Field Reports From LPL’s Investment Manager Research Team

Jeffrey Buchbinder (00:08):

Hello, everyone, and welcome to LPL Market Signals. I'm your host for this week, Jeffrey Buchbinder, chief equity strategist at LPL, and I am pleased to be joined by Scott Froidl from our investment manager research team. Thanks so much for joining this week, Scott. We are interested in hearing what you are hearing from active managers that you talk to all the time. And boy, you, you talk to a lot of them. So why don't we start just by hearing from you. How many active managers do you talk to in a year, typically? And, talk about how much experience you have, because I know you're. I mean, we're both young, but I know you're a little bit of an old timer.

Scott Froidl (00:54):

Mr. Buchbinder, you living legend, my friend. Thanks for having me today. I really appreciate it. To that question, roughly 300 a year for several, several years.

Jeffrey Buchbinder (01:07):

That's a lot. <Laugh> I believe our team has cleared a thousand manager meetings a year in the past. That is a lot. And certainly we value, for any of you who are with asset managers that we talk to, we value your insights. Not only do we value them as we evaluate managers, but we value them because the macro team takes a lot of these learnings from you and uses that as a component of our process to figure out what we should be doing in our recommended asset allocation. So this is part of that process right here. You're kind of getting a look behind the curtain. So, it is Friday as we're recording this before the Labor Day holiday, September 4th, but you will release this on Tuesday. So hopefully you had a wonderful, long weekend. So let's get to it, Scott.

Jeffrey Buchbinder (01:59):

We've got, I guess six kind of buckets of topics, things that you ask active managers, and, you've been kind enough to agree to sort of summarize and synthesize all of those learnings to, to share out what you think is most interesting. So let, let's start with, an investment thesis that maybe came up, more frequently, maybe some thesis that changed or frankly that maybe an active manager had and then they took it away.

Scott Froidl (02:33):

Happy to discuss all that. Just a little way, by my background, for those of you who don't know me, I'm co-head of the manager research team with my good friend, Carter France, who oversees the fixed inside, fixed income side of the shop. And then as Jeff alluded to, I'm a voting member on the Strategic Tactical Assets Asset Allocation Committee. So a lot of these manager, portfolio management team comments feed into our views and STAAC to help make decisions as a collective group. I got into business in 95, had the pleasure of being a financial advisor in the trenches like you, first 10 years of my career, so that really gives me an appreciation for everything financial advisors go through on a daily basis. I had 40 or so mid-year review calls recently covering a bunch of topics that we're going to talk about today.

Scott Froidl (03:20):

Those calls were from July 23 through August 17. So pretty, pretty fresh comments covering 63 vehicles on the coverage list. And just as a reminder, our coverage list, builds categories out like Baskin-Robbins has flavors of ice cream. We have different clients with different needs, with different time horizons, and we also look for good pairing options and models, for instance, Momentum Manager with a quality manager. So getting into the comment, the question first off on common themes and what are we, what are we hearing? There's a wide divide this year on the mid-year convers- conversations, believe was widespread yet confidence in how the gains would be disrupted were all over the map. Rate and concentration risks, were prevalent out there. A lot of comments regarding that. And then the case for quality and valuation discipline and broader leadership, tons of comments out of those 40 calls over the last several weeks.

Jeffrey Buchbinder (04:20):

Yeah, certainly no surprise that a little bit of a, let's call it a sprinkle of AI on top of your ice cream there, that will come out as we, continue the discussion. So, have some of the managers changed their approach to AI? Have you had some managers that have come into the year thinking, you know, they're AI bulls and they really want to be leveraged to that theme and then they've moved off of it and are doing something different?

Scott Froidl (04:46):

Yeah, you're spot on. The landscape is changing dramatically with AI and the movers and shakers hear a lot about the, the picks and shovels companies now and the data centers and cooling and, and all those kind of themes that fit across the market spectrum, across large cap growth and blend and the value teams combined, the strongest thesis for AI remains the, the multi-year capital spending cycle, Jeff. Many teams said spending by large cloud platforms and demand for computing and memory and storage, power and data infrastructure exceeded their earlier expectations. Several argued that the opportunities broadening beyond the initial hardware beneficiaries and software and data services, the industrial infrastructure and selective financial and healthcare businesses.

Jeffrey Buchbinder (05:34):

Yeah, I recently spent some time with a growth manager, more personal than business, but certainly he was very impressed with the, and surprised by the magnitude of this build out, as have I.

Scott Froidl (05:48):

Yeah. The growth conversations, Jeff, that I had, had a lot to do with, you know, growth managers kind of pay up more, obviously that's no secret to anybody, but they're willing to accept those premium valuations supported by the earnings revisions and the persistent demand. But however, those value and core teams were more likely to question whether every perceived beneficiary can earn an adequate return on that investment. But the shared conclusion was not that the theme is ending. It was the next phase may reward selectivity more than single, simple exposure.

Jeffrey Buchbinder (06:22):

Wait, let's move on to the next topic, Scott, which is, an out of consensus view. I starred this, you gave me a list of these six questions. This one's one I have a star on because I think this is going to be really interesting. So did you hear some out of consensus views or any views that just really, really surprised you?

Scott Froidl (06:40):

Yeah, there were several outliers that kind of stood out, thinking through those conversations. Outliers that challenge investors examine the less discussed issues such as the, trusted data economics or misleading beta measures, the semiconductor returns on capital, market structure, the dividend valuation and the possibility of future computing oversupply. One team warned that, reported cash flow can be misleading in both directions, overstating temporary beneficiaries, while understanding companies investing for durable advantage. And then however, another team, which is more contrarian growth team argued that much of the semiconductor complex might not be earning its cost of capital. And then finally, some managers identified dividend yield, low volatility, value spreads, life science tools, housing, onshoring, all less crowded opportunities. So, those are some of the things that kind of stood out from the calls over the last few weeks.

Jeffrey Buchbinder (07:37):

Oh, there's a lot in there. The cash flow debate, we've written about that recently. If you value these big tech companies on earnings, they look pretty cheap, but you look at them on cash flows and they don't. As that sort of divide has emerged, have you heard about managers maybe using a barbell? Has that language come up where you want, you know, a combination of maybe beneficiaries of tech sell-offs paired with the tech? Are they thinking about it that way?

Scott Froidl (08:11):

Yeah, I think what they're doing is they're being more cognizant of their position size, mindful of the bets against the index. Some of those managers that were really overweight, some of those mag seven names have pulled in some of those, those names based on all this CapEx spending they're doing and, and the leveraging up some of the balance sheets that they're seeing there. And then all of them are seemingly digging into those picks and shovels and trying to find that next kind of earner of all that AI money coming out of there from all the GPU spend, et cetera, that's going to be driving the market demand for AI.

Jeffrey Buchbinder (08:50):

Yeah, they, and we are thinking about sort of the duration of the tech cash flows, so. Yeah. In the short term, the, the spending is happening, obviously, with the picks and shovels, the semiconductors, for example. And so that's, that's coming in, that's cash, but then, with the depreciation schedules, the big tech, it's really not going to necessarily pay off, for a while, some more long duration. So, we've been thinking a lot about that in terms of how do you, how do you assess the duration of the AI place and where are the best places in the cycle to be? We touched on that in last week's weekly market commentary on lpl.com, so you can check that out if you're interested. It's a real, really interesting topic because tech offers. Well, it's also related to software versus chips debate, right?

Jeffrey Buchbinder (09:43):

Right. We like software a little bit more just because it got beaten down, certainly. But, the short duration that may be better positioned to, manage through a potential fed rate hike would be, the chips maybe over the large language models and the, and hyperscalers.

Scott Froidl (10:06):

Yeah, that was a common theme, the baby out with the bathwater, Jeff, in regards to the software space, you know, tons of names selling off, just everybody in the fear mode. And a lot of names, these portfolio managers were felt overdone and they were dabbling and kicking the numbers and playing the devil's advocate role to see, you know, what's worst case scenario before jumping into some of those names. It, to your point, consensus favored the durable AI investment, the quality, profitability, and broader market participation, but they're warning on momentum and concentration, inflation, the interest rate risk, some of those things kind of stood out there.

Jeffrey Buchbinder (10:44):

Yeah, we sort of segued into our next topic, which is mispriced areas of the market. So, of course, software comes to mind there. what other areas did you hear when you asked folks where they think, the market might be mispriced and, where the opportunities might be?

Scott Froidl (11:07):

To your earlier comments, you know, you brought up software. We've seen some of those names start to move since I started these, investor manager calls with portfolio management teams July 23rd. You've also seen some healthcare names really, really take a move there, but, you know, that's some things that stood out in my conversations with the PM teams, healthcare, industrials, financials, life sciences tools, some select software business they were talking at the time were among the most frequently cited areas where sentiment or valuation may not be fully reflected in the fundamentals. And then one manager claimed that dividend paying businesses were, are, were near a historically wide relative valuation discount. So that was pretty interesting to hear as well.

Jeffrey Buchbinder (11:49):

Yeah, we certainly have portfolios, playing that theme, no doubt. I think that with software, the folks that were able to determine the difference between mission critical software and/or software that was well positioned for AI versus software that wasn't, that could potentially be eaten <laugh> by AI, as the saying goes, being able to differentiate that was a real alpha opportunity here. The, some of these software stocks have nearly doubled in just, I think, maybe even more than doubled in some cases over the last few months.

Scott Froidl (12:24):

Yeah. Yeah, that's correct. And I heard a lot of, you know, look at these, these software companies have a ton of data. And some of these companies, it's maybe AI is going to eat their lunch down the road, but it's going to take a while to replicate what they've created. It's not that easy. So some of the fears were overdone on some of these names, and these portfolio managers were picking up nickels on the street and jumping into some of these names.

Jeffrey Buchbinder (12:50):

Yeah, couldn't agree more. Not surprised, to hear that at all. Certainly cybersecurity is an example of an area that's had a really nice run after being sort of misunderstood, during the, June swoon, I guess we'll say when everybody's worried about, vibe coding disrupting software businesses. I agree with you. I'm hearing that too, that, it's going to take a long time. The, just the debate around AI and whether it's going to be productive or disruptive or how much of each it's going to be, that's going to be with us for years. With, this will not be resolved by year end or probably even 2027. And so, to us, that helps the market kind of hold onto the gains that it's enjoyed here on this AI run, because more people are going to have to be skeptics to really knock this, this market down.

Jeffrey Buchbinder (13:46):

That's not necessarily what I'm hearing from you, Scott, or active managers. That's sort of me synthesizing the views of the macros, Research Team here at LPL. So, let's go to risks now a little bit more. I mean, we listed a couple of them, but, which risks do you think are maybe underappreciated based on your discussions with managers? Did they highlight any that you though were interesting?

Scott Froidl (14:15):

Yeah, I mean, I would say the most common risk was the higher for longer interest rates and the renewed inflation, teams linked the risk to fiscal deficits or energy shocks, geopolitical conflict, and financing needs created by the head of capital spending was major issues brought up multiple times. Several noted the rising long-term yields, which our stack team is focused on, on a daily basis, it could put pressure on long duration assets, even if earnings remain resilient, others focused on liquidity or leverage in the market's ability to absorb the debt or the equity issuance. And then the next cluster of concerns really came from the concentration of crowding. Managers worried that the pause in capital spending and slower monetization or a change in the technical position, it could affect far beyond the initial beneficiaries. Some also question whether beta and momentum have become overlapping expressions of the same dominant theme.

Scott Froidl (15:16):

This is important because portfolio construction warning diversification by name or sector may offer less protection if the underlying economic drivers shared. So just a, just a few key risks there. The beta momentum one is more, prevalent this time than it has been in years past. Usually we always hear fiscal spending or policy or all these kind of, geopolitical concerns, but, this is kind of a new one that popped out this time.

Jeffrey Buchbinder (15:44):

Yeah, that, the fact that so much of the S&P 500 is an AI trade makes this a really unique environment, right? I mean, if you just add the mag seven to tech, you're already pretty close to half the market - Yeah. I believe. So how, how are managers managing that risk? Are they, is, are they pretty much just running these things through, quantitative tools or do they just have to assess sort of stock by stock what the AI sensitivity is? Anything you can share there?

Scott Froidl (16:23):

Yeah. So a lot of teams use, BlackRock's Aladdin system or Barra or different factor measures to, to see how stocks correlate that they might bring into the portfolio with other stocks already owned or what happens if they sell a stock to the remaining stocks in the portfolio's correlation, because they don't want to get over their skis into any one theme and have a big bet on portfolios. Most of the time, it's a diversified portfolio. So we have a handle on that. Our team, you know, has to understand the ins and outs of the risk controls of every product on the coverage list, that we examine, and, that way we know what to expect in different market environments. So, I mean, to your point, 33% or so in Russell 1000 growth semiconductors, I believe about 70% of the names could be tied to AI today.

Scott Froidl (17:10):

A bunch of names rolled out of the Russell 1000 value index that benefit, benefited a lot of managers that don't buy software. It rolled into the growth index, and now those Russell 1000 value benchmark managers that can't invest in those, the software names sold off early when they rolled out on the reconstitution, and those value names, managers didn't benefit from not only those when they were out of the index. So a lot changing with the indices, today.

Jeffrey Buchbinder (17:38):

Yeah, that, that PM, the growth PM I talked to recently, knew that. I mean, most managers knew this was coming, right? Actually bought some, some semiconductor and memory exposure ahead of the reconstitution, knowing that the benchmark was going to change so dramatically. So, managers that were on top of that, certainly, look better, to us as, as you guys do your work and evaluate, where you want to put client assets, obviously, in a very important responsibility. So, thanks for that, Scott. That's really interesting. Glad we have your team helping us with this stuff. There's a lot, a lot to watch, a lot to monitor, needless to say. So let's go to the next topic. This is topic five out of six here, best market environment for various strategies. The. I mean, when I first got introduced to this business, what I observed, and many were talking about, was when the mega caps lead, active managers tend to lag because they cannot own or typically choose not to, own enough to keep up.

Jeffrey Buchbinder (18:48):

But this market has actually seen the mega caps lag recently, or at least have a lot of dispersion, right, which I would think would help the active managers. So what do they say when you ask them what kind of environment's best or, or any other, comments on how the environment has affected performance recently?

Scott Froidl (19:09):

Back to the Baskin-Robins flavors of ice cream. We have different styles in each category. So a deep value manager's answer to that question, Jeff, might be different than a contrarian in the large value category or a dividend growth manager, a dividend yield manager or a core manager. So they're, they're all giving us answers, and we know what to expect based on their style of investing. So one excuse we heard a ton of, when momentum and beta are hot is all those quality focused managers, quality first, then growth, for instance. We're supposed to underperform when, when the market's red hot, right? But they're going to outperform when that market's really selling off. And in my career, but doing this is 95, you win by not losing over the long term. You want to get as much upside as you can, but you really want to protect on that downside too.

Scott Froidl (20:00):

So it's a balancing act. We need to be aware of what risks these managers are taking.

Jeffrey Buchbinder (20:07):

Yeah, I think we, we've benefited from that perspective in the portfolios we manage from an asset allocation perspective, because while we are overweight equities, at LPL Research, we are doing it carefully because we're leaning into quality and we have an overweight energy, which of course is acting defensive. So our risk metrics look really good. I'm sure you're seeing that with a lot of managers that you're watching, Scott, where, you know, they're not, not necessarily getting the up capture on the huge NASDAQ winning leading days, but over time, that diversification is really starting to work.

Scott Froidl (20:48):

Yeah. I mean, back to your point, quality, quality, quality. I heard a ton of that on these 40 calls. Not everybody's a quality manager, but when asked which factors were the cheapest in the market today, quality was overwhelming. When I asked which was most expensive, momentum. So I would say 90% of the, those, the question was answered in that regard. So how do you put these comments from these 40 portfolio management teams to work? Just three ideas, comes to mind, and Jeff's the guru here, but let me just throw a few out here. The first is to seek proven compounders with visible earnings, cash conversion, and return on capital. And then the second is unappreciated beneficiaries where fundamentals are proving with the narrative remains impaired, such as we talked about healthcare or industrials, financial data, and software businesses.

Scott Froidl (21:41):

And then the third would be to portfolio balance, you know, emphasize that valuation discipline, the low volatility, the dividend growth, the lower beta where appropriate. The mid-year message is not a simple choice between growth or value, it's a call to separate the durable economics from the crowded narratives. And AI is going to be a continued powerful long-term story. So the distributions returns is likely to become more selective, over the years.

Jeffrey Buchbinder (22:12):

Love it. Really, great job, Scott, sort of summing up all the takeaways. I want to double click on your industrials comment. I think this is a really interesting time to bring that one up because that sector has really struggled lately. It's one that LPL Research still likes. So, that is certainly not getting quite as much attention as the AI hot dots, we'll call them. Sort of a second derivative play on AI. You mentioned cooling and sort of the, the data center, construction plays that are not necessarily servers or semiconductors or routers or things like that. So we think actually that, that is a very timely idea. Watch the technicals. They are kind of at a key inflection point, we'll say. But our bias, on the team, the STAAC, the Strategic and Tactical Asset Allocation Committee is to still favor and overweight to, industrials on top of that energy, the idea, that I mentioned.

Jeffrey Buchbinder (23:17):

So really great stuff. The, this year has been better, at least lately, certainly, for active managers, as a whole. And we think in LPL Research that favoring quality is going to be a smart strategy here from the macro side. And it sounds like, Scott, you agree, and a lot of these managers are certainly fitting into that bucket. So, favor quality, be careful with your momentum. I think that is, a good, good takeaway. So, we'll go ahead wrap there. Scott, thank you so much for joining, bringing your, your deep, deep insights on active managers, your many years of experience. We're your many years of experience on the active management side. I know you are as good as it gets at, bringing these insights to our team, and we greatly appreciate it and certainly use it as part of our quest to really understand how the market is positioned and, you know, how to dissect the environment across factors, drivers, opportunities, risks, et cetera.

Jeffrey Buchbinder (24:29):

So appreciate what you guys do. Certainly for, LPL advisors listening who you, who want more from Scott's team, please reach out, let us know. They're happy to help. They've got a great story to tell. So, with that, we'll wrap. So, Scott, we'd love to have you back, to talk out to managers again at some point down the road. Appreciate your participation. Thank you to all of you for listening to another episode of LPL Market Signals. We'll see you next week. Take care.