Morningstar - Q2 2024 - 53

return on tangible equity for 2024 is 12%. That's
a really attractive set of characteristics.
How do we calibrate the risks? Wells has been
in the regulatory penalty box for longer than
expected, but we do expect that the asset cap is
going to be lifted. Also, Wells Fargo has one
of the highest office commercial real estate
exposures of anything in our portfolio, and we are
overweight financials writ large. Our stress
test indicates that potential losses might be in the
range of 1%-3% of market cap-meaningful,
but manageable.
Another one that I'd touch on is Norfolk Southern
NSC. A rail system is typically not something
that you're going to find on sale. It's an assetheavy
business, but the asset intensity is what
provides the moat. It would probably cost north of
$100 billion to replicate the Norfolk Southern
network. Just imagining the complexity of trying to
permit 19,000 miles of track through the midst
of all the cities they traverse is mind-boggling.
When we were buying last year, it was trading at
a substantial discount to its peers. You might recall
the Ohio derailment that Norfolk Southern
suffered. In the two or three quarters after that
derailment, Norfolk Southern lost relative market
cap of about $10 billion. Our view was that
while the accident was tragic, Norfolk Southern
was likely to spend much less than that $10 billion
to make things right. And a year later, the bulk
of the dollars going toward remediation have been
spent, and it appears to be in the $1 billion
to $2 billion range. That's before any insurance
recoveries, which might be material.
Overall, we're finding lots of interesting
opportunities out there. Some of them are
traditional deep value, and some of them might be
considered higher-quality franchises.
Earning Your Fees
Thomas: Our data shows that total assets in passively
managed funds finally surpassed those of active funds
at the end of 2023. What are the implications of that?
Nygren: Some of that has been self-inflicted
by the active industry. What do you need to
do to justify the fee that you're charging? That
has changed over my career. The average person's
access to the stock market 50 years ago might
have been the neighborhood stockbroker, and that
was a very expensive way to access the market.
Just offering a fund of lots of big companies
and charging 1% for that provided a better deal.
Then the index fund came in and said we'll
give you that big old diversified portfolio almost
for free. And too many active managers clung to
the old business model of providing basically
a closet index fund, never taking enough risk to
risk getting fired from their accounts.
Paying attention to active share and the fee
you're charging relative to active share is really
important. Our diversified large-cap portfolio tends
to have an active share of around 85% relative
to the S&P 500. If you look at active share
divided by our fee, our fee goes from looking like
we're in the upper half of the mutual fund
universe to being very low. That's something fund
managers need to think about.
Tax efficiency is also something they need to
think about. We've seen advisors shifting out of
open-end mutual funds to separate accounts
because they think they're getting better
tax efficiency. Funds that are tax-aware can have
significantly better tax efficiency than a separately
managed account can. But it's an argument
that the fund industry is not spending much time
making and is, therefore, losing.
We've also allowed the passive investors to get
away with defining risk. If you define risk as
how I deviate from the index, Oakmark looks like
a very risky fund. Well, we don't think our
investors should care how much we deviate from
the index. Our investors are trying to grow capital
over time. They should care a lot about how
far below zero we are in bad years. And we look
pretty good relative to the S&P 500 on that
metric of risk. But we've allowed the industry to
define risk by tracking error and standard deviation
of returns as opposed to drawdown risk.
Hoeft: We don't think it's an either/or between
active and passive. Clearly, there's room for both.
But rising passive assets, we believe, make the
role of a successful active manager more valuable,
and I'd argue the active task becomes easier.
For example, we've seen a decline in the quantity
and quality of sell-side research resources over
the last 20, 30 years, and we would connect that
to the increase in passive investing. If you have
your own internal research team, as we do, and as
Harris does, you have a relative advantage today
that has only improved.
Burt Malkiel and others have pointed out in recent
years that less and less of the movement of a
company's equity price-something like 15% less,
versus 20 or 25 years ago-is linked to things
that are specific to the firm. This increasing
disconnect between what's actually happening
with the companies and what's reflected in
equity prices is consistent with increased passive
flows. Passive investors are still making an active
investment choice if they go with a passive
alternative. It's just that they've outsourced the
decision to the index manager who follows
what is popular. Growth in passive assets just
sets the stage for future outperformance
for active managers that have a repeatable
investment process that could add value, because
the premium grows for price discovery.
There have been too many high-cost, lowperforming
active mutual funds in the marketplace.
This is probably the largest single driver of passive
gaining share in the past. But not all active
funds are created equal. We look at the net-of-fee
performance we have provided for our fundholders
over the benchmark and then denominate that
by the fee. Over the past 25 years, we've
generated about $4.50 for our clients in returns
above that which was generated by the S&P for
each $1 we've earned in fees.
We think there are lots of opportunities to perform
well for clients. And we think this mutual fund
model has a lot of longevity. The question that
prospective fundholders should ask is whether the
fund and manager that they're evaluating are
capable of generating long-term returns relative to
a passive option in excess of its fee. K
Tony Thomas is associate director of equity strategies
for Morningstar Research Services LLC.
Photography by Matthew Gilson and David Lees.
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Morningstar - Q2 2024

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