Greggory Warren (Morningstar) did this interview with us in November 2019. We have covered asset managers and food producers.
In a small series between the years, we are sharing this transcript and some transcripts of evergreen interviews now.
We have discussed the following topics:
[0:00:00] Tilman Versch: Hello YouTube! We just talked with…
[0:00:02] Greggory Warren (Morningstar): Greggory Warren from Morningstar.
[0:00:04] Male Speaker: And we talked about economic moats and asset managers.
[0:00:07] Tilman Versch: If you like it, subscribe to the channel, and leave a comment. Thank you!
[00:00:12] Tilman Versch: Hello, Greggory! Nice to have you here in Luxembourg at the International Value Investing Conference for an interview. You’re working at Morningstar. Would you please tell us a bit more about your background?
[00:00:25] Greggory Warren (Morningstar): I’ve been with Morningstar for about 14 and a half years. I was there in the early days of us picking up a much larger presence of equity research. Before that, I was a buy-side analyst for a then investment management shop for almost a decade.
As far as coverage goes, for the ten years until I started covering the US-based asset managers in 2008-2009, I covered packaged foods, packaged goods, and consumer products. They brought me over to the asset managers during the financial crisis, which is probably the worst possible time to be picking up the companies. But within a year, I also started picking up Berkshire Hathaway, which I’ve covered since.
At this point, I pretty much covered the 12 largest US-based asset managers and the three Canadian asset managers. Morningstar overall is an interesting shop. It started as fund research historically. We started picking up equity research in the mid-90s. Still, we became a much bigger presence during the spitzer years, the post-settlement from the dot-com bubble, where we were one of the recipients of larger independent research contracts. We bought in a lot of analysts to start covering a lot of companies. I was part of that initial wave. And then, we’ve continued to grow the business from there. Much more catering now to institutional clients and fund managers but also advisory shops. So, a wide array of different kinds of clients that we work with.
Right now, in the US, we have, I think, 65 analysts. We’ve got another 20 here in Europe. And also, another 20 in the Asia Pacific region. Our longer-term aims are to grow the analysts’ base both in Europe and the Asia Pacific region. In the US, it will be more about being very selective about the companies we cover. Our coverage tends to skew more towards moat firms.
For people unfamiliar with Morningstar’s research, we assess companies based on their competitive advantage and look at five sources of competitive advantage they could have to assess whether or not they have an economic moat. Then we have three different designations. A white moat is a firm that’s likely outer and their cost of capital over 10 to 20 years. A narrow moat firm is at least for the first ten years. And then, a no-moat firm, we do not have the confidence that they can consistently do it over the next 10 years. That helps segregate our list, but like I was saying, from a coverage perspective, we tend to skew more towards the moat firms because it tends to be more on the wheelhouse of the clients that we serve.
[00:03:25] Tilman Versch: Interesting. What other value investing concepts play a role for Morningstar?
[00:03:30] Greggory Warren (Morningstar): I think Morningstar historically has been a bit more value-orientated. The concept of economic moat comes from Warren Buffett. It was a phrase that he threw out. He wanted one of the companies he owns to be a castle with a white moat around it. We took that sort of concept and applied it because it’s very easy for people to grasp and understand a defensible position for an individual company.
We’re not a sell site shop. We’re not incentivized to push stocks just from a trading perspective because we don’t have a trading desk. We’re more true independent researchers. I think there’s a bit more of a value bent to how we look at things because we run discounted cash flow models for all of the companies we cover. We have a very consistent methodology across the board. What we’re trying to do is get investors into securities and goods quality names at reasonable price points.
We have an array of potential outcomes and uncertainty rating that goes with that. It determines what sort of discount or margin of safety we’d expect or need to have to recommend a stock at certain levels. There is a lot of value built into how we look at the world and recommend stocks overall.
[00:04:57] Tilman Versch: How do you define moats?
[00:04:59] Greggory Warren (Morningstar): A moat is just that sustainable competitive advantage. As I was saying, there are five different sources. There’s the cost advantage and tangibles, efficient scale. I always blank out on this! [Laughs]
[00:05:16] Tilman Versch: No problem!
[00:05:16] Greggory Warren (Morningstar): There’s a network effect. I tend not to have a lot of these because most of my companies don’t. We are looking at those sources of the moat and how that helps the company either have pricing power or the ability to generate excess returns over a longer period. Then, we’re going to look at their competitors and their subsets.
For example, I cover US-based asset managers. I’m not just looking at the 12 companies that I cover, but I’m looking at the broader universe of 150 companies. It’s an advantage working at Morningstar because I have a lot of good quality fund analysts that I can tap into to get their insight on a lot of different companies and what they’re doing and how they’re attacking the market, and how they’re competing with their publicly traded brethren. So, there is a big focus on digging down into what gives a company an advantage over its peers and whether or not it’s sustainable over time.
With the asset managers, the two big drivers of moat tend to be switching costs and intangible assets. Switching costs is kind of inherent in the business overall. At annual redemption rates, they’ve historically been about 25-30% for US-based asset managers. Most of the companies I cover are lower than that.
We look at switching costs overall. We’re also looking at organic growth. Are they retaining the assets longer, and retaining clients longer, but are they also growing the book of business? From that perspective, that’s important. Then the intangibles are the identity. It’s the branding. It’s the quality of the firm, the reputation. A lot of qualitative aspects of the business. As analysts, we’re always looking at things quantitatively, but it’s also important to look at the qualitative aspects and rank them within the organizations.
[00:07:21] Tilman Versch: When we talk about specific moat brands, Kraft-Heinz at Berkshire comes to my mind, where we may see a change in the economic moat. Maybe it’s getting smaller. How do you feel about that?
[00:07:37] Greggory Warren (Morningstar): I think it’s no moat at this point. It’s already been reduced by our analysts. I think the interesting thing is, my background covering packaged goods, there is always a conversation around this, and I’ve always tried to figure out if there’s a way for me to ask a good question at the annual meeting that speaks to this. I’m of an aged demographic that grew up with many branded products and what I would call a baby boomer branded product. It seems to be the more and more I look at it, that branding power is diminishing because it’s not as important to the next generation, Gen X or the Millennials, that are coming up through the economy.
The question is, how long does brand power last? Is it as effective as it used to be? For example, if you look at retail supermarkets where Kraft-Heinz competes, it’s a lot tougher to get pricing power than it maybe was 20 years ago. At the onset, you’re competing against the private label operators who own stores themselves or license them out. In a lot of cases, you’re up against private companies who have a different profit motive or different incentives. You may need to generate 18-20% operating margins, and they may be happy with 10%. It’s a much, much tougher environment for them to compete in. I think brands work and build pricing power where you have a niche and where there aren’t as many competitors overall to nibble away at that advantage.
Margins at consumer goods companies
[00:09:20] Tilman Versch: So, your advice would be, if we look at a consumer goods company like Unilever or Nestlé, that maybe in the long term of 20-30 years we should be aware of a reversion to the mean in terms of margins because of this?
[00:09:36] Greggory Warren (Morningstar): I think our consumers will also agree with this. In many ways, I think you need to focus on firms embracing the change in their marketplace or embracing the brand shift that’s taking place. So, they’re willing to fold in newer businesses or newer ideas. It’s the same thing with the asset managers because we talked about staying time too. I think the four traits that we look at with the asset managers probably hold true for a lot of other companies because basically, we’re looking at differentiation, cost competitiveness, and repeatable investment processes, which is not necessarily the same thing for a lot of other firms but then also adaptable business models. For an asset manager, I think the hardest one of those four to alter or change is the adaptable business model because culture is a really difficult thing to change. When you have a people business like asset management or some financial services, it’s a lot more difficult. I think with packaged goods firms, it’s easier to move into that adaptable business model. I think the harder part for them is the differentiation.
Outstanding asset managers
[00:10:48] Tilman Versch: About the asset managers, what are outstanding asset managers in the US that you are covering?
[00:10:55] Greggory Warren (Morningstar): I cover the 12 largest US-based firms, and traditionally, for long-term investors, I recommend just BlackRock to your price. I see the rest of the group as more investable when they get cheap enough, and it’s more of a trading idea as supposed to long-term hold. With Blackrock and T. Rowe, I know what the headwinds are, but I also know what the tailwinds are to get them past the headwinds that the industry is facing overall.
Headwinds and tailwinds in the asset managing industry
[00:11:30] Tilman Versch: Headwinds and tailwinds, what are they?
[00:11:33] Greggory Warren (Morningstar): You have the pressure of continued growth of passive on the headwind side. You’ve got investors looking for better products and better fee structures. You’ve got the potential for a fee in margin pressure overall on the industry.
From a cyclical perspective, we’re getting in this phase now where there is a likelihood to slow down if not a recession in the US market at some point, which will also prompt a downturn in the markets overall. This run that we had on the bull market for the past 10+ years has been easier for the equity-heavy guys who have been getting priced out on parts of the market by cheap ETFs to still grow their book because the markets continue to rise. So even if they’ve had outflows, they still saw record levels of AUM year after year. But if we are going to prolong the market downturn, it’s a lot harder for them to generate the same level of profitability they had previously.
As far as the tailwinds go, there isn’t a lot for many more traditional active asset managers. There are some players out there that aren’t necessarily public but are still good shops. Dodge & Cox is a fantastic equity shop, still getting inflows and still a good business. If it were public, I’d want to own it. But overall, if you don’t have passive products in your portfolio, you’re struggling to find organic growth. The overall market rewards both organic growth and higher levels of profitability. That’s why T. Rowe and Blackrock get put in this different category because they have a little bit of both.
For Blackrock, it’s the ETF business. Passive products are about two-thirds of their product set overall. iShares is growing at this point. High single, low double digits on an organic growth basis. That’s relative to passive products, just index-based products growing in around 7-8 and then active products on the equity side at negative 2% to 4%. So, it’s a much better position to be in overall, so I know where that’s coming from. When I modeled the company out over 5 and 10 years, just because of the shift in product mix and the continued growth of ETFs, they’re the only company where I see the potential for fee stability. If not, fee improvement and margin stability and improvement over time.
Everybody else got modeled in fee and margin compression. It depends on your product set as to how exposed you are to what’s coming down the pipe. T. Rowe is equity-heavy and active, but T. Rowe has bucked the trend mainly because they have some of the best performances in the industry. Upper quartile performers every time frame. You go back historically year after year for 20-30 years. They have a good process. They believe in shooting for better investment returns instead of just gathering assets, so they incentivize their managers to do the right things for the long run, and they pay the money on a three- and five-year return basis.
They’re looking at the size of the fund to make sure it’s manageable and it’s not getting too big. They also have a good development program internally, and they have a mandatory retirement age for a lot of their managers, so they continue to move, have a process, and stick to it. That’s helped them over the long run, where a lot of other asset managers have struggled. So, from that perspective, on the tailwind side, they have some headwinds, not necessarily the industry factor, because about two-thirds of their business is retirement-based. But right now, as we look at it, they potentially have some headwinds from continued outflows for baby boomers because we’re in that phase where they’re retiring, so a lot more money is coming out of 401k plans than is going in.
In the meantime, what they’ve been doing is trying to access distribution on the retail side of the business, and they found a moderate amount of success there. We think that probably in the next 5 to 10 years, they’re going to do about 1-3% positive organic growth, which is pretty good for an active equity manager. And by 2025, the baby boomers, the millennials, will have caught up on an earnings perspective, and they’ll start to compensate for the outflows coming from the baby boomers. So, we’ll start to see some positive shifts there. So probably by the end of the 10-year timeframe, we’ll be at a mid-single-digit organic growth rate. Again, for the rest of the industry, I struggle to see that kind of growth.
[00:16:25] Tilman Versch: Thank you very much for the first part of the interview. I’m happy to get back to Berkshire for the second part of the interview.
[00:16:31] Greggory Warren (Morningstar): Perfect, thank you.
[00:16:33] Tilman Versch: Thank you!
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