passive. We’re really excited about the market becoming much more short term because it just creates more alpha for what we do.

[00:48:59] Alan

I mean, the growth of passive has been relentless. At what percent of the market being passive does it become problematic? As you say, it’s throwing up more opportunities for you. But is that something… Does it become unstable at some point because of too much passive flows?

[00:49:16] David

You need someone in the marketplace to act as a (liquidity provider or whatever) liquidity provider but also if the market was 100% passive, everybody would just be buying all the time or selling all the same time and all the same stocks.

You see someone who’s trying to discern where value is or where non-value is, we do that, whether it be short term with hedge funds or longer term with us. You do need some. I don’t know. That’s a good question. I don’t know what the answer to that is. But I could tell you with every 1% that the market is more passive, our opportunity to add alpha gets better. And so, I hope we will never see that date. That wouldn’t be good if passive was 99% of the market someday in the future. It wouldn’t be good for a lot of people. But again, as investors it’s a really good thing for us.

[00:50:05] Alan

You touched on earlier the change in the composition of the index, say, versus 2006. I think it was 45% in financials, energy, and staples, back then, and obviously much more towards technology these days. Is that just a cyclical phenomenon or is that, you know, a structural change that we should expect it to see sustained over time? And you know, what are the implications of that? I mean in terms of the cyclicality of the market, if anything?

[00:50:32] David

Well, it’s interesting if you think, the 45%, it was energy, it was financials, and materials. Those are also, that 45% is also lower margin, but it’s also more cyclical. So, I would make an argument the market has become less cyclical over time as the most cyclical components.

If you basically take out energy, materials and financials, the market, even in the great financial crisis, peak to trough was down less than 10% of earnings. And even if you go back to the COVID downturn, which is a short downturn but a downturn, XO3 sectors, the market was down like 7% earnings growth.

So, the rest of the market tends to be less cyclical than those sectors. So, as those become a smaller part of the mix, the market becomes less cyclical, at least from an earnings perspective, than it has been historic. Again, the earnings fell dramatically. I think it may have been 40%, 50% in the last downturn. We went from an expectation we’re going to do $95 to like $60 of SPF under earnings. So, it fell dramatically and last downturn.

So, what I would tell you is the market has become less cyclical and I think this will continue, I would think, at least from an earnings perspective. The big constituents, Apple, Microsoft, there’s probably more debate around Nvidia, more debate around what Tesla would be in terms of earnings, but I think a lot of those big companies will continue to grow earnings at a healthy pace over the next five or 10 years.

The challenge is, whether it be energy. Energy doesn’t really grow earnings very fast. They pay a little bit of a dividend, production growth is very, very low, buy back a little bit but doesn’t grow very fast. Staples, I’ve seen a lot of secular challenges, don’t grow very fast. Regional don’t grow very fast.

So, and you know, a lot of the things are under secular challenge, you know, it be a Comcast or Charter, you know, don’t grow very fast. So, I think, over time, and we model out to the end of the decade. You know, the top 100 companies in the marketplace will go from, I think our mass is from 60% of earnings today to 68% of earnings in 2030 is the way we’re looking at it.

[00:52:44] Alan

Yeah, so, is the point then that, okay, you can’t necessarily compare the S&P multiple today versus 2006. But even allowing for that is high versus what’s recent. Yeah, yeah. Okay.

[00:52:56] David

Once you do the segmentation.

And again, I would just also say the one thing, and I don’t want to get too far on tangent here, but what I would say is you also can’t compare the US market to like the German stock market. It’s so different. You know, autos are a tiny fraction. That’s X Tesla bar mark, but they’re a giant part of the German DAX. Chemical companies are a very small part of our money but they’re a large part of the DAX. Financials are a big part of the FTSE 100 or Footsie, the Footsie index in Europe. So it’s, it’s just.

You can’t compare apples to orange because the companies are so different. Growth rates are so different among the US versus Europe or Japan or Australia.

[00:53:36] Alan

Does it even make sense to have these geographically focused funds, ETFs? I mean the analysis, yeah, okay, because the analysis will be like that, oh, the German economy is doing terrible. Oh, get out of German stocks.

But hey, look at the DAX. It’s the top performer this year. So, you know, why is that? You know, it seems like that global sector would make much more sense.

[00:54:00] David

I completely agree. I think it’s funny, what we found over time is actually having international stocks in a portfolio, not only does it reduce returns, it actually increases risk. Because what happens in an economic downturn, the dollar strengthens. And again, almost all these companies have a giant portion of the revenue outside the US, or outside of Germany, if you’re a German company. So, this whole aspect of getting a whole bunch of diversification benefits from owning a UK company or owning a UK index or German index, it really is just a big folly, if you will. People really shouldn’t, you shouldn’t think about diversification from that perspective.

[00:54:41] Alan

Okay. We touched on a little bit on Nvidia AI, but curious to get your thoughts on how AI is impacting the investing world. Obviously, it’s impacting stock valuations. But in your role, are you using it, are your analysts using it or not in terms of the stock analysis and valuation, et cetera?

[00:55:01] David

Not really. What I would tell you is again, AI may help out with trying to help with very short-term data points where it’s easier to amalgamate data off of websites or web scraping, all that kind of stuff. I mean, there are things we’re doing with AI that help try to make us more productive.

I still listen to every transcript of every company that we invest in, every company we could invest in, but there’s a lot more summarization analysis you do. You know, there’s things we can do with facts, which is kind of our way. We look up information. It’s a service, it’s easier to search for things so it can make you a little more productive. But I don’t think it… So far, it has not had a big impact on how we invest.

We have internal tools we’re looking at in terms of trying to create our own little copilots, where we can ingest all our information, and hopefully all of our research, and hopefully find insights. But I would say it’s really early days, for AI, having a big impact on the investment process so far, at least for longer term investors.

[00:56:01] Alan

And in terms of sectors that are companies that it is impacting, I mean if you read some of the research people are saying, you know, the impact on productivity growth could be kind of like anywhere from 0.1% per annum to 1% per annum. So big, big, big variance in expectations there. What’s your sense?

[00:56:20] David

I think we could be surprised by the productivity benefits with AI. Again, it’s so early, it’s so fun. We have so many really good use cases like marketing, legal, programming. We have a lot of really good use cases that you can extrapolate that to a whole bunch of other sectors and say this is going to be amazing. But we just don’t know. It’s still so…

It’s funny, we have this giant industry, with trillion dollar companies, and still early. It’s very, very early in the process around how much productivity we’re going to get out of this. So, it’s really hard to make a definitive conclusion.

I just go back to programming. We all told our children, hopefully my children ignored me, thankfully. Go become a programmer. Go become a programmer. Because that’s a huge upside. There’s incredible demand for that.

The problem is GitHub Copilot costs $19 a month. If you buy four subscriptions to GitHub Copilot, you can get rid of your fifth programmer. The programmer costs over $1,000 a year.

The savings from that are off the charts. Documentation, translation, there are other things, documentation, management, you know, where it’s just off the charts. That kind of benefit you. Customer service, huge benefits. Going through a drive through at Burger King, having an AI on the other side instead of a person – huge benefits. There’s a tendency to extrapolate to everything else, It’s hard for investment management. It’s not as easy with investment management as a drive through Burger King. I hope, I hope that…

[00:57:55] Alan

You would think so. Yeah, yeah.

Just conscious of time. There are a couple of quick questions I wanted to get to. One was obviously you’re running the Capital Appreciation Fund. It’s very much bond equity. I mean if you were running a longer-term portfolio, maybe an endowment, unconstrained, I mean what would asset allocation on that look like, do you think, on a kind of a five to ten year view?

[00:58:19] David

Oh, that’s a really good point. Well, I would tell you the first thing is I wouldn’t own any mortgages because the risk/reward is not very good. I wouldn’t own any international stocks. You get a lot of great companies and great diversification buying the US market. So, if a combination of kind of GARPI, US stocks, high yield, leverage loans, and the other area that I would be interested in, I’d probably have (which I can’t) some private equity there – mid-market private equity as opposed to large kind of private equity.

Those would be the four assets: GARP stocks, high yield, leverage loans, and mid-market private equity.

[00:58:56] Alan

Interesting. Good stuff.

We always like to wrap up by getting just some advice for people, maybe coming into the industry, or people who want to get to be better investors. I mean things that have been influential for you and either books you’ve read or advice you’ve got is there anything you would pass on?

[00:59:12] David

You know, one of the best books I read, we have a book club here that I actually started. A gentleman, Kahneman, Daniel Kahneman, who just passed away, I believe, recently. He wrote a book called Thinking Fast and Slow. It’s just about how we as human beings make decisions. How you know, there’s a tendency to make decisions based on not really good information.

It’s the idea of kind of thinking fast is how we traditionally make decisions. Maybe more emotion, not a lot of inputs.

Thinking slow is actually thinking about all the different ways in which you can make a decision, all the different inputs you can use. And actually, you know, having those inputs, having those samples, if you will, has helped you make a better decision.

And again, as investors, I think Thinking Fast and Slow is probably the most important book, as an investor, I’d read in a long period of time. Even though it wasn’t really written for investors. It’s probably relevant to life and other things as well, but just how we make decisions and try and take the emotion out of it. I think that’s a great book by, again, a great man, a Nobel Prize winner, actually.

[01:00:15] Alan

Absolutely. Well, great stuff.

Thanks very much for coming on, David. It’s been great to get your insights and fascinating to hear about how you’re running your portfolio, so we very much appreciate it. So, stay tuned. As ever, we’ll be back with more content on Top Traders Unplugged, so we’ll speak to you soon.

[01:00:37] Ending

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