Does Equity Have a Place in Your Portfolio? With T. Rowe Price’s John Linehan


Stewart: Welcome to another edition of the Insurance AUM Journal Podcast. My name is Stewart Foley, and I’m your host standing with you at the corner of insurance and asset management with John Linehan of T. Rowe Price. How are you John?

John: Well, thanks for having me Stewart.

Stewart: John is the portfolio manager of the U.S. Equity Income Strategy and the chief investment officer of equity for T. Rowe Price. You’ve been there for a while, you’ve been at this for a while. In this crazy time, we were just talking about this, quite a bit of choppy water out there, yeah?

John: It sure is.

Stewart: T. Rowe Price is a household word. It’s been in the investment arena for many, many years. $1.2 trillion in assets. I did not know this, you’re in 52 countries, but in the insurance asset management space, particularly general accounts, what are you guys doing?

John: Within the insurance industry, we’ve run money on behalf of insurance since 1985, and we still have our very first general account insurance client. We’ve managed right now over $10 billion in general account assets. And we view this as a important channel for us.

John: We have dedicated investment representatives there to serve the channel. I can tell you right now about a third of our assets in this channel or our equity about two thirds are fixed income. Actually, one of the separate accounts that I manage is a general account mandate.

John: So, we have a fair amount of history on this and a lot of experience, and very much look forward and try and partner with each one of our insurers. One of the great things I think about T. Rowe is we are very thoughtful about trying to provide customized solutions to our clients. And in the case of the insurance industry, that’s a very important requisite and that each insurance company will have very different needs, and we want to work with them to meet the needs of each individual client.

Stewart: Yeah, it’s interesting you put it that way. I have an old corny saying, insurance companies are like snowflakes, right? From a distance, they all look the same, but up-close, all different, which leads me to my second question, which is, how do you think about, you run a lot of money for other large institutional channels, whether that’s pensions, endowments and foundations and whatnot. How do you view insurance asset management as being different than those other institutional channels?

John: I do think it’s different. First of all, I think it’s much more of a customized solution that you have to provide to the client. And second, the needs are very different. I actually am on the board of a small insurance company myself, and actually I’m the board member that’s responsible for overseeing our investments.

John: So, I have firsthand knowledge of the difficulties right now that insurance companies have trying to manage risk, preserve their investment portfolio, but at the same time find acceptable yield and acceptable return in a very difficult marketplace.

John: I think if you think about the needs of an insurance company, a lot of it, for a lot of our other clients, they’re going to think much more in terms of total return, where you look at both capital appreciation and dividend yield. A lot of our other clients are far more tax efficient. When we think about the insurance channel, we have to be very thoughtful about taxes for specific clients, and we have to be very thoughtful about trying to present a product that meets their needs, that has both the opportunity for capital appreciation, but also can return yield for the clients, which is very important to them.

Stewart: Yeah, and I mean, everybody talks about this all the time, it’s an incredibly low yield environment, right? We’ve found insurance companies, I’m hesitant to use the word stretching for yield because they’ve expanded their opportunity set quite a bit already, right? How do you think that insurance companies can balance the need for investment income, with their core objective, their roots, if you will?

John: I think it’s become increasingly difficult. In the past, fixed-income has been a very kind of VC out where you’re able to get a fair amount of return, that creates the necessary income for your business model without taking a great deal of risk. But in an environment where you have the ten year yielding below 70 basis points, it’s all bit impossible to put your money into treasuries and get a yield that will be sustainable for the business model.

John: If you look at corporates, if you look at high yield spreads, if you look at mortgages, which have also been traditional places that insurance companies have looked, the spread compression you’ve seen there has been very significant. Right now, high yield bonds trade less than 500 over treasuries, where you’re taking a great deal of risk. So I think when we think about yield, it’s really what is the acceptable risk per unit of yield in a way?

John: And I think in that environment, equities should be a thoughtful part of an investment portfolio in that you are able to get some yield, but in the longer term, you’re also going to get some growth. There’s a lot of benefits and virtues to fixed income, but one of the drawbacks of any fixed income investment is you have limited upside and almost unlimited downside. And I think at least with equities, you’re clearly going to have more downside, but you’re also going to have more upside. And over the longer term, hopefully the upside potential will more than outweigh the downside risk.

Stewart: Yeah, not only are rates incredibly low, but there’s absolutely no sign of them going up anytime soon, right? And you had mentioned that the US treasury is at 70 basis points or so, even there it’s still trades wide, considerably wide to Germany or Japan or a number of other countries, right. So there’s nothing that looks like gee, rates are going to go up. I was talking with an insurer the other day, their book yield was 1.6%. And to your point, you can’t run a business long run, an insurance company cannot survive like that. It’s just impossible.

Stewart: But you mentioned you’re on the board of an insurance company. This gave me a chill down my spine, as I recall earlier in my career, going to board meetings with my investment committee book and going through it, and looking out over my reading glasses and seeing a guy like you with your set of experience, right? And going, “Oh boy, I hope this person doesn’t ask me a question and blows me out of the water.” So that leads me to my next question which is, how does the security get into your portfolio?

John: Well, at T.Rowe we very much think of ourselves as bottom up investors, whether it’s in fixed income or in equity, we really believe that the best way of generating longer-term performance for our clients is to know our companies, to know our industries better than anyone else out there. So we spend a lot of time investing in a research platform, both within fixed income and equities.

John: In equities right now we have over 175 analysts on a global basis, that will research different companies in different industries, trying to get unique insights. As a portfolio manager, my responsibilities are to craft the portfolio, I’m responsible for the construction of portfolio but a lot of it is working with my analyst. We’ll travel with the analyst, we’ll go meet companies, we’ll ask them about trends, we’ll try and come up with very comprehensive models on the companies. And we’re looking for those companies that we think really offer a differentiated opportunities, where we have very good, longer term fundamentals for the company.

John: And also with my product, which is an equity income strategy, also have a reasonable valuation opportunity and yield obviously, given the name equity income.

John: So a lot of it really is leveraging what we believe to be a core strength of ours, which is deep fundamental equity investment analysis. And we feel that we do that extraordinarily well, this is a platform that we invest in on a very consistent basis. One of the great things about T. Rowe is we take much more of an apprenticeship model to how we invest.

John: So everyone within the equity division starts off as an analyst, plies their trade, develops their craft and over time they’re asked to take on more responsibilities, some of which could be portfolio management responsibilities. So by the time you become a portfolio manager at T. Rowe Price, you have a number of years of being an analyst, you’ve worked very well within that industry, you’ve got a good track record.

John: So we’re really trying to identify those individuals out there that we think have a unique set of talents that really differentiate people as great investors, and we want to leverage that over the longer term.

John: So how names get into the portfolio, it’s really a function of rolling up your sleeves, doing a lot of hard work, working with the analysts, going and meeting with companies and trying to understand better the basis for the investment.

John: In today’s world of COVID, we’re not doing a whole lot of meeting with companies, but I can tell you that probably half of my day is spent on Zoom calls with management teams, I’ve already had two today as an example. And we’re hoping that by understanding the companies better than anyone else out there, that offers us unique insight, which we can translate into performance for our clients longer term.

Stewart: Hopefully those other two Zoom calls weren’t as fun as this one is going to be?

John: Actually one was insurer, so –

Stewart: Really?

John: … before this call, yeah.

Stewart: That’s great. All right. So you’re talking value growth, right? We were talking before this call and I mean, I’m not going to throw you under the bus, I’ll just throw myself under the bus. I’ve got a fair amount of gray hair, right. And that experience can help, and maybe not so much. Right now, we’ve got the Fang stocks, we’ve got a lot of valuation that to me as an old school guy might not make sense. Right. Can you talk about growth value in this space, in this market?

John: Stewart, I think one of the conundrums right now that faces anyone looking for yield in this market is, it almost forces you into the value part of the market, because that’s where the yield is. And one of the difficulties has been over the last year, where value is underperformed growth by more than 40%. And over the last 10 years, where growth is significantly outperformed value.

John: It’s a much more difficult case for a lot of people to make for why you should invest in value stocks today. I think a lot of investors have gotten the memo that this time is different in terms of the amount of change in disruption. When you see a number of the platform companies, the quote unquote Fang Stocks that have taken significant market share, have taken advantage of significant network externalities that have benefited both their platform and their business model, and have been off to the races for quite a long period of time. Those are all very valid points.

John: I think for those of us that do have gray hair, it’s also interesting or important to put that performance in context. Which is if we go back in time, even with the extraordinary out performance of growth relative to value, if we go back just from the post-war era, value still outperform growth, even with the huge run in growth stocks over the last decade.

John: So in the longer term, I think any balanced portfolio that wants exposure to equity should have both some element of growth in it and some element of value. The setup that we have right now, they’re starting to do science spectra of access. So if you look at valuations for growth companies relative to value, they’re at levels that we haven’t seen since 1999, 2000.

John: If you look last year, 92% of the weight of the Russell 1000 growth index beat the average Russell 1000 value company. So all you had to do was in essence pick a growth stock and you won, and if you picked a value stock you lost.

John: Investing rarely is that easy where you can take that thematical approach for a long period of time and do very well. And I think in the context of insurance companies as they think about yield and risk, it’s very difficult maybe dinner or market where you see an outsized returns over the last several years. But in reality, those outsized returns have been much more growth oriented. If you look at the value part of the market, actually value returns have been pretty mediocre at best, on a one-year basis or even a three-year basis, the large cap value index is pretty much flat.

John: … We feel very good about the companies that we’re invested in, these are companies that have a fair amount of cashflow today. We think that they’re well representative of the market. And it’s an opportunity to get that type of yield with some upside exposure, these aren’t the high flying companies where you’re going to see huge risk, we’d like parts of the market right now on actually one of the parts of the market that we like a great deal is the insurance industry.

John: If you look at the PNC industry right now, we’re entering into a hard market for the first time in a number of years, and yet the stocks aren’t really reflecting that at all. That’s a real opportunity in our mind. The life insurance companies, we think that the life insurance companies are better business models than maybe the stock market might think, and the market is very fixated on the impact of lower rates on these business models and not understanding that a number of these companies, the larger companies have pivoted very well in reaction to lower rates.

John: So we view that this environment is pretty conducive to yield investing, and we think that when you think about a high yield opportunity where you’re only getting in essence about, just under 6% yield. And if you go back and think about what happened during the COVID crisis, one point high yield bonds were down every bit as much as the S&P 500 market. So I’m not sure that you’re actually getting a lot less risk at times with high yield.

John: And what I can tell you is that, at 3% yield and the opportunity for growth kicker, in this environment I think it’s a pretty interesting and lucrative opportunity for people.

Stewart: Yeah, it certainly is. It certainly is a different dynamic than, as you mentioned a while ago, when the ten year note is at 5%, the whole value equations, you can look at it differently, but when the 10 year note is below 70 basis points, you’ve got to kind of recalibrate your framework.

Stewart: Okay. So let’s go back to the Fang stock argument, right. And everybody knows that there’s been a tremendous amount of flow into passive. You guys are an active shop. If I’m an insurance company, why do I hire an active manager when I can just buy an ETF or buy an index and leave it alone? What’s the argument for active in here?

John: I think there’s several arguments for active within the insurance sector. First and foremost, as you mentioned, we are a big active shop, and we’re a very strong believer and deep seated fundamental investment analysis is a real cornerstone for our investment capabilities. Over time, we realized that we have to have a compelling value proposition for our clients. Part of that’s going to be having a performance record that can stack up or beat the indices. But I think it goes beyond that, I think especially as we think about the insurance channel, each insurance company is different and having a solution that’s much more customized to the needs of the insurance client is critically important.

John: I mentioned earlier that one of the accounts that I manage is for a general account insurance client. I’ve managed that account now for over 15 years, and we’ve spent a lot of time, we know the client very well, and we work with this client. At times their needs are very different than what a typical investor’s needs are going to be. At times we’ve had to monetize tax losses for the client, and other times we’ve had to realize taxable gains. You can’t do that in a passive product.

John: We’ve had very strong conversations about the market, about where we are relative to fixed income, what the yield environment looks like for the markets. Having that partnership I think has allowed them hopefully to make better investment decisions, not only within the context of value investing or income investing, but I think overall for their portfolio.

John: Passive works well if you need kind of a boiler plate solution, but the old adage, if you’ve seen one insurance company, you’ve seen one insurance company. And typically most insurance companies don’t want a boiler plate solution, they want more of a customized, thoughtful approach. We believe we can offer that and still have the performance proposition that is equal to, or better than a passive. And hopefully if we do our job well, we can offer both a compelling performance proposition and a customized solution proposition to the channel. And we think that that’s a very important one, two punch to have in this context.

John: So, what I would say is, over time passive has done very well, just because it’s been a very easy way for people to get access to markets, I think over time as people have different needs, passive maybe works a little less well.

John: The other thing is also passive, typically if you see speculative excess in the market, passive just reinforces that speculative excess. What we believe is that it’s being very thoughtful, not every Fang stock is the same, not every software as a service company is the same. And trying to differentiate between the winners and losers and finding those companies in the index that we think will do better than others, that’s a key source of performance differentiation for us hopefully in the longer term

Stewart: And a yield kicker to boot, right? Obviously we’ve talked about yield in there.

John: Well, within my strategy, I think having that yield kicker, there obviously you can get passive solutions that’ll have yield associated with it. But again, one of the things that we’re trying to do with our equity income strategy and other income strategies at T. Rowe price, such as our dividend growth strategy as well, we’re not investing in companies just for yield, we’re looking for companies that have very attractive fundamental characteristics, compelling valuations and also have yield associated with it.

John: But we’re not looking at companies just on the basis of yield alone. And I think if you have a passive product, they’re not going to try and differentiate on the fundamentals, they’re just going to buy those companies that are the highest yielding companies. And sometimes that’s a very good place to be, but other times it’s not. And I think having an experienced set of eyes that tries to figure out where the opportunities are in the market, even within the higher yielding sectors is really important.

John: In this environment where there’s so much cycle of change, so much disruption, it’s really important to try and differentiate between the winners and the losers, those companies that are quote unquote value traps. And that scream cheap, look cheap, but they’re cheap of a reason and that reasons can become apparent several years from now.

John: And one of the things that we really are trying to do mightily is trying to identify these traps, avoid them at all costs, and hopefully over time that will create a very strong investment product for our clients.

Stewart: It’s good stuff. And now what I want you to do, this is the question I told you I was going to surprise you with at the end. So this is take off your CIO of equity hat, and put on your John Linehan mentor hat. And I know from reading your background that you went to Amherst, so, you’re 20 now… By the way, I’m a professor, I teach a couple of classes here in Chicago land.

Stewart: So you’re 21 years old and you’re coming out of college in this environment. And you look at yourself, what would you tell your 21 year old self in this environment?

Stewart: You can think for a minute, because I’m putting you on the spot. But what I always find with my students is they want to hear from a person like you who’s reached your level of success. They want to hear what your thoughts are as far as… They’ll benefit from your experience.

John: I think the advice I would give to individuals is don’t overthink it, follow your passion, follow what you love, and typically good things will happen. If you try and fake it and you try and get into an industry because it’s the higher paying industry, or it’s a more prestigious industry, but you don’t really have an affinity or an interest for it, it’s a very long, hard slog.

John: I would encourage people to follow their passions. If you can find a career where you’re passionate about it, typically good things are going to happen. Stewart, we mentioned earlier, I’m a value investor, I actually came out business school in the late nineties at the height of one of the last growth bubbles. And rather than try and get into growth investing, which is all my counterparts at Stanford did, as a huge hotbed for technology, I went into value investing at a very difficult time, and people thought I was somewhat crazy to do so. But it really followed what I knew my passion to be and where my heart was as an investor. And when the market turned, I was in a good place.

John: And I guess what I would tell people is know who you are, know your capabilities, and try and be who you are, and not try and manufacture yourself to be something that you’re not, because in the longer term you’re going to have far more career fulfillment, and you’re probably going to be far more successful, really playing to your strengths than trying to be something that you’re not.

John: The other piece of advice I would give my 21 year old self is try and get to bed at 2:00 AM on weekends. I think that test would have been a far better approach for me than maybe some of the weekends I’ve had, but in all seriousness the other advice I would have is, also find a good balance in your life, your life shouldn’t be all about your career, nor should it all be about everything but your career. But trying to find a balance so that you can have a good quality of life is also going to be critically important to your ability to have a fulfilling life over time.

Stewart: It’s good advice. And I really appreciate you being on. It’s fun. One of the great things about hosting these podcasts is I learned so much from our guests, so I appreciate the education. John Linehan, US equity, income strategy, portfolio manager, and chief investment officer of equity at T. Rowe Price. Thanks for being on John.

John: Thank you.

Stewart: Thanks for listening. This is the insurance AUM Journal Podcast. If you like us, you can find us on all the major platforms. Please follow us. You can also reach us at podcast@insuranceaum.com. Thanks so much, and we’ll catch you next time.

AUM as of June 30, 2020