Joel Tillinghast has powered the Fidelity Low-Priced Stock Fund (FLPSX) to a 13.7% average annual gain since its inception in December 1989, beating the Standard & Poor's 500 stock index by more than four percentage points a year. While the fund's performance has faltered in recent years — it has trailed the S&P 500 by 2.64 percentage points a year the past five years — Tillinghast remains an icon among those who look for value in unloved stocks. In a recent arjuna-design interview, Mr. Tillinghast talked about how he picks stocks, what it's like to run a $39 billion fund, and why Japan offers so many compelling investment opportunities.
arjuna-design: What's the allure of low-priced stocks? You could have done quite well with some high-priced stocks, such as Apple, Google or Berkshire Hathaway.
Mr. Tillinghast: "Low price" has two meanings. One is share price, which, at the start of the fund was under $15. Now it's under $35, which is less than the median stock price on the New York Stock Exchange. The other meaning is "low valued," which means a stock is selling for less than its intrinsic value. Low-Priced Stock tries to buy those that are low-priced by both ratings. Research coverage of stocks that have low prices is spottier, and there's an opportunity of market inefficiencies. For the undervalued part, there's lots of statistical evidence that stocks that are statistically cheap outperform. Research still adds value.
I've had companies tell me, "We don't want our stock to be in the hands of a bunch of value investors." The best way for them to do that is improve profits and help shareholder value. If they go out there and do that, I'm happy for them, and they can escape being a low-priced stock.
arjuna-design: Low-priced stocks are usually priced low for a reason. What do you have to be most mindful of when buying low-priced stocks?
Mr. Tillinghast: It's a combination of things: You don't precisely get at the investments' risks that security analysts pay attention to. One of those is making sure that it's an industry you understand. Some industries are just baffling to me, like unprofitable biotech stocks — I don't know how to value them, since the science can take any direction. If you're doing it at home, unless you're a doctor, stay away from unprofitable biotech.
It's also about working with good people. You don't want fraudulent companies, where management are idiots who build a white elephant that will lose a lot of money. It's like in detective stories, where you are suspecting a lot more people than who are doing something bad. And the balance sheet is something that really trips up a lot of people. If the balance sheet is bad and prices start collapsing, there's really no floor until they're playing taps.
arjuna-design: One reason low-priced stocks are low-priced is bad management. What's the best indicator for management performance?
Mr. Tillinghast: Sometimes there are occasions when you get value from site visits. I can think of one mobile home company that had a badly laid out factory floor with inventory in corners. It eventually got bought out by one with better manufacturing practices. But a lot of the time site visits are like looking at Potemkin villages. You have to look at the numbers or ask a competitor. No one is going to say, "Yes, we're crooks here."
arjuna-design: Given the U.S. market's run-up, is it harder to find worthwhile stocks that sell for $35 or less? Is that why your cash level is above normal?
Mr. Tillinghast: The cash level is down to about 9%, but it is still kind of high. The perfect stock would be one that has great management, honest and capable, in an industry I understand. It's resilient and growing, has a good balance sheet, and it's selling at a low price-to-earnings ratio. In the current market, you have to trade off: How vile a management will I take if PE is attractive and it's not a bad business? You're settling for two or three out of your checklist. It's not my favorite way to invest — avoiding losing, always being a bit defensive. I hate it when it's entirely a defensive game.
arjuna-design: You lagged your Morningstar category fairly significantly last year. What do you chalk that up to, and do you generally agree with the category that Morningstar puts you into?
Mr. Tillinghast: The cash position and foreign currency exposure, especially post-Trump. The American market was one of the strongest in the world, and we had a lot of British stocks. The U.K. pound went from $1.50 to $1.20, so that's a 20% loss on valuations. Some British companies had a margin squeeze because they were buying in dollars or euros and selling in pounds. They had to suffer a margin squeeze or raise prices, which they did, so sales were pretty slow. I didn't have enough in banks, and had gotten too stuck in the view that rates would stay low and that the regulatory burden was here to say. I underweighted them and that was a mistake: The world changed in a positive black-swan way for the banking industry.
arjuna-design: The fund is about 63% in the U.S., with the rest abroad. Your biggest overseas allocation seems to be Japan. What draws you to the Japanese market?
Mr. Tillinghast: Japanese companies have the strongest balance sheet of any nation in the developed world: 50% have cash that exceeds debt. That's incredibly strong and much lower than in the U.S. and around the world. In small caps, the price-to-earnings ratios can be low: There are still lots of companies with PEs of 8, 10, 12. Interestingly, Japan hasn't had the exit of small companies from the public market that the U.S. has had. There are nearly as many small-cap companies in Japan as there are in the U.S. The U.S. has suffered a steady exodus of small-cap companies, and Japan has many more undervalued small caps with great balance sheets.
arjuna-design: The fund is $37 billion. Is that becoming more difficult to manage?
Mr. Tillinghast: Since there has been a steady flow of redemptions, the fund has contracted by several billions. The steady flow of redemptions is one reason for the cash. It's become more difficult to manage in that I have to manage selling stocks and decide which ones I like the least constantly without become so defensive that I'm missing new opportunities. I have six people on the team — Team Joel — who manage slices of the fund, about 6% of it. If something bad happened to me, the obvious plan would be that they would step in. I'm very careful when I get to a bus crossing, especially in Boston, because they drive like maniacs. Beyond that, I have the small-cap team at Fidelity for research, which has a dozen or more analysts. And as the largest user of small-cap stocks, I have a disproportionate call on their time.
arjuna-design: What's your sell discipline?
Mr. Tillinghast: It's the opposite to the buy criteria. Do I realize I don't understand as much as I thought I did? Do I realize that management is not as skillful or honest as I thought, or that the business is more ephemeral or less competitive than I thought? Do I think the stock is selling for more than intrinsic value? If I can check those, it's a candidate for sale.
arjuna-design: Given the market's recent gains, do you think it's due for a correction?
Mr. Tillinghast: It's not anything anyone can time. Investors have to think about what sort of returns they can make on the market. I'd suggest [looking at] the earnings yield, which is the inverse of the PE, which would suggest a 5% to 6% return, which is pretty mediocre by historical standards. But the alternative is bonds that pay nothing in Europe, or U.S. bonds that pay 2.5%.
GMO talked about this in terms of hell versus purgatory. Hell is the idea that we've reached a permanently lower level of market retunrs: Bonds yield nothing and stocks are capitalized at current PEs and margins we have today. It would signal a world of low returns. Purgatory is worse in the short-to-intermediate term, meaning we have to revert to the mean, which means a shellacking correction at some point and negative returns across the investment universe. I don't know which one to believe. If it's hell, it means a 5% return on equities, a 0-2% return on bonds, and that won't meet pension fund obligations that are based on an 8% return. If it's purgatory, it will culminate in a terrible bear market someday.