How One Portfolio Manager Climbs the Wall of Worry

Tuesday, July 27, 2010

The last few months have been challenging for many in the investment industry as the market corrected 17% from highs on the back of sovereign debt issues in Europe. After the preceding 80% rally in equities off the March 2009 lows many are claiming the bear market is back on and we are in for a double dip recession. So I called up one of the smartest guys I know to get his opinion on the state of the markets and the economy and to see how he is handling the wall of worry.

Jason Stephens, CFA is a Portfolio Manager at Thompson Investment Management, Inc. located in Madison, Wisconsin. Stephens runs separately managed accounts and is co-manager of the firm's three mutual funds: Thompson Plumb Growth Fund, Midcap Fund and Bond Fund.

The last couple of years have been extremely tumultuous for the investment management industry. Can you tell me a little bit about how you felt? Did you ever think the world was going to end? How did you deal with client fears?

I don’t think that we ever thought the world was going to end necessarily, but it certainly was unnerving to sit in our research room watching the market plummet. We had some ideas about problems the country was facing with respect to leverage and low savings rates, but we weren’t quite sure how they would manifest themselves. So when things actually started falling apart, I wouldn’t say that we were surprised, but we were certainly taken aback by how far things went. It was nerve-wracking.

We have fixed income products, equity products and direct relationships with a lot of clients, so at the same time we were trying to figure out what was going on and how to position ourselves, we were also concerned about making sure that our clients were comfortable. At that point in time, because everything was so synchronous with respect to the decline, unless you were in U.S. Treasuries it was hard for anyone to be comfortable at all. We spent a lot of time talking with clients to help them understand the fundamentals of the investments they held. We talked to them about specifics -- about the idea that Coca-Cola would not likely go bankrupt and despite what’s going on at GE Capital, GE will probably be okay. And, I really think that helping clients understand the nature of that which is in their portfolios is the best thing you can do.

As even those with decades of experience under their belt stated that they had never seen a market like the one of 2008 in their tenure, do you think living through this relatively early on in your career was beneficial in any way? Did you learn any valuable lessons during the Panic of 2008 that you did not realize before?

Yes, I think it was incredibly beneficial. I worked with two individuals, one who had more than 40 years of experience and the other with 35 years, and both of them said they had never seen anything like it. And by never seeing anything like it, I mean the credit markets freezing and house prices plummeting in the way that they did. That just hadn’t happened since the Great Depression.

If you talked to most people in 2007, it was apparent that there were some major things that were out of whack with respect to personal saving and with respect to leverage as I mentioned before, but there was very little prognostication that what eventually did happen would happen. Nobody had lived it before.

I think the lessons that we will learn from it haven’t really been learned yet. It will be very interesting to see what happens over the next 3 to 4 years as we recover and rebuild from what happened. The mood right now is still so negative, so pessimistic and people are still in such shock that I think it’s hard for people to see the light at the end of the tunnel. It will be informative for all of us to see what happens next. Because I do believe that our industry is generally overly pessimistic about whether US has the ability to recover from this. We are more optimistic. Capital moves freely and quickly and will be re-allocated and I think we will see that happen and it will be interesting to see how that plays out.

Is there anything that you look back on and think, ‘had I known what I know now I would have done this differently’?

Yeah, there are a couple things. Specifically, one was that we knew something wasn’t right and the way we reacted to that knowledge in our equity portfolios was to buy what we thought were the more conservative financials -- to lean the portfolio toward more conservative names in those areas where we thought there was risk, when the real risk was a systemic meltdown. If we had been able to see that coming, we certainly would’ve been positioned differently.

The other thing we learned after a tough year in 2008 in our large cap equity fund was that if we had equal-weighted the portfolio during that period we actually would have been competitive with our benchmark. In actuality, with the weightings we had we under-performed our benchmark pretty significantly. For us, it caused us to change the way we manage this fund. We are much more neutral with respect to individual position sizes now than we were before. We believe we have a competitive advantage in our ability to pick stocks but what we hadn’t done well during that period was finding the correct position sizes.

With 10-year returns on equity indexes negative, what do you say to the crowd claiming 'buy and hold is dead' and that it’s no longer a viable strategy?

It depends on how you define ‘buy and hold’. If you’re talking about sitting on a banking stock forever and never looking at it, which is something that people used to do, or sitting on AT&T or Exxon forever, I do think that that is dead. It seems funny now for one to think of AIG as a solid, stable organization, but it was and it’s basically gone now. So this idea that you can buy a stock, even Coca-Cola, and nothing will ever go wrong is a bad idea. So, if that’s what you mean by ‘buy and hold’ then I agree with you.

If you’re talking about doing fundamental analysis and having a time horizon longer than a day or a quarter, then I completely disagree. I think that we’ve only seen one half of the story with respect to what has happened in the market’s reaction to the recession and the credit market dislocation. That is that the market overreacted to the downside to some admittedly horrible circumstances. I think we’ll look back in 3-4 years and we’ll see what good fundamental analysis has produced over this period. Having a 2-3-4 year time horizon can still benefit investors and I don’t think you need to trade portfolios every day. I think it’s a knee-jerk reaction to how far the market has declined and how much volatility we have seen. Assets have relative values to investors that are calculable, and stocks currently look very attractive. If this is true, capital should flow to equities from less attractive assets over time. For this reason, I don’t think that in the long-term it says anything about how solid long-term fundamental investing is a bad idea. I believe it will continue to prove itself for investors.

What is your primary strategy in your investing process? With so many different approaches to the stock market, why do you believe this is the best method to invest?

I don’t think there’s necessarily one right way to invest. There can be a lot of different strategies that work well, but for us considering the expertise that we have, the strategy that we employ is ‘growth at a reasonable price’ or the GARP model. What we’re trying to do is pretty simple. We try to find companies that can grow their earnings at an attractive rate over the next few years, and not pay too much money for them. We analyze their balance sheets, their business models, cash flows, those kinds of things. It’s really not any more complicated than that, it’s traditional, standard fundamental investing.

We’re probably a bit more bullish than most and we have over the last several quarters gotten more aggressive. This has worked out in the quarters where the market has been going up but when the market takes a breather, we’ve tended to lag.

Do you think because 2008 is so reticent in investors’ minds that we underestimate our ability to rebound from the recession?

Yes, this is a recession that hit Wall Street hard when past recessions have not. People on Wall Street lost jobs this time around. To steal a concept from my associate James, “If it’s raining in New York and it’s sunny in the rest of the country, Wall Street thinks that it’s raining everywhere.” And I think that’s true. I’m not trying to pick on Wall Street. I think it’s just human nature. With our industry being concentrated there, and it being hit pretty hard it’s difficult to be optimistic. For example, if you live in a town where the auto plant was shutdown, you’re unlikely to see how things can be recovering anywhere else.

Company fundamentals tend to color our views. We continue to see companies with a lot of cash, good margins, moderately growing revenues with an ability to grow earnings well. One thing to notice is that while individuals’ and our country’s balance sheets are bleak, corporate balance sheets are phenomenal. I’m certainly not the first person to talk about this, but I’m not sure investors actually believe this situation will create an attractive story going forward.

I think, what was it, in an issue or two ago, I read a BusinessWeek lead article complaining about how companies have too much cash on hand that they’re not spending. It seems to me that’s a pretty good position to be in relative to where we were two years ago.

Oh yeah, in our midcap fund in just the last six or seven months we’ve had a handful of companies bought out. In 2009, that would have been unheard of. I think companies were holding things close to the vest because they didn’t want to take any risk with a future so uncertain. Companies are now gaining a bit more visibility and I believe that cash will be employed. Not all companies will employ it well, but they will start to employ it.

What do you think about the current economic recovery? Do you think any aspects have gone largely unnoticed? I’ve largely thought that productivity has been an underappreciated story, what do you think?

Yes, that’s a good point and I think it’s why margins have been so high. But, I’m not sure that anything has really gone unnoticed. There’s more transparency now, maybe more than ever. Everyone follows every little detail and tries to draw some kind of broad conclusion from it. So I would almost think the opposite, everyone is paying too much attention to every detail. They’re missing the overall story.

We’re in earnings season again, and this is the fourth earnings season in a row where things look pretty good. Companies have more visibility and it’s improving every earnings season, and that is what should excite investors and that is what people should pay attention to. Everyone is trying to find the answer by digging through every report and they’re missing the forest for the trees.

You see the market wiggle on every data point when most economic releases follow a jagged pattern. They don’t follow a straight line, and there are all kinds of surprises along the way. Every small surprise either way makes the market shoot up or shoot down.

I know you are primarily bottom-up managers but with the equity market 10% off the highs since April, where do you think we go from here? Are you concerned about the debt problems in Europe and the slowing global growth story?

Whenever something like a crisis in Europe occurs, it is certainly concerning. But, I think the impact was overblown. The contribution of these countries to our GDP is not so significant that it could derail our recovery. I think the worry was more that ‘X happens, then Y will happen’. There is a general sense that the recovery is fragile, and any negative shock could derail it.

The idea of slowing global growth because of massive deleveraging is reasonable, but trying to predict what is going to happen over the next several years from a macro perspective is a perilous thing. What we try to do is follow companies and listen to what they’re seeing. Most companies that we follow are global and there are pockets all over the world that are growing at a decent clip, and as long as there is growth occurring we remain fairly optimistic.

Another thing that people forget is that companies can grow earnings a lot faster than we can grow GDP. There is a very reasonable case to be made for fast growing earnings, at least in the short-term, in the midst of lower economic growth in the US. While over a five year period that may not be such a promising story, for now it looks fairly good. And when you take a look on a valuation basis and you see, at least in the middle of last week, the S&P was trading around 11 times 1-year forward earnings, I’d say that is discounting a lot of pain.

On a different note, do you believe the so-called "flash crash" hurt investor confidence in the integrity of the stock market? How did you react to it?

I think it was absolutely terrible and hurt investor confidence. I immediately started receiving calls from clients. You can talk clients through a lot of ups and downs by explaining what’s going on. They are very smart, and they understand the way we invest and are comfortable with it. When things happen that are almost unexplainable, it rightly concerns them. And, without a clear answer, I do think it is very damaging. While people have short memories, I don’t think enough time has gone by to forget about this one yet. I’m not sure a reasonable explanation has even come forth yet, which makes people even more nervous.

The Thompson Plumb Bond Fund, of which you are a co-manager, has had a great run. With short-term bond yields near zero, how do you manage to generate returns for shareholders?

Generally, when credit spreads are wide we tilt the portfolio toward a heavier corporate weighting and when they are narrow we tilt it more toward agencies. Right now, credit spreads are probably in the more reasonable range. We’re still buying a lot of corporate bonds right now, and as long as we continue to find deals with companies that we think are high-quality companies, we’ll continue to do so. This is allowing us to capture some yield that is significantly more attractive than Treasuries or Agencies. That said, with all yields as low as they are and the fund being short-term with a duration of less than 3 years, it’s getting more and more difficult to find yield.

The biggest risk we see in the short-term besides credit spreads widening is interest rates rising in some kind of a step function, so we’ve made the duration of the fund pretty darn short. Of course our outlook can change over time.

I think we certainly won’t see the returns going forward that you would’ve seen over the last several years, because rates reached high levels in the late 1970s and have been declining ever since. This provided a tailwind for bond investors, but we’re likely facing the opposite now. Our goal is to hunker down and be cautious with respect to interest rates, and still find values in individual issues that can help produce attractive returns for shareholders.

What do you like and dislike most about being a money manager?

I like that it’s a constant learning game and we’re always trying to solve a new problem. It’s very interesting and stimulating. It sounds corny but it is. If we do a good job the results are tangible, and there’s a good feeling that comes from that.

I don’t like things like the flash crash. I didn’t particularly enjoy the market taking a dive like it did for no fundamental reason.

But the majority of my job I like. I enjoy talking with clients, I like interacting with my co-workers, they’re all very bright and I learn from them everyday and that makes it very enjoyable.

Any advice for people just starting out in the business?

There are many things you learn in college and from the CFA Institute with respect to fundamental analysis that are incredibly valuable. Take advantage of both. At the same time, don’t be afraid to learn about many different types of analyses. Where the job market is concerned, I think you have to be willing to be work for less money right now than you would’ve gotten 5 years ago, if you want maximum flexibility. We’re in the Midwest and in a pretty small community compared to New York, but we probably had a disproportionate number of finance professionals relative to the size of the city. We have a lot of people changing careers here, but I believe this is a short-term phenomenon. So I believe if you hang in there and get by, more opportunities will present themselves eventually.

Thompson Investment Management, Inc. is an investment advisory firm based in Madison, Wisconsin. John W. Thompson, founder of Thompson Investment Management, Inc. has been an Independent Investment Advisor since 1984. They specialize in investment portfolio management for institutions and high net worth individuals through individual accounts and their proprietary mutual funds.
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