Growth by stress

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

Morningstar's "Redefining Growth" panel included Robert Hagstrom of Legg Mason, Dennis Lynch of Morgan Stanley (and Van Kampen), and Alex Motola of Thornburg. But before the panel got under way, Robert Hagstrom met a few of us in the press room for a quick sitdown whose topic was electric, to say the least (free-form paraphrase, as usual)...



Robert Hagstrom
of Legg Mason.
Hagstrom: Inflation in electric rates will accelerate for the US consumer, and people will be getting pretty upset. The demand for electric power and exceed supply. In fact, when asked what kept them up nights, Google named the supply of electricity as their #1 concern going forward. That's because Google is the #1 consumer of electricity in the state of California.

After the panel assembled, the conversation focused on other topics.

Lynch: All sensible investing is value-based. The difference is that growth investors invest in higher than average P/E ratios and value investors invest in lower P/Es. Higher P/Es are not always expensive — earnings are often driven by accounting assumptions. We seek value beyond the obvious P/E.

Motola: We seek seek securities that are mispriced based on misperceptions. The marriage between value and growth approaches characterizes some of the best investment strategies.

Lynch: Momentum sounds dirty, but we don't sell our winners right away because we want to capture some of it. Indexes don't sell their winners. To quote Robert Hagstrom, who said several years ago: "When everyone hates 'em, we buy 'em. When everyone loves, we hold 'em."

From left: Moderator Karen Dolan of Morningstar, Robert Hagstrom of Legg Mason, Dennis Lynch of Morgan Stanley (and Van Kampen), and Alex Motola of Thornburg.

Hagstrom: Since March we started repurchasing financials because that's where we believe the doubles, triples, 4-baggers and 5-baggers of tomorrow are. The problem is which, and when. Mispricing goes up with complexity (of the balance sheet).

Motola: Recently we've moved toward biotechnology with names such as Gilead, Alexian, Genentech, and Celgene, which we believe have a good growth profile.

Lynch: Inflation and demographics are pluses for healthcare, but government regulation and creative destruction are big ifs. Reimbursemnent changes, for example, can come quickly and catastrophically.

Hagstrom: The healthcare model is broken, and biotech is probably its best growth opportunity. Big pharma is no longer growth. Under a new administration we may be insuring 43 million people and we don't know how that will affect earnings.

Hagstrom: [on turnover] Value managers buy crappy companies and hold on forever. We buy great companies and hold on forever. Growth guys should keep their turnover ratios lower, but value guys' should go up.

Hagstrom: [on quality of management in financial service] Goldman did it right because they're great at risk management. They watched out for the black swan.

During a gaggle after the panel discussion:

Hagstrom: You don't make a lot of money unless it's accompanied by a lot of stomach-churning stress. The probability of recession is going up, and that hurts GE. I think our next problem is deflation — of real estate, M&A prices of businesses, and wages. Everything but commodities is going down in price. That would have a big impact on financials. I would hope Bernanke would drop the rate to 1 percent. Europe is even more pessimistic than the US. They're even closer to deflation because they've raised rates. Meanwhile, I'm still a bull on emerging markets.

Alex Motola of Thornburg in the Exhibit Hall at the Morningstar Investment Conference 2008.

Berkowitz: "Study the jeweler"

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

This morning two stock pickers, Bruce R. Berkowitz of Fairholme Capital Management and Susan M. Byrne of Westwood Holdings Group, discussed their approaches to finding the best values in today's market in a chat entitled "Let's talk bargains." The following is a free-form paraphrase of what was said.

Susan: We're devotees of growth overseas, but we're value managers. That has led to buys like MasterCard, which went from $50 to $300 in 18 months because no one understood the the increasing market share of consumer credit in the developing (as opposed to the mature) markets. Likewise, Nike. Two-third of their business is outside the US, the pressures felt by US consumers that would make this stock unattractive are irrelevant. Nike is growing 20 to 30 percent elsewhere.

Bruce: Healthcare is becoming attractive again with low P/Es now (as low as 10) versus 40 to 50 not so long ago. And the tidal wave of aging baby boomers, combined with rising oil prices, means we're driving less and needing more healthcare.

Susan: The US may make the effort to conserve energy, but if we do, will some other nation take up the slack, keeping prices high? We own energy without overweighting, but we don't know what the answer as to whether US energy conservation will make a difference in this new world.

Bruce: With oil over $70 a barrel, alternative sources of energy may make economic sense, but they take so long to bring to market (over 10 years for nuclear plants, for example). Energy prices remind me of the Internet bubble — too much media euphoria and crawls on cable news alerting you to the minute-by-minute price of oil.

From left: Moderator Russel Kinnel of Morningstar, Susan M. Byrne of Westwood Holdings Group, and Bruce R. Berkowitz of Fairholme Capital Management.
Susan: Banks, if not the most hated area of investment right now, are maybe the most confusing. They were never the most transparent industry, but it as if they said, "We can't lose market share to London, so let's go nuts." There will be a race to the bottom in the next two to three years among those that are deleveraging. We don't yet have the answers as to who will be left standing to support the weaker when it all shakes out.

Bruce: [Of the bank crisis] "If you don't know jewelry, know the jeweler." In this case, the jeweler is not so hot. A decade of non-cash profits just exploded. That's why we count the cash, not the clicks, eyeballs, or other non-cash measurements of a business.

Susan: [Of value investing] We're not patient, so we seek good value and "something happening." For instance, in drugs, we examine what they are doing, where they are headed, and which aspects of their business strategy are undervalued. Exceeding inflation is the point of owning equities, so that's why we seek "something happening."

Bruce: We look for three things: (1) free cash flow yield, (2) a rock solid balance sheet, and (3) a good sense of what management does with that free cash. The current environment is where the seeds of great performance are planted. Sears, for example, generates $6 billion in free cash on 130 million shares, has a strong balance sheet, lots of land, and very strong brands.

Susan: [to Bruce] But you don't know if management will make the highest and best use of that land that you feel is the value behind the stock.

Bruce: That's when you study the jeweler. Reading between the lines, we observe how they renegotiate leases, how they buy and sell real estate, and we come to the conclusion that they're doing it right, but it's happening under the hood, Buffett-style. Value investing is not rocket science, it's investigative reporting — do it right, and maybe something good will happen.

Accentuate the cognitive

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

This morning Bill Bernstein, a former neurologist who has since become a financial guru and founded EfficientFrontier.com, gave a free-form talk about his investment approach.

Various rebalancing tactics were examined
Bill Bernstein. Photo
via Leigh Bureau.in order to take advantage of differences in return that exist among asset classes. "I believe threshold rebalancing is better than calendar rebalancing — but I can't prove it," he stated, noting that wide thresholds (1-2 years) were better than narrow (3-4 times per year), and that calendar rebalancing should occur no more frequently than once annually. This gives your winners (and losers) a chance to run and receive the benefit of their momentum before the rebalancing takes place.

Bernstein claimed not to be especially interested in behavioral finance, despite his having practiced as a neurologist for 25 years. He did assert that it was good for examing and exposing one's own biases, however. Like piloting a plane, investing is an exercise in learning to master (and often contradict) your instincts.

Emotions generally pose a greater threat to individual investors than to financial professionals. Bernstein suggests that the greater threat to investment professionals is cognitive, versus emotional, mistakes. The two most important errors he cited were (1) not knowing enough investment history to give proper context to whatever upheavals are occurring in today's markets, and (2) making the mistake of equating economic growth with equity returns. The example he gave for the latter was China, where massive economic growth over the last decade and a half was not matched by comparable equity returns over the identical period.

"This time it's different"

Greetings from the Morningstar Investment Conference in Chicago, where we'll be liveblogging through Friday.

The opening address at the Morningstar Investment Conference in Chicago was given by Mohamed A. El-Erian, Co-CEO and Co-CIO of PIMCO.

Three weeks ago in Barron's, he identified four major global trends:

• Realignment in global growth


• Return of inflation


• Structured finance diminishing the barriers to entry


• Wealth transfer among nations

His latest book, When Markets Collide (McGraw-Hill), describes the causes of the recent traumas in the financial system, and will be published this month.

Today El-Erian characterized investment infrastructure as undergoing a vigorous global retooling that will will affect the financial services industry as much as the individual investor. In front of a chart that depicted the market's regard of Citi and Goldman Sachs as riskier than Brazil or Mexico, he hammered home the point that in our new, different world, smaller countries and institutions would have suffered more from recent dislocations in the markets. But now it is precisely the most sophisticated financial systems, particularly in the US and the UK that are suffering the most. Government policies are not up to the new challenges and have failed to act as circuit breakers in this new environment. "Just in time" risk management, as practiced by industry leaders, has failed.


Mohamed A. El-Erian at the Morningstar Investment Conference
The US consumer faces headwinds because of the housing market, and the fact that a house can no longer be used as an ATM when home prices fall. Meanwhile, in emerging markets, consumers are getting richer and are building new middle classes and reaching new heights of consumption. Both these newly enriched consumers in India, China and Brazil, as well as the stressed US consumers, will be facing new inflationary pressures to which neither is accustomed.

The implications for investors will be to insist on clarity about their return expectations as well as risk tolerance. They will need to revisit asset allocations for secular robustness and choose among new investment management vehicles in the context of new configurations of risk.

PIMCO's ways of addressing these phenomena include "constructive paranoia," which consists of management constantly asking itself "What can go wrong?" and hardwiring mechanisms to second-guess its own conclusions.

Investors should not treat the recent behavior of the market as a "one-off" — don't think we're going back to business as usual. The crisis we are facing also involves opportunity, as long as investors don't fall into the trap of narrowly framing asset classes.

Additional quotations: "The rest of the world will still outgrow the US." "We are living in a world of permanently higher (and more volatile) commodity prices." "Correlations among asset classes will change." "The financial services industry must evolve from products to solutions." "We [PIMCO] see 1-2 percent growth in the US economy for the next two years." "This time is different, and I say that very seldom."

Crystal ball alert: He also revealed that PIMCO is working on a forward-looking [!] index for the bond market.

The takeaway: Invest more heavily in both international equities and bonds as well as additional asset classes (see his portfolio above).


Mohamed A. El-Erian