Interview: Windsor II and the quest for value
May 05, 2014
Since its inception in 1985, Vanguard Windsor™ II Fund—a large-cap domestic value stock fund—has been managed by a group of external advisors, including Dallas-based Barrow, Hanley, Mewhinney & Strauss, LLC. Known for its commitment to value investing, the firm oversees about 60% of Windsor II's portfolio, with the remainder divided between Lazard Asset Management, Hotchkis and Wiley Capital Management, and Sanders Capital. Vanguard Equity Investment Group also manages part of the fund.
We recently sat down with two associate portfolio managers on the Barrow, Hanley, Mewhinney & Strauss team, David Ganucheau and Jeff Fahrenbruch, to hear how their experiences have shaped their approach to managing Windsor II and their thoughts on current market and economic conditions.
How have your experiences shaped your approach to making investment decisions?
David Ganucheau: I like to say I've had two jobs in my life—I've mowed lawns and I've managed money. When I was growing up, I had a lawn-mowing business, and my father was a money manager. He's a value investor, and at one point in the '70s he worked with one of our firm's founding partners, Jim Barrow.
"We've delivered top-quartile performance for bottom-quartile fees, and we think that fits with the culture of Vanguard and its values. It matches our style, and we're happy to be on the team."
— David Ganucheau
I had an apprenticeship from a young age. My dad used to come home from work with statistics on stocks—detailed descriptions, price-to-earnings ratios, valuations, historical financials—and we would go through them together. We did it for fun. It led to my first stock idea in the early '80s: Braniff Airlines. I bought it because it was a buck a share. It went bankrupt shortly thereafter! But it was a great lesson in how to find value in unlikely places, and how not to.
That experience taught me to look for companies with good balance sheets. It also taught me that just because a stock is down doesn't mean it's "cheap." The third lesson was about the importance of buying good, sound businesses—not just marginal businesses that look like bargains but whose earnings disappear, and the next thing you know, you’re left with nothing. I've been following those lessons ever since.
Jeff Fahrenbruch: I grew up playing golf, and to afford it I flipped burgers and washed golf carts. From that experience I learned the value of a dollar, and I became a value investor at a young age.
I was also a really competitive person. That competitive nature helped me to succeed. When I got introduced to this business I found that for someone with a competitive nature and a strong intellectual curiosity, this business is as good as it gets. I've been in love with it ever since.
Describe your investment philosophy and the key factors you focus on when making investment decisions.
David Ganucheau: Our philosophy is really very simple. We focus on buying good companies with discounted valuations that are down for reasons we can identify, and that we think are temporary. We do that over and over and over again.
The key valuation parameters that we focus on are discount P/E, discount price-to-book, and we also want a dividend yield premium. Our portfolio, as a whole, should always have these characteristics relative to the broader market.
Vanguard Windsor II Fund
Assets: $48.3 billion*
Number of stocks: 261*
Median market cap: $73.0 billion*
Benchmark: Russell 1000 Value Index
Expense ratio: 0.36%**
Minimum investment: $3,000
*As of March 31, 2014
**As of February 26, 2014
All companies run into problems from time to time, and they'll often trade at a discount, especially when the market is so short-term focused—and getting more short-term with more money going into hedge funds. A lot of managers and investors these days are more concerned about current performance than what it's going to look like at the end of the year. We look at things on a three-to-five-year time horizon.
And so, when companies run into problems, the people who are short-term-focused sell them off, often without really looking at them closely. That gives us time to decide whether the companies' problems are temporary or permanent. If we think they're temporary, we may buy them. That's how it works.
Jeff Fahrenbruch: We're also looking for good companies trading at a discount. And we look at the quality of companies in a variety of ways, from free cash flow generation—whether management is using the cash flow in a smart way—the return on invested capital that the company is generating, and the company's long-term growth prospects. We don't want a company that's in secular decline.
We believe in putting together a portfolio that has both a valuation advantage and a fundamental premium to the market. That's a recipe for long-term success.
What's your view of U.S. markets and the economy at the moment? Are you optimistic?
Jeff Fahrenbruch: The economy hit a speed bump through the winter, probably due to the severe weather we had across the country. But it does look like the underlying trend is improving.
Fiscally, governments are not in good shape, but corporations are in great shape. Profit margins are healthy and balance sheets are strong. Consumers are recovering. We're adding jobs and the housing market is improving. If you look at consumers' balance sheets, as measured by the Federal Reserve's financial obligation ratio, we're now down to the healthy levels where we started the last two big economic expansions in the '80s and '90s.
David Ganucheau: That's true, but I think we'd both agree that the market has had an incredible run from the bottom it hit in 2009, and that fact by itself could be reason for near-term caution. There could definitely be some volatility.
"We focus on the fundamentals of companies rather than looking at the economy to see where we should invest. That's how we arrive at the investments that we buy—just on the merits of the companies alone. We don't spend a whole lot of time forecasting the economy, but we don't ignore it, either."
— David Ganucheau
One of the things we did recently was to look at the earnings yield of the market, which can be a fairly good predictor of long-term returns. What we found was that when the market has an earnings yield like it does today, just under 7%, it has historically produced average returns of 8% over the following ten years. That's a decent return. It's lower than what we've experienced in the last few years, but it's still a good return. At Barrow, Hanley, our portfolios have a higher earnings yield than the market plus a dividend yield premium, which positions them well for the future.
I would add, however, that we are "bottom-up" investors. We focus on the fundamentals of companies rather than looking at the economy to see where we should invest. That's how we arrive at the investments that we buy—just on the merits of the companies alone. We don't spend a whole lot of time forecasting the economy, but we don't ignore it, either. It's critical to know what part of the business cycle you're in. For example, you could make the mistake of buying cyclicals at the peak of a cycle, when they appear cheap on a P/E basis, but when they're really value traps.
What do you make of the Federal Reserve's policy moves? Does the Fed influence your portfolio decisions?
Jeff Fahrenbruch: Interest rates have remained a lot lower than anyone would have predicted five years ago. That has led to some financially distressed companies getting bailed out, and it's pushed investors out the risk spectrum to find attractive returns.
What we've seen in the market over the last few years is that smaller-cap companies and companies that pay little or no dividends have outperformed. But now, with the Fed tapering its monetary stimulus and the economy improving somewhat, we would expect that to reverse and for the cheaper larger-cap stocks to outperform.
Traditionally, your portfolio has had a healthy exposure to dividend-paying stocks. What impact does an uncertain interest-rate environment have on your outlook for those companies?
David Ganucheau: While we do look for stocks with healthy yields, we're always aware of where we are in the interest rate cycle. When interest rates go up, the three biggest laggards are typically utilities, telecoms, and REITs. If you look at our portfolio, we are underweighted in these areas as a whole.
"I think the best advice we can give to investors is to simply follow the rules that Vanguard was founded upon: Focus on low-cost investing and maintain a long-term view of the markets."
— Jeff Fahrenbruch
In terms of the dividend-paying stocks we own, we try to find companies that can meaningfully grow their dividends. Our research shows that those companies that not only produce dividends, but actually grow those dividends have meaningfully outperformed over long periods of time. If you look at the companies that we own, the median increase in dividends in 2013 was 10%. That's the kind of dividend growth that's embedded in these companies, and we think it will lead the portfolio to outperform.
What sectors or stock characteristics do you find attractive?
Jeff Fahrenbruch: One of our biggest portfolio overweights today is in health care. Concerns over health care reform and the weak overall health-care utilization environment have depressed these companies. We believe most of them are now trading at a discount valuation, but they are better than average companies. They have great balance sheets and strong free cash flow, and a lot of demographic trends are moving in their favor. After all, we're all getting older, and there are still large areas of unmet needs where these companies are developing new products. They're also taking their existing products and selling them in emerging markets, where health-care spending is growing quickly.
We've seen better performance from large-cap pharmaceutical and managed-care companies that had been beaten down by health care reform. They've finally started to turn around, although they haven't yet recaptured the significant underperformance of the last ten years. It seems like every biotech company is being priced as if its drug is going to succeed and be the next leader. A few will, but they can't all work out that way.
Large-cap technology stocks also look attractive to us. There's a large bifurcation in technology stock valuations between the newer, more popular companies and the old incumbents. Today the market is pricing the new companies as winners and the old companies as losers. But we look at the established positions that many of these older companies have and we see chief technology officers trying to reduce complexity by minimizing the number of vendors with which they deal; and we feel that if these old incumbents can evolve enough, they have a much better chance of winning in the long run than the market is pricing in today.
David Ganucheau: I'd add that we believe financial service companies still represent good value, even though they've performed strongly over the past few years. Large banks, in particular, have much better balance sheets and capital levels than at any time since before the financial crisis.
Loans aren't growing very fast, but that has a silver lining to it. With low growth in balance sheets comes very solid underwriting, and credit costs go very low for long periods of time. After the Great Depression, credit costs went sub-normal for 35 years. Credit costs can stay low in this type of environment for a very long time, when banks aren't taking on excess risk with marginal loans. Earnings are also still depressed, partly because of elevated legal and regulatory concerns, but also because of the interest rate environment.
Do you have any final thoughts for investors?
Jeff Fahrenbruch: I think the best advice we can give to investors is to simply follow the rules that Vanguard was founded upon: Focus on low-cost investing and maintain a long-term view of the markets.
David Ganucheau: We're excited to be partnering with Vanguard on Windsor II. If you look at the history of our firm, we've delivered top-quartile performance for bottom-quartile fees, and we think that fits with the culture of Vanguard and its values—looking out for the investor by providing competitive service at low costs. It matches our style, and we're happy to be on the team.
- All investments, including a portfolio's current and future holdings, are subject to risk, including the possible loss of the money you invest.
- Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors' shares, when sold, may be worth more or less than their original cost.
- Opinions expressed by Mr. Ganucheau and Mr. Fahrenbruch are their own, and do not necessarily reflect the views of Vanguard or its management.