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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

So, we've just come back from our summer break. Mark, you went away?

Mark LaMonica: I did.

Jayamanne: You went to a couple of places or a few places?

Lamonica: A couple or a few. I went to three places if we want to get specific.

Jayamanne: Okay. Where did you go? I went to Hong Kong, I went to Macau, and I went to Bangkok.

Jayamanne: So, you went nowhere in Africa?

LaMonica: I did not go anywhere in Africa, and I believe we've had listens in all three of those places. So, I could not help us there.

Jayamanne: Very inefficient traveling. So, I want you to particularly tell me about Macau because you had a bit of a strange experience.

LaMonica: I had a strange experience. It's just a strange place.

Jayamanne: Tell us about it.

LaMonica: Well, it's like Vegas but no fun. I don't know. You show up and you've got the Venetian where they have the ridiculous canals inside around 800 Gucci stores in a single mall.

Jayamanne: Did you buy anything?

LaMonica: I bought nothing. I just mocked stuff there. Big Ben was right outside of the hotel I was staying in and then the Eiffel Tower is a little bit down the street. And yeah, it's like Vegas but I was trying to find a place to get a drink and there was only one place as far as I could tell in this little section of Macau that I was in, which is where all the casinos were, that was actually open before 5 o'clock.

Jayamanne: That's crazy.

LaMonica: Yeah. Yeah, it is.

Jayamanne: And so, the reason I know that Mark had a bit of a strange trip is because on social media, he normally posts nothing, but he documented every part of his Macau trip and how much he hated it.

LaMonica: And were you just excited about each new post that came up?

Jayamanne: Yeah, exactly. So apart from that, you had a good trip?

LaMonica: I did. I did. But it's good to be back and recording again. So, we'll get into today's topic and one thing we always strive for on the podcast is transparency. And of course, we do this because we don't want this to be an academic view of investing. There's a lot of that out there. And we want to talk about the way that we invest and that's not because we think anyone should do what we're doing. But we do hope that our own thinking will help other people think about their own investments and their goals and how to achieve them.

Jayamanne: And thinking is a valuable thing for all of us to do. We want investors to be thoughtful so they will stick with their strategies over the long term and know what to do. And most importantly, what not to do when things get stressful.

LaMonica: So that is the premise of this episode. So, the real world and textbooks are often miles apart. The real world is messy, it's full of emotions and we face temptation and greed and then of course fear.

Jayamanne: So, think about how to make Siri and the real world.

LaMonica: Here's the thinking, Shani. And to transparency, I guess.

Jayamanne: Something I support today because the transparency is about you.

LaMonica: Yes, today we're going to talk about my top 10 holdings, but we're going to do it for a reason and we're going to talk about selling.

Jayamanne: Which is something that is rarely talked about. We read financial media, and it is full of opinions on what to buy and where the opportunities are. And there are several reasons for that. The first is that many people are simply looking for ideas. New ideas are exciting, it allows us to dream of the riches that are just around the corner.

LaMonica: Which was certainly the case in Macau with all of the gambling. But hopefully, most people who listen to this podcast know that that sort of pursuit of riches is not exactly a recipe for building long-term wealth.

Jayamanne: So, let's start at the beginning. We hear and we say over and over again that valuation matters when you're buying something.

LaMonica: And buying significantly overvalued shares lowers the chances of good investing outcomes. Investor expectations are baked into share prices. So high share prices mean that investor expectations are also high.

Jayamanne: And those expectations may be completely unrealistic or there may be an accurate assessment of a bright future. The former often means shares will fall significantly when the market comes to the realization that the future prospects don't look quite so bright. In the latter, simply meeting high expectations will result in average returns. Those expectations have already been priced in.

LaMonica: And the beauty of buying undervalued shares is that the expectations are easier to beat. Investors are too gloomy about the future exceeding those low expectations generally results in strong returns.

Jayamanne: Individual shares and the market in general tend to gravitate between periods of being overvalued, undervalued and fairly valued. That is because investors tend to be driven by emotions. Sometimes we collectively get overly excited about shares. Sometimes all we see is doom and gloom.

LaMonica: And these swings in emotion tend to be reinforced by changes in price. And the price changes exasperate those swings. Our confidence in future returns goes up after periods of strong returns. More investors jump into shares which causes them to climb even higher. When prices fall, it reinforces negativity. More investors expect a drop to continue, and they sell shares, the market falls further.

Jayamanne: So, given that buying undervalued shares increases the chances of good investing outcomes and buying overvalued shares decreases them, does that mean that overvalued shares should be sold?

LaMonica: Not so fast, Shani. So, this will bring us to our favorite part of Investing Compass and that is bashing professional investors. It is, it is. We are not bashing professional investors. We are simply saying that we take a lot of cues from professional investors, and we probably shouldn't.

Jayamanne: A professional investor in charge of a managed fund would likely argue that the right decision is to sell overvalued shares to buy undervalued shares. This ignores the vast differences between the two sets of investors.

LaMonica: And trying to replicate the approach of professionals means we are giving up our biggest advantage as individual investors, taking a long-term approach.

Jayamanne: And fund managers may say that they are long-term investors, but many of their motivations are decidedly short-term. Underperforming the index for even a single year can cause investor outflows. This focuses fund managers on relative performance over shorter time periods.

LaMonica: Also fund managers are agnostic about after-tax outcomes. Tax is paid by the end investor and won't impact the performance of the fund. This indifference to tax removes any impediment to selling an overvalued share that has appreciated significantly.

Jayamanne: And as you probably suspect, individual investors are different. Our focus should be on achieving our goals. For most investors, the year-by-year performance against an index is irrelevant.

LaMonica: And trying to avoid short-term underperformance is not a reason to dump a great holding. It also allows us to focus on the outcomes that matter – that is after-tax returns. Constantly generating capital gains through short-term trading is not a recipe for success.

Jayamanne: Okay. So, now it's time to talk about you, Mark. So, any decision to buy or sell should start with goals and an investment strategy designed to accomplish those goals.

LaMonica: Yeah. So, my goal, as I think I've talked about a lot on here, is to generate income over the next 30 years. And my investment strategy is reflective of that goal. So, my strategies create a stable and growing income stream by investing in shares and ETFs. And I want to identify securities with above average, sustainable and growing dividends by focusing on quality companies with sustainable competitive advantages, strong financials and low business risk.

Jayamanne: Okay. So, now it's time for your top 10.

LaMonica: Okay. Well, before I get into it, it would be remiss not to add that the following list does involve some selection bias. These holdings didn't make it into my top 10 by chance. They all performed relatively well, which is why they became top 10 holdings. So other thing is that this is a snapshot in time. This list does change based on fluctuations and prices. I'm not adding to the positions that I currently have where I have longer holding periods.

Jayamanne: Okay. So, why don't we start with your top five then? Your top five are ADP, Cisco, Diageo, Brookfield Infrastructure and Pepsi. You've got Pepsi in there, Mark, but I've only ever seen you consume Coke.

LaMonica: Yeah, I mean, that is true. But I would like to say that I am a firm believer in consuming the products of companies that I own. After all, a little bit of that money I spend gets returned to me as the owner of the company. And I've always found that that's very cool and really helps me stay grounded in thinking about the fact that as a shareholder, I am an owner of a company. But you know, Shani, you do need to draw a line somewhere and I do not like Pepsi Max. I think Coke Zero is much better. But besides my soda preferences, let's get back into the top 10. We'll go from 6 to 10. This is like a countdown.

6 to 10 is Johnson & Johnson. I do use their Band-Aids. Phillip Morris, I will probably plan on taking up smoking right after the recording. Microsoft, I use their software at work. Vanguard Australia High Yield ETF. I'm sure I use some of the products of some of the companies in there. And American Tower and they own mobile cell towers or mobile phone towers, and my calls probably go through them every once in a while.

Jayamanne: Okay. So, let's talk a bit about how Morningstar views your shares. So why don't we start with moat ratings?

LaMonica: Okay. Well, the Vanguard ETF obviously doesn't get a moat rating. Of the nine remaining securities, eight have narrower wide moats and the other one is not rated by our analysts and that's Brookfield Infrastructure.

Jayamanne: So, does this mean that you just take our analyst ratings as inputs?

LaMonica: Well, the interesting thing is of those nine shares, eight of them I bought before I joined Morningstar.

Jayamanne: It's like you were born to work here, Mark and die here.

LaMonica: And die here? Well, hopefully not today. But yeah, we'll see what happens. I think I was born not to work at all.

Jayamanne: Okay. So, what else do you see from this list?

LaMonica: Okay. Well, the same eight out of nine that we rate have low or medium uncertainty ratings, which is a rating based on the business risk. And remember that I want to buy low business company. So that's another good sign for me.

Jayamanne: So, let's take a look at your biggest holding, which is ADP, that currently has a 3-Star rating from our analysts. So, we think that it is fairly valued. Would you consider selling that and perhaps moving your money into a 5-Star stock, which represents undervalued opportunities, which we talked about being better opportunities for investors?

LaMonica: Well, ADP may be fairly valued now, but that wasn't always the case. So, if you go back and look at between 2016 and 2020, the shares were considered overvalued. And actually, the smallest amount that they were overvalued was 27%, which means that the whole time for four years, they were very overvalued. And as you can guess, I didn't sell.

Jayamanne: And for the majority of that time, you worked for Morningstar, so you had access to our research.

LaMonica: I did. But the criteria I used to sell something is if it no longer meets my investment criteria. And at no time did ADP even come close. It is lower levels of business risk and financial risk as demonstrated by the medium uncertainty rating from our analysts. Company also continued to raise a dividend, something that has now happened for 48 straight years. The sources of sustainable competitive advantage still applied as customers faced high switching costs of moving their payroll services to a competitor. So, in short, nothing about my original thesis had changed. The company still aligned with my investment strategy.

Jayamanne: And this is a really important point. The downsides of selling are considerable. The first is tax. We can use an example to illustrate the impact that taxes have on returns. If an investor is fortunate enough to buy a company that has doubled in price, we can explore the tax consequences of selling.

LaMonica: Okay. So, purchasing a share for $1,000 and selling it for $2,000 with a holding period of less than a year at a 37% marginal tax rate results in capital gains of $370. That would require the new investment opportunity to outperform the sold share by 18.5% to just break even, assuming the taxes are paid separately. The taxes are paid out of the gains and only $1,630 is reinvested. The return would have to be 22.69% to break even.

Jayamanne: If the same scenario is run with long-term capital gains discounts applied, to shares held for more than a year, the taxes would be $185. In that case, it would require the new investment opportunity to outperform the sold shares by 9.25% to just break even, assuming the taxes are paid separately. If the taxes are paid out of the gains and only $1,815 is invested, the return would have to be 10.19% to break even.

LaMonica: And that is a high hurdle rate, and it does not include any transaction costs associated with the trades. But there are other reasons to not sell. As investors, we want to truly understand the businesses that we own. The more we understand a business, the less likely we will panic and sell when the price plunges in an irrational way. Longer holding periods give an investor an opportunity to truly understand a business.

Jayamanne: And there are downsides to this, of course. Investors can form attachments to certain positions.

LaMonica: And maybe that's why I don't drink Pepsi, Shani.

Jayamanne: Maybe, Mark. But being a good investor means trying to remain as rational as possible, while acknowledging that complete rationality is impossible. Forming an attachment to a share is a form of irrationality. However, when combined with a clearly defined investment strategy, a long holding period is a more reasonable approach than the trap of constantly churning a portfolio, a trap that many investors fall into.

LaMonica: And this means accepting that a position may underperform for years. This is done with the confidence that over the long term, a great company will be rewarded. It is done knowing that what matters is after-tax returns adjusted for inflation. And it's done knowing that other factors besides performance may play a role in achieving your goals, like lower volatility or generating income.

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Jayamanne: The last point to make about valuation levels is that simply reacting robotically to changes in the relationship between price and fair value is to ignore common sense. Investing is both an art and a science. It's hard to estimate the fair value of a share. It involves making a series of assumptions about an unknowable future. At Morningstar, this is done using a consistent methodology and the rigor of peer review. Yet, it's still a glimpse into the unknown. This is why a margin of safety is so important in investing that accounts for the unknowns.

LaMonica: Our analysts do this for 1,600 shares globally, only a small fraction of which will end up in my portfolio. I'm not running a quantitative fund where I buy all of our undervalued shares and automatically sell out of them when they become overvalued. I am selecting a relatively small number of shares based on several attributes. The relationship between price and fair value is only one.

Jayamanne: All we can do as investors is make sure we have established the foundation needed for successful outcomes. We need to establish and document our goals. We need to write down an investment strategy that gives us a good chance of reaching those goals and selecting an appropriate asset allocation. Then we buy investments that fit our strategy and monitor them to make sure they continue to align with that strategy.

LaMonica: And then, Shani, we wait, which is certainly easier said than done. Waiting involves resisting the temptation to constantly tinker with our portfolio. Waiting is not changing a strategy based on the latest headlines and predictions from commentators. Waiting means ignoring the false signals we receive from the constant fluctuations in price. Waiting involves patience and discipline, and those are two qualities in short supply.

Jayamanne: Okay. So, why don't we use a couple of other shares as an example? We were joking around about Pepsi, so why don't you go through some specifics around Pepsi and how it fits into your investment strategy?

LaMonica: All right, sounds good, Shani. So, Pepsi, of course, is best known for their namesake soda, and they are the world's second largest drink provider behind Coca-Cola. About half their sales are carbonated beverages like Pepsi, Rockstar, and Mountain Dew, but they also have non-carbonated beverages like Gatorade. But the largest part of the revenue comes from savory snacks, which is things like Frito-Lay, Cheetos, Doritos, Tostitos, and they are the world's largest seller of savory snacks.

Jayamanne: And this is the first clue that they operate in a non-cyclical industry as many consumers will continue to purchase these products, no matter what the economy is doing.

LaMonica: Exactly, Shani. And that is one of the contributing factors to the fact that our analysts give them a low uncertainty rating. Our analysts also believe their balance sheet is excellent, and they're well placed to fund growth initiatives internally. They have strong cash flows and a lot of cash at very low debt levels, and those are all things I like.

Jayamanne: So how about the dividend and the sustainability of the dividend?

LaMonica: Okay. So, let's look at the current dividend. So, the current yield is close to 3%, and the payout rate is 80%, which is reasonable given their financial position, low business risk, and strong cash flows. Better yet, over the last 10 years, the dividend has grown at a compound annual growth rate of just under 7%.

Jayamanne: So that certainly puts your definition of a strong dividend growth. When did you buy the shares?

LaMonica: So, I actually bought the shares back in 2008, and I don't want to know what you were doing in 2008, Shani, because it's always depressing. But the dividend is up 191% since then.

Jayamanne: And 2008 is an interesting year since we were in the GFC. Did that impact your decision?

LaMonica: Yeah. Well, Pepsi obviously wasn't one of the sectors that got hammered in the GFC, like financial services, but the GFC caused all shares to drop, and Pepsi fell around 33% during that time period. So, it was on my watch list, and I got to pull the trigger during that time and picked it up at what, I guess in retrospect, was a cheap price. So, it's up around 240% or 13% a year since then, which is certainly a nice result.

Jayamanne: Which is good for a fairly boring business and a demonstration that valuation matters. We won't spend time on this, but it also has a wide moat thanks to the intangible asset of its brand and cost advantages from its scale.

LaMonica: Yeah, so it's just right in my sweet spot, Shani.

Jayamanne: Okay. So, let's pick one more of your top 10 holdings to go through. So how about American Tower? In this case, it was relatively recent patches of yours, which you bought back in September 2022.

LaMonica: Yeah. Well, I had been a big fan of American Tower for a long time, and I think we talked about it on the podcast back before I bought it. So go back and find that episode. I don't even remember what episode that was, but sometime after we started this. And the issue that I had, even though that it was on my watch list for a long time, was that it was always really expensive. And there are two ways we can look at valuation. We can explore the dividend yield as one measure, because I'm interested in that, because I'm interested in income.

Jayamanne: And going back the last 10 years, I can see that until recently, the highest yield that traded out was 2% in 2016.

LaMonica: Yeah, which isn't great. And the other measure, of course, that we talk about a lot is price to fair value.

Jayamanne: And the last time it was undervalued, and it was only slightly undervalued, it was 2016.

LaMonica: Exactly. And in 2022 and 2023, things began to change. 2022, the yield jumped to 2.8%. Never dropped below fair value, but it became fairly valued. And that's when I pulled the trigger.

Jayamanne: So, before we get into the specifics about why you like the company, let's talk about buying something fairly valued.

LaMonica: Well, I certainly respect our analysts' opinions, but they don't know my goals and approach. I think the research reports are an invaluable input into an investing process, but that process is mine. It's reflective of my goals and the strategy I have to accomplish those goals. For the previous six years, the shares are trading in the overvalued range at one point as much as 56% overvalued. Shares had fallen 23% in the last year, which was consistent with the share market declines in the US over that time period. I think it was a case when a great company was getting dragged down by the market, and some great companies never get undervalued. I just didn't want to miss the opportunity.

Jayamanne: And so, we talk a lot about behavioral risk, which is basically the risk that our emotions cause us to make bad decisions. When you say that you didn't want to wait too long, did you think that perhaps the emotion of greed played a role?

LaMonica: Yeah, it's a really interesting question. For me, I think greed works a little bit in the opposite way. So, I get greedy for lower prices. So, in many cases, I don't pull the trigger because I keep hoping the share price will go down more. And this greediness for a cheaper entry point has led to me missing opportunities, and it certainly happened during COVID.

Jayamanne: So, what's happened since?

LaMonica: Well, the first thing is that it's way too early to judge this as investment. I just bought it a couple of years ago. I hope to hold this for decades, like the other positions in my portfolio. But I averaged in around $190 as a cost basis. And right now, the shares are trading at $211. But they did get a lot cheaper during 2023. They fell as low as $160, but I'm so comfortable with my decision.

Jayamanne: So why do you like the company? Well, this would be a position where I'm looking for dividend growth, as the yield is a bit lower. But I think they have a good chance at continuing to grow the dividend. It has averaged 20% a year in the previous decade. And while I assume that will drop, I still think it will exceed my growth target. And since my purchase in 2022, the dividends are a up 18%.

Jayamanne: So, can you talk a little bit about the business in general?

LaMonica: Yeah, I mean, very, very similar. It's a non-cyclical company. So, they have mobile phone towers and data use continues to expand, which of course bodes well for mobile phone towers and mobile phones are not something that most people would give up in a recession. They also have a moat due to the high switching costs for phone companies to move their equipment to another tower and efficient scale as the market is rather concentrated, which means new competitors are unlikely to jump in. Just checks a lot of my boxes. Moat, non-cyclical, boring business with a history of growing the dividend.

Jayamanne: So, Mark, I think that that interrogation is over.

LaMonica: Okay. Well, that wasn't too bad. We will have to come up with another interrogation of you for a future episode.

Jayamanne: We've already done mine. It was a portfolio construction episode.

LaMonica: That was literally three years ago.

Jayamanne: Okay. I guess it's my turn.

LaMonica: Exactly. Exactly. But thank you all for listening. Really appreciate it. If anyone has any questions, my email address is in the podcast notes. And yeah, thanks again for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)