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Mark LaMonica: Hi, and 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.

Shani Jayamanne: We have another guest episode for you today, and this one is a good one. We've got Dan Kemp, who is the Chief Research and Investment Officer, and prior to that was the Global Chief Investment Officer for Morningstar Investment Management. He is an experienced multi-asset fund manager, which means that he has his head around most asset classes that investors and listeners care about.

LaMonica: Okay, so he is an underachiever, is what you're saying in that intro.

Jayamanne: Yeah, exactly. Yes.

LaMonica: So basically, in that intro, you said he was an underachiever, and you also said this is a good one, which I think is insulting our other guests.

Jayamanne: I feel like I say this is a good one for all of them, but it is genuine.

LaMonica: It loses a little meaning when they're all good guests, but anyway, Dan is going to join us from London, which is very nice because to make this podcast recording work, he has joined us before he has had his Weet-Bix.

Jayamanne: I think they actually call it Weetabix over there, Mark, an extra…

LaMonica: I barely know what Weet-Bix is.

Jayamanne: But you did do that challenge where you tried Australian food and you gave it a rating out of 10. And I don't remember the exact rating that you gave it, but I think it was around a 4, which coincidentally is a number of years we've held The Ashes consecutively.

LaMonica: Okay, shouldn't you wait till Dan comes on before you start?

Jayamanne: To tell him this? Yeah.

LaMonica: We'll keep this civil, and we'll talk a little more about Dan. So, Dan is going to speak to us about threats and opportunities in the current market.

Jayamanne: And as part of this, he is going to go through the team's process for evaluating investment opportunities first at a market level and then at an individual level.

LaMonica: He is also going to speak a little bit about investor behavior and steps investors can take to limit poor behavior that impacts investment outcomes.

Jayamanne: He is going to speak about current threats that investors need to pay attention to in the market and then about opportunities that they should be paying attention to.

LaMonica: And lastly, there are a few factors that are impacting the profits of companies. So, Dan will go through these factors and then speaks about what investors can look for in companies that indicate that they're able to protect their earnings.

Jayamanne: And we're really excited about this episode and the insights that Dan can offer. So, we hope that there are some takeaways for you as well that you can use when building, maintaining and monitoring your portfolio in the current environment.

LaMonica: All right. So, Dan, thank you very much for joining. We did a little bit of an introduction to you during the introduction of this podcast, but maybe if you just want to talk a little bit about your role at Morningstar, that would be helpful for listeners.

Dan Kemp: Mark, hello. Yes, it is great to be with you today. Thank you so much for having me on. So, my role at Morningstar is that I'm the Chief Research and Investment Officer. So, my job is to look after our researchers and our investment managers around the world and try and bring together all of our insights to help investors reach their goals. Well, that's the goals of using our research to make their own investments or allowing us to manage their portfolio for them.

LaMonica: Okay, great. So, I'm going to ask a big, loaded question at the beginning, but Morningstar Investment Management, when you're looking for investment opportunities, how do you evaluate if a particular market or sector is attractive, and then how do you find those individual market opportunities? So, is it a top-down approach, bottom-up approach, a little bit of both? How do you go about that?

Kemp: Yes, you're absolutely right. That is a really big question. So, the way that we think about it is to take a step back and think about what really investment is all about. And as I mentioned, it's about helping people reach their goals. Some people just have spare money to invest, but for most people, we know they're saving towards something. They might be saving towards their retirement or to send their children to university or to pay off a mortgage or whatever it is, they're saving towards a goal. And so, the most important thing when we think about investment is what's the best way of getting someone towards that goal.

And there's really two parts to that. The first is that you want the highest return possible, so that shortens the time taken to reach that goal. Or the second thing is that you want to minimize the amount of risk you take to reach that goal. As human beings, we're not very good at coping with the ups and downs of markets. Some of us are better than others. Some of us are able to accept more risk than others. And so having the right level of risk in portfolios is really important.

So, we start from that very high level. How do we maximize the amount of return we can expect per unit of risk that we take on behalf of investors? And all of the academic evidence going back a long way has shown that one of the best ways of doing that consistently over a long period of time is to think about valuation. And what that means is if you can buy something at a discount to what it's truly worth, and if you can avoid those assets that are overpriced because everyone is really enthusiastic about them, then you're able to improve that overall return for each unit of risk you accept. So, whenever we're thinking about an investment, whether it's an individual company or an entire market, we focus on valuation.

And we spend a lot of time thinking about what a company or an asset is really worth. And of course, higher-quality assets are worth much more than the lower-quality assets. And so, we think through that lens of working out what an asset is worth, and then trying to find opportunities where assets are underpriced, whether that's a company or a market, you can do this in a scalable level. And so, we look at each market, each security at a time to find the most attractive, and then we put them all together into a portfolio. And when building a portfolio, the key is to try and make sure that portfolio is robust to a range of possible outcomes. So often, when investing, we get a bit overconfident, and we just focus on one possible outcome. We decide that we think the economy is going to get better or it's going to get worse. And so, we position the portfolio just for that outcome. Whereas actually when building a portfolio of good value companies, then the key is to make sure that portfolio can survive a range of possible outcomes, economic outcomes, political outcomes, and continue to deliver for investors long into the future.

LaMonica: Okay. We'll get into areas that you see as overvalued and undervalued in a little bit. But one thing then – I like this question, and there's parts of it that I don't love about this question, but it seems like there's a lot of uncertainty right now. And there's certainly uncertainty around where interest rates are going, if inflation is coming down, there's geopolitical issues that people are dealing with as they're trying to analyze markets. How should we think about that uncertainty as investors? Because I think it always exists, but it particularly can feel, I guess, at a time very, very uncertain. And I think a lot of people are feeling that way right now.

Kemp: Yeah, Mark, you absolutely put your finger on it there, where you said that there's always uncertainty. The genuine definition of uncertainty is operating in an environment where not only do we not know which outcome will happen, but we don't even know the range of possible outcomes. And that's the environment that we operate in every day, all of us. Although we think we know what's going to happen ahead of us, in reality, there are constantly events that come out of us that surprise us and remind us that we live in this uncertain world. And so, we've seen it most recently in geopolitics, of course, and the terrible conflicts that we see around the world. But equally, we've seen it in economies and financial markets going back over the last 15 years. The financial crisis was a surprise to most. So, we're constantly being surprised.

And so, one of the most dangerous things that we can do as investors is assume that we know what the future holds. It's a very, very tempting way of thinking that if we can only correctly forecast the future, then we can build the ideal portfolio. But unfortunately, that's impossible. And even if we think about the future in terms of probabilities, and that's the right way of investing, that still allows ample room for us to be surprised. And so, from an investor's point of view, the most important thing is to understand that you are going to be surprised on your investment journey. There's no way around that. There's going to be economic shocks and political shocks and all these other things that are going to come at you. And it's the way that you respond to that surprise, the way that you respond to that uncertainty that's so important. The most successful investors are the ones that can deal with that uncertainty, can overcome it, and can remain invested, remain focused on the long term. The least successful investors, unfortunately, are those that when they're surprised by this uncertainty, they then make decisions that they then go on to regret.

LaMonica: And maybe let's talk about, because there is, as you said, there's so much potential bad news out there, or real bad news out there, that obviously that can lead to poor investor decision-making. Are there any, I guess, kind of opportunities and under-the-radar things that you think we're missing as investors when we're so focused on this negativity?

Kemp: Yes, that's exactly the right way of thinking about it, that we have to be balanced in the way that we think about the future. Sometimes it can feel really smart if we are very skeptical about what the future holds, very skeptical about what's going on, very skeptical about the ability of companies to grow and deliver into the future. And that's often a weakness of people like me that think a lot about value, that you can get yourself into a negative frame of thinking if you're not careful. And we know that there are great businesses out there, that there are opportunities for businesses, that there's positive events going on. And it's important that our perception of those and our search for those is not clouded by all this negativity.

So, to give you an example, probably my favorite example at the moment, is that people, economists, even central bankers have been expecting a global recession for a long period of time. And every time we get to another quarter, we get to a new set of results, then those expectations are pushed back, and the economists tend to keep their view that there's going to be a recession, they just push it later. And what that's really saying is that they were too pessimistic about the quarter that has just gone past, but they remain pessimistic about the path ahead of us. Now, in reality, that should show us that often the economy, often the investing world turns out to be better than we expected to be, particularly when we're surrounded by these terrible events and all of the other concerns, whether it'd be inflation, whether it'd be the high cost of living that people are experiencing, there's lots of bad things happening. But that can cloud our judgment and lead us to miss the good things going on.

So, from that more positive perspective, then we can say that there's plenty of economies around the world that are doing absolutely fine, and within those are companies that are making good profits. We've just ended what we call, or about to end rather, the reporting season in the US. So, in the US, every three months, all businesses report how they've done over the previous quarter. And that's just coming to an end now for the third quarter in the US. And when you look at those results, what you see is that there was a lot of surprise on the upside. The companies generally did much better than expected. That's the sort of positivity that we can forget if we just focus on the headlines that we see every day and all of the bad news that was surrounding that.

LaMonica: Okay. Before we sort of get into valuations, kind of one more question. Running a company is hard in the best of times. And obviously, we've seen a challenging environment, I think, for companies in general, because obviously the cost of going out and borrowing money has gone up. Inflation can change. Of course, buying patterns of consumers can change, certainly, the cost along a supply chain. I guess when we're looking for these companies that you were mentioning earlier that can perform well throughout any market environment and over long periods of time, what are some attributes of great companies that you particularly look for when you're thinking about investment opportunities?

Kemp: Yeah, Mark, again, that is absolutely core to the investment process, because when you think about valuation, then the right amount to pay for a share of a particular business will depend on, as you say, that quality of the business. If the business is very high-quality, then it's clearly worth a lot more than a business that is low-quality. And we've seen that particularly in the tech space over the last decade or so that great businesses have been recognized for the opportunities that they have. And we've seen the price of those businesses rocket now. Arguably at times, they've gone too high and too far. But nevertheless, that's a demonstration of how when you find quality businesses, they're worth a lot more.

Now, the question you asked is how do you identify these quality businesses? We have a pretty disciplined framework here at Morningstar. We look for companies with what we call moats. That sounds a bit odd, but it is based on something that Warren Buffett said a long time ago, when he said that when he looks for companies, he thinks of them as being a bit like castles. And he wants them to be as defensible as possible. So, when he thinks about a business, he thinks about the competitive pressures that they face, thinks about the other challenges of operating in a dynamic environment. And he wants really strong businesses that are difficult for others to attack. And so, he doesn't just want high walls, as he puts it, we don't just want high walls, we want a business with a wide moat around it that makes it impregnable to competitors.

And there are various different types of sources of that moat. So, in some cases, a business might have a much lower-cost manufacturing process, which is very difficult to replicate. In others, it might be that they have intellectual property or permissions, regulatory permissions that are very difficult to replicate. So, we look for businesses with those really strong moats. And we published this research. Anyone who subscribes to our research is able to see how we think about these businesses and where we think they derive their moat. And when we find those moats, what that means to us is they're likely to deliver a higher return for shareholders over the next 10 or 20 years. And if they deliver a higher return for shareholders, then they deserve to have a higher valuation than a business that doesn't have a moat that can easily be competed away by another strong business or a difficult sector or difficult market conditions. So, we're looking for those high-quality strong businesses. And even then, we want to find ones that are undervalued. That's what our analysts spend a lot of time doing, finding these strong businesses and then identifying the ones that are priced below what we think their fair value is.

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LaMonica: All right, so I've teased this throughout the podcast so far, talking about what – and you can pick markets or sectors or individual companies. I guess, where is your team and where are you finding cheap valuations? Since you talked about how big of a role that should play in the investment process. So, if we look at the current market, yeah, where are some of these cheap valuations?

Kemp: Yeah, absolutely. It's a really interesting market at the moment because for most of the last decade or so, there's been particular markets that have become unloved. And in that environment, we can look at whether it's a particular industry sector or a particular market. And there's been a lot of negative sentiment, a lot of negative news around that market or that sector. And that's provides a really good opportunity. So, as we go back through time, energy companies in the early part of 2020 were a great example. You remember that the energy price went negative briefly one afternoon that technically a company would pay you to take oil away from them. And so that was a nadir in terms of people's perception of energy companies. And as we looked at energy companies in 2020, what we saw was that there were some very good companies in that market, but they'd probably been using the earnings that they'd received from selling oil, selling energy, not as well as they could have done. And we took the view that providing management of those businesses did the right things, that they were careful about their investment, they were careful about paying back their debts, that actually, energy companies could be a great opportunity. And that was amidst all of the noise around the type of COVID pandemic and as I say, the concerns about what the OPEC, the big oil cartel would do. And so, we were enthusiastic about energy companies at that point. And you'll have seen how well they've done in the intervening few years. That's an example of in the past, we've been able to find a particular market.

Another example is the UK equity market. Now, you're going to assume that I'm biased here, because I'm sat in London. But in reality, we cover about 500 different asset classes and markets and different types of bonds and companies around the world. And our analysts identified the UK as being a really unloved market, both partly because of the Brexit vote that we had a few years ago and the fallout of that, but also because the type of companies that are listed on the UK market and make up the index there. It's a lot of old-fashioned, unloved business types, a lot of banks and financials and energy companies and miners, I mentioned. And so, the UK is really an unloved market. Again, that's an example of where we've found a market as a whole that looks unloved, that looks good value.

We're now in a slightly different environment in that as we look across the world, there are fewer pockets of extreme undervaluation. There's fewer pockets of extreme overvaluation. Even if we look at the US market, which looked quite expensive to us a couple of years ago, even that market now looks less expensive. It doesn't in the view of our analysts across the world look incredibly cheap. It looks a little bit undervalued as a whole, but within that, there are pockets of value. Now, those pockets of value exist in different sectors at an individual company level. And that's true across the world. It's true in Australia as well, that if you look at the market as a whole, there are some sectors that look more attractively priced than others, but it's really when you dive into those sectors, you find individual companies that represent the real value.

So, we seem to be moving or have moved from an environment where the key thing was to pick markets and sectors, and you could find the best value there, to having to look a little bit deeper at individual companies, at smaller parts of the market. And this is where not only having a big team is quite important, so that you can cover the waterfront in terms of looking at those opportunities and so having that research available is really important, but also potentially opportunities for active managers. And as you know, active managers have gone really out of favor over the last decade or so. It's been very difficult to beat market indices, particularly in the US and the global indices. But when we're in an environment where we see a lot of differential at the individual company level, then actually active managers have some great opportunities. So that's quite a big shift we've seen over the last few months and last couple of years.

LaMonica: All right, great. Dan, well, thank you very much for joining me, joining us. I'm sure everyone really appreciated hearing your insights, I guess, number one, how to think about markets, some of the behavioral issues we have, and of course, opportunities today. So, I really appreciate it; the listeners, I'm sure appreciate it. But thank you very much for joining.

Kemp: Well, thanks, Mark. It was great to be with you.

LaMonica: Great. And thank you, everyone else, for listening. As always, we would love any comments or ratings in your podcast app. And thanks for listening to Investing Compass.

(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.)