“State of the Market” Video Roundtable – Transcript

ROSS ANDERSON:

Hi, Fools. Ross Anderson, here. I am one of the certified financial planners with Motley Fool Wealth Management and I'm joined today by three of our portfolio managers. These are the guys that are actually choosing the stocks and picking the investments for the SMA portfolios. Happy to have with us Bill Mann, Bryan Hinmon, and Dave Meier.

BILL MANN:

Hi, Ross.

DAVID MEIER:

Hi, Ross.

ROSS ANDERSON:

Thanks, guys. So what we're doing today is really just spending some time together because we've got some folks that are brand new to our service. We've got investors that have been with us for a little while. I just wanted to get your take on what's going on in the markets and help them understand how the program works and maybe how it's different from things they might have experienced in the past.

So just starting with what we're seeing in the markets, Bill, can you just share your thoughts on some of the volatility and the pullback we've seen over the last few months?

BILL MANN:

This is actually something for people who haven't been with us on the SMA side. We've been talking about the fact that it's been a very difficult market to invest in over the last three years. You've had markets that have been pushed very much by macroeconomic forces here and overseas, and so all the volatility is very hard to adapt to and it's very hard to emotionally take. These are great times for us. We're seeing companies that we didn't think we were going to be able to buy at good prices that are at levels that we really would like to buy them.

So I think that what you're seeing now in the market is something that's going to pay off for us over the course of years. And those are the time frames that you need to worry about.

ROSS ANDERSON:

So as Warren Buffett says, "Be greedy when others are fearful and fearful when others are greedy."

BILL MANN:

Yes.

ROSS ANDERSON:

We feel that right now that's a time that we can actually take advantage of.

BILL MANN:

Yeah. I think what a lot of people would like to know is what's the market going to do over the next little bit and when it's going to stop dropping. And frankly, not only do we not know, I don't think that we think that anybody knows. So the way that we feel about it is that you don't wait until you see robins to start looking for spring. These are great times to buy stocks.

DAVID MEIER:

One of the things that we do know, though, is we do know our process. And that's looking and evaluating the quality of companies, trying to figure out what's an attractive price, and marrying the two together and we're finding a lot more opportunities today.

BRYAN HINMON:

I think the other piece of that is large caps, right now, are off about 9% year to date. Small caps are off about 14% year to date. If you were a consumer of any goods (you're going out to buy a big appliance or something like that), a sale of 9% is really not all that massive a sale. A sale of 14% is a little better of a sale, but it's still not like anyone is giving away the farm, so we're keeping that in context. After a five-year, six-six year bull market at this point, pullbacks like this are pretty common. Fairly common. This one has happened pretty rapidly, but like Bill says, we are beginning to see bargains appear.

BILL MANN:

One thing that I would want to stress is that in a lot of ways, the indices have lied to us over the last year, and beyond American large caps, almost every other segment of the market, here and overseas, has already been in pretty dire straits over 2015.

I mean, 2015, if you think about it in a lot of ways, was a volatile trip to nowhere. We visited a lot of different prices, but the one area that really didn't feel the pain was large caps. One thing that people need to keep in mind, as they're looking at what the stock indices do, is that in a lot of ways they haven't been giving a real accurate picture about what's been happening over 2015. So we've actually been dealing with volatility in a lot of the segments that we like for some time, now.

ROSS ANDERSON:

Sure. Dave, you mentioned a word that I wanted to touch on while we spend some time together, today, which is process. And everything from the way that you guys evaluate companies, I think our investors would love to understand that a little bit. And specifically if you could touch on how you use the Motley Fool's research. We've got a lot of our clients that come from The Motley Fool's more traditional channels where they're in a service that's making a recommendation and they can choose whether or not to implement that. You, here, in the Fool Wealth system, get to make that decision for them. How do you leverage that and what's your process?

DAVID MEIER:

Well, we use it just like they do. It's an idea. It is a nice set of research that we get to look at. But as professional money managers we do follow along and do our own research in order to make sure that we're making the best capital allocations that we can based on all of the information that we get and not just from The Motley Fool.

BRYAN HINMON:

Like Dave was saying, it's really an input into our process. It's a tool, it's a pretty powerful tool, and I don't think a lot of people understand how powerful it is. The Motley Fool, Motley Fool Asset Management, and Motley Fool Wealth Management think about businesses in a different way than many other investors out there. We're long-term focused business owners. It's a different mindset than many investors, so we can't rely on much research that's done outside of our four walls. So to have the research that's done by the Motley Fool analysts throughout the newsletters that we read — to have them be philosophically aligned — that's research that we feel more comfortable trusting as a starting point than other research that may come across our desk.

BILL MANN:

We get a lot of Wall Street research and almost all of it — correct me if I'm wrong, guys — is generally what's the stock going to do over the next quarter or six months. Maybe at the outset they'll say, "Here's what the stock's going to do in a year." So it is really nice to be able to lean on some philosophically aligned research where they say "this is what we believe the business will look like five and 10 years from now." So we have a great starting point from which we can make our own assessments.

DAVID MEIER:

You talk about process, and one of the things I mentioned earlier was that we look at business quality. As part of that process, we define quality on four measures. We look at management and the incentives, we look at the economics of the business, we look at what we think the business's competitive advantages are, and then we say, as for sales, how are those things going to sustain over time. That's unique to us and what we do in our research to try to make the best investment decisions for the SMAs.

ROSS ANDERSON:

That's fantastic. As you guys are managing a portfolio, much like one of the customers on the newsletter side would have to do on their own, if they buy a stock and let's say it's not going well (whether that's over a short time frame or even if they've been patient and it's a longer time frame) can we just talk about that? How do you think about winners versus losers? How do you make that sort of decision as to whether it's a broken thesis or it's something we should add to? How does that go in your minds?

BILL MANN:

I think the thesis point that you made is spot-on. Volatile times like these, as I said before, are actually great for us, because volatility is where bargains are. That's where they're made. People panic. So I don't worry so much about a stock price moving as part of being right or wrong, but the thesis itself. And when you buy a stock, what you're doing is you're basically saying I know better about the future of this company than the market does.

The market's a lot of people, and a lot of really smart research goes into the thought process of the market. But you're saying I know more and I know better over this period of time. And sometimes companies really do disappoint, in which case we tend to be pretty merciless. But the stock price moving — that's a piece of information. That's what the market is telling you that it feels about a company on any given day. And that can change a lot more than the thesis itself.

BRYAN HINMON:

And if I think about the question inside your question, Ross, it's what do you do with positions that are losing money? Well for us, we define risk as permanent loss of capital, and so a paper loss isn't necessarily a loser for us.

BILL MANN:

It doesn't feel great…

BRYAN HINMON:

It doesn't feel great and we very much feel that pain, but that's not necessarily a loser for us. So when we think about permanent losses of capital, we find those typically come in a couple of different flavors.

One is where we've made a mistake in the analysis, and another is where we've made a mistake in managing the position. So let's unbundle those a little bit. When we make a mistake in analysis, we can either just be wrong or we could have done poor analysis. We're going to be wrong. Every investor is going to be wrong from time to time.

BILL MANN:

Yes.

BRYAN HINMON:

We can't avoid that. We can try and minimize it, but we can't avoid it. But poor analysis we can avoid, and we avoid that by focusing on businesses that we've followed for years by leveraging the research as a starting point that the Motley Fool newsletters are putting out, and by having a very collaborative process across our seven investors that are managing money for the SMAs. So we have processes in place to avoid poor analysis, but we're going to get some wrong. That happens.

And when it comes to position management (managing each position), we have taken pains to lay out what we think the guidelines are for each of the SMA portfolios in terms of position sizing. When we'd like to add. When we'd like to trim. When we would sell a position. And our team of seven holds one another accountable for those in our daily research meetings.

ROSS ANDERSON:

I love that you mentioned that, because it's not just each of you guys making a decision in a bubble on the portfolios that you're either the lead portfolio manager for or primarily responsible for. But can you just talk about those meetings of what goes on when you're talking about which companies get to stay, and which ones you like? Can you just walk us through that a little bit?

DAVID MEIER:

We have a very strong culture of collaboration in our firm. It's a tremendous asset for us. One of the things when I came down that Bill told me was to check my ego at the door. It's not about you. It's about all of us making the best decisions for our members. And once we all get on that same page, we can have real debates about and real discussions about, "Is this really a good idea? Do you understand it?" Maybe I have something that I can interject based on my experience. Maybe Bryan says, "You know what? I don't think you're looking at this correctly." We can have what some would argue as difficult conversations, and they're just a part of our everyday working environment, and we're extremely comfortable with them.

BILL MANN:

We describe it as being us against the idea. We go into these standing meetings that we have every day, and we practice affectionate hostility. Like it is us just trying to beat up the idea itself. Just stress testing it every way we can think of doing it. I think over the long term that the outcomes are going to be better in that type of environment. That it really gives us a better chance of coming up with the correct thesis as opposed to one that someone is simply married to.

ROSS ANDERSON:

That's great to hear. I think that our clients — particularly those that are new to us — might be new to this experience of actually seeing the individual portfolio positions, particularly if they've come from another money manager where they haven't had that level of transparency before. On many days our activity level is nothing, and so sometimes people might think, "What are these guys actually doing?" And so just to understand — and I say that jokingly — that you guys are actually, every day, looking at these portfolios and these positions and trying to state the merits of each single one … I think that's great for people to hear.

One of the questions that we do get a lot is on our more robust portfolios. So we get three, four, or even five of these models and these asset classes together, it tends to be a lot of positions. In many cases it's 80+ positions if you've got international, and one of the signature strategies, and all of these things together. Is that too many? Is it tough to deliver outperformance when you've got that many positions?

BILL MANN:

No. I believe that the market is fairly efficient, but I don't think that fairly efficient and totally efficient are the same thing. So there is a school of thought that says that you should have concentrated all of your money on your absolute best ideas, and some people have taken that to the logical extreme and said, "I've got three ideas." I don't believe that that's a good experience for people and I think that that is rather extreme.

So, yes. We actually do believe, because of the way that we have sliced the portfolios, in sleeves, that within each portfolio that it's designed for us to outperform over the long term. And keep in mind that the long term is what we're worried about.

BRYAN HINMON:

The portfolios, themselves, on average, have about 20 to 30 holdings at any given point in time, and by SEC definitions, that's a fairly concentrated portfolio. In fact, if we were to hold 20 to 30 positions in a mutual fund structure, we would have to call it a different type of mutual fund. It can't be a diversified mutual fund. So that's actually a fairly concentrated portfolio.

Now what you're alluding to is you're putting together two to five of those 25 positioned portfolios and you get a portfolio that has ballooned a little bit in position sizes. But I don't think that that means that we run the risk of closet indexing or just performing like the market is going to, because we tend to invest with high conviction, so our best ideas are heavily weighted in those portfolios (relatively heavily weighted).

There is a statistic that has come to prevalence in the last couple of years in the mutual fund world called active share. And I won't get into the math of it, but it's simply a measure of how much you deviate from your benchmark index. And the thinking is that if you have a very low active share score, you are, in essence, behaving like the index and not earning your fees.

BILL MANN:

Which are probably higher than the index.

BRYAN HINMON:

Right. And if you have a high active share…

BILL MANN:

Probably…

BRYAN HINMON:

…it means that the portfolio that you have built looks dramatically different than the index. It doesn't mean that you are going to perform better or worse, but it means that what you have chosen is dramatically different than the index. In our experience with the money we manage for the mutual funds, our active share has been very, very high. And so all I'm saying, there, is philosophically, when we build portfolios, they tend to not look like the index. Now we do lose some of that when you push portfolios together, but I certainly don't think that we run the risk of looking like an index anytime soon.

DAVID MEIER:

And the last thing I would add is within the indices, there are buckets. I have so much in this sector. I have so much in that sector. We are strictly bottoms-up. We are not looking at how those indices are divided up. We are looking, again, for the best opportunities and the bottoms-up stock picking will take our allocations within the portfolios based on sectors to wherever they are. So there's another reason why I don't think we run the risk of being a closet index.

BILL MANN:

It has never been said in our group that we don't have enough utility exposure. Let's go out and find the best utility. It's just not how we think. And so almost by definition, if we're not looking at sectors where either we feel like we've got an advantage, or we don't feel like there's good potential for capital returns, we are going to be wildly different from any benchmark.

ROSS ANDERSON:

That's great to hear. One other thing just functionally about the SMAs that I think we get a lot of questions about, just because maybe people haven't seen it, is just the use of cash, because when we present these portfolios they don't look like they have any cash in them. We're showing a percentage that's allocated to Supernova, or Everlasting perhaps, and then allocating those.

When people see cash, what are they looking at? Do you have a target for that? What's its purpose in your portfolios?

BRYAN HINMON:

It's going to vary based on each strategy, but by and large, each SMA strategy intends to be near fully invested. With that said, the cash level is typically a signal to us. If cash starts to build above normal working capital of 1-3%, that's a signal that we're just not finding enough bargains to invest that capital, and we take note of that. That might cause us to take our position sizes down a little bit because the market may have run up, or something like that. So it's organic, really. We intend to be fully invested, but if we notice that cash is building, it usually means that we're just not finding the opportunities.

The one outlier, there, is in the PRO model portfolio, where cash is a strategic asset. The cash balance tends to look big in the PRO SMA model because I set aside cash to cover potential obligations — so that means positions where I've taken a short position or a potential option obligation. It's really not true cash. It is cash that is spoken for elsewhere in the portfolio, and then the remainder of cash is dry powder, so it's used as an opportunity to invest later or to manage the net exposure for the portfolio.

DAVID MEIER:

I think that's the best way to think about it. It's dry powder. We typically consider fully invested having a little bit of dry powder, because there's always something that can pop up that we would want to try to take advantage of, so there will always be a few percentage points of cash available.

BILL MANN:

I think it is really important, and you guys have said this. When we think about cash, we don't want to wake up in the morning. It's not our goal to manage a cash portfolio. That's…

BRYAN HINMON:

It doesn't sound fun at all.

BILL MANN:

It's doesn't sound fun at all.

ROSS ANDERSON:

It's a pretty sleepy job.

BILL MANN:

Maybe someday. But at the same time, we don't wake up in the morning thinking, "No matter what, I have to swing at something." We will swing when we're ready. We will swing when we see opportunities to put the money. Obviously there's a pressure for us to invest and people want us to be fully invested, but I would hope that people are comfortable with the fact that the reason that we may not be investing is because we are cautious. We are trying to be cautious with their money.

ROSS ANDERSON:

That's great to know. Any final words as we wrap up things that you would want, whether it's a new or existing member or client of The Motley Fool Wealth Management SMA program to know that you don't think we shared with them yet?

BILL MANN:

The thing that I would say is obviously it's been a pretty hard environment to invest in over the last two months, and as I said earlier, in a lot of other segments of the market it's been hard, really, starting from 2014. And these periods of time happen, but if you were to think about the people in 2008 who got hurt the most, they were the people who sold. They were the people who panicked and got out when every time you would look at the news, people would say they'd be looking for the bottom as opposed to "is this a good price to buy things."

And it turns out that it was, and so I am a strong believer in our country's ability to continue to make good capital decisions. To generate capital. I believe in commerce and I think that people really just need to relax about the volatility because it takes care of itself over time.

BRYAN HINMON:

In 2015 — I'm going to ballpark these numbers for you, but they're pretty close to correct — almost half of the S&P 500 was down 20% or more. Two-thirds of the Nasdaq was down 20% or more, and I think 78% of small caps were down 20% or more.

BILL MANN:

In a flat market.

BRYAN HINMON:

In a flat market. Our jobs are getting more fun than they have been in a couple of years, because we're finally starting to see some fat pitches come down the pike and some real opportunity. That's how we approach these markets — investing for the SMA clients and investing our own money, as well. We are getting more and more excited.

DAVID MEIER:

I think you touched on a lot of good points, and the one I would like to reiterate is one of the ways that we think we have an advantage over the market is how we handle ourselves. It's our behavioral advantage. And we truly are long-term investors. We think about businesses in terms of decades — not years or quarters — and we invest accordingly.

And what we would ask is if you want to come and join us — and we'd love to have you — have the same mindset. Think about them as businesses. Think about them as owners. Don't think about them as stocks that trade up and down. That's tough on your psyche. And know that we're doing the same thing and we're managing your money in the same way that, again, we would manage it ourselves which is business-focused, long-term investing.

ROSS ANDERSON:

That's great. Well thank you Bill, Bryan, and Dave. It's been a pleasure having you with us. Whether you're brand new to the Motley Fool Wealth Management program or you've been with us for a little while, we appreciate the faith that you place in us to help you along this ride. Thanks, and Fool on!

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