The Found Money Interview: Morningstar’s Bill Rocco on Value, Real Estate, International Markets and more

William Samuel Rocco
Senior Mutual Fund Analyst, Morningstar, Inc.
Bill Rocco has been with Morningstar since 1994 and is now a senior mutual fund analyst focusing on international funds, particularly emerging market offerings. Until recently his beat also included a number of real estate funds. He also specializes in socially responsible funds and regularly writes the Fund Spy column for Morningstar.com, the company's investment Web site. He holds a bachelor's degree in political science from DukeUniversity and a master's degree in comparative politics from GeorgetownUniversity.
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What's the essence of the Morningstar approach? Most of the sell-side research is provided by brokerage firms trying to gin up activity among their clients, but Morningstar attempts to do something very different.
We could have a long discussion on that, but basically, our mission is to help individual investors and people who work for individual investors make good investment decisions, by supplying them with independent data and commentary on mutual funds, stocks, and other investments.

When looking for stocks, Palmerston Group pays careful attention to the incentives that align or don't align the company's management with the owners, its shareholders. When it comes to mutual funds, what are the best incentives to align the interests of fund managers with those of fund owners?
That's an excellent question. At Morningstar, we have something called our Stewardship Grade, which quantifies exactly that. It looks at a variety of metrics—the corporate culture, the regulatory environment, the quality of the fund company board, fees, and manager compensation. All of those factors are important, but one thing of particular interest to us is, to what extent does the manager own the fund or a similar fund? We like to see that the manager has a significant investment in the fund. Then there’s the question, what is “significant”? In most cases, we like to see at least $1 million. Of course, there are a lot of variables that go into that—such as the type of fund and the manager's age and personal circumstances. We wouldn't expect someone who lives in New York and runs a New Jersey tax-exempt bond fund to be invested in it, for obvious reasons. In situations like that, we like to see that the manager owns other funds in the same family in significant amounts.

One topic today is real estate funds, some of which you followed for a while, including the one at Third Avenue, a fund family owned by many Palmerston clients. What were the main factors that you looked at when you were covering those funds? And how is manager Michael Winer's approach similar to or different from that of the others?
When analyzing any fund, the first things we look at are what we just discussed: the overall Stewardship Grade. We also look at fees, the quality and experience of management, and long-term performance, as well as the type of fund and how it might fit into a broader portfolio. Then we examine more specific factors, such as the fund’s strategy and how it compares to those of similar funds. For example, is a particular fund well within the mainstream of its category or is it something of an outlier?

There are a good number of real estate funds, of course, but Mike Winer has a pretty distinctive style. The first and most important difference is that, whereas most real estate fund managers favor REITs...

He has a really heavy concentration in real estate operating companies—
Right, and he also considers other types of real estate securities as well. You can go to the Third Avenue website and see what the current breakdown is. REITs are the bread and butter of most real estate fund managers, and Mike certainly invests in such securities, but he has a preference for real estate operating companies. That’s largely because real estate operating companies can reinvest their cash flow back into the business for growth, whereas REITs have to distribute most of their income. In addition, he'll buy retailers or agricultural companies that have large real estate holdings.

Mike's fund is not, by prospectus or by name, an international real estate fund, but he does pay more attention to overseas opportunities than most real estate fund managers do—it's worth noting that there are not enough international or global real estate funds at present to break them out into a separate category.

This distinctive style, particularly the relatively limited exposure to REITs, means that Mike’s fund is probably not the best option for investors who are seeking income. Pure REIT funds make more sense for such investors. The flip side of that is that Mike's fund is less interest rate sensitive than most of its rivals. Rising interest rates hurt REITs in a number of different ways: There's the financing issue—higher interest rates raise the cost of borrowing for REITs. Also, many people buy REITs for income, and if higher interest rates make other alternatives look better in that regard, that hurts REITs.

How does that affect the results?
It's a two-edged sword. When domestic REITs are struggling, other things being equal, Third Avenue Real Estate will have an advantage over most of its peers because it has less exposure to such securities. Real estate operating companies are not immune to what's going on with the REITs, but in the past, when interest rates have spiked or REITs are struggling for other reasons, this fund has generally held up significantly better than its rivals. Of course, there is no free lunch in investing, so the same strategy that is advantageous in certain environments will often be disadvantageous in other environments.

Also, Mike runs a fairly compact fund, issue-wise. Real estate funds tend to be fairly concentrated, but his is more so than average. So, individual names matter more to his fund’s performance than they do to your average real estate fund. That means that if there's a problem with a major holding, it can really hurt performance in Mike’s fund.

However, there's a real upside to a compact strategy when the manager is talented, and Mike is certainly talented. He has picked many more winners than losers over the years, which is why his fund’s long-term returns are good. Moreover, Winer relies on a strict value discipline that provides significant downside protection. Like the other Third Avenue managers, he focuses on securities that are “safe and cheap.” They look for securities that are quite cheap and have strong financials, which provides significant downside protection. 

You mentioned Third Avenue's "safe and cheap" approach. Could you expand on that?
All the Third Avenue guys are real balance-sheet hounds. They really spend a lot of time poring over balance sheets and getting a real sense of what makes the company tick. Not that other managers don't do that, but the Third Avenue gang seems to spend more time on it than most of their counterparts do. What Mike does is what Marty Whitman and Curtis Jensen and Amit Wadhwaney do on the family’s other funds. Strong financials are essential to their approach. They also want to make sure that the company’s management can execute its strategy and that the business is understandable. That said, they are not shy about going into complex businesses if they can understand them. You’ll often find conglomerates and holding companies in the Third Avenue funds, though perhaps less so in Mike’s case than the others—even though conglomerates or holding companies that own diverse businesses are often hard to value and hard to analyze.

Another Third Avenue rule is “price conscious rather than outlook conscious”--
That reminds me of something about all of the Third Avenue managers—they're very patient. All of their funds have very low turnover. They readily look beyond short-term problems and don't care very much if consensus earnings estimates for the next quarter are going to be disappointing.

So they look at the long-term outlook rather than the short-term.
Indeed. A lot of times, something they buy will get cheaper and they will add to it. They add to their holdings on weakness in the belief that the value of the assets will eventually be recognized. So they're willing to overlook a sales problem or a product problem or bad news or whatever. That's where the “safe” part of their strategy comes in. They believe that companies with strong finances can withstand short-term problems, and the Third Avenue managers have often been vindicated for their patience. That’s not to say that they never make mistakes; they certainly do. But that's their process and they’ve generally executed it well.

Mike Winer was in the real estate industry, wasn’t he?
Yes. You can get his bio off the Third Avenue website.

That must be an advantage.
He's certainly not the only real estate fund manager with such experience, but I think having such experience is really helpful. There's a lot of value in having been on the operational side. Most businesses are complicated, and having done it and knowing what it takes to be good at something is important; having been on the other side helps you evaluate managers and whether they can execute their business plans. 

Do you think Third Avenue’s increased international holdings constitute some sort of warning about overvalued U.S. real estate assets?
I don't claim to be an expert, but I do think it's a comment to some degree. From a price-of-the-security perspective, I do think so.

As we all know, real estate funds of whatever stripe have done incredibly well over the last several years. And anyone who expects the same kind of absolute return over the next few years that we've seen from the last few years is likely to be disappointed. Of course you could have said that a year ago, and 2006 is turning out to be very good year. But people need to have realistic short- to medium-term expectations about real estate funds.

It's advantageous if you're a value manager, or a growth manager for that matter, to have a broader purview. Mike has that advantage more than most because he's not limited to REITs. Having an international purview adds to that. I wouldn't make too much of it because it's not officially a global fund. Partly it's a matter of valuations here, partly it's because he has a larger staff and the resources to look at a larger universe of opportunities. Those opportunities exist abroad partly because of the increase in REIT legislation [in many countries].

Palmerston Group, in general, is extremely value-oriented. We love fund managers who find stocks trading at substantial discounts to their true value. Among the international fund managers that you follow, which in your view are the best bargain hunters?
That's a good question. There are a lot of different ways to approach value, as you're well aware, and I think that the Third Avenue people are some of the strictest and most distinctive in the way they do it. They're not the only ones who will get into things like distressed debt, but you don't generally see mutual funds doing that. I believe David Winters [at Wintergreen Advisors] does some of that, and there may be some other managers that do. David Herro of Oakmark runs their International Fund and their International Small-Cap Fund [with Chad Clark] and their new Global Select Fund [with Bill Nygren]—I think he's a good value manager. There's a certain similarity between what Herro does and what the Third Avenue people do, in that they go wherever the bargains are and they're not afraid to buy stocks in bunches. If they find a lot of opportunities in a given sector or a given country, so be it. They're not benchmark-conscious.

If you're going to get a benchmark-like fund, why pay the fee for management? Why not get a manager who does what he or she does and has the courage of his or her convictions? It's certainly true of Michael Winer and the rest of the Third Avenue people. It's also true of David Herro at Oakmark. I think he's good. I think the Causeway team at Causeway International is good, although that fund is closed right now.

Even though you won't be directly involved with real estate next year, is there a big real estate story that you expect to happen?
Only that I expect something to happen! Not to be glib, but predicting what's going to happen—you can take 15 or 20 people who will predict something about this part of the market or that, and one may be right if he or she is luckier than someone else.

The crucial thing is that, at some point, and I don't know if it will be during 2007, real estate funds are going to have to slow down.

Within your focus of international investing, where do you see the greatest dangers in 2007, and where are the best opportunities?
Again, with the same caveat about predictions, I think the greatest danger is of people chasing returns, particularly in riskier types of funds. There's a lot of evidence, particularly with aggressive, riskier funds, that people buy at the wrong time. A couple of quarters or a year into a strong rally, they discover China funds, India funds, Brazil, emerging markets funds, and they decide they're going to buy, and they don't ask themselves, "Do I have the stomach for the worst this type of fund can offer?" And then [when they can’t,] they get out [at a loss]. So the biggest danger that I see is that investors will make too much of the truly spectacular absolute returns that various emerging market funds have turned in over the last several years, and that they will get into, say, a China fund or an India fund rather than a diversified emerging markets fund, and not have the stomach for what happens.

I suppose the better opportunities would be in larger-cap, growth-oriented names. Those are the areas that have generally lagged. I tend to share the Palmerston Group’s value orientation—other things being equal, it’s better to focus on the areas that have been out of favor and be wary of those that have been in favor. That’s especially true when those that are in favor have been in favor for a long time and in absolute terms have done spectacularly, and are risky, which is true of the emerging markets.

Thank you very much.