Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, I lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Gina Martin Adams, chief equity strategist at Bloomberg Intelligence. Gina, thank you for joining me today.
Thank you for having me, David. I'm delighted to be here.
So I first wanted to ask you about a note you wrote recently regarding valuations masking slowest EPs recovery. Since I believe it was twenty eighteen, can you give the audience kind of an overview of what was happening?
Yeah, I think a couple of things really come to mind. The first is that valuations have really done the heavy lifting in the S and P five hundred bull market
since twenty twenty two. If you go back to that bullmarket low or the big bear market low from twenty twenty two and classify this recent three year run as a big ballmarket rally, we've had trailing twelve month earnings that have grown just fourteen percent this is the slowest pace of non recessionary growth in the index for a rolling thirty some odd month windows since at least early
twenty eighteen. Despite that really slow earnings growth, almost painfully slow earnings growth, we've had more than seventy percent price appreciation in the S and P five hundred, and this year in particular has been really interesting because it's sort of turned that relationship on its head for the first time in a long time. Earnings may actually grow faster
than valuations. This may be one of those rare years in the S and P five hundred where we get some earnings growth allowing companies to grow into valuation multiples that have expanded so very quickly over the last three years.
Great, well, I'd love to hear our guest thoughts on this, so I think it's a great time to introduce David Jaru to the podcast. David is a chief investment officer of US Equity at TROW Price and a portfolio manager for the Capital Appreciation strategy, including the Capital Appreciation Mutual fund ticker p RWCX and the Capital Appreciation Equity etf ticker TCAF. David, thank you for joining us.
H it's a pleasure. Thank you for having me on.
So let's start with your thoughts on the market dynamic that Gina has observed on with rising valuations and a slow EPs recovery.
No, I think it's I read the artic thought that was a very thoughtful analysis, and then you don't see most people addressing. But as Gina said, if you kind of go from the market trough in twenty twenty two, the market with basically trot about you know, fifteen or sixteen times forward earnings, today we're kind of, you know,
twenty two or twenty three. So we've had basically the market and Multiple go up by about fifty percent off the trough, sort of trough to peak, and Ernie's growth, which again and as Gena says, is starting to get a little bit better. This year, we'll probably end up doing double digitaries growth or let's least at least high school digitaries growth this year after a couple of years of what I call kind of somewhat sub parties growth in both twenty three twenty four. Great.
Great, So let's switch over to your funds. So let's let's talk specifically about the capital appreciation strategy. What is the investment process. You know, how how do securities make their way to the portfolio?
Sure, you know, you know there's we think about the sp FI FI. Let's just we'll take it through equities. We'll talk a little bit about fixed income, and we'll talk about kind of process. What I would tell you is, you know, there aren't five hundred great companies in the sp five hundred, right, you know, we believe there's only about one hundred and twenty five stocks that we call investable.
And when I need investable, what does that mean? It really means, you know, when we look back and what are the five or six characteristics that kind of cosset stocks in to perform? And we want to avoid those five six characteristics. What are the five six characteristics? You know, bad management teams, secular risk, you know, extreme valuation and inability to do a high school digit kind of total return,
poor cap allocation. Those are the kind of things if we basically get the whole last P. Five hundred and we may say, if we can avoid companies that have one or two, one or two or more of those fatal flaws, their odds about performing are really really low.
So we want to we want to basically remove basically three hundred and seventy five companies that we invest in, So we invest the one hundred twenty five hundred companies that have none of those fatal flaws where we think the odds about performance over any kind of three five ten year basis are quite hot. So that's kind of
our equity selection basis. The other thing about our equity selection basis is we tend to have in our north stars at five year i r R, what is the expected earnings five years out, what is the expected multiple we're going to get, and what is the kind of embedded i rr we're going to try to invest obfuly in the highest risk just at irs we can, and the equity sleeve, in the fixed income sleeve, we you know, we compete against kind of a Bloomberg ag However, we
tend to think the Bloomberg gaging is actually not the best universe. That's a universe built based on the size of different markets. Are supposed to attractives of different markets. So you would see us investing much heavily you know what we call high quality leveraged loans, high quality high yield bonds with very very low risk of default. And then selectively by treasuries when the treasuries are attractive as
they are now. So again we're focused on not the largest markets, but we're the best risks returns over time. And if you look at over time, the best risk of rewards and fixed income are not mortgages, not triple A securities, but double B credits, leverage loans. That's where the risk of reward is the highest. The last thing I would say is that we tend to be kind of countercyclical. In twenty twenty two, when the market was
facing difficulties, we were adding to lot of equities. We were adding to semiconductor companies, we were adding to pyxicality. During this Trump tariff noise that drive the market down to four to nine hundred, we put four billion dollars to work in three day period of time. During COVID, we put nine billion dollars to work in less than a month. So you will almost always see us acting counterintuitively to the market. Marketing going lower, we're adding to
risk assets. Market goes higher, we're reducing risk assets. And that process, over the last nineteen years since I've been managing these strategies has added a lot of alpha to the strategy being a little bit countercyclical when because we know when markets go lower, the odds of losing money actually go lower, the odds actually generate above average returns
go higher. And again, you know, we know we are willing to invest into uncertainty in those kind of periods of time in the mark, whether that be in fixed income or whether that be in inequities.
So before we dig a little bit deeper into that, I just wanted to ask a little bit about the two different fun types. I know, we you know, the big difference is obviously the ETF doesn't hold fixed income whereas the mutual fund does. But are there any differences between the equity portfolios of the you know, between the mutual fund and the ETF.
The ETF would have will have more names, you don't have a little bit lower track year. The ETF has a slightly different objective. The e TF wants down from the market over time. It wants to do with always having a risk profile that's less in the market, and it also wants to have a a taxial income that is basically zero and has a you will always have a dividend below that of the market. So we say we can outform the market with less risk and more tax efficiency over over a long period of time.
David, you mentioned all the factors that you do to use to avoid stocks, sort of avoiding the fatal flaws? Is the language that I loved you used? What do you what are you most attracted to? So how do you define capital appreciation potential? I know you mentioned I is a really critical component of your process, But are there other factors that you use? How do you identify those high RRR companies?
Well, if you think about again, we think about the five hundred companies and the SPIF hundred, maybe a couple of companies outside the SPF hundred. We reduce that three hundred and seventy five companies that don't have one or more of those fatal flaws GITA, and then we'll basically myself and my team, we will basically actively model those one hundred and twenty five companies. We will look at
their earnings power today. We'll look at their earnings power where what we think is going to be twenty thirty twenty thirty one. We'll look at what the dividends that
are likely to pay over that period of time. We'll look at what the right multiple for that company is and then that will basically spit out an internal rate to return, and then we're trying to find companies that have an attractive risk to just return, but also with a as narrow of a range of outcomes as possible is really key to our process, right, So if you look at our portfolio today, we would have an IRR
in the portfolio in the low teams. In the equity market that was as hot is during COVID in the mid twenties, during twenty twenty two, was in the mid teens. During the Trump tariff tantrument, if you will, it was also in the mid teens. But we compare that relative to what we perceive as a market i AR that's kind of in the mid seele digits and the potential to hopefully generate kind of mid you know, five hundred BIPs or more alpha versus the market over that period
of time. So we're literally looking at one hundred and five companies that meet our criteria where we think there's a high odds of outperformance and the you know, we're trying to find that you're roughly the highest sixty on a risk us basis within the equity, sleep of the balance strategy, cap appreciation, and maybe we're like the top ninety stocks within the cappreciation ETF.
You mentioned the SMP five hundred a few times, but it sounds like you're amenable to ideas outside of the SMP five hundred when and if it's appropriate, can you talk to us about you know what you know many people would suggest are really clearly very high valuations for certain select groups in the s and P five hundred. How are you navigating that right now? And is that pushing you into ideas outside the United States or even ideas in private markets not necessary?
Maybe yes and no, Maybe yes and no to that to that point, you know, there are great companies outside the US, I would say coming great companies outside of the US are rare. So one example of a great company outside the US is Kadie National C and Q. It is an oil sands oil producer. The average major in the United States has a reserve life of like
nine years. That means Exxon or Chevron has to go out every couple of years and spend it Shad's capital to buy Hess or buy Pioneer, whereas C and Q does have to do any acquisitions at all, they have twenty nine years reserve life, they can continue producing, and their continued to extend that reserve life. They traded a discount to C and Q or to Exon, and yet they grow production faster like four percent versus three percent.
They have a higher dividend yield UH, and they have better cap allocation UH and so and again a very very strong tremendous on a free cash to that allows them to buy back stock, pay a dividend. It's almost
five percent. So we do see opportunities out there. However, I would say is when when we do the micro analysis, when we go through look at all the companies in Europe, look at all the companies in Japan, like all the things in Australiak at all the other companies in develop market economies, we don't find a lot of great companies. We think, you know, the US has more than its
fair share of great companies. And while the European and Japanese and Australian indexes are trading at lower valuations, in the US index is there's a there's a reason for that. And what what is in Europe is mostly you know, low quality banks, low quality materials, companies, energy companies that don't want to be energy companies, utilities that don't have the same characteristics as US utility. There's no mag six, there's there's very little, you know, attractive kind of businesses
and kind of garpie companies. So if you do it an apples apples basis, we don't think the US is expensive relative to what you can get in Europe or Japan or Australia. Now your question on private markets, I do see opportunity in private markets. Again, we own four companies that are that are not public companies today. That's about you know, maybe let's call it four percent of our equities are in privates. We tend to own more what we call it kind of more stable private equity
type businesses. So we would own a company like broad Street or Hub, which are both insurance brokerage companies. They're a little smaller than the Marsh mcclennan's or Aon's of the world, but they trade for lower valuations. They are able to do more acquisitions at low multiples, and they've been in creating value at it let's call it a mid to high teenh pace versus the public guys who kind of are growing, let's call it a ten percent pace with great management teams at evaluation that is below
marsh or on. So we've chosen to take advantage of that kind of that private versus public market arbitrage and own some of those companies in size. We also own Weimo. Weymo is a private company. Obviously, they are the leader in autonomous driving. The last mark there I think publicly was in the you know, the forty to forty five
billion dollar range. We're a big believer that when Weimo goes public, given the giant tam It has, that that will be a company that will probably have a market value of somewhere rotween two to three hundred billion dollars. I think Tesla has proved that, you know, autonomous driving is really really hard, Tesla's not ready for prime time, and that Weimo is by far the market leader and autonomous driving today.
But I did want to ask, you know, in the perspectives it does talk about opportunity, opportunit hunistic investments in the portfolio. Is there a percentage that you limit these two No.
Actually, it's it's an interesting question, David. What I would say is, I think everything we're trying to do is a little bit opportunistic, right, We're trying to take advantage of marketing efficiencies. We're trying to take a longer term horizon than other market participants. Some you know, some some situations like we, you know, we've bought hole Logic. Hole Logic is a company that we haven't really owned in the past. The company's trading at sixty four sixty three
dollars a share. There's you know, there's been a you know, a I think a Financial Times reported that multiple private equity firms were looking to take hole Logic private at seventy two dollars. I think it would make sense that, you know, that would they would be able to generate a very high return if they were to do that.
Given how attractively valued Hole Logic is. We believe that, you know, that that company could still go private, probably at a higher valuation, so that I would describe that as an opportunistic investment. You know. Another opportunitist investment is
kind of Beckton Dickinson. Beckton Dickinson's has some challenges around tariffs, some challenges around weakness in China, but this is a company that has a massive some of the part's discount, they started going down the path of rectifying that supply. Some of the parts discount they're selling off in an arm T transaction some of their dignostics and life science tool businesses to Waters. We think that'll be a value
creating endeavor. We think they'll end up spinning off their pharmaceutical systems business as well, maybe do another rm T with that transaction. And once you keep doing you know, once you do that arm T with the pharma systems business, once you get Waters transaction done. This is a company. It's basically traded for eight times earnings, which has the potential especially they continue to buy that stock to grow
earnings in the you know, the low teens. Most companies that have low teens earnings growth don't trade for eight times earnings. They trade for more than like key to twenty times earnings. So we think Beck then this is also kind of an opportunistic investment. We've also had Catalyst in place with a starboard who's probably one of the better activists in the marketplace actively involved in the stock
as well. So we will own a number of names where we think there is some kind of hidden optionality ow producing investment where we think we can make a lot of money in the near term.
David, could I ask a little bit about kind of how you navigate some of the key risk factors that we think about as equity strategists. So one of the things we're thinking about a lot this year is concentration risk. In the fact that you know, effectively only ten percent of the S and P five hundred is now actually driving gains in the market. We think about the MAG seven as a specific risk within that concentration risk. I noticed in your portfolio that you have pretty heavyweights in
Microsoft in the video. At the same time, you know, navigating a big difference in positioning in Amazon and Apple. Maybe talk to us broadly about how you're thinking about the biggest stocks in the S and P five hundred, how to navigate the risks as well as the benefits that they provide to your portfolio.
You know, that's it's it's a great question. I would just I don't think we should really talk about the MAG seven anymore. There's really no reason for Tesla to be included in the MAG seven. Tesla is losing share in all of its end markets. It's autonomous driving efforts are are flailing. This is this. If we're gonna put Tesla in the in the Mag seven, we should put GM and Fords and every other you know, Toyota in the Mag seven as well, because it doesn't Tesla's not
a stock anymore. Tesla is a cryptocurrency. Tesla is a It is a it is a purely speculative vehicle, so it doesn't has no characteristics like the other companies in the Mag seven. But if you you know, think about the Mag seven, So we to your point, we have a large overweight in the Mag seven. In Microsoft, we think you know, it trades at a very reasonable valuation
even after a big move in the stock. This is a company that is you know, clearly a winner a market, probably the fastest growing company in kind of cloud computing. We think that growth rate has been accelerating and potentially could accelerate off a very very large base. You know, just a great company, great management team. And actually, if you think about AI, focusing on inference not on training,
inference is more durable than training. In addition, you know, I think they've actually said no to open AI in some cases, which I think will end up proving to be a very wise capitallication. Decision that hurts the growth and the short term. So we love that. We love We love Amazon for a lot of the same reasons. You know, cost Go trades for fifty times earnings. Walmart
trades for thirty five times earnings. You know, Amazon, even with a great cloud computing, a retail business that grows faster than both of those companies I mentioned, is still trading in the low thirties. It doesn't make any sense from my perspective. Again, not as fast is growing as amaz as your division, but still very very fast growing. And again we think Aws, which is kind of growing in the mid ties, can accelerate over time. I already
mentioned no no position in Tesla. Tesla could fall ninety percent and we wouldn't buy one share of that. We had an underweight to Apple, Apple has You know, Apple is a great company. I do wonder in five or ten years, well, we'll still be using Apple devices and
the same we were using today. You know, Apple will generate somewhere between twenty twenty five billion dollars a year from Google for its its tax, if you will, there's a very high probability that Google's ability to pay Apple that that very large, high margin revenue stream will go away, maybe as early as AUGUSTA this year, depending on a court decision. So again, you know, Apple and Google or names. We have a little bit of an underweight on were
underweight in video as well. It's not that in video is not a great company. We just think there's a better rist reward if you want to play aig PUS in am D. You know, today in video it's basically one hundred percent you know, let's called ninety five percent market share of all GPUs acceleraties in the marketplace. We think, in talking with all of our doing all of our channel checks and research says in five years that share is going to go from ninety five percent to seventy percent.
A m D today has let's call it a three percent market share of GPUs on the on the A I side, new products get very you know them four hundred class gets really good feedback from channel partners, and we think a MD can clearly be a fifty percent market share over time next in the next five years. In that case, AMD's that's probably going to triple, whereas in video can still go up, but probably not nearly as much as as a m D. Another company we liked a lot that helps offset the underweight to in
video is Amfanol. Anthonol makes a lot of the connectors and switches that basically go between GPUs that basically allow GPUs to work, makes allows large clusters of GPUs to work, and honestly, for ANFLOL, it doesn't real matter if in video works or a MD works or custom silicon works, Anthonol's connectors are needing all those situations. So again underweight in the video, but still a overweight to what it called AI GPUs.
I'm glad you brought up this Tesla conundrum because it's been one of my frustrations of kind of this MAG seven construct as well. And as a result, I just really quickly looked up on the terminal here as to who are the seven biggest stocks, because I think that was the original kind of construct is the biggest and
Broadcom is actually in there now. I know that Berkshire has occasionally jumped in in the place of Tesla, So to your point, Tesla's been in and out of even the top seven if you use top seven as your construct of of MAG seven, but that's maybe here nor there. I just found it very interesting and we won't tell Elon Musk that.
You know, you can tell you mustag you want, you can tell that he doesn't deserve it anymore. You have to grow. You have to grow to be in the max seven.
You cans fighting words. Okay, hold it, hold him to that. I will hold him to that.
Okay. Good.
So I wanted to ask does bond analysis affect your equity decisions at all?
It does?
It?
Does it? Does? I mean? We we are we have the ability to go where we see value in the marketplace. Right, So I always think about, you know, having a double b rated Hilton bond, right that's earning six percent, that has a beta of point two? What is the risk reward of that that Hilton bond relative to a low risk equity that you know, like a utility that might have a beta point five? Right, So, we we have the ability to go where we see value in the marketplace.
And some of the way that manifests itself is, you know, during the COVID downturn, you know, we were selling bonds and buying equities. During the Trump tariff tantrum, we were selling bonds and buying equity. Today with the market being very, very richly valued as you know, again Gina's thoughtful analysis highlighted, you know, our fixing can exposure, you know, has gone from back in twenty twenty two kind of high teens
percentage of the portfolio today in the low thirties. So we have the ability to go where we see the value, and we can change that bond allocation as well. Back in twenty twenty two, we were mostly in leveraged loans because we thought you had free optionality if rates ever went up, and they did, and today we have a
little more balance because rates are higher. You'll see us having the almost fifty percent of our portfolio and kind of five year treasuries and you know, a low teens kind of exposure to leverage the loans and a high stealage exposure to high quality, high yield. So we can change the mix of equities versus debt, but also the mix of debt and actually the mix of equities too. In twenty twenty two, when the market is really cheap, we owned a higher beta mix of equities. Actually started
buying a video. We bought somemic connectric companies, We bought in industrials because everybody believed that there was one hundred percent chance we're going to recession. We said, even if there is, even if we do go into recession, all those cylical companies already pricing it in. So just because Jamie Diamond was saying we're going into recession, the market believed, it believed that was happening, and but it was already fully priced in. So it created a really attractive restueward.
If we went to a recession, there were that we had limited downside. If we didn't go into recession, all those cyclicals would pop in, which they did. Today is the inverse. Everybody is very, very bullish on the economy. Everybody's bullish on a cyclicality, everybody's bullish on beta, and we're taking the other side of that. So we're adding to utilities, we're adding to lower beta stocks, we're adding
to healthcare. We're kind of doing you know, because not because you know, we're betting the time is going to fall off the cliff. We just think over a five year basis, you know, buying Goldman Sachs at two times tangible book value, you're not going to make a lot of money. Buying JP Morgan at fifteen times, you're not going to make a lot of money buying select industrials
at twenty five times earns. You're not going to make a lot of money, but buying really great utilities at a discount of the market where their business is inflecting positive on an organic growth basis. Healthcare comes is a little bit out of favor today, but where the long term sol looks really good. But there's all these idiosymocratic ideas that we like. That's we're always kind of going where weceive value, not what the market is telling us
we should like. I think that's that that that ability to think independently the market is really important to our strategy and important to our success over time.
Well, I think we're all in trouble then, because our sector scorecard right now is telling us also move into defensive ideas. So watch yourself. We all have the same idea. We could be in trouble. But I would agree with you. In general, the market seems to be a little bit optimistic,
which is crazy to think about three months ago. You know, for a hot minute, we were pricing kind of really devastating conditions emerging, and then we pivoted so quickly and we roared back, And I think that's been a really
big challenge for investors. But if you think the dynamics of trade as one of the big policy issues that has emerged this year, are there any nuanced changes that you're making in your portfolio specific to trade policy risk and the evolution of tariffs and the changing global trade relationships that have really kind of hit us this year as a major risk to stocks.
You know, not really, I would say a couple of things. One I would say in the market was very very to your point, the mark was very, very concerned about tariffs early April, early in mid April, right and the market fell off again. We use it as an opportunity to buy directions. But today the market is just you know, I think they believes is the Taco situation and it
won't manifest itself. I would say, as someone who is, you know, again a chief hit investment officer, one of the things in addition to managing money for my clients is trying to be a trying to think about bigger
picture issues for the market. I think when that one of the reasons that we had so much conviction to put four billion dollars to work in three days at the market's bottom was a some of the work we did to the that came up to the you know, talking with you know, law school professors, talking to constitutional scholars, and we believe very strongly, uh, you already saw it
kind of it C decision on this. I think by the you know, let's call it early next year, the vast majority of tariffs that this president's put in place will be ruled on constitutional. Maybe not all of them, but the vast majority of those tariffs will be ruled on county that you could actually argue that's a little bit of a bullish sign for the market that again, the Supreme Court, I would bet in the seven to one or seven two or eight one decision will strike
down the vast majority of the tariffs. The ITC already came back three zero. That was a Obama, a Bush, and a Trump supporter who probably don't agree on anything, could agree that the tariffs were unconstitutional. And I think we'll see that at the Supreme Court. And so I think the vast majority of the terrafs, maybe maybe the Chinese terraffs, maybe the Illudin was still terraf, might stay in place, but the vast majority of the other terrafs will be ruled unconstitutional.
I also want to ask about management teams. So you know, we talked about what you look for in companies and you know what you're avoiding when it comes to looking at management teams. Do you have any set of process where you're you know, is there like a way you're evaluating them or certain things that you look for.
Well, there's a couple of hats we really want to invest alongside management teams where the cap allocation is excellent. I think if you look at a lot of the giant winners for our strategy over the last decade or more, whether that you know, AutoZone, O'Reilly, five, Serve, Texas Instruments, Dan or her Roper, those were all companies that had excellent cap allocation that really we're able to generate very attractive returns with an efficient capital structure almost all of
those cases. So capital location. We also want management teams that are operationally sound, where they you know, again they generate nicety in creminal margins on incremental sales. They don't they don't have big operational hiccups all the time. They they what they promise they're going to do, they actually
deliver upon to the best extent they can. I think those are the you know, good operational prowess, good capitallarcation, and you know companies that that that that that run their business as well well.
This is a great discussion, David. We really appreciate your time and thank you again for joining us.
No, thank you for having me great questions as always, Thank you and.
Gina, thank you for being my co host today.
Oh my absolute pleasure. Thank you David, and nice to meet you. David. Thanks for thanks for joining us.
My pleasure and I want to thank our listeners. If you liked the episode, please subscribe and leave a review. Also, if you'd like to see more of our research, go to b I FI on Go n BI Stalks Go on the Terminal Until our next episode. This is David Cone with the Inside Out.