Dan Kemp's best tip for successful long-term investing: Beware market narratives

-- | 19/05/2022 Text size Decrease

Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Today, joining me is Dan Kemp. He's the CIO at Morningstar Investment Management. Dan, thank you very much for joining us. Dan Kemp: Hello, Emma. It's great to be here. Rapaport: Yes, I have to say, you know, I have followed you for quite some time. And I'm thrilled that you're joining us. I know you've come a long way. So thank you very much for being with us today. So I really want to understand from you, because I know you have this big understanding of global trends in investment management, and in asset flows and all these things. So I want to get from you a sense of really how you're viewing the future, and how you are constructing portfolios to deal with everything that's going on right now. Kemp: Well, the future is everything when it comes to investment management. We get so tied up sometimes in the past and looking at past returns, but in reality, they are irrelevant. They're just a way of (scoring) what's behind us. When we're investing, it's always about what's ahead of us and not ahead of us of the next sort of days and weeks. But what's ahead of us over months, years and even decades for most investors. So I'm delighted we're talking about the future, the future is everything. And we're really challenged as humans, when we think about the future. Rapaport: Yeah, so let's focus on the now for a second. So, in the last six months, it feels like the conversation has been, okay, there's lots of things going on, relatively well after the pandemic, with the economies reopening and, companies are starting to report, and their earnings are still looking pretty decent. But on the flip side, we have this like growing list of just, bad things for investors to worry about. They're worrying about Russia, they're worrying about interest rates, worrying about the Fed Reserve, they're worrying about all these other things that can go wrong. And you know, for me, it makes it very difficult to sit here and say, okay, well, I'm going to think about the long term without focusing on these short term issues. So how do you weigh those two competing narratives? Kemp: Yes, and narrative there is key because as we look ahead, then what's going to dominate returns for investors really depends over -- about the timeframe that you're thinking about. So if you're just thinking about the next 30 years, if you can lock your investments away in a box and not think about them for 30 years, then really, it's going to be the fundamental quality of the businesses in which you invest, that's going to be what drives returns. Over the next five to 10 years, it's really going to be about the valuation of those investments, that's what dominates, returns over that sort of medium term. And then as we get closer, and we worry about those headlines, you're talking about and those narratives, then it's the market momentum, its popularity, it's the way people feel, that drives those very short term returns. And so it's really important to build your investment process, depending on the timescale you're thinking about. Now at Morningstar Investment Management, we think about that five to 10 year period. And so we're valuation driven in our approach, and when you're thinking about that time period, one of the greatest dangers is that you get attracted to one of these narratives, because for all humans, when we're faced with a really difficult question, and one of the most difficult questions is what asset price is going to do over the next few years, we try and naturally answer an easier one. So instead of thinking through the question, what will asset prices do? We instead think, what's the story that most appeals to me, we don't do it consciously, it's subconscious. And so we get drawn to narratives, for example, that the world is sliding into war, or that recessions coming over the horizon or inflation is going to dominate, and we're going to go back to the 1970s. We tend to build these narratives and then invest around these narratives. When you are a professional investor, it's really important to build a portfolio that can deal with all of these narratives, to have a robust portfolio that's not tied to any one particular view of the future, but can cope with whatever the future brings along. Rapaport: So, you're not saying at this point, you know, value is going to come back up, and therefore I'm going to put all my portfolio into energy stocks. That's not your approach. Kemp: Exactly right. So we normally think about diversification and some people get confused and think diversification is all about holding lots of different things in portfolios, but it's actually about holding things that will behave in different ways. It's not about the number of assets. It's about making sure that you have some assets that will let's say, perform well in a recessionary environment, other assets that will perform well in inflationary environment. So you're not just tied to this one single narrative, but whatever the future holds, you have a portfolio that can keep getting you towards your goals and and that should be the key for all investors. Rapaport: So let's talk about the big narrative that's going on right now it feels like everyone is talking about the Federal Reserve, the direction of interest rates, you know, what's going to happen with inflation? Are we going to hit a recession? And that, you know, for me is a narrative that's not, you know, hasn't just been happening the last couple of weeks, it's been happening the last two years this discussion. So how do you approach a narrative like that? How do you approach thinking about it building into the portfolio? And then also trying to put it aside for a second. Kemp: Exactly right. So you have to think about what that narrative means to a portfolio. So if it were to play out, what impact would that have on the portfolio, and also, how much of that narrative is already priced in, because so often, it's not about what's going to happen in the future. But whether that's already discounted in current prices. So at the moment, we've seen very high prices for inflation protected securities, that's when people are most concerned about inflation, well, that's already reflected in the price. And so if you own these assets, although normally they're linked to inflation, if that's already reflected, you're not going to make any excess returns from holding those assets. Equally, some people will be starting to buy stocks now that are likely to do well in a recession. So some of that recession is already priced in. So very often, it's good to look at things that aren't being talked about. More broadly, think about the opposite of where the dominant narratives are, because that's where you tend to find the best bang. So for example, in the depths of the COVID recession in 2020, we were looking at energy companies, we were looking at banks, people hated those stocks at that point. But because of that, there was no good future priced in and so they've subsequently delivered higher returns, well, that now looks like more positive views are baked into those prices, they're less attractive to investors. Rapaport: Let's pick up on one on the narrative. And I know that you discussed this yesterday at the Morningstar Investment Conference. But, one of the narratives that feels like it's very batty right now, or very, very popular is ESG, or environmental, social and governance. Is that something, is that a narrative that you're buying into right now? How are you thinking about approaching ESG in your portfolios? Kemp: Yeah, well, so we run dedicated ESG portfolios. So for clients that want to align their portfolios with their values and their preferences, then we have portfolios specifically designed for those folks. But more generally, we think in the environment that we're in, you have to take into account the additional risks that come from changing regulation, changing consumer preferences towards the environment, and towards social issues and governance. And so we build that into all of our investment analysis, we would expect everyone to build those risks into their general portfolio analysis. And that's what's typically referred to as ESG. But actually, that's not what many end investors care about, they typically care about having a portfolio that doesn't conflict with their value. So if they're very anti-tobacco, for example, they may not want to invest in tobacco stocks, that's a very different thing from building risk into the portfolios. And sometimes those two things get conflated. And people start investing along with themes and forget about the importance of valuation. So again, it's not just about spotting a theme, let's say alternative energy. That's a very popular theme at the moment, but how much of that future growth is already priced in. So I think it's really important to separate the financial aspects of ESG, which should be in everyone's analysis, and then incorporating individual preferences, which will only apply to a smaller group of people. Rapaport: And just to close out, you've been in Australia for a week or so, couple of weeks. And you've come over from London, and I'm sure you've been to lots of places. But do you have any observations about the Australian market that you see that's different or that maybe excites you? How's it been being down here? Kemp: Well, I think the whole country is exciting, frankly. I mean, it's just been wonderful to be here. It's my first trip to Australia. And it's just such a beautiful country. But I think the challenges facing investors here are very similar to the challenges that are faced by investors everywhere. A lot of the narratives that we're talking about are really global narratives. And so they're dominating everyone's views across the world. Of course, the difference in Australia is that many of people's equity investments will be focused on the Australian market. And that has a different shape to it than the U.S. market or the U.K. market or South African market. And so it's really important to think about how these these different narratives, these different risks will impact the market that dominates your portfolio that will be different in Australia to what is in the U.S. where they have a far weighted exposure to technology and far less exposure to resources. So the impact may be different, the way that you address your portfolio may be different, but the challenges are exactly the same. Rapaport: Wonderful. Thank you so much for joining us today. It was a thrill to talk to you. Kemp: Thank you. It's great to be.