Morningstar Advisor - October/November 2010 - 39

These guys were at least mildly cheap in absolute terms. Quite frankly, that is the best thing that we can say about any of the asset classes we look at right now. Unfortunately, mildly cheap is about as good as it gets.
Ben Inker

one of the five finalists for Morningstar's Manager of the Decade award, has a history of buying primarily small- and mid-cap companies. When we see managers such as Romick and those at GMO get on the same page in regard to an investment theme, we want to learn more. We invited Romick and Ben Inker, GMO's head of asset allocation and manager of GMO Global Balanced Asset Allocation Fund GMWAX, to discuss this subset of the equity market. Our conversation took place Aug. 24 and has been edited for clarity and length.

Lots of high-quality businesses are far more cyclical in nature. We wouldn’t put these into our compounder bucket, because at the end of the 10-year period, margins may not be where they are today. I’m not suggesting that one shouldn’t own these businesses; we just put them in a different bucket. What we talked about in the call was that for the first time in our history we’re able to see companies—compounders—that have high returns on capital, generate tremendous cash flow, are doing good things with that cash flow, have businesses that have a defensible position, and that we think will be in a better place 10 years out than where they are today.
Leggio: Do you know these compounders when you see them, or do you use some sort of quantitative measures to find them? Romick: There isn’t a long list of companies that make this cut. There are certain firms that you know just from having followed companies for so many years. But admittedly, we look at quantitative measures—unlevered return on capital above X and the incremental return on invested capital of Y. Those kinds of things.

sense. So we spend a lot of time thinking about what incremental return on capital a company achieves for their reinvested cash flow.
Leggio: Ben, your firm has a quantitative process for identifying high-quality firms. Ben Inker: We’ve got three major characteristics that we’re looking for. We want companies that have shown they can earn an aboveaverage return on capital, that return on capital has been stable over at least an economic cycle, and that they have low debt.

Defining High Quality
Ryan Leggio: Both of you have been talking a lot recently about high-quality stocks. Steve, what’s your definition of a high-quality company? Steven Romick: Are we talking about

I don’t think that is a tremendously different definition than almost anyone else’s. From our perspective, it is not necessarily the case that these are companies that you expect to outperform. They are high-quality companies. They may or may not be high-quality investments. If they’re overvalued, they’re going to lose. What has struck us in recent years is that the market just doesn’t seem to much care about these characteristics. For the first time ever that we can see, we can get these characteristics at a discount to the overall market—which is what has caused us to be interested in making them a big part of our portfolio.
Leggio: One group of companies that isn’t in either of your portfolios is financials— even household names like Wells Fargo WFC and American Express AXP. Why don't you consider these high-quality companies?

high-quality stocks or high-quality companies?
Leggio: Both. Romick: Because what we were really talking about in our conference call was the nature of what we view as a compounder. A compounder is a company in which we’re very confident that the business 10 years from now will be in a very good place and will give us a good compounded rate of return. The business won’t disappear; its competitive moat will not have deteriorated over that time frame. The question is not, “Will you get a rate of return?” but, “What will the rate of return be?”

Balance sheet is something that is an overlay, because one presumably has the ability to create a balance sheet that would be optimized. We see a lot of managers use balance sheets and cash flow poorly. Some managers simply default to repurchasing their own stock. It’s almost like buying stock willy-nilly. It doesn’t matter what price. Well, it’s got to meet a hurdle rate for it to really make

MorningstarAdvisor.com 39


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Morningstar Advisor - October/November 2010

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2010

Morningstar Advisor - October/November 2010
Contents
New on MorningstarAdvisor.com
Contributors
Letter From the Editor
What estate-planning strategies are you and your clients doing before the end of the year?
Next Steps for ETFs
Investment Briefs
Taking It Personal
A Model Practice
Find the Right Fit
Will REITs Put You in the Penthouse?
Prepare for the Worst
Tips for Common Family Situations
Might Makes Right
Built to Last
Four Picks for the Present
Tactical Strategies Miss Their Mark
Time to Hop on the Commodities Bandwagon?
Retailers Balance Caution and Catalysts
In Search of … Recession Survivors
Turmoil-Tested Small-Cap Funds
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Rise in Second Quarter
The Third Rail
Morningstar Advisor - October/November 2010 - Intro
Morningstar Advisor - October/November 2010 - Morningstar Advisor - October/November 2010
Morningstar Advisor - October/November 2010 - Cover2
Morningstar Advisor - October/November 2010 - 1
Morningstar Advisor - October/November 2010 - 2
Morningstar Advisor - October/November 2010 - Contents
Morningstar Advisor - October/November 2010 - 4
Morningstar Advisor - October/November 2010 - 5
Morningstar Advisor - October/November 2010 - New on MorningstarAdvisor.com
Morningstar Advisor - October/November 2010 - 7
Morningstar Advisor - October/November 2010 - Contributors
Morningstar Advisor - October/November 2010 - Letter From the Editor
Morningstar Advisor - October/November 2010 - What estate-planning strategies are you and your clients doing before the end of the year?
Morningstar Advisor - October/November 2010 - 11
Morningstar Advisor - October/November 2010 - Next Steps for ETFs
Morningstar Advisor - October/November 2010 - 13
Morningstar Advisor - October/November 2010 - Investment Briefs
Morningstar Advisor - October/November 2010 - 15
Morningstar Advisor - October/November 2010 - 16
Morningstar Advisor - October/November 2010 - 17
Morningstar Advisor - October/November 2010 - Taking It Personal
Morningstar Advisor - October/November 2010 - 19
Morningstar Advisor - October/November 2010 - A Model Practice
Morningstar Advisor - October/November 2010 - 21
Morningstar Advisor - October/November 2010 - Find the Right Fit
Morningstar Advisor - October/November 2010 - 23
Morningstar Advisor - October/November 2010 - 24
Morningstar Advisor - October/November 2010 - 25
Morningstar Advisor - October/November 2010 - Will REITs Put You in the Penthouse?
Morningstar Advisor - October/November 2010 - 27
Morningstar Advisor - October/November 2010 - 28
Morningstar Advisor - October/November 2010 - 29
Morningstar Advisor - October/November 2010 - 30
Morningstar Advisor - October/November 2010 - 31
Morningstar Advisor - October/November 2010 - Prepare for the Worst
Morningstar Advisor - October/November 2010 - 33
Morningstar Advisor - October/November 2010 - 34
Morningstar Advisor - October/November 2010 - 35
Morningstar Advisor - October/November 2010 - Tips for Common Family Situations
Morningstar Advisor - October/November 2010 - 37
Morningstar Advisor - October/November 2010 - Might Makes Right
Morningstar Advisor - October/November 2010 - 39
Morningstar Advisor - October/November 2010 - 40
Morningstar Advisor - October/November 2010 - 41
Morningstar Advisor - October/November 2010 - 42
Morningstar Advisor - October/November 2010 - 43
Morningstar Advisor - October/November 2010 - 44
Morningstar Advisor - October/November 2010 - 45
Morningstar Advisor - October/November 2010 - Built to Last
Morningstar Advisor - October/November 2010 - 47
Morningstar Advisor - October/November 2010 - 48
Morningstar Advisor - October/November 2010 - 49
Morningstar Advisor - October/November 2010 - Four Picks for the Present
Morningstar Advisor - October/November 2010 - 51
Morningstar Advisor - October/November 2010 - Tactical Strategies Miss Their Mark
Morningstar Advisor - October/November 2010 - 53
Morningstar Advisor - October/November 2010 - 54
Morningstar Advisor - October/November 2010 - 55
Morningstar Advisor - October/November 2010 - 56
Morningstar Advisor - October/November 2010 - 57
Morningstar Advisor - October/November 2010 - Time to Hop on the Commodities Bandwagon?
Morningstar Advisor - October/November 2010 - 59
Morningstar Advisor - October/November 2010 - 60
Morningstar Advisor - October/November 2010 - Retailers Balance Caution and Catalysts
Morningstar Advisor - October/November 2010 - 62
Morningstar Advisor - October/November 2010 - 63
Morningstar Advisor - October/November 2010 - 64
Morningstar Advisor - October/November 2010 - 65
Morningstar Advisor - October/November 2010 - In Search of … Recession Survivors
Morningstar Advisor - October/November 2010 - 67
Morningstar Advisor - October/November 2010 - Turmoil-Tested Small-Cap Funds
Morningstar Advisor - October/November 2010 - 69
Morningstar Advisor - October/November 2010 - Mutual Fund Analyst Picks
Morningstar Advisor - October/November 2010 - 71
Morningstar Advisor - October/November 2010 - 72
Morningstar Advisor - October/November 2010 - 73
Morningstar Advisor - October/November 2010 - 50 Most Popular ETFs
Morningstar Advisor - October/November 2010 - 75
Morningstar Advisor - October/November 2010 - Undervalued Stocks With Wide Moats
Morningstar Advisor - October/November 2010 - 77
Morningstar Advisor - October/November 2010 - VA Sales Rise in Second Quarter
Morningstar Advisor - October/November 2010 - 79
Morningstar Advisor - October/November 2010 - The Third Rail
Morningstar Advisor - October/November 2010 - Cover3
Morningstar Advisor - October/November 2010 - Cover4
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