Morningstar - Q3 2022 - 60

Investors
often, that's because they've got a business that
they can price for.
Davis: On the inflation issue, bonds obviously
are important. We used to talk about TINA-there
is no alternative [to stocks]. Well, if you get
bonds going up, there's going to be an alternative.
One reason inflation is of interest is that it has an
impact on interest rates. The Fed is basically
dual-mandated. They've solved the unemployment
problem, and now they have to deal with
inflation. They're not going to stop until they see
that crack. What that changes is the discount
rate. When I value something, the risk-free rate of
return is one of the things I think about.
I do worry right now. We know already that people
with incomes of $50,000 or less are feeling the
pain and are starting to make choices. And I think
we're going to see more of that.
One of the things that we're looking at a lot is the
margin structure. We went to an industrials
conference where everybody in the room told me
they could get pricing. I'm thinking to myself,
let's see what happens six months from
now or a year from now. That could be a very
different story.
We're seeing pretty good increases in inventories.
So, we're asking a lot of questions: What is
the makeup of your inventory? What [amount of
inventory] is work in progress? What is raw
materials? What is finished goods?
We want to be very careful about real versus
nominal. If sales are up because prices are up, but
the company is actually selling less, I have
to be aware of that. This should be a time when
people that are in our business of equity selection
should be able to do a little bit better. But it's
going to be a tricky period.
Thomas: What is the merit of active management in
the equity-income or dividend-growth space?
Hart: You have someone managing to a specific
mandate that you agreed to-that's why
you bought the fund. As long as that person has
a track record of consistently doing what
they say they're going to do, when things get
tough in the market, you don't have to
60
Morningstar Q3 2022
wonder what's going to happen to you. If
the market's going down, you're not necessarily
tethered with an anvil to something that's going
down. No one loves volatility. I think equityincome
investors probably like it a little bit less
than other people.
Everybody always says it's a stock-picker's market.
And when the market's always going up, how
do you prove it's not? But in environments like this,
where things get choppy, you see who really
has pricing power, or who's just saying they have
it under the guise of a little inflation. Who
can deliver?
Davis: It really is sticking with your discipline.
This is a time where you better know what
you're doing and why you're doing it. We stick
with looking at free cash flow and what
we're paying for a dollar's worth of it. It's sort of
the Jerry Maguire of the investment world:
Show us the cash.
One thing I've learned in my career, in down
markets especially, is that larger companies do
matter, because a lot of them have the experience,
and they've been through it before. The
second thing is that liquidity matters an awful lot.
People underestimate the importance of liquidity.
And quality, but you better be able to define
it. For us, it's cash earnings, not reported earnings.
It's looking at profitability margins, structures,
return on assets, turnover of assets, and balance
sheets. People forget about balance sheets. But
when you get into a tough time, you don't
want to forget about the balance sheet. When
things are good, you don't pay a lot for a good
balance sheet. I equate it to homeowners
insurance. It doesn't cost you a lot, but if you come
home some night and your house is ablaze,
it's got to be in place. You can't do it afterwards.
In 2020, people thought dividends were defensive.
Dividends are not defensive. What's defensive
is quality.
Thomas: Don, as a manager of a Vanguard fund, what's
the value of active management in this space?
Kilbride: There's plenty of room for both active
and passive. I don't know that we have to
come down on one side or other of the debate.
But the value proposition with active management
is that active managers are forward-looking.
They don't rely too rigidly on history or on any
other metric to build their portfolios. The
mutual fund that I manage has 43 names. Most
indexes are 10 times that. I think that's the
real differentiator between active and passive.
Digging Into the Details
Thomas: What questions do we have from the audience?
Audience question: When it comes to dividendgrowth
investing, how attractive are foreign
markets compared to U.S. markets today?
Kilbride: The dividend culture's much stronger
outside the U.S., particularly in Europe. My
background and my strength are large-cap U.S.
dividend-paying companies, so that tends
to be where we do all our stock selection. There's
a growing desire for dividend growth in the
U.S., but the culture clearly is more profound
outside the U.S. for a variety of reasons-more
family-owned companies, for example, or
older businesses where that's been a much bigger
part of the value proposition.
Audience question: In which industries or sectors
are you finding the most attractive opportunities
for your style of investing today?
Davis: We were putting a lot of money into
healthcare. It is our largest sector right
now. Toward the end of last year, healthcare
companies were trading at below-market multiples,
with great free cash flow. We bought a
company called AbbVie ABBV; that's been a great
one for us. We owned Eli Lilly LLY, and that's
done incredibly well. We own UnitedHealth UNH
and Anthem ANTM. Those names have done well.
With the move that they've had, I have to
reconsider a little bit. But you still have some
names. Look at a Bristol-Myers. I've had my
differences with them in the past, but it has a 9%
free cash flow yield right now. They have
a follow-up to [anticoagulant medication] Eliquis
and a good balance sheet.
Industrials are interesting as some of them
have come down. We own Union Pacific UNP.
https://www.morningstar.com/stocks/xnys/abbv/quote https://www.morningstar.com/stocks/xnys/lly/quote https://www.morningstar.com/stocks/xnys/unh/quote https://www.morningstar.com/stocks/xnys/elv/quote https://www.morningstar.com/stocks/xnys/unp/quote
Morningstar - Q3 2022

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