Watch Out for These Investing Red Flags

Jeffrey Ptak: Hi, I’m Jeff Ptak with Morningstar. At this year’s Morningstar Investment Conference in Chicago, our manager research analysts will share insights on what scares them, the red flags that make them pause, probe further, or rule out a fund altogether, and how advisors can use this practical know-how to spot risks as they’re conducting their own analysis. Research Director Andrew Daniels is here today to discuss some of those red flags. Andrew, thanks for being here. Welcome.

Andrew Daniels: Thanks for having me. Appreciate it.

Ptak: Of course. You’ll be part of a panel with a few colleagues where you’ll talk about specific red flags that could come up in the course of evaluating a fund. Maybe it makes sense to take a step back and walk through the process that is the organizing principle for the analysis that you conduct. Do you want to walk through those phases of the process?

Daniels: Sure. Happy to. At Morningstar, our manager research process is all focused on People, Process, and Parents. We use Morningstar’s treasure trove of data to help us meet with managers and come to the right decision on whether to partner with those managers, whether to recommend them or not. We’re always doing a lot of background work on those managers in advance of coming to a meeting with them. We do meet with every manager that we cover, but we’re doing a lot of work behind the scenes to make sure that we come to those meetings as prepared as we possibly can. We want to think like those managers and be as prepared as we possibly can, assessing their trading histories. Why do they join the firm? Understand their credentials and their path to where they’re currently at in their career. After the meeting, the work is constantly ongoing.

The research doesn’t really stop, and we meet with a manager every 12 months at least, sometimes more often, and we’re always testing and refining our existing views on a strategy.

Ptak: Let’s start with the first phase, which is preinterview, before you even talk to the PM. What’s an example of an issue that might arise in that phase that raises a concern, and how might that inform the way you approach the interview with the portfolio manager?

Daniels: I would say a pattern of personnel change is one of the first things that we are looking at. Is this a firm that people want to come and stay at, or is it more of a building block for them to go somewhere better in their careers? That’s something that we are looking at. It’s not just about team stability, but it’s also about the overall investment culture. I think another case that we look at is: Is this a star manager, where they might be an excellent portfolio manager, and maybe they have a strong current team around them; however, that current supporting team doesn’t feel like they have a pathway for upward mobility, and so they’re looking for other jobs elsewhere. That’s something that we’re going to look to tease out in the research process as well. That’s what we’re looking for going into the interview, looking for not just how the team is structured today, but to understand the whole historical reference point of how changes have developed over time, how personnel decisions are made in practice, and whether team members want to stay there for the long term.

Ptak: One of the tougher things to evaluate, I’d imagine, is the investment process, and it has to be even more challenging in situations where you don’t have access to the portfolio manager, which is true of a lot of financial advisors out there. We’re very fortunate that we enjoy the sort of access that we do enjoy. Can you talk about the sorts of things in the preinterview phase that you might be looking at and trying to make an assessment of a strategy’s investment process, and what might jump out to you before you even get to the conversation with the people?

Daniels: Yeah. All the data that we are looking at is telling you some sort of story, and it’s our job to figure out what that story is before we go into a meeting with a manager. For instance, many managers say that they are quality-oriented. We are looking to test that through the data that we are looking at. Are their quality metrics actually better than benchmarks, or are they looking at, are there a handful of heavily indebted companies? Are there some companies that don’t have real good returns on invested capital? Do they have negative cash flows, things like that? If we see situations like that, we’re always going to ask about it in meetings and press ultimately whether the manager is doing what they’re saying that they’re doing. Portfolio turnover is another area. A lot of managers say that they are long-term oriented, but in practice, that might not always be the case. Now, there might be reasons for that. Perhaps you’re looking for a quality company and the current financials don’t paint a rosy picture, but you’re buying a company now and expecting that thesis to unfold over time. Let’s say negative cash flows might be a current problem, but if you have a management team that is actively working to bring down debt levels and improve the financial picture of the company, that’s a situation where the fundamentals aren’t currently reflected in the stock price.

We just want to understand the whole thesis of what’s going on behind the decisions that are being made. Yeah, there could be reasons for diverging a little bit from the current picture, or there could be bad reasons, and that’s definitely a thing that we’re looking to tease out in the process.

Ptak: Very interesting. Let’s move to the next phase of the process, which is the manager interview itself. What might be an example of a situation that arises where the way a manager responds to a question that you’ve posed to him or her might set off some alarms in your mind?

Daniels: I’ll bring it back to the quality picture. I think one thing that I look at is if a manager says that they’re quality-oriented, but then you see these situations where they are diverging from the process in terms of not actually finding quality companies in the portfolio, that’s a red flag. Again, there can be specific situations where there might be relevant justifications for that, but if you see it consistently over a long period of time, that’s definitely a red flag.

I think we’re also testing the insights of a manager. How well does a manager know their current holdings in their portfolio? Let’s say you have a large team that’s supporting the manager, you might not need to know every company super in-depth because you are relying on the analyst team, and your job as a portfolio manager is really to unearth the best ideas from the team. However, if you work for a small shop where the manager constantly touts the benefits of having a small team and how collaborative it is, I expect to see the manager have very in-depth knowledge of those particular holdings. If they don’t, then that signals, OK, well, there’s probably a problem here where the depth of knowledge isn’t what I would expect it to be.

It depends on the team structure, depends on the team’s size. Bigger is not always better, but if you do have a small team, I do expect the research depth to be better unearthed by the portfolio manager, for sure.

Ptak: Beyond those dimensions, I would imagine that you’re also using the interview to sort of get a sense of what makes the manager tick, maybe presenting them with a scenario or asking them about a set of circumstances and sort of getting a feel for how it is they respond to that. Maybe you can talk a little bit about some of that body language, if you will, that you might be able to observe in the course of an interview with a manager.

Daniels: Yeah. This is one of my favorite parts of the interview because, really, at the end of the day, you’re assessing temperament, you’re assessing their level of passion for the job. Do they love what they do? Are they coasting? This comes out in a meeting, and you meet with a manager or their investment teams several times and come to a conclusion. We might ask: Tell me about a position that hasn’t gone your way. What did you learn? What were the implications of that? You can learn a lot from asking questions like that. Do they respond defensively in the name of underperformance? Do they acknowledge their deficiencies and strive to get better? There are really big behavioral traits that you can assess, asking questions such as that. I think for me, it comes down to, is this a manager that is trying to do the right thing?

Do they self-correct any issues with the process? At the end of the day, no manager is always right. This is a business where a great manager is still wrong just under 50% of the time. It’s a humbling business. You have to be willing to bounce back from your errors, but make sure that those errors are not repeated consistently going forward. We want to make sure that a manager is humble, constantly reflective, and introspective. There is a very fine line between being confident, which I think is a trait that we like, and being arrogant, which is a trait that I think, ultimately, will show up in process deficiencies over time.

Ptak: Maybe we’ll shift to the final phase, which is postinterview and everything that happens off schedule, and as much as I think we would like things to unfold on a tidy schedule, they don’t always. Maybe you can talk about the sorts of circumstances that can arise after you’ve conducted an interview with a PM that could be cause for concern or at least warrant further scrutiny. Maybe it’s a personnel change, an organizational announcement like a fund merger. What are the sorts of things that come up? How do you deal with them?

Daniels: We update our ratings at least every year, but we are always looking at the strategies that we cover to make sure that we’re on top of any sort of unexpected changes that come up. It could be a manager change, could be a fund merger, it could be a firm acquisition, something along those lines. We want to make sure we’re on top of that. I think in terms of a manager change, the best practice is to have those be well-telegraphed in advance. Treat us as a partner throughout the process. We understand that changes do happen over the course of a career, but the best asset managers, I think, are constantly grooming investment talent, that next generation of people, because turnover is disruptive. If you have a star manager who is nearing the end of their career, something that we are always asking about in meetings is, who’s the next generation of talent?

What are they doing to develop that next generation? Do they have analysts who are kind of growing up within the firm, rotating their coverage around different sectors, different types of companies, to kind of build that portfolio management skill? Is the portfolio manager starting to groom them to eventually take the reins? Do they become a named portfolio manager alongside the lead manager at some point? Is the transition orderly and done in a well-telegraphed manner? Those are some of the things that we’re looking at. For a fund merger, those can be very disruptive. This is a human capital business, and disruption to the culture is a very important part of our assessment of the Parent Pillar. We just want to make sure that the asset management firms are thoughtful and planning this out in an appropriate manner, and there are a lot of firms to get it right, and there are a lot of firms that get it wrong.

Ptak: Very interesting. Well, thanks so much, Andrew, for sharing your perspectives with us. Look forward to learning more at the Morningstar Investment Conference. I’m Jeff Ptak from Morningstar. Thanks for joining us.