July 14, 2015
In a desperate attempt to build a "safe" portfolio, investors and advisers think they have found safe havens in both fixed income and equity markets. But are they just swapping one risk for another? Listen to Rupal J. Bhansali's exclusive webinar or read the transcript below.
Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies and taxes. The use of currency derivatives and exchange-traded funds (ETFs) may increase investment losses and expenses and create more volatility. Investments in emerging markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market.
Past performance does not guarantee future results. Click here for the most recent Morningstar Ratings™ for Ariel International Fund and Ariel Global Fund. Click here for the most recent Morningstar Rankings™ for Ariel International Fund and Ariel Global Fund.
Performance data quoted represent past performance. Past performance does not guarantee future results. All performance assumes the reinvestment of dividends and capital gains. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For standardized performance, the expense ratio and performance data current to the most recent month-end for Ariel International Fund, click here. For standardized performance, the expense ratio and performance data current to the most recent month-end for Ariel Global Fund, click here. Click here for a Fund prospectus.
As mentioned in the article Ariel International Fund (Investor Class) had average annual total returns of 15.4% for the three-year period ended July 14, 2015. Ariel Global Fund (Investor Class) had average annual total returns of 16.2% for the three-year period ended July 14, 2015. As mentioned in the article Ariel Global Fund (Institutional Class) had average annual total returns of 16.5% for the three-year period ended July 14, 2015.
In this replay, Ms. Bhansali candidly discusses a number of individual companies. These opinions were current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
Some stocks mentioned were held in Ariel International Fund and Ariel Global Fund at the time of the initial presentation. These stocks do not represent all of the holdings in the Funds. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel International Fund and Ariel Global Fund. Click here for the top ten holdings for Ariel's mutual funds.
Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond’s investment value by resulting in lower bond prices or an eventual decrease in income. Treasury bonds are issued by the government of the United States. Payment of principal and interest is guaranteed by the full faith and credit of the U.S. government, and interest earned is exempt from state and local taxes. A REIT (real estate investment trust) is a security that invests in real estate. REITs receive special tax considerations, have potentially high yields, and offer a liquid method of investing in real estate. Risks include interest rate and overdevelopment risk. Utility stocks are known as defensive stocks because they historically provide higher-than-average returns in a declining market. In addition, utility companies may return dividends that are likely to offset declines in the company's stock prices. Risks of utility companies include the reduced potential for capital gain and the risk that the stocks may decline in value resulting in a loss. Consumer staple stocks are considered to be noncyclical in that the demand for the products made by these companies does not decrease in a recession. Consumer staple stocks have historically experienced lower volatility.
July 14, 2015
Matt Ackermann: Good afternoon. I'm Matt Ackermann, the Director of Digital Content here at InvestmentNews, and welcome to today's webcast, "The Dangerous Game of Chasing Stability," sponsored by Ariel Investments.
In a desperate attempt to build a safe portfolio, investors and advisors think they've found safe havens in fixed income and equity markets, but swapping one risk for another is not reducing risk. So what can you do to deliver exactly what your clients are clamoring for: high returns with low risk?
I'm excited today to hear this conversation between some great panelists. And I'd like to pass the baton to today's moderator. She is a Contributing Correspondent here at InvestmentNews and the Managing Editor and Executive Producer of Consuelo Mack WealthTrack, Consuelo Mack. Consuelo, the floor is yours.
Consuelo Mack: Thank you, Matt. And today's topic, "The Dangerous Game of Chasing Stability," is a timely and a provocative one. Are we actually taking on more risk than we intend or even realize we are by gravitating to traditional so-called safe-haven investments in both our fixed-income and our equity portfolios? Is there another approach that is truly less risky that can deliver desired results?
Today's guests say there is and they are both employing it. Rupal Bhansali is the Chief Investment Officer of International & Global Equities at Ariel Investments, where she oversees all research and strategies in those areas. She is also Portfolio Manager of two top-ranked funds which she launched in late 2011, the five-star-rated Ariel International Fund and the four-star-rated Ariel Global Fund.
Ariel International has delivered 16 percent annualized returns over the last three years, putting it in the top 5 percent of foreign large-cap value funds, according to Morningstar, and Ariel Global Fund has delivered 16 percent annualized returns, placing it in the top 25 percent of its world stock category. And, incidentally, Ariel Global Strategies, which was started by Rupal when she arrived at Ariel in 2011, and from scratch, now has $2.6 billion of assets under management.
Also joining us is Mark Cortazzo. He's an award-winning financial advisor. He is Senior Partner of Macro Consulting Group, which he founded in 1992, and now oversees more than $900 million in assets under management, largely for high net worth individuals. Mark was recently named to Barron's Top Advisor List for the seventh consecutive year, and InvestmentNews has also identified him as a top transformational advisor. And I am delighted to say that both Mark and Rupal have been my guests on WealthTrack and will be again in the future.
Before we begin our discussion, we want to encourage our audience to submit questions to us. Some of you already have. We will try to answer as many of them as possible.
And Rupal is going to start off, and, Rupal, I want to ask you as a lifelong self-described independent-minded contrarian investor, tell us why chasing stability has become a dangerous game.
Rupal Bhansali: Thank you, Consuelo. That really sets the stage for, I think, some of the remarks I wanted to make to this audience. It seems as if investors, exactly as both of you pointed out, are clamoring for stability, having been, perhaps, hurt by the volatility exposed in 2008, the financial crisis. And ever since there's been a great deal of fear around anything that represents volatility. And, frankly, there has been a great deal of an obsession, I would almost call it today, for stability.
And the risk of thinking in terms of stability and volatility as two extremes and desiring one and avoiding the other, can represent some very contrarian and sort of out-of-the-box outcomes which I think the average investor may not be paying attention to. And, of course, as financial advisors that is exactly our job, to make sure that people don't have blind spots when they are driving their car on the way to retirement.
And I think that this blind spot has to do with thinking that the past represents the future. If there's one statement the SEC has always asked all of us to make, no matter what we do, is that be careful, the past may not represent the future. And in fact what may appear to have been very stable may actually prove to be very volatile in the future. And by not thinking about it in advance, and, frankly, preparing for it in advance, means that you can expose yourself to a whole lot more risk than you actually bargain for.
Frankly, that's exactly what happened in the mortgage market and the reason why Bear Stearns and many of the investment banks finally went under is because their risk models, where they had used VaR, which was a very commonly used tool at the time which even regulators used, which is the notion of value at risk, did not incorporate correctly the risk of volatility, and in fact relied upon stability to persist. And when that changed, that caused a lot of them to become extremely exposed and undercapitalized, to the point where a few them, as we well know, had to be rescued.
So that is why we really need to carefully analyze a portfolio for not its experience of stability and volatility, i.e., not the past experience, but the future exposure. That's the way to think about risk. It's in the future. It may present itself even though you've not experienced it in the past. And I wanted to give you some examples of that.
In the first slide that I think you have in front of you you will see that stability, I'm going to argue, may actually be more risky than investors assume, and actually volatility may prove to be less risky. And that's because investors in the marketplace, whether it's an equity security, a bond security or any asset class, tend to price these things into the price of that asset class. And so because bonds have been traditionally viewed as more safe than equities, there's a great deal of stability that's already priced in, and to the extent that there is more volatility in the bond market, the prices do not take that into account and therefore may not represent future returns and only represent past returns.
In fact, if you look at what investors have done in the bond market because they wanted to chase stability and were averse to volatility, they have actually accepted the certainty, because we know what interest rates are today on the 2-year, 10-year and 30-year bonds — that's the given, therefore it is certain that those interest rates will be what the coupon says they are. On the other hand, they are hoping that they will prove less risky or equally risky in the future as they have done in the past over the next 2-, 10- and 30-year time frame over which those bonds might mature.
And that assumption that the past may be reflective in the future is a very incorrect assumption, as many investment banks found out, as many regulators found out. And we fear many bond investors and naïve investors who are owning these instruments thinking that they're going to be stable may actually prove to be quite risky. And they've locked in the returns, but they've exposed themselves wide open to the risks. And that's the thing that has to be pointed out to them.
What are some of those risks? Let's look at them. Why — how is it possible that the dream of stability can turn into a nightmare of volatility? And the central notion here is that just because you have — an investor has swapped one form of risk for another form of risk, it does not mean that you have reduced risk. In fact, all you've done is swapped risk. And it's a risk that the investors are not thinking about, which are not priced into these instruments, that actually may come back to haunt them, as we found in the 1960s, when interest rates were very low in many parts of the world, particularly the US.
And then in the 1970s and '80s, as interest rates shot up, it wreaked havoc on the portfolios of many sophisticated institutional investors like pension plans and insurance companies who were extremely exposed in their allocations towards bonds, which did not keep up with the rising rates of inflation in the '70s and '80s. And, frankly, they lost a lot of money in bonds where towards the latter part of that decade switching to equities, which had appeared extremely volatile during that period, and, frankly, had been more volatile than even bonds, proved to be the way to hedge against inflation.
So bonds were not pricing in inflation risk. They were not pricing in credit risk. In fact, over that time frame many countries defaulted on their obligations. Recently, as we've noticed in the sovereign bond crisis in Europe, Greece has had difficulty repaying the bond. Hitherto in the last five years, in fact, in the history of the developed countries, no developed country nation has defaulted, and if Greece were to default they would be among the first countries to do so in recent history. So that is a notion of credit risk, which was not priced into Greek bonds about five years ago, and today we see that Greek bonds are trading at extremely wide spreads, because it's not just inflation risk. Frankly, inflation in Greece is not the problem. It's the creditworthiness.
So these are the kinds of risks that you can still expose yourself to in the fixed income market. It's not just interest rate risks. But that is not to say that the interest rate risk itself is being paid for. As we know, interest rates can fluctuate. They can go up as much as they've gone down. And, as we saw on the previous slide, interest rates have gone way down. And, in fact, if there's one bet that most people ought to make is that they are more likely to go up than down, which means that the negative returns from bonds can be meaningful. So, again, the idea is people think they have reduced risk, when in fact they have only swapped it. They just don't realize they've swapped it.
At this point you are thinking is this only true of the bond markets, or is this something that has happened in the equity markets? And I would argue actually this obsession with stability has actually found its way into the equity markets. Many fixed-income proxies such as utility stocks, consumer staple stocks, REITs and so on and so forth, that are really fixed-income proxies have become quite overvalued.
And one example that I'd like to point out is Procter & Gamble, which clearly is viewed as a blue-chip consumer staple, and there is an expectation of stability in an investment like P&G, versus there's clearly an expectation of volatility in a company like Toyota, which being in the auto industry can be fairly cyclical and therefore fairly volatile. Note, however, that for many years the two performed pretty much in sync. And in fact, the red line, which is Toyota, has way outperformed Procter & Gamble in the last couple of years.
And this is just one example of how a consumer staple, which actually traded at a premium to what Toyota, which is a consumer discretionary and therefore perceived and priced, more importantly, as volatile, can actually generate returns. And in fact Procter & Gamble has not only not performed well, it has underperformed the benchmark as well as its peer group. So stability in and of itself does not guarantee performance. And in an investment portfolio you are not just looking for the investment portfolio to stay static or stable, you are looking for it to grow.
That said, you clearly want it to grow with lower risk. So remember I talked about Toyota, which I think we all would agree is a pretty fine automobile company. They make good products. Chances are that eventually those good products will translate into good revenues and earnings for them. And if that company is undervalued and, frankly, is at a bargain price, as it was at one point, then it can make for a very good investment.
So the real message here is that sometimes what appears to be stable can prove to be a poor investment and what appears to be volatile can prove to be a very good investment. There is nothing intrinsically low-risk and high-return about stability. And in fact this example of P&G shows that it was the opposite.
Is there a way in which to think about how to position a portfolio so that you take advantage of what you see very transparently out there in the market, and that is, if stability is not always your friend, as I just described it, is volatility always the enemy, or actually can you take advantage of volatility? And I would argue that not all volatility is bad. In fact, when volatility is priced into that investment opportunity, whether it is a bond or an equity, but I'll stick to equities, because that's my area of expertise, that actually you can generate some very good rates of return indeed with very low risk.
This is the opposite of how the conventional person thinks about stability and volatility. The notion is that stability is low risk and volatility is high risk, but actually the difference between or the tipping point between risk and reward is the valuation, i.e., what is priced in? In fact, if all the stability is priced in and none of the volatility, that investment can prove to be very risky and low reward, and, on the other hand, if all the volatility is priced in and the stability is not, you can actually take advantage of that. So it is low valuations that reduce risk, and high valuations increase risk.
Is there, again, a way in which one can take advantage of this? And I discuss such opportunities, because this is exactly what we do at Ariel. We try to make volatility our friend. And it is the friend of the long-term investor. It is the enemy of the short-term investor. But the advantage of doing that, by casting your net wide and waiting for things to come to you and making sure that the risk is priced in and the volatility and all the concerns that people have are priced in, is that you can grow your capital, your principal amount, because you can get capital appreciation from that investment opportunity as the risk is priced in but the reward is not. And in fact, if you buy those investments with a degree of underlying quality, either from the business that the company has, the brand equity, the reputation, the track record, the balance sheet quality, the management quality — and, again, in the previous example of Toyota we found all those to be true — you can actually have some current income, as well, because stocks pay reasonably good dividend yields if you choose them well.
So the dividend yields can provide the current income and the stock going up can provide the capital appreciation. So, again, you've achieved growth of capital, current income, and yet you achieve your long-term goals. All you've done is change your means. And those means, as I described earlier, is contrarian investing.
Because I've practiced it for the predominant part of my career, which spans about 25 years, let me tell you why some of these principles of contrarian investing work, and how is it — how would you as a financial advisor talk to a lay person who may not really understand the construct of contrarian investing and needs a simple explanation? What does contrarian investing mean, plain and simple? It means buying things when they go on sale.
Think about it. When you go shopping and you are able to buy exactly what you wanted to buy, but it happens to be on sale, clearly that's a good deal. So instead of buying full price, when you buy things on sale chances are you're getting a better value, provided, of course, you make sure that you're buying good quality stuff. So we are not talking about buying things on clearance. We are telling you just to buy things on sale.
So contrarian investing is to be patient, not buy the hot stuff off the rack, off the fashion runway, which everybody is chasing and is going to pay up for. It's almost like an auction situation where the highest bidder wins. It's a Pyrrhic victory even if you win that auction. You don't want to chase those opportunities. You don't want to chase that merchandise. You want it to come to you. And, generally speaking, things that are classic in nature, that have a long shelf life, that are quality, if they go on sale, that's a better way to own them than to buy them when everybody else is chasing them at the first time they became available. So that's where patience comes in.
I know by now you are dying to think about what are some of the specific examples in the way in which contrarian investing has worked in the past, and how has the payoff been. So indulge me with a thought experiment. One of the things that also characterizes contrarian investing is it tends to be things — the best opportunities tend to be those that are most misunderstood and most out of favor. It's almost the opposite of owning something that everybody wants to own, which by definition then becomes a crowded trade.
So one trade that was a complete lonely trade back in the day which was under our nose for all of us to invest in but we failed to, and they have absolutely shot the lights out, is the tobacco stocks if one owned them in the late '90s. If you recall, there was clearly a lot of concern about litigation against tobacco companies. There was regulation. There was marketing regulations, etc., that prevented them from, again, expanding their consumer base. If anything the number of smokers in the end market has declined.
And yet this investment, which appeared to have a lot of volatility, frankly a lot of that bad news got priced in. Tobacco stocks have had some of the best rates of dividend-per-share payout, of dividend yields, as well as of capital appreciation, as this particular slide tries to show you.
So what are some of the tenets of contrarian value investing? Like what are the core criteria or things that you should expect to see for it to fit this definition that it's truly a contrarian value investment opportunity? It is three things.
One is it must start out by having very low expectations about the future. So it's almost as if all the bad news or the worst case scenarios are priced in, and in fact people don't expect things to get any better. In fact, they think they will get worse. As a consequence, they tend to become quite out of favor, because who wants to own something that everybody else is running away from? There is a fear syndrome. There is a herd syndrome. And the contrarian trade stands alone. It is not part of a crowd. And that's why we often call it the lonely trade.
The third thing that usually accompanies something where there are very low expectations and it is out of favor, and it almost happens as a consequence of the de-rating, which also occurred to the tobacco stocks, is the valuations start getting very, very low. And the tobacco stocks actually started out on a PE multiple, believe it or not, of 5 times, close to the peak of what we know was the S&P 500 bubble in the '99-2000 period. When the S&P was trading probably closer to 50 times and the NASDAQ was at 90 times, here is this sector trading at 5 times.
So you can see how that setup played out. And today the multiples on the tobacco sector are closer to the S&P 500, for example, so they've re-rated 3x the underlying earnings and the dividend and the cash flow generation have gone up many-fold, to the point that you've had close to 1,500x the performance of the benchmark, roughly speaking. So this is the power of contrarian value investing where there is a franchise. There was brand equity behind those tobacco companies. And things got extremely difficult for them, and, yes, all those difficulties were real. But because they were priced in, that volatility gave you a tremendous opportunity.
So that's sort of one example of contrarian investing, a powerful one that has worked out in the past. But you might ask is there something that has worked out just in the last couple of years? Again, remember the kinds of companies that I've chosen are extremely large cap in market cap. I'm not talking about some undiscovered company that was a microcap that became a large cap. I'm talking about businesses that have been around forever and yet, despite being under our nose, because we don't want to look for things that are volatile, and in fact we want to avoid them, we miss these opportunities.
One example is China Mobile. This is a $150 billion market cap company, so clearly extremely investable, both in the ADR form as well as locally in Hong Kong. This is a company that has 700 million wireless phone subscribers. Think about it. Even Verizon, which is a dominant wireless service provider in the US, has only about — in a population of 300-odd in this country, even if they had 50 percent market share, and they have close to 45, they would have 130-odd million subscribers. You're talking about 700 million subscribers, the largest cell phone company in the world.
And people salivate about the emerging market opportunity of the consumer, the burgeoning consumer, the growing consumer. And here I think all of us would agree that wireless phone services are a consumer staple, because I don't think any of us can imagine life without our phone. And here is a company that has done nothing but underperform — you see that blue line — since 2013, during which time major market indices have gone up quite a bit. This stock did nothing and was ripe for a contrarian value setup.
And the reason it was doing poorly is because there were very low earnings expectations because the company had disappointed for a couple of years on its growth expectation. They had deployed a particular technology in their network which did not allow them to avail of some great handsets being introduced in the world, which is the iPhone and so on and so forth. And that meant that they lost some subscriber market share.
However, there was an inflection point where the past was not going to represent the future, where they were installing a new network and with a new chip set and capability that will allow them to avail of other global handsets such as the iPhone 6 to work on their network. So we knew that they would be able to regain that market share. What they had been hurt by was a temporal development lasting a couple of years, nonetheless. But that's the sort of patient investment opportunity where people were looking at the past earnings and saying, gee, everything that can go wrong goes wrong and will continue to go wrong, failing to appreciate that change.
You could buy this company literally just about two years ago when markets were rip-roaring and full of a crowded trade, here was a lonely trade on 10 times earnings and a 4 percent dividend yield. The stock has actually gone up since that time. And, again, this is a kind of investment opportunity that is a large holding in our flagship mutual funds that Consuela referenced. And this should not surprise you, because this is a quintessential contrarian value investment opportunity. So, with that, you will again want to understand an idea that is yet to work in the future, because China Mobile has partially started to work in the recent past. Of course, we think there's more to come.
But I did want to leave you with even in this market, which everybody argues it's extremely hard to find opportunity, whether you talk to a growth investor, a value investor, a long-term investor, a short-term investor, they all are sort of struggling to find ideas, here is a megacap under your note that, again, fits this notion of contrarian value investing, and that stock is GlaxoSmithKline. We all know that healthcare stocks have had a huge rally in the last couple of years. In fact, biotech stocks, the NASDAQ healthcare sector, has been on fire.
And yet this stock, which is represented by the blue line, has pretty much done nothing over the last couple of years, as you see on this chart in the blue line. It's gone up marginally about 10 percent, but, remember, over that period the S&P is up probably by about 55, 60 percent. So clearly very out of favor, very much a stock that has underperformed, which I told you is some of the setup that you need for a good contrarian value.
Now, more importantly, I told you we want to buy things on quality, not on — on sale, not on clearance. So this company has some very good things going for it. It's got a terrific vaccines business. I think you all will agree vaccines are a consumer staple. We can't live without them. And in fact there are only a handful of companies in the world that can make vaccines, so the barriers to entering that business are extremely high.
You have to be government certified to be able to sell a vaccine. As you know, the government administers a lot of these very life-threatening vaccines to children all over the world. So this is an example of a consumer staple that is not called a consumer staple, doesn't trade like one, it's at a huge discount in the consumer staple sector, and yet we think that some of the products they sell are consumer staples.
In fact, another portion of their business is, about 20, 25 percent, is consumer staple items like toothpaste. Glaxo actually sells the Aquafresh toothpaste, which competes, of course, with Crest of Procter & Gamble and Colgate of Colgate. But this is a classic consumer staple product set. And they just got in a new management team to improve the operating margin. So this is a consumer staple business that's undergoing restructuring. It's underearning its potential. And therefore people have sort of gotten a bit fed up with it and given up on it, but that's why it's out of favor.
And the third business, as its name suggests, the healthcare company, they had a bit of a setback in the respiratory franchise, which makes Advair. Anybody who has a child with asthma or any sort of COPD problems where the lungs don't function effectively, Glaxo kind of rules that space. And, as you know, things like asthma, and pollution around the world is increasing, so the incidence of respiratory diseases is likely to increase over time. And so this is a play not just on developed markets, because the incidence of asthma is increasing worldwide, but it's also a play on pollution in emerging markets. So this is a way you can get sort of a global growth industry exposure at a value price.
A lot of people buy companies like Yum! Brands because they are known to sell consumer products to a growing emerging market consumer, and Nike, and so many of these classic iconic brands. But people don't realize that even in healthcare there are certain products that doctors won't switch you out of, because once you are stable on a certain kind of medication to switch medications is quite risky. So there are sort of attributes of GlaxoSmithKline that we do feel offer some core quality businesses that have undergone some temporary setbacks that have scope for improvement, and because of that the stock is very undervalued in our favor, and here you can clip a coupon. At the time of making this slide it was a 5.5 percent yield. It's actually a 5.9 percent yield. So that's a very good rate of return while you're being paid to wait as the earnings come back.
I think, just to leave you with some final thoughts on how to think about talking to your investors, because I've explained to you how contrarian investing works, some examples of the past that you can share with them, and why it works, more importantly. But I think the key points to make to the investors is that risk should not be defined as short-term volatility but permanent loss of capital, which can happen in the bond markets, as investors in Greek bonds found out. It can also happen if it does not keep up its purchasing power, as a lot of pension plans found out in the '70s in the US bond market.
Explain the critical role of valuations as opposed to constantly thinking about asset classes. It's not just about stocks, bonds and real estate. It is about what is the valuation of the real estate asset class. What is the valuation of the bond asset class? What is the valuation of the stocks in your portfolio, and so on and so forth? And I think the role of valuations is critical in thinking about whether something is going to offer you a return or something is actually going to offer you risks, as opposed to simply thinking that risk or return is intrinsic to the asset class.
A lot of people going into the housing crisis in the last couple of years thought that real estate was extremely low risk, and they found out that actually it wasn't. So there's nothing intrinsic about real estate. People will give statistics, "Well, in the last 50 years we've never had such a nationwide downturn," and so on and so forth. And guess what? Experience does not equal exposure. We had the first nationwide housing crisis that America has ever seen.
And this is why it's not about asset classes. Risk exists everywhere. Your central question is to ask am I being paid to take the risk? The risks exists. You just don't know it. So valuations tell you whether you are being paid to take the risk or not.
And, finally, a lot of contrarian managers will underperform in the short term. When I was buying Toyota in the Ariel funds at inception in 2012, the stock kept falling. And if I had many such stocks in the portfolio with a long-term value, and the upside returns were very attractive, but in the short term, because people were afraid and people were thinking about the worst case scenarios and pricing it in, they were selling off the stocks, we were actually dollar cost averaging down. But in the short term it makes performance look very bad.
But there's a big difference in looking dumb and being dumb. And in the fullness of time, as we have now come to realize, Toyota stock has gone up a lot from that standpoint, and investors, which properly explains the kind of results we've managed to have in our mutual funds that Consuela referenced, is because a patient investor with the contrarian value mindset I've talked about, as long as you're buying the stocks on sale and not those that are offered on clearance, i.e., which nobody else wants ever — so we don't believe in distressed investing or deep value investing, we're talking about quality companies that are available on sale — you can make what I'm going to call performance statements in your portfolios, as opposed to what I'm going to describe what a lot of investors try to make, which is fashion statements.
Owning Apple, which, by the way, we don't, and we have good reasons not to, because a lot of the good news and expectations are extremely high in Apple stock and people have priced those in, that means if things don't work out, then the chances are that you are actually going to lose money in that stock. On the other hand, Microsoft, which is quite the hated stock out there, which people think is a dinosaur, which people think the best days are over and behind it while they think for Apple are ahead of it, is priced as if it was a very poor company to own. And, frankly, if you look at the underlying earnings, the cash flow generation, the stability, the power of Windows in the enterprise world, which is the Office applications, etc., I would argue that you might want to apply the moniker of Microsoft as an enterprise staple even if it's not a consumer staple.
So just because it's called an enterprise staple, does that make it any less of a staple? I don't think so. But this is the kind of way in which you want to think. You want to apply what I'm going to call a little bit of out-of-the-box thinking, a little bit of dose of unconventional way of looking at things. And that is a setup for contrarian value investing which we believe works in the long run, but you do need to be patient in the short run.
And so the final thoughts are that, like anything in life, it's all about managing expectations. So, while contrarian value investing can deliver good return with low risk in the long run, it can fail to do so in the short run. And that's why expectations have to be managed. A good advisor will focus their clients on, "I will make sure you reach the destination. Don't dwell so much on the journey." And the journey is the short term. The destination is the long term.
And you do need to think about being a bit uncomfortable. Investing is not easy. It is not comfortable. But when you are uncomfortable, that's sometimes when the best investment opportunities present themselves. And if you're not able to be a contrarian investor yourself, well, outsource it to someone who can do that on your behalf. I don't mind if I have stomach-churning moments and I don't sleep at night in the short term, because I sleep very well in the long term, and I can do that contrarian value investing. So I doesn't have to be something that the investor themselves practice on their own, because it's extremely hard. It takes a lot of constitution and knowhow. But you can outsource it. That's why mutual funds exist.
So, it doesn't also have to be all or none. It doesn't mean that just because you've hit upon this idea and it works that you encourage your clients to put all their money into contrarian value investing. You can start somewhere. I don't think any decision has to be all or none. It can be some. You can figure out the like paths to making that some happen, but don't let it become an all-or-none decision. You can benefit from some of this. Start the journey. Walk the walk.
That's all I had to say in my prepared remarks. I hope I've given you a flavor for how this can be of help, and I'm happy to take any questions.
Consuelo Mack: No, you certainly have, Rupal. That was great. And also we've got Mark Cortazzo on the line, as well. We've gotten some questions from the audience.
Rupal, I want to ask you, Ariel Investments is known as a value investor. What's the difference between being a value investor and a contrarian value investor?
Rupal Bhansali: Well, oftentimes a value investor can take different forms, which is you can be a deep value investor, you can be a relative value investor. And so I think that value investing can come in different sort of flavors, if I call it such. Contrarian investing is a particular aspect of value investing. It's a particular way in which to approach value investing, which is when you buy things that are extremely out of favor, and it is that lonely trade, as I described, it offers superior risk — superior return for lower risk. That's a very special part of value investing.
It is not, for example, to be compared to relative value investing, where someone can just buy a stock which is trading at a discount on the S&P 500, or relative to its history. That's relative value investing. That would not in and of itself be contrarian investing, because a lot of relative value trades can also be crowded trades. People own something just because they feel like they must. So that's the distinction.
Consuelo Mack: All right. And a question from the audience about the tobacco stocks that you own, and Ariel — this is the question — Ariel is known as a socially responsible investing firm, yet you are investing in the Ariel International Global Fund in tobacco stocks. How do you reconcile the two?
Rupal Bhansali: Well, you are correct. The heritage of Ariel's domestic strategies have been around SRI in the past. But when Ariel brought me onboard to initiate and launch these international and global equity strategies, it has always been the intent of Ariel as well as myself to do what I've done best in the past. And in the past we've not run these screens on our strategies, and we didn't want to disturb a good thing. And so I've just continued to do what I've always done before, and I think the results and the performance speaks for itself. So at some point in the future we don't rule it out, but certainly today we just wanted to carry the tradition of what I've done very well in the past, which is running the money unconstrained.
Consuelo Mack: So Ariel is allowing you to continue to be an independent-minded portfolio manager (inaudible - multiple speakers).
Rupal Bhansali: You could say that. Exactly. Thank you. That's well put.
Consuelo Mack: Mark, let's bring you into this. You provided me with some research independently about the performance benefits of value investing. And I know that you believe in value investing, as well, at Macro Consulting. And I'd love your thoughts on value investing versus contrarian and if you differentiate between the two.
Mark Cortazzo: Well, I think that you have to be a bit of a contrarian in many cases to buy value stocks. And, as an advisor, the tough thing with buying value stocks is the reason things are typically trading at an attractive valuation is because they're out of favor, they're the ugly duckling. So when the tech boom was running its course in '98 and '99 you had value-oriented stocks that the market cap that they were trading at was less than the cash that the company had on hand, but you couldn't get someone to buy that stock without a cattle prod, because the only thing that was hot was biotech and technology. So your thought process and what you're — the ponds that you fish in tend to be contrarian, and you tend to fish alone a lot if you're a value manager. I'd rather fish alone than with a big crowd.
Consuelo Mack: We got a question in about how do you feel about dividend-paying stocks as a way to create some stability as you look for growth, and, Rupal, you were talking about that in your presentation, but why don't you just elaborate a little bit more on that? And also I'm going to ask you the same question, put the same question to you, Mark.
Mark Cortazzo: Great.
Rupal Bhansali: Yes — sorry, Mark. Go ahead if you wanted to address it first.
Mark Cortazzo: No, you can go ahead, Rupal.
Rupal Bhansali: All right. So I think that's a really great question, because a lot of the stocks that I referenced clearly had a dividend yield, and yet we don't call ourselves a dividend yield fund, for example, or an income fund. And there's a reason for it, which is sometimes a high-dividend yield can be representing a stock that is going on clearance. And a good example of that is all the high dividend yielding banking stocks that you had in 2008 which went bust and the dividends went to zero.
So you want to be careful to not screen just for high dividend yielding stocks. And because we don't do that, and we will often buy stocks that don't pay a dividend, however have the potential to pay a dividend, we think that's a better way to go instead of running a (inaudible) screen on it, because that's exactly what got a lot of investors in trouble in 2008. The dividends got cut. And this is why specifically I mention Glaxo. We expect them to pay the dividend, which is a big difference.
The other thing to point out about the dividend yield is there are many jurisdictions where the tax treatment towards dividends versus share buyback can be very different. For example, Australia has stocks yielding 7, 8 percent dividend yields, because the Australian investor gets something called a franking credit. Now, in the US, the total yield, and we define the total yield as the dividend yield plus the share buyback yield, because share buyback (inaudible) form of returning money to shareholders, the tax code in the US incentivizes company more toward share buybacks than toward paying out a dividend yield, which are taxed often at ordinary income rates.
So we don't want to disadvantage the investor by looking at a metric that can get skewed, depending upon tax treatment and so on. We'd much look at what I'm going to describe as total return, i.e., what can you make from both? And this is why if you look at the total return on the S&P 500 it trumps the total return on the NASDAQ, because over time the S&P 500 companies have generated more dividends and grown them over time, whereas the NASDAQ stocks tend not to be a dividend and tend to be more expensive than the S&P 500. So I think a better way to look at stability is what can give you better total returns, not just higher dividend yields?
Consuelo Mack: And, Mark, how key is the dividend function for you with your investment strategies, as well?
Mark Cortazzo: It's very important. We run a separate dividend component of the portfolio with individual equities. And it's not just what the yield is, it's what's the quality of that yield. How sustainable is that? What percentage of earnings is it? We see frequently when we're doing screens companies that are paying more than 100 percent of their earnings out as dividends. And that's not sustainable for very long periods of time.
And so it is nice to be able to get paid while you're waiting for the equity appreciation, so having that as a component of the portfolio. The one thing that is very important to emphasize to clients, particularly, is that a utility or a high dividend paying stock is not a replacement for a bond. It has very different characteristics. And I think that there are people that — there are large bond funds that started buying equities for yield. And it changes the risk profile and the metric, and I think having transparency and having the clients have clear expectations is very important in having them be successful and weathering when the storms come. So the dividend yield is very, very important.
If I can take a left turn on this question, the other issue that we're seeing a lot of with new prospective clients coming in and people inquiring or friends inquiring is on the fixed-income side of the world. And the one-year number, three-year number and five-year number on high-risk fixed-income asset classes like preferred stocks, like high yield, like convertible bonds, the numbers have looked just fantastic, because the more risk you've taken the more you've been rewarded.
Consuelo Mack: Right.
Mark Cortazzo: In 2014, beginning of the year, everyone was expecting the 10-year Treasury at 3 percent to go up. We had a 100-basis-point decline in value, and that really juiced up the performance on these asset classes.
But just as a quick reminder, I know it was a long, long time ago, back in 2008, but when the equity markets got hurt convertible bonds went down about 30 percent, high yield went down between 25 and 30 percent, REITs went down 40 percent in '08. So these are things that act like stocks although they're called bonds. And if you're building bonds in the portfolio as a risk mitigator, these are not effective when you have times of stress in the markets.
Consuelo Mack: And do you think they're extremely risky now at current valuations?
Mark Cortazzo: Absolutely. If you look at the spread that you're getting paid on high yield — the one important message, the most important message that I've gotten talking to people is about the market usually will surprise you. People have expectations. Those prices are — those expectations are baked into the price, and you're usually going to be surprised at some point. And if you expect Tesla to take over the world and have — be the only car manufacturer that's left, and if you expect Apple to be 50 percent of the S&P 500's market cap, I think that you're going to be surprised. And so the expectation on these things, this spread you're getting over good quality on high yield is tiny, and for the amount of principle risk that you're taking, I don't think that the risk-reward is there. And so the relative valuation compared to historic norms, and what — asking yourself what are the good things that can happen, what are the bad things that can happen, from where we are today. The most dangerous statement I hear from clients and even some advisors is the market is doing well. This asset class is doing well. No, that assumes that it's going to continue. They have done well.
And I was texting my wife about all the shopping references, so now I understand the difference between clearance and sale, so I can comment to that. I wasn't sure what most of that meant and I was going to try to throw a sports analogy in just so we get some testosterone in the presentation, but what you pay for something really does matter. And when you've got clients saying, "I want to buy XYZ stock, or I want to buy real estate, or I want to buy gold, it doesn't matter what I pay for it, it's going to just continue going up," that's when we know that trade's done.
Consuelo Mack: And Rupal's nodding her head here in complete agreement. Rupal?
Rupal Bhansali: Yes, and I think, Mark, one other observation I would make is exactly what you said earlier about the dividend yield stocks, that you actually take the time and the effort to understand whether the dividend-paying ability is going to sustain itself. So you look at the payout ratios, and if someone's paying over 100 percent, then that dividend yield is a head fake. And so I think it's important to remind financial advisors and their clients that you can't run a naïve screen and just go willy-nilly and buy all the high dividend yielding stocks out there and not do your homework.
I've never thought investing is a DIY profession. I think it's left to people who do it full time and do it for a living, and it's okay to pay a few hundred dollars for them to manage your money, because, frankly, 24x7, doing that kind of research, making sure that you've crossed your t's and dotted your i's on these funds as opposed to naively jumping into something is really important. And that's why I don't believe in a naïve strategy of just buying high dividend yielding stocks and certainly don't recommend that investors do that on their own without all the homework that someone like yourself does.
Consuelo Mack: And, Rupal, it's very difficult to get our heads around seeking growth in income with less risk by embracing volatility in a lonely trade. That's from your Slide 10. So why are you so convinced that embracing volatility in the lonely trade is the way to go? And, Mark, I'm going to ask you is it, as she mentioned at her closing of the presentation was that in fact that this is appropriate for some portion of your portfolio, this kind of contrarian investing, and I want to know, after Rupal answers the question, what percent of the portfolio can a client live with in these kind of lonely trades? So, Rupal, first to you, why are you so convinced that this works?
Rupal Bhansali: Well, I think my career has demonstrated that for me, and I think that the results we've shown in our investment strategies, as you pointed out, for the Ariel flagship strategies, I think speak for themselves. Ultimately a theory has to be validated in evidence, and ours is rooted in that, I guess. That's one observation I would make quickly.
But the other reason, and the reason why this works in practice is because of the central role and the critical role that valuations play in either helping you generate a return or lowering risk. And I think that what happens with contrarian investing is that definitionally, when you're buying something that's out of favor, disliked, it tends to be undervalued. And that's — valuations are far more important.
And I think you've known this from the real estate market. Even prime property in central Manhattan failed because it was overvalued. There's nothing wrong with the property. It's just it got overvalued. And on the other hand, at the throes of the crisis there were condominiums in Miami going for a song, and nobody wanted to touch them. But that's what made for a great investment opportunity. So I think that's why contrarian value investing works. When something gets out of favor it also tends to become quite undervalued.
Consuelo Mack: And, Mark, how much can you convince your clients to stomach the concept of looking dumb? How long are you willing to look dumb, for instance, and look like — and own something that you are very uncomfortable with?
Mark Cortazzo: Yes, that's the difficult part about value investing. You are assumed that you are wrong until you're proven right. You're buying the fun, trendy stocks that everyone's buying. There's safety in numbers there. And no one's going to fault you when everybody was buying Lucent and it goes from $70 to $0.50. Well, maybe some of your clients might fault you for that. But it was the most widely held stock.
So if you go back to the '20s and you look at five-year rolling periods, more than 80 percent of the time value stocks have outperformed — have had a premium over blend. It's about 200 basis points consistently over long periods of time of outperformance. So it is a tough trade. If you're charging 1 percent a year and you can get more of the client's assets into value-oriented stocks, which is tough to get them to do because it's not what they want to do, you can earn your keep and still provide alpha.
But it is — it's like a great diet or a great workout program, Consuelo. It is — the best program is the one that your clients do. And sometimes — I've used this analogy a bunch. My kids are now going to college, so it's not quite as relevant. But when they were young we'd mix their green beans in with the applesauce or with the mashed potatoes. And maybe it wasn't perfect. They were getting more sugar from the applesauce. But they ate the green beans.
So if you can make it part of the portfolio — but you have to explain to clients that there are a lot of strategies that work over time, but they work over time because they don't work all the time. And consistent outperformance, if that's what you're looking for, it's very — if you're picking a particular philosophy or strategy, value stocks were out of favor during the '90s, and you looked really dumb for a long time until you got very, very smart.
So I think if you educate the client and they understand and this isn't money that they're going to be touching, this is kind of that back-end money that they're going to build into their portfolio, they're then rewarded very consistently over time for it. And it makes sense why they're being rewarded consistently, because they're doing what Warren Buffett does. He's buying when nobody else wants to buy.
The oldest joke in investing is how do you make money, you buy low and sell high. This is what buying low and sell high feels like. It doesn't feel good. It doesn't feel comfortable. And one of my favorite investing quotes is what's comfortable is rarely profitable, because that's already been priced into that trade, because everyone knows it's a great idea and a great deal, and it's priced at that level.
Consuelo Mack: Let me ask you both about your time horizon, because I know, Rupal, you said that volatility is a friend of the long-term investor and the enemy of the short-term investor. But, I mean, how long do you stick with a GlaxoSmithKline, for instance, that underperforms the market? I was looking at your chart, and it was — it had underperformed for over two years. I mean, how long do you stick with it, and kind of when do you say, okay, this is just not working?
Rupal Bhansali: That's a great question. And I think what's really important to understand is that you need a portfolio of such ideas. You cannot bet on any one of them. Because they can perform at different rates. I can tell you that for a couple of years I owned Nintendo in my strategies, and they, too, underperformed in the last couple of years, till this year they went up 50 percent, because finally people understood that this company had great content and could be monetized.
So it does take a couple of years. But Nintendo performed this year, while GlaxoSmithKline has yet not performed. So you need to have different companies with that setup so that at the portfolio level something or the other is always working out while something else is not working out. So that sort of cushions that journey. That's one.
This is why I said that you need to cast your net wide. You cannot just do it with one or two stocks, because they may or may not work out, and certainly they may not work on the time frame. But as long as you keep — there's always something that's working out and there's something that's not working out which will work out in the future. That's one strategy.
And the second thing to keep in mind about the time horizon is that in general businesses tend to perform over a business cycle, and which I think typically is somewhere between at least three years to seven years. So I'm going to say about five years is what you're going to look at. That said, as a professional investor, it's not like we wait till the end of five years to take stock of the situation. We are monitoring these investments day in and day out. This is a full-time job. And so when we see that there is something happening in the underlying company or the business that does not fit our investment thesis or our expectations, we can certainly as an active manager liquidate that position instead of letting the damage continue for a couple of years, or in value.
So this is an actively managed strategy. Contrarian value investing is about being both — casting your net wide, waiting for those opportunities to come your way, then waiting patiently for them to work out and not capitulating, but also having a portfolio of them.
Consuelo Mack: And, Mark, as far as the allocation among your portfolios, I mean, I'm assuming you kind of take the same approach with asset classes, right?
Mark Cortazzo: We do. And we have either some form of liability matching, where we've built a ladder or had some cash flow or some liquidity built into the portfolio that will buy a client time for some of these strategies to work out. And if you're buying dividend-paying stocks you do have that cash flow that you can utilize to lessen that pain.
But the equity part of your portfolio you shouldn't be looking to liquidate shares — maybe taking the cash flow, but not liquidating shares on that investment for at least five years. This is a long — I mean, long-term investing is long term. And I think people's timetables have changed, and the equity markets have been — performance has been measured in nanoseconds. And that's not the purpose of owning stocks.
You own stocks because maybe you don't have the ability to start your own business. It gives you the access to have ownership in several different industries, in several different companies, and over long periods of time reap the benefits of those companies creating value. The cost that they sell their goods and services at should be greater than the materials and the employee expenses and distribution of those goods and services, and over time they can do that and make money and be profitable, and you share in that as a shareholder. And it's not this week or this month. It's over time.
Consuelo Mack: Is there anything innately wrong with seeking stability of returns, or is it just that they are extremely dangerous now because they're overvalued? Rupal?
Mark Cortazzo: I would like to jump in on that.
Consuelo Mack: Oh, Mark, go ahead.
Mark Cortazzo: On the fixed-income side we've been talking about doing screens, and this is something that you and I have talked about, Consuelo, that really scares me. And hopefully the advisors on here take note of this. We've done a number of screens on fixed income for duration, because people are concerned that rates are going to rise and the amount of volatility they're going to experience in a portfolio.
And we're seeing portfolios that have bonds that are trading at premiums, that have higher coupons, that have 20-, 25-, 30-year maturities, but the duration calculation is based on the current interest rate and those bonds coming due in the next two years or three years because of call provisions, etc. If we get rates [gap] up 100 basis points, 150 basis points, the duration on that portfolio could jump up to double digit.
And looking at — this is just like what Rupal was saying. It's not the past experience. It's the going forward. And if you look at what is in that bond portfolio, and you guys can go do screens yourself, but there's portfolios that have 2 and 3 percent, or 2- and 3-years durations on their portfolio, that have more than 50 percent of the portfolio in bonds that are out 15-plus years. And you get that extension risk when rates rise, and what you thought was going to have very little volatility can have extreme volatility. So that, if we're looking at stability and risk, and that's a great measure that people look at, it's a very deceiving one in funds that might have call provisions in the bonds.
Consuelo Mack: And, Rupal, the last comment to you is the innately is seeking stability a problem or is it just that it's extremely overvalued right now?
Rupal Bhansali: Exactly. It's more because it's overvalued. We totally understand. If a stable investment is undervalued, go for it. There's nothing intrinsically against stability. But there's also therefore nothing intrinsically against volatility. So you can make volatility your friend if stability's the enemy, if it's overvalued, and then it can flip around. Sometimes volatile stocks, like NASDAQ was a classic example, volatility became a fetish in and of itself, because it gave you upside risk capture, and people were actually chasing a lot of concepts, and stability became undervalued.
And in fact if you look at what's happened in the next decade, a lot of companies that produced commodities or oil did extremely well and actually offered a great deal of stability, because it's hard asset from the ground. So, absolutely, it's all about the valuations, and, frankly, it's all about whether something is a crowded trade or a lonely trade. At this point in time stability is a crowded trade, volatility is a lonely trade. When that changes you should change your allocation, too.
Consuelo Mack: All right. Rupal Bhansali, from Ariel Investments, Mark Cortazzo, from Macro Consulting, "The Dangerous Game of Chasing Stability." Thank you so much, both of you, for participating in this. I also want to thank the audience for their questions. And we want to thank our sponsor, Ariel Investments, and the InvestmentNews audience, as well.
And I want the audience as well to know that a replay of this webcast will be available at InvestmentNews.com/webcasts within 24 hours if you would like to share the webcast with a colleague.
Thank you so much for joining us, and have a good rest of the day.