Will McKenna: This week on Capital Ideas we've got part 2 in our series about 50 years of managing fixed income portfolios at Capital Group. We’re talking to current veterans and a few retired portfolio managers about their experiences and lessons learned over decades of investing. In this episode, my colleague Dan Indiviglio kicks it off with Mark Brett, the retired principal investment officer of Intermediate Bond Fund of America, and then Dan catches up with David Daigle, the current principal investment officer of American High-Income Trust.
I'm your host Will McKenna, let's get into it.
Dan Indiviglio: Thanks so much, Mark, for taking some time out of your day to join us, what have you been up to since you left Capital?
Mark Brett: I'm not staring at screens and managing money. I'm getting on with my life, and I'm into fixing old cars. I've been racing my 1937 car and starting a YouTube channel about it. I've driven my 1925 car down to Sicily and back, and I've been restoring the 1948 Allard, which is getting on the road now. So busy with that. There are charities I support, which really matter to my heart, and also my wife Pina is in the Salvation Army. I've been supporting her a bit with that. So pretty busy time.
Dan Indiviglio: Yes, it sounds like it. Given your passion of cars, is there anything you can connect from that world to when you were an investor and some lessons you learned over the time?
Mark Brett: Oh yeah, and most of these lessons come from mistakes by the way. With the cars and with investing, I think the number one would be stay balanced. And the corollary of the cars would be, I'm out in my old car in a race, everything's great, it's a sunny day, I'm flying along, and at some minute I'm drifting nicely through a corner, and I go, I've got this. Typically, that comes a millisecond before the crash.
And it's true in investing as well, you need to maintain a sense of balance. In investing, you get good times and bad. And a lot of people focus on weather forecast of what's happening instantly in front of them. But it's more important to think ahead a bit and just say, well, there could be showers. I need to be prepared. I need to be a bit balanced. And I think initially in my career, I would try and build a portfolio that was perfect and aligned with my view of the world.
And I learned that, in fact, I don't know everything. Who knew? Shocks happen. Surprises happen. Markets react in strange ways. So, I learned that it's better to have a great degree of balance in a bond fund. If it's all lined up. It's either going to be brilliant or terrible. And that's not how bond funds should be. So, balance is really good.
Dan Indiviglio: And when you talk about balance, is it in terms of not being too overconfident?
Mark Brett: Yeah, it's mentally unbalanced more than physically. You know, you start to get hubris. You start to think, yeah, I've got this. I'm the one that knows what's going on here. Well, maybe, most likely not. You know, the world tends to come along and bite you in investing, and with many other things, if you think that you're the one that knows everything. You don't. And it's best to be prepared well in advance.
Dan Indiviglio: Mm-hmm. So, then it sounds like sort of consider other views.
Mark Brett: Yeah, and it's listening to other really contrary views. Exactly. I mean, people who come along with something that's totally contrary. A wise old PM once said to me, you need to be able to hold two entirely conflicting ideas in your head at any one time. That's OK.
Dan Indiviglio: Okay, what's another lesson?
Mark Brett: Well, another one I think, is that money and credit and debt matter an awful lot more for markets, especially bond markets, than growth and confidence and management stories about the future. And I've seen enough focus from the street on growth forecasts; its what economists do. That's like forecasting tomorrow's weather, even if you got it right, who cares? You should focus on the climate. But also, maybe an analogy with medical things, you can go in for medical procedures and be very confident about them. But what matters is your genetic makeup and your medical history. Or with the old cars, what matters is it a smooth track. Are there bumps? Is something going to come along? And I think money and credit are the things that trip people up over and over again.
The other thing in that, think about money, is whose money and who drives it. And you hear a lot of people in the newspapers who say the consumer is two-thirds of the economy. So, you focus on them. Well, yeah, that's true as an accountant, but they're not the people who drive swings from boom to bust. So, investment swings a lot more than consumption. Corporate sector gets fueled by easy money and then gets pulled back by tight money. And that's the thing that then swings unemployment and so on.
On the flip side, if you look at consumer confidence indicators, I have tortured that data within an inch of its life. I guarantee you it has no forecasting power whatsoever. At best it's the snapshot of today. And yet people talk about it all the time like it's got information content. It has none. And so, trying to figure out where the money's going and these cycles in money and credit, I've learned right from the beginning, where my first job in the city was a statistical assistant for a monetarist in the 80s, money’s really, really important. It's horrendously difficult to understand, but it is the most important thing in swinging markets around.
Dan Indiviglio: What's the third revelation perhaps from over the years?
Mark Brett: Oh, the third one, I still have the memory of this. And I know where I was and when I was. It was 1986. The little broken firm I worked for had been taken over by Barclays. We had this big forex trading operation. And I'd come up with this, what I thought was a brilliant currency trade idea for the trading desk, which let's just say it wasn't going well. So, I sneaked in one day to see the big guy. He was nearly seven feet tall. He had one of those mustaches, like they always have for the bad guys in the 80s. So, I said, “Well this trade idea that’s not going well …” And he said, “Stop.” He had a very deep voice. “Do you know the first rule of trading?” And he pointed at this word. He had it on his computer. He just had the word “surrender” on his computer. And I went, “What?” He said, “I already cut it. Don't worry about it. What's your next idea?”
I thought, what is he talking about? And he's right that sometimes there are two errors as human beings that keep going wrong: We cling on to bad ideas. At some point you've got to wake up and say, you know what, I'm wrong. Let's cut it. Move on. It's very hard psychologically to do that because at the same time you want to find long-term things that others disagree with. And the other one, from Wayne, was: Never ignore the bloody obvious. And that sounds trite, but it's so true.
It's thinking of the internet bubble in ‘99. I think all of us looking in at it thought, this is a bubble. It's going to blow up. I just don't know how. But it's, you know, it's there. But we didn't sort of think through the implications of it. The same is true of the housing bubble in 2007. It was obvious that there's a housing bubble. But what does it mean? And actually, it was a huge deal, also because it was about money and credit.
And so, this “never ignore the bloody obvious” turns out to be something that, if you're a sophisticated investor, you feel embarrassed pointing at the obvious. But sometimes it's just the big thing. You just gotta take note.
Dan Indiviglio: So, Mark, three main lessons it sounds like. One is to stay balanced, two is to worry about the money and three is to surrender when necessary. Is there something going on in markets, some investment ideas, some security, anything that would sort of capture all these lessons in some way?
Mark Brett: We've had a bunch of policies brought in since about 2015-16, which are really negative for growth compared with inflation. They raise prices and they cut growth. They're inefficient, gritting the wheels. The classic one would be Brexit, which was an economic suicide note. I still think that. The evidence is really clear. But you could also add tariffs. Tariffs are a tax on consumers. Companies pass them on. That is inefficient. That doesn't help the economy. It raises prices. It's all it does. And there's a whole bunch of these kind of, what I describe as bad South American policies that have been coming in with the different governments we've had. And they are all pushing inflation upwards.
The next one is something I haven't mentioned, but because it's so long term, it is important. There is a very long cycle between the share in the economy that goes to labor versus the share that goes to capital. And this has swung around with sort of 20-year cycles almost. We've got used to the idea that capital is winning out over labor, but since about 2015-16 that ratio started to turn, and you can see individuals and workers fighting, saying, “Hey I want my share, enough!” And the policies haven't come through yet, but they are fighting. And I think that labor-capital share is going to be swinging upwards for the next 10 or 15 years, one way or another. And that in itself is likely to keep inflation going up.
And maybe the final thing is something I mentioned earlier in money and credit, and you came back correctly, Dan. We have these ideas of efficient balance sheets, which basically means leverage the company as much as you possibly can and assume everything's going to be great, and then it isn't great, and then you get trouble. And companies now are in that situation, and you can see the reaction is to raise prices and try to squeeze more margins out of the consumers
Dan Indiviglio: Well, great stuff, Mark. Thanks so much for talking to us today.
Mark Brett: Thank you, Dan. It's a pleasure to talk to you.
Dan Indiviglio: So today, speaking with David Daigle, he's a fixed income portfolio manager at Capital Group. He is based in New York and he's the principal investment officer of American High-Income Trust, our mutual fund that focuses on high-yield corporate bond investments.
Well thanks for taking some time to talk. David, so let's jump right in. And you've been a Capital Group for about three decades. Can you tell me some of the most impactful lessons you've learned over that time?
David Daigle: Sure, and thanks for inviting me, Dan. The first one I wanted to mention is the importance of cycles. And the longer that you do this job, the more you realize that the risk reward differs in different cycles. So, if you're investing in equities at the peak of the equity market when valuations are at their extreme high levels, your forward returns are going to be lower. Conversely, a lot of times when you see a company that struggled and an industry that struggled, those can represent some amazing investment opportunities if you get that cycle call correct.
So, in my career, when I started at Capital in 1994, we were in the middle of a technology boom. I was still relatively new in my career and did not appreciate how rich markets were at that time. I didn't have the experiential learning of going through multiple cycles. But one of our equity portfolio managers did, a gentleman by the name of Jim Dutton. And I remember Jim writing an email to the group right around the top of the market, and he was frustrated because he was lagging the markets. He ended the email by saying, is this a blow off or what? And I just remember that hit me as a young analyst. Here's a gentleman who's been investing for decades saying this is ridiculous. And he was right. And so what turned out is if you invested at valuations that were extremely high, your future returns were low. And that's exactly what happened.
In our market, in the high-yield market, we had a period from 1998 to 2002 where cumulative total returns were effectively zero. So, this is for an asset class that at that point in time was yielding more than 10% on average over that five-year period. So, it just struck me as being something that you had to learn to do this job well, to learn about cycles, where you are, and always have an awareness of where you are in that process.
Dan Indiviglio: Makes sense. Any other interesting lessons?
David Daigle: So, the second one I'd point to is about relationships and management. This is an area where I think Capital as an organization does extremely well in cultivating relationships with management teams and understanding those management teams. It was a skill that I had to develop that I didn't have coming into Capital. But I had a lot of great mentors that I was able to watch and was able to learn from that.
I've always felt that if I can build a mutually symbiotic relationship with a management team where I'm providing value to them and they're providing value to me. Those are the relationships that will endure over many, many years. The way that we can provide value to management teams is by sharing insights with them about how we think as investors, what the investment community is looking for, maybe what the rating agencies are looking for, and really conveying that to them.
Conversely, they can share information with us about how they see their competitive positioning, what they think of other competitors that they compete against, what they think about the regulatory structure in which they operate, what their dreams and aspirations are on a five-year view, on a 10-year view. We're sharing information with them, they're sharing information with us. And that's where I think you build this really lasting, tight relationship.
And what has happened with me over time is people that I met 25 years ago I still know today, but you see them show up in different roles. So, they may have left company X and gone to company Y and then moved on to company Z and now they might even be retired and sitting on boards. But you see the same people. And so, it always helps to build those relationships early in your career because they will pay dividends for many, many years to come.
Dan Indiviglio: Makes sense. Do you have a final insight to share?
David Daigle: Yeah, the third one is a little bit more germane to fixed income. And it's something that we do that really doesn't occur on the equity side of the organization or among the investment community on the equity side. But it's really about structure.
In equities, when you own stock in a company, you're a shareholder. You're an owner of that business. The company, the board, owes you a fiduciary duty. As a creditor, you're in a very different legal position vis-a-vis the company. So as a creditor, you have a contractual relationship with the company. The company doesn't owe you any fiduciary duty, and there are very often multiple bonds or multiple loans, and I'll use bonds and loans interchangeably, but each contract has its own set of terms. It will have a different maturity date, a different interest rate. It may have security, collateral, so it may be a secured bond or loan. And all of these things, it will have covenants of some form, especially if it's a sub-investment grade bond.
And so, each individual contract, bond or loan is something that as an investor you need to understand the nature of the structure of that instrument. We have to analyze a corporation the same way that an equity analyst would. But our focus is going to be more on the balance sheet, less on earnings growth, that's going to be more on liquidity and debt structure and less on investment and growth in the future.
And we think of that contractual relationship with the company as being just another risk element. So, if you buy a bond, a corporate bond, you're being offered a risk premium above what you would get paid on a sovereign bond. So, if the 10-year Treasury is yielding 4%, you're going to go buy a corporate bond, you'll get 6% or 8% or 10% or whatever. That premium, the delta between the Treasury yield and the corporate yield, is a risk premium, and you're getting paid differential risk premiums depending on the risk that you're taking.
So, an investment-grade company will have a lower risk premium. A high-yield company will have a higher risk premium. A company that has a bond with really terrible covenants, that bond will have a higher risk premium than a bond with better covenants. And so everything we do in fixed income is really thinking about the structure of the bond, understanding the nature of the risks that you're being asked to assume, and then pricing those risks. And so it becomes a little bit cumbersome, but once you've done it a lot, there are sort of shortcuts along the way.
Let me give you one recent example where this is really important, and it mattered a lot. When one of the banks that recently failed was taken over by the FDIC, that bank had both operating company bonds that were issued by the regulated bank and they had a holding company bonds that were issued by the unregulated holding company. Now typically a holding company bond would be more risky than an operating company bond. It would carry a higher risk premium, a higher yield. In the case of this bank, the bonds at the regulated bank recovered zero. So, when the FDIC stepped in and took over the bank, those bondholders got wiped out with zero recovery. The holding company bonds, because the holding company had assets other than its investment in the regulated bank, the holding company bonds actually have value and will recover much greater than zero. It's too early to tell what the ultimate recovery will be, but you were much better off being a holding company bondholder than an operating company bondholder because of the structure.
So, this aspect of structure is something that, if you talk to any fixed income investor, they'll tell you that it is a core and essential element of fixed income investing. And it's really quite unique to fixed income because there's no corollary in the equity market.
Dan Indiviglio: Thanks so much for your insights. I appreciate your time.
David Daigle: Thanks, yeah.
Will McKenna: OK, there you have it. Special thanks to Mark Brett and David Daigle for coming on the show.
We're always trying to get better, so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com. And if you like what you heard today, please follow us on your favorite podcast platform.
For Capital Ideas, this is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.
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