The Gordon Asset Management Podcast

#39 - T. Rowe Price Capital Appreciation Revisited w/ Ira Carnahan

• Gordon Asset Management, LLC / Ira Carnahan • Episode 39

Share episode

The Gordon Asset Management Podcast welcomes back Ira Carnahan to the show.  Ira Carnahan is a portfolio specialist working on the Capital Appreciation Fund at T. Rowe Price Investment Management.  We've invited Ira back on to give an update on the T. Rowe Price Capital Appreciation fund  and discuss their new Capital Appreciation Equity ETF (TCAF).  For more information, please visit troweprice.com. 

Please refer to the important disclosures at the end of the podcast.

Outro music compliments of Id Obelus: https://idobelus.bandcamp.com/

INTRO:

You are now listening to the Gordon asset management podcast. Join us as we take you on a journey through the enigmatic world of finance and uncover the mysteries of the markets.

Todd Zempel:

Welcome to the podcast. This is Todd Zempel. I Hope you enjoy the intro I put together today. All of the voices that you heard were deep fakes, ai generated voices. So, if the SEC is listening, no, those were not endorsements. Those were all fake voices. At any rate, on the podcast today we have a very special guest, Ira Carnahan. Ira is a portfolio specialist on the T row price capital appreciation team and that team Manages one of our favorite funds called the T row price capital appreciation fund. Now, it's been a little while since we had you on the podcast, Ira, but given some recent news within the firm, I thought it would be timely to invite you back on. Welcome the podcast, Ira.

Ira:

Thanks so much, todd, it's. It's great to be on.

Todd Zempel:

Absolutely now. One of the primary reasons we wanted you back on the podcast is because you recently Reopened the T. Rowe Price Capital Appreciation fund on a limited basis. Can you explain exactly what's going on there?

Ira:

We closed the capital appreciation strategy back in 2014 and what we've done much more recently is selectively reopened. So it's it's still broadly closed, but Folks in certain working with certain advisors are able to now invest in strategy, so we're really excited to be able to do that now.

Todd Zempel:

Now, naturally, my first question for you is can you explain what exactly goes into the thought process behind closing a fund to new investors and reopening it, and or reopening it on a limited basis?

Ira:

So the key driver in both the closing and the the limited reopening is what's best for shareholders.

Ira:

So if you go back to 2014, when we closed the strategy, we at that point were seeing really substantial inflows.

Ira:

I mean, we're talking, you know, several billion dollars a year, potentially as we looked out over the next few years and the pace of inflows was going to make it tough for us to Invest the money as well as we'd like to with that, with that level of flows, and so the decision was made to to close it off because, you know, again, we didn't want to do anything that was going to compromise the returns of existing shareholders. If you kind of fast forward to the last, the last year plus in 2022, we actually had Modest outflows. You know, with the market down so much, a fair number of investors just naturally Pulled their money out of a strategy. We had a good year but nonetheless, folks with the market down Pull, pulled money out, and so it gave us the opportunity to to reopen in a limited way. You know, as I mentioned, it's not a broad reopening but with select advisors, we're now a long folks to put money back yet Beautiful, beautiful.

Todd Zempel:

Well, thank you for that. Let's take a step back. So we recorded a pretty prolonged podcast back in 2021 where you really did a deep dive on the strategy. So for anybody who's interested, I definitely Recommend you go back and listen to that podcast. But for the new listeners, can you just give us a really broad overview of the T-Row price capital appreciation fund and the objectives and how it operates?

Ira:

Sure thing. So when you think about capital appreciation, we offer multi asset investing in the strategy. So our sort of what we would call neutral or typical allocation is about 60% of the strategy in stocks and 40% of the strategy in bonds and in some cases cash. So 60-40 split there and we can vary that depending on where we're seeing the best opportunity. So if the stock market is down a whole lot, we may increase the allocation to stocks and on the other hand, if the stock market is really warred ahead and we think it's really highly valued, we might own less of that in stocks. But that's the starting point and we're managing the strategy with three different goals in mind and these goals correspond to different time horizons. So over what we would call the short term, which is a one-year horizon, our goal is to outperform the S&P 500 on a risk-adjusted basis. And so when I say risk-adjusted basis, I just mean returns adjusted for volatility. And if you look at how we've done meeting that goal over 19 of the last 20 years, we've outperformed the S&P 500 on a risk-adjusted basis. I would hasten to add that in the one year we did, we were mighty close, so it was just a very small difference Over the intermediate term and we think of the intermediate term as a three-year horizon we have what we consider the capital preservation part of our mandate.

Ira:

So this is a capital appreciation strategy.

Ira:

We're very much about growing returns, but we also want to protect the downside for our investors and over a three-year rolling period, we want to, at a minimum, not lose our clients' money, even if the market's really tough.

Ira:

Now, again, we aspire to do a lot better than just not losing money. But again, even if the market's down a lot, we want to, on a rolling three-year basis, not lose money. And again, if you look historically, we've been much less likely than, say, the S&P 500 to have negative returns over a three-year period. And then, finally, the long-term goal and we think of that as over a full market cycle that includes both up and down years we want to deliver equity-like returns, s&p 500-like returns, while taking much less risk than the S&P. And if you look over the tenure of our current portfolio manager, david Giroud, managing the strategy, which goes back to 2006, he's returned over 100% of the S&P 500's return while taking 68% of the S&P 500's risk. So again, all the return with about two thirds of the risk. So those are the three different goals that we're looking to beat as we're managing the strategy day to day.

Todd Zempel:

Now, with those goals in mind, to me they really speak to somebody that is saving for retirement. Is that who you typically find is investing in this fund?

Ira:

You know, we have a range of folks in the strategy. We certainly have a good number of folks who are retired, who are approaching retirement, but we also have younger investors as well. I can tell you personally, I for years have had all of my money that's not in T-Row Price stock has been in this strategy, and so it can really function as a single investment for folks who want to use it that way. And so we've got a large number of individual investors in the strategy and again it can be used for, I think, a variety of different situations. It's particularly effective if you're in a tax shielded account, because then the gains, the dividends and so forth, you don't have to pay taxes on them right away. But again, we have folks who own it both in taxable and non-taxable accounts.

Todd Zempel:

Now moving on to investment management, so there are multiple camps of investment managers, right? Some make investment decisions based on what's going on in the broad macro environment top-down decision makers. We have others that are more bottom-up, making decisions based on what's going on with individual companies or securities, and then we have others that look at both of those two things. Where exactly does T. T-Row Price Capital Appreciation fall on that spectrum?

Ira:

So I would characterize us as primarily in the individual security selection camp, so building the portfolio from the bottom up. If you think about how we spend our time the portfolio management group on the strategy 95% of it is on looking at individual companies, trying to find the best ones across all the different sectors of the market, and the amount of time we devote to the individual companies and the amount of time we devote to these kind of broader macro questions that consume much of the business news is much, much smaller, and there are a couple of reasons for that. One is we think we have the greatest advantage relative to competitors in individual security selection. We like to think that we know our companies better than anyone other than the legal insiders, the boards of directors and the company management teams, and when we're minimally involved with the companies we own, we think that gives us a real competitive advantage.

Ira:

I think if you look at folks who focus mainly on macro investing, we believe that's just a lot harder to do. It's also a lot riskier way of investing, in our view. If you think about it investing in a bunch of individual companies, we might own 60 or so stocks If we have a good hit rate, if the majority of those picks work out as they do typically, there's a very good chance year to year that we're going to outperform because we get to make so many bets. Even if you're a good macro investor, maybe you have a 60% chance of being right. Well, that means you're making one or two calls a year, you've got a really high chance of underperforming in any given year. It's a much less consistent, steady way of trying to make money.

Ira:

We think both we have a bigger advantage competitive advantage focusing on individual securities, and we also think it's just a lot less risky way to invest. Again, we do pay attention to the macro. We're aware, if the market is way down, if everyone's just in the dumps and they're thinking about the economy, we're going to want to lean the other way. If you go back, for example, to 2008, 2009, when we had the great financial crisis, we took our equity, our stock exposure, way up by early 2009 because the bargains were just so compelling. Similarly, if you look in 2020, when COVID hit, drove the market down by a third in a matter of weeks, we again shifted the portfolio significantly to take advantage of all the negative sentiment. So there are elements of both, but the biggest piece is going to be the individual securities election.

Todd Zempel:

So, Ira, you mentioned that the portfolio is always going to be somewhat balanced, somewhere around 60% equity, 40% fixed income. How much latitude do you have in dialing up or down the equity exposure based on the current market conditions?

Ira:

So by prospectus we can't go below 50% equity and historically we've never gone below kind of a mid-50s percentage, so that would be kind of the lower end At the high end. If you go back to the COVID period, we got up into the low 70s percent bit and the most extreme example in our investing lifetimes was again in late 2008, early 2009,. And we peaked out briefly at close to 80% equities when the market was just super-duper low. But that was an extreme case. I think again, normally we're going to be operating between the mid-50s and the low 70s.

Todd Zempel:

Now, Ira, if you read the Morningstar Analyst Reports on your fund, there's multiple references in there to your contrarian approach and also that you are growth-focused, growth-oriented. To me, if you're contrarian, that typically means you're a little bit more pessimistic, and if you're growth-oriented, that means you're more optimistic. How do you reconcile the contrarian pessimism and optimistic growth orientation?

Ira:

So I think part of the reason that we've had the strong results that we have is we like to think taken some of the best from each of the different approaches. So we're growth investors in the sense that we are looking for companies that are generally healthy, that are growing their revenues, improving their profitability, generating a lot of free cash flow. Those are the characteristics we like to see. We like to see companies that are in industries that have long-term good prospects. So those are all things you would associate with a growth investor. But the value piece of what we do is we care a lot about the prices that we're paying for these securities.

Ira:

So a traditional growth investor might look for the fastest growing companies and valuation or price is a very secondary concern. For us it's a very important consideration. So, basically, what we're doing when we're paying securities, we're looking five years out, so right now 2023,. We're looking out to 2028 and we have estimates of what we believe revenues, earnings and so forth are going to look like on that five-year horizon for the different companies that we own, and we're looking for the ones that offer essentially the best risk-adjusted returns over the next five years, and so growth is going to be important and what they're going to deliver in 2028, but so is the price that we pay today, and I think that operating with elements of both is really helpful. We would describe our style as what we call GARP, or Growth at a Reasonable Price, and if you look over long spans of time, it's in that garpy piece of the market that you've had the best combination of strong returns and moderate risk.

Todd Zempel:

Now, Ira, we've had a very strange 18 months in the market. Last year, growth was a horrible place to be. Broadly speaking, the fixed income markets had suffered one of the worst years in history, and then this year we had extreme pessimism coming into the year. Yet the markets have totally rallied and growth has done very well. Can you just walk us through how you and the team at T-Rail Price Capital Appreciation navigated the last 18 months in the market? Sure, thing.

Ira:

Yeah, it's almost like today is like a mirror image a year ago. Really, we have all this growing exuberance today and again, just almost the exact opposite of what we were seeing a year or so ago. So we went into last year, into 2022, very conservatively positioned. So if you look at how much we had in stocks, that was at a below typical level. If you look at how much we had in tech stocks in particular, we were way underweight the tech sector going into last year, we were overweight utilities, which are kind of the other end of the spectrum there, and it turned out to be good positioning.

Ira:

Tech obviously got hit really hard over the course of 2022. Utilities, even though not the sexiest sector, ended up doing quite well for most of the year. And so you know, given the contrarian strain to what we do, as tech got beaten down really hard, we gradually went from being way underweight tech to moving to modestly overweight and with utilities, we went from being way overweight to modestly underweight, you know, by the end of the year. So again, we're constantly kind of looking for ways to move against the consensus. I mean, the reality is, if you're investing with everyone else, just doing the same thing as everyone else, you can't outperform, so you have to thoughtfully be contrarian, and that's certainly what we tried to do last year.

Ira:

I think you know this year there was great pessimism about what might be ahead, near certainty. We were going to have, you know, recession if you were to listen to the commentators. And you know our view is that, you know, few things are certain in the investing world and when a really strong consensus has emerged that something is going to happen, we're going to want to tend to lean the other way. So we were overweight equities, you know, coming into this year and again, that's turned out to be a good call.

Ira:

Now, you know, if you look at any individual security, it would have been hard to predict that some of them would have taken off as much as they have. You know, todd, you mentioned the AI phenomenon and we believe AI is for real. But you look at some of the stocks, I mean it seems to have moved all the tech stocks up. You know we're not of the view that all of them are going to be equal beneficiaries of this. So I think it's been a little bit indiscriminate and again, we've tried to try to allow for that in our positioning.

Todd Zempel:

Now, ira, when I log into Morningstar as of July 2023, if I'm looking at the fund, it shows that the price to earnings ratio, price to sales ratio both are a little bit higher than the category average. If we're looking over the horizon and we are seeing some potential storm clouds slowing economic indicators, is that higher valuation cause for concern in your mind?

Ira:

So I think we have been.

Ira:

If you were to look at our equity exposure, you know, as a percentage of the whole strategy over the course of this year there's been a gradual downward trend there and I think it's fair to characterize that as gradually taking off risk. Some of the statistics you'll see online, like with Morningstar, showing that the price to earnings ratio of our holdings versus the market appears. This can be a little tricky to interpret because you know when we own a stock it's typically because we believe the earnings estimates of the consensus or the street are too low. So if you were to look at our own estimates, you know the price to earnings ratio would actually be below that of our peers or below that of the market. So those are based on consensus estimates. Our own estimates would suggest we're getting, you know, paying lower valuations than that would say. But yeah, I know, I think as the market has moved up, you know we see less near term upside for sure and I think actually you see a little bit better value or increasingly good value on the fixed income side.

Todd Zempel:

Well, speaking of the fixed income side, can you walk us through how the portfolio is positioned there?

Ira:

So if you, you know, if we kind of go back again kind of brief history here to 2022, we were very conservatively positioned in terms of interest rate exposure going into 2022. So, you know, kind of an academic measure of how sensitive your portfolio is to moves and interest rates would be the duration of the fixed income portfolio. And our duration was very short going into 2022, much, much shorter than our peers. And what that meant in practice was that, as interest rates went up substantially, we fared a lot better than most other fixed income investors because we just didn't have the same interest rate vulnerability. You know, I think again, kind of going back to the beginning of 2022, our view was that, you know, interest rates just didn't have much room to go down further. They certainly had a lot of room to go up and so the risks were just kind of skewed pretty, pretty dramatically at that point. It's a lot more balanced right now. You know, interest rates have gone up a lot and so we've gradually taken up the duration, the interest rate exposure of our portfolio. So we've gone from about again, a year and a half fixed income duration to now about three and a half years, still shorter than our peers, but it's definitely longer.

Ira:

If you look at the particular types of assets we own in fixed income, there's been some shifts there. So, going back to the start of 2022, we were very heavy in leveraged loans or bank loans, which are adjustable rate securities which, again, aren't going to be hurt in the same way if interest rates move around. Today we've trimmed some of those holdings. We still have a significant allocation there, but it's less than it was. And we've increased our exposure to treasuries. You know, at start of 2022, we had none. Today we have about 10% of the portfolio and 10-year treasuries, and then we also have a little bit higher exposure in high yield bonds, which have, you know, a set interest rate to kind of lock in some of the higher rates that we're seeing today. So you know, kind of roughly speaking, our fixed income allocation is roughly, you know, kind of one-third treasuries, one-third high yield bonds and one-third leveraged or bank loans.

Todd Zempel:

Now, ira, one of the other interesting things happening at T-Row price is the addition of several new ETFs, and one of them is TCAF T-C-A-F, the T-Row Price Capital Appreciation Equity Fund. Can you walk us through what that fund is?

Ira:

Thank you, Sure, so it's the full title Capital Appreciation Equity ETF, and so you'll notice in the title of equity. So this is 100% equity ETF, in contrast to capital appreciation which is, as we talked about, 60% equity, 40% fixed. So that's one important difference. The goal of the Capital Appreciation Equity ETF is basically to give our investors superior alternative to S&P 500 index products, whether they be index funds or ETFs. We, instead of owning 500 names, like the S&P index fund does, or ETF, we're going to own 100 names and we've chosen what we believe, what David Giroux, the lead portfolio manager in the rest of the Capital Appreciation Team, believe are the best long-term companies, long-term stock investments for the portfolio, and we've chosen 100.

Ira:

And essentially we've eliminated the companies that we believe can't grow very fast over time, that are in industries that are going to face longer-term challenges, companies that don't have what we think are strong management teams, companies that don't generate a lot of cash flow, companies that have poor capital allocation, don't do a good job of investing their cash flow.

Ira:

So we've taken out what we believe are the inferior companies and the S&P 500, narrowed it down to what we think are the 100 best and we're going to own that in this ETF and it'll be just started about a month ago, but it's a low turnover strategy. We'll have turnover in the 5% to 10% range of year Because of the ETF wrapper. It'll obviously be highly tax efficient. We'll even have a little bit lower dividend yield than the S&P, so that'll improve the tax efficiency even further relative to an S&P index. And I think if you just look at the historical performance of our equity investments in the capital appreciation strategy since David Giroux took over in 2006, we've outperformed the S&P equities by about 4% points a year, a little bit over that. And if we have even a portion of that, a good portion of that, in this strategy, which we think we will, it should offer great returns with great tax efficiency and a very low expense ratio as well.

Todd Zempel:

Now with this ETF, how are the individual positions weighted? Are we to think of this as a smart beta type play, where the positions are just driven by the algorithm, or is this truly actively managed, where you guys at the helm are determining the weighting of the underlying holdings?

Ira:

No, this is actively managed. So we've chosen again what we think are the 100 best long-term names. They're not equally weighted. They're going to be weighted based on somewhat on their size, but more significantly based on how much we believe they can offer in terms of outperformance and moderate risk. So there'll be substantial difference in weightings across the 100 holdings.

Todd Zempel:

Now for Current clients that are in love with the T-Rail Price Capital Appreciation Fund. Can they think of this new ETF, TCAF, as just the equity component of the broader T. Rowe Price Capital Appreciation Fund? How should they think about this?

Ira:

I think that if you compare the ETF to the Capital Appreciation Fund, it's substantially different because it's all equities. As a result, you would expect it to have higher volatility than a fund that's 60-40. You would also expect it to have, along with that, somewhat higher volatility, also somewhat higher returns, given that it's all equities but it's an all equity product. So that's an important difference. If you compare it just to the equity sleeve of the Capital Appreciation Strategy, it'll be a lot more similar. It is more names it's 100 names versus 50 or so in the Capital Appreciation Strategy's equity sleeve. We'll also have lower turnover roughly 5% to 10% turnover versus more like 50% turnover in the Capital Appreciation Equity Sleeve.

Ira:

Of course, the reality is you can't buy the Capital Appreciation Equity Sleeve If you want to have just the equity exposure with a Capital Appreciation Approach. This is a go-to product. We see this product again. It'll have, I think, different appeals to different investors. I think our biggest focus is offering what we believe is a great alternative to a traditional S&P 500 index funds that owns some great companies but also owns what we would view as some pretty inferior companies.

Todd Zempel:

Now, with the advance of this T-Rail Price Capital Appreciation Equity Fund, are we to expect sometime in the future to have a T-Rail Price Capital Appreciation Fixed Income Fund as well?

Ira:

No, I think for a number of reasons, that would be tricky to do in an ETF format. Really, the demand has been when we've talked to clients over the years has been more on the can we get an equity strategy?

Todd Zempel:

Well, Ira, we've talked about the new ETF, we've talked about the mutual fund. Let's take a step back and talk big picture. There's a lot of news going on, a lot of conflicting data out there in the economy. From where you sit, you, as well as David Jarreau, the portfolio manager for the T-Rail Price Capital Appreciation Fund do you have an opinion on whether or not the US will see a recession here in the near term?

Ira:

I think David's view is that we will likely avoid a recession, but we may have one. But if we do have, I think the important thing is that if we do have one, we're not talking about, in our view, a massive, really ugly recession. We all think of 0809. We certainly don't see a repeat of anything like that. So it'll be more of a garden variety type recession. If we have one. If you're a long-term investor, you've got that five-year horizon, as we do. That's the kind of thing you can almost look through, Because we're just periodically going to have recessions. That's reality. If we have one isn't going to be the trajectory-altering situation that we had in 0809. So I think we're much more focused on where we're seeing the best values as opposed to trying to thread the needle. Will we or will we not have a recession? I think we're in the camp. We're pretty comfortable. It won't be a severe win if we have one.

Todd Zempel:

Got it, Ira. Thank you so much. Really appreciate your time today. Was there anything that we didn't touch on that you think is important to share with our listeners?

Ira:

I think, todd, just one thing I would add about capital appreciation is that we do have this big focus always have on controlling risk. If you look at our performance versus the markets over time, again it's been quite good. It tends to be particularly good, though, when the market gets rougher, when it gets more volatile, when things get tougher. If you look at how much the equity market has advanced so far this year, our view would be it's unlikely to continue to be vertical here. So again, if things do get a little tougher, a little choppier, this is a strategy that should do especially well. So we think there's never a bad time to invest in the capital appreciation strategy. Again, it's had great results over time. But particularly when the markets up a lot, that risk protection that we offer can be, I think, extra valuable.

Todd Zempel:

I totally agree. Well, Ira, thanks again for joining us on the podcast today. I really appreciate it.

Ira:

No, it was great. Thanks so much for having me.

Todd Zempel:

If you'd like to learn more about T-Row Price, capital appreciation or any of their other investment offerings, please do not hesitate to visit their website TRowePrice. com, or reach out to us at WealthQB. com.

INTRO:

Thanks for listening. If you enjoyed the show, be sure to click subscribe. Gordon Asset Management LLC is a registered investment advisor. For more information about our firm, please visit wealthqubcom.

Todd Zempel:

The information in this podcast is presented for educational and entertainment purposes only and is subject to change without notice.

INTRO:

Opinions expressed are those of the participants and don't necessarily reflect those of Gordon Asset Management LLC its producers, hosts or guests. Information presented should not be construed as tax, legal or investment advice or a recommendation or solicitation for the sale of any product or strategy. Investors are encouraged to seek advice from qualified professionals to determine whether any information presented may be suitable for their specific situation. Investments involve risks. Neither Gordon Asset Management LLC nor its podcast participants shall be liable for losses resulting from decisions based on information or viewpoints presented on this podcast.

People on this episode

Contributor

Todd "Z" Zempel

Host
Contributor

Glenn Moore

Co-host
Contributor

Joe Gordon

Co-host