Two veteran managers of the Vanguard Primecap Fund discuss the firm’s storied history, how they run money, and more.
Our guests this week are Joel Fried and Al Mordecai of Primecap Management. Primecap is the longtime manager of several Vanguard funds, including Vanguard Primecap, as well as the Primecap Odyssey family of funds. This year, Vanguard Primecap will celebrate its 40th anniversary as a mutual fund. Over its life, Vanguard Primecap has handily topped the broad U.S. stock markets and relevant growth indexes, and Primecap’s other funds have also racked up impressive results. Morningstar has recognized Primecap for its successful record in shareholder-friendly practices on several occasions, most recently in the 2022 Morningstar Awards for Investing Excellence, when our analysts named the firm as the winner in the Exemplary Stewardship category. Before that, Primecap was a two-time winner of Morningstar’s annual Manager of the Year award.
Background
“U.S. Morningstar Awards for Investing Excellence: The Winners,” by Sarah Bush, Morningstar.com, April 20, 2022.
“Morningstar Awards for Investing Excellence: Exemplary Stewardship Nominees,” by Gabriel Denis, Morningstar.com, March 14, 2023.
Funds and Companies Mentioned
Primecap Odyssey Aggressive Growth
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guests this week are Joel Fried and Al Mordecai of Primecap Management. Primecap is the longtime manager of several Vanguard funds, including Vanguard Primecap, as well as the Primecap Odyssey family of funds. This year, Vanguard Primecap will celebrate its 40th anniversary as a mutual fund. Over its life, Vanguard Primecap has handily topped the broad U.S. stock markets and relevant growth indexes, and Primecap’s other funds have also racked up impressive results. Morningstar has recognized Primecap for its successful record in shareholder-friendly practices on several occasions, most recently in 2022, when our analysts named the firm the winner of its annual Investing Excellence Award in the category of exemplary stewardship. Prior to that, Primecap was a two-time winner of Morningstar’s annual Manager of the Year award.
Despite this success, Primecap does not ordinarily speak publicly, so Christine and I were thrilled to have the opportunity to chat with Joel and Al. Joel is president, director, and a portfolio manager at Primecap, which he joined in 1986. Al is vice chairman, director, and a portfolio manager at Primecap, which he joined in 1997. Together with Theo Kolokotrones, Mohsin Ansari, and James Marchetti, Joel and Al oversee management of Primecap’s funds.
Joel and Al, welcome to The Long View.
Joel Fried: Joel Fried: Thank you, Jeff, and thank you, Christine, for hosting us today. We always greatly enjoy our interactions with Morningstar, and it’s a pleasure to talk with you today.
Ptak: Likewise, we’re very much looking forward to this. I think that the place where we wanted to start was with your firm and its history. Primecap is obviously very respected in investing circles, but I’d venture to say the average person probably isn’t too familiar with your firm. Given that, can you give a quick thumbnail sketch of Primecap, how much money you run, how many employees you have on staff, maybe a stat on a number of relationships, clients you have, and that sort of thing?
Fried: Fried: You bet. Primecap was founded in 1983. We are based in Pasadena, California, which incidentally was just named by The New York Times a couple of weeks ago as one of the 52 must-see places in the world this year. It’s only one of seven places in the U.S. that made the list. That will be my one shameless plug for Pasadena. We manage about $130 billion in assets. Approximately three quarters of those assets are in Vanguard funds that we subadvise, primarily the Primecap fund, the Capital Opportunity Fund, the Primecap Core Fund, and the U.S. Opportunity Fund. A little less than 20% of the assets are in our own family of mutual funds, the Primecap Odyssey funds. And the balance is in separately managed accounts for 20 pension fund, endowment, foundation, and sovereign wealth fund relationships. We have 40 employees, roughly two thirds of those are investment professionals, including client services and trading, and one third are operations and support.
Benz: We want to delve into the Vanguard relationship in a minute, but before that, we wanted to get into Primecap’s history. It’s been chronicled elsewhere, but some of our listeners probably don’t know the firm’s origin story. So, we’re hoping you can talk about how Primecap got its start.
Joel Fried: Our three founders—Howard Schow, Theo Kolokotrones, and Mitch Milias—were senior portfolio managers at the Capital Group. Even back in 1983, when Primecap was founded, Capital was a substantial organization. It had offices around the world and managed about $30 billion in assets. That was a big number back in 1983. Howard, Theo, and Mitch had a desire to work in a smaller firm. Their idea was to create a new investment company, one that would preserve the investment philosophies that had served them so well at Capital, namely, fundamental research, long-term time horizon, individual decision-making, and a focus on companies that could evolve in a materially better way than their valuation suggested. But this new company would be small by design. By limiting the number of client relationships to 20 and limiting the number of employees, the founders believed that they could minimize the time they spent on noninvestment matters, and thus spend the vast majority of their time managing money, which was their real passion. And thus, Primecap was born in the fall of 1983. Our original business plan was to have 20 separately managed accounts. Each account would be a minimum of $25 million, and ideally, if everything went right, we’d have a $500 million firm. That’s really how it got started.
Ptak: Primecap, as I mentioned before, it’s not as familiar to the public, and that’s for a pretty, I think, understandable reason, because your firm—you don’t advertise, you don’t speak to the media, or otherwise really promote yourself. And that’s unusual for a mutual fund firm. Why did you choose that path originally, and why have you stayed on that path through the years?
Al Mordecai: Jeff, every decision we make is geared toward supporting our mission, which is to provide superior investment returns for our clients. Hubris is a common pitfall in this industry, and we do our best to avoid it. While it may make one feel good or important to go on CNBC or to be profiled in a business magazine, we’ve never understood how that’s going to help us help our clients achieve superior returns. To the contrary, going on TV to broadcast one’s best ideas is more likely to hurt than help our clients. So, we try to limit such distractions, as Joel was talking about, so that we can focus on investing. Regarding advertising, we don’t want to grow to be too big. Becoming too large in terms of assets managed limits the universe of investable stocks, which results in the portfolio looking more like the very index that we’re trying to outperform.
Benz: You’ve obviously played a critical role in shaping and upholding the firm’s culture, but to what extent do you think some of those choices the firm has made about how it operated, for example, focusing on research and portfolio management rather than sales and marketing and being on CNBC, were influenced by how the firm was established at the outset?
Fried: How we operate today is profoundly influenced by how the firm was established at the outset. As you mentioned, to date, our focus has been almost entirely on research and portfolio management, with little regard to sales and marketing. You shouldn’t take away that we ignore our clients. Quite the contrary, we spend as much time with our clients as they require. It just means that our focus has never been on actively marketing or soliciting new business. We’ve always maintained a Field of Dreams mentality: “Build it and they will come.” We’ve believed that if we provide a superior product, assets would find us. And, fortunately, for the last 40 years, that philosophy has worked pretty well.
Ptak: How did you apply that approach to ushering in the next generation of leadership at the firm? There had to have been some cautionary examples of, call it, botched succession plans that at other firms where you thought to yourselves, we can’t do that. So, did that inform your approach on how you went about that critical transition that your firm has undergone at least once as you move from one generation to the next?
Fried: Jeff, this is a really important issue. We believe recruiting and succession planning are among the most important things we do, second only to managing assets. We’re quite proud of how we’ve handled succession planning at Primecap. We’ve successfully transitioned leadership from the founders to the current generation, and we’re well on our way to developing the next generation of leadership. We’re such a close-knit group and we’ve worked together for so long that perpetuating common culture occurs organically. I’ve worked with Theo for 37 years. Al and I have worked together for 27 years. We’ve worked with Mohsin for 23 years and James almost 20. And when we think about the next generation of leadership, we’ve worked with Greg, Anil, Jared, and Shanshan, on average, about 15 years each. We’re all on one floor in one office. We all sit in the same meetings every day, day after day. We’ve discussed thousands of ideas together. We know how one another thinks. And importantly, we repeatedly tell the stories of Primecap that reflect our history, our values, and our culture.
I’d also add that from a portfolio perspective, we think our multicounselor system is ideal for succession planning. In a typical mutual fund, there’s a single portfolio manager. If that manager leaves, you don’t know exactly how the fund might change under a new manager. However, with our system, if there are five managers on a fund and one manager leaves tomorrow, 80% of the fund will be managed exactly the same way. So, the multicounselor system is optimal for continuity.
Benz: I wanted to follow up on that and talk about Capital Group as well, this idea of sleeves—of portfolio managers being in charge of sleeves of each of the funds. Can you talk about that and why you use that structure, why you think it works well for you?
Mordecai: The biggest advantage, as Joel discussed, is that when a portfolio manager leaves the firm or stops managing money, as was the case for the two founders in 2012 and 2014, you don’t have a major change in the fund. As Joel was discussing, if one of the five of us leaves the firm, for example, roughly 20% of the assets of each fund would be distributed amongst the remaining portfolio managers. This is in sharp contrast to mutual funds with only one portfolio manager, where 100% of the fund may be changed by the new portfolio manager. This provides the continuity and stability expected by our fund shareholders.
Ptak: I wanted to jump back and talk about how it is you came to work with Vanguard managing funds like Vanguard Primecap. I think it had its roots, if I’m not mistaken, in a professional relationship that the late Jack Bogle had previously forged with one of your late founders, Mitch Milias. Is that right?
Fried: Somewhat. Jack Bogle and Mitch had definitely crossed paths professionally. When Jack was at Wellington, Mitch was involved in the transaction in which a company was sold to Wellington. However, I think Jack’s interest in Primecap was more a function of his awareness and respect for Howard’s record as the lead manager of AMCAP Fund, while Howard was at Capital. AMCAP was American Funds’ flagship growth fund. At the time Primecap was founded, it was the longest running fund on the Forbes Honor Roll. So, shortly after Primecap was formed, Jack Bogle and Jack Brennan—Jack Brennan eventually succeeded Jack Bogle as Vanguard’s Chairman and CEO—came to see us. Jack Bogle asked if we would be interested in running a growth fund for Vanguard, a fund that would be similar to and compete with AMCAP Fund. Ironically, our initial response was no. Mutual funds were not in our business plan. As I described, our business plan was 20 separately managed accounts. And after having just left a large organization, we were reluctant to immediately partner with another large organization. Fortunately, after sleeping on this decision for a few days, we concluded that perhaps managing a mutual fund wouldn’t be such a bad idea. And thus, the Primecap Fund was born, as was what is now an extraordinary 40-year relationship with Vanguard.
Over the ensuing years, that relationship evolved, and we have partnered with Vanguard on additional products. In 1998, we assumed management of the Capital Opportunities Fund. This is an aggressive growth fund that had been managed previously by another firm. In 2002, we launched the U.S. Opportunities Fund, which is a U.S.-based product for European investors. And in 2004, the Primecap Core Fund was launched.
Benz: Can you talk at a high level about how you arrive at estimates about the strategy’s capacity and the sorts of things you monitor, engaging where the funds are versus your estimates?
Mordecai: Christine, we really want to be sure that our high-conviction ideas can become meaningful positions in the funds we manage. So, we don’t want the funds to become too big for their given mandate. And also, we don’t want to become so large that we begin to look more like an index fund because we can only buy larger-cap companies.
Ptak: I wanted to talk a bit about incentives. At a high level, how do you structure incentives at the firm to ensure that you align practice and behaviors with the long-term focus you aspire to? For instance, how do you motivate your analysts and PMs to go deep and come up with fresh ideas without unintentionally encouraging overtrading, for instance?
Mordecai: That’s a great question, Jeff. Structuring incentives to support the long-term focus of the firm is critical to our success. First, we rarely hire people laterally from other firms, especially if those firms are short-term oriented. Next, our compensation is tied to long-term performance. It would be disingenuous and even self-defeating to, on the one hand, believe that the biggest market opportunities arise with a misunderstanding of the long-term potential of companies, and on the other hand, measure and compensate analysts and portfolio managers mostly on the short-term performance. So, advancements at our firm in terms of compensation, promotions, becoming a shareholder of the firm, and growing assets managed, are based on long-term performance, both of the individual’s sleeve and also of their stock recommendations and their impact on our clients’ returns.
Benz: We wanted to ask about Adobe specifically. It’s a stock that you’ve held more than 30 years and over that time it’s gained nearly 19% per year, making it something like a 23-bagger. So, despite that success, the stock did experience a 40%-plus peak-to-trough drawdown in roughly three of every five rolling 36-month periods. So, given this, how do you structure your process to consider the bear case that might be getting priced in for a time but without according that pessimism maybe more weight than it deserves?
Fried: It’s a great question, Christine, and definitely more of an art than a science. We don’t have an algorithm for situations like that. We believe every situation has to be evaluated on its own merit. If you think about long-term holdings like Adobe, we continually reevaluate them in the context of the next five to 10 years. That’s how we deal with and protect ourselves from overly discounting short-term pessimism. We keep our sights on rolling five to 10-year time frames. So, when we think about Adobe over that time frame, we believe the demand for high-quality digital content will continue to grow unabated. The demand for this content almost always outstrips the available time of artists and designers responsible for producing the content. Adobe has a near monopoly on the software tools used to power that content creation. And with the advent of generative AI tools where Adobe has established clear product leadership, we think that will dramatically improve the speed and efficiency of content creation and also expand the market.
Ptak: I wanted to turn and talk about decision-making for a minute. It’s clear that you very much value collaboration, but my understanding is you’re not big on committees. So, I wondered why is that and what have you found is preferable when you’re trying to bring diverse perspectives to bear on a question or issue?
Mordecai: The reason for that, Jeff, is that the best investments, in our opinion, are usually those which aren’t understood by the masses. If a group of people, a committee, all agree a stock is likely to be a good investment, it’s more likely that the stock’s price reflects this consensus view and therefore it won’t be a good stock. We think the best investment ideas are usually ones which are understood by that lone, hardworking individual who is met with and studied the company, their competitors, their suppliers, their customers and so on, and who has developed a view independent of and different from the consensus view.
We say that good investments are like fragile flowers. They can be stomped out easily. Why? Because the market already disagrees with your assessment. Also, by having individuals manage money and tracking their individual performance, we have an accountability, which can’t exist if decisions are made by committee. Decisions made by committee run into that success has many fathers while failure is an orphan problem. Regardless of whether you do well or poorly at Primecap, your results are attributable to you. And this is critical in trying to assess an individual’s contributions. Regarding questions or issues, we do meet daily, as Joel discussed earlier, and encourage each investment professional to speak his or her mind on any topic. It’s very much the Socratic method because we realize that the right answer may come from any of us. Sometimes the newer analysts may see something that Joel and I don’t. Other times Theo, who started in the business in 1970, may have a perspective the rest of us will benefit from.
Benz: We wanted to ask about Nvidia, which you’ve owned since 2005, obviously way ahead of the current mania. And I have to think that the recent mania in the shares has surprised you a little bit or maybe not. But in situations like that where there’s a frenzy to own a name, how do you prevent thesis creep where you perhaps attempt to fit a narrative around some move in the stock to justify sticking with it versus making the more uncomfortable decision to trim a position like that or sell it outright?
Fried: Christine, this is a little bit like the Adobe question. Every situation has to be evaluated on its own. But I will say that generally thesis creep is less of an issue at Primecap than at most places. Our natural inclination is somewhat contrarian. So, if there’s a frenzy, to use your word, to own a particular stock, we are much more likely to be distributors of that name than trying to evolve the narrative to justify the valuation. Ideally, we like to find value where others don’t. So, when stocks become universally loved, our tendency is to look for reasons to sell, not to buy. Conversely, when there’s widespread pessimism surrounding a name, our inclination is to give that name a second glance.
Ptak: I wanted to go back to the sleeve system that you employ. And I was curious how the five of you collaborate in constructing and managing the portfolios. Do you ever discuss position size, sector exposures, other attributes, or make adjustments? Or do you run them pretty much bottom-up and just let the chips fall where they may, so to speak?
Mordecai: It’s more the latter than the former. Each of us individually is focused on our sleeve of each portfolio, knowing that we’re accountable for the performance of our sleeve. We do get some diversification from having five different portfolio managers, each with a different background. But any interference into what a portfolio manager can or can’t own defeats the accountability and the value of decision-making discussed previously. We do have some limitations. For example, as a firm, we limit ourselves to owning no more than 15% of an individual company. We can’t buy more of a stock and a fund once it’s at or above a 5% position within that fund. But our aim is to maximize individual discretion for each portfolio manager because we believe that gives us our best chance at outperforming the market.
Benz: Each fund holds around 140 to 200 positions. To what extent is the number of holdings explained by some of the divergence you naturally get in running the sleeves independently? And related to that, would one find that the sleeves you run are more concentrated?
Fried: Certainly, the large number of names is partly attributable to the fact that each fund is an aggregation of the five individual sleeves. Although there is significant commonality among the sleeves, approximately a quarter of each sleeve are names that are unique to a particular manager. So right there, you’d have double the number of names that you’d have in a single managed portfolio. The other factor contributing to the large number of names is that all of our analysts also manage portfolios in the industries they cover. It’s critical to our process that analysts manage real portfolios. However, this results in a long tail of small holdings and a large number of names that would otherwise be the case if analysts didn’t manage portfolios. Despite the large number of names, the funds have consistently been quite concentrated in their top 10 holdings.
Ptak: You mentioned your analysts. I wanted to talk a little bit about hiring and training. I don’t think we delved into it too much earlier when we were talking about your firm’s culture, but you have a history of hiring individuals who don’t have traditional business or finance backgrounds and then training them as analysts. And to be sure, the analysts you’re bringing in, they’re no slouches. They’re very accomplished and talented. But why not focus on, as so many firms do, say, business schools or seek experienced hands who you can pluck from elsewhere in the industry? Why hasn’t that been your approach?
Mordecai: Thanks for that question because this is something that’s very important to us. Recruiting or retaining strong investment analysts is of paramount importance to our firm as it is vital to our mission of providing superior performance. It’s our most important goal after investing and the two are actually related. We’re one of very few firms who are investing based on the long-term prospects for each company.
So, as I mentioned earlier, hiring someone from another firm with a short-term mindset isn’t going to work here, especially since we believe this is one of the greatest inefficiencies of the market. For recruiting, we do actually hire from top MBA programs. We review every single resume at several of the top schools, invite a small percentage of them to interview. And what we’re looking for first is raw intelligence and work ethic. We are looking for diversity, not only from underrepresented groups, but also in terms of backgrounds, majors, life perspective. We want people who we believe can think independently and correctly. Our most senior people go to each round for the first round of interviews. The process is extensive with second-round interviews in our offices, including meals together, spending lots of time with them, all with the goal of hiring only one to three candidates a year. As with stocks, we’re often countercyclical with hiring. We’re more likely to be hiring when the industry is not hiring. Another advantage we have is that we look at candidates without prior investment experience, which means we aren’t competing with other investment firms who are looking for such experience.
Finally, I’d add that our recruiting process is unique in that we’re radically transparent. I don’t try to sugarcoat the firm, because we’re trying to recruit people who will want to be at our firm for an entire career ideally. Our model is different from other firms, especially investment banks or consulting firms who are perfectly happy to work someone nearly to death for three years and then have them leave. At three years at Primecap, we feel our analysts are just coming up to speed in their industry. And so, it’s a disaster for us if they leave at that point.
Benz: I wanted to follow up on the hiring process and just ask about how you evaluate. You mentioned you’re looking for raw intelligence and work ethic. Are you looking for the tangibles on those things like GPA and things like that or are you evaluating that through the interview process?
Mordecai: It’s a little bit of both. It’s a good question. We do look at GPAs. We do look at GMAT scores and those types of test scores. So that is sort of the initial screen. But ultimately, what we found out, Christine, is we’ve got to meet with the candidates, and we ask them questions. We don’t try to trick them or anything. But we are looking for candidates who don’t just give us the canned answer that one might expect from a business school student, but who think about things differently. And it can be something very mundane. It doesn’t have to be an investment idea. It can be something about a business school class or some kind of philosophy or something like that.
Ptak: That’s helpful. I’m curious about the process by which you inculcate analysts. I’m sure it varies depending on a multitude of different factors. How long will your analysts typically follow a name before you initiate a position?
Mordecai: It varies by analysts and by industry that they’re given to cover. On average, I would say, it takes about a year to start recommending names for most analysts. We want our analysts to work with a sense of urgency, but we acknowledge that it takes time, usually years, to really get to know an industry and the stocks within that industry well better than the market does.
I’ll share with you one brief story. One of our founders, Howard Schow, was once asked, Howard, how do you use your analysts? Howard thought about it for a minute, and he responded, after about three years. Now that can be daunting for a new analyst to think that they may not be used for three years, and we certainly have examples of analysts that have been used where their ideas have become big ideas in our firm before three years. But Howard’s main point was it takes time in this business. We’re asking people to develop a thesis where they understand something better than the rest of the world does, and we just don’t think that can happen overnight.
Benz: You mentioned that Primecap’s analysts, in addition to their core research duties, are also given the opportunity to invest a small portion of each fund’s assets and names that they cover. Can you talk about that, what purpose that serves? And, also, how you measure the net benefit conferred by permitting the analysts to run money at the margins?
Mordecai: We think analysts need to manage real money because paper portfolios just aren’t the same. I used to work in Admiral Rickover’s Navy nuclear program. He believed that sailors in the nuclear program should practice on real prototypes with real nuclear reactors. Only then will they appreciate the gravity and consequences of their decisions. A mock-up would be cheaper, but not as good. The same goes for managing money for our clients. Paper portfolios just aren’t the same. Finally, analysts are measured against their respective indexes, so over longer periods, this is the best way to measure their performance and there’s nowhere to hide if it’s a real portfolio. This is also excellent training for those who will eventually become portfolio managers.
Ptak: If I may, I wanted to quickly follow up on that, just ask for an example of a name that began as an analyst position at a nominal weighting but then was mainstreamed, so to speak, into the portfolio as a larger position when one of the portfolio managers added to it, and how common is that?
Fried: Jeff, that’s actually most of the portfolio. It’s actually the lifecycle of really most holdings. Typically, when an analyst or a portfolio manager recommends a new name, it’s bought by only one or two portfolio managers. It’s much, much less common to be immediately embraced by all of the portfolio managers. If you think about it, that’s very consistent with the way we think about investing. We think that really great ideas are only recognized by individuals. So, if an analyst presents an idea and it’s immediately embraced by the whole group and seen so easily, it’s likely that won’t be such a great idea. But the way names become large holding is that by repeatedly discussing the idea, portfolio managers become comfortable with the name and gradually introduce it into their respective sleeves. That’s how names become large positions when, over time, multiple managers buy the same name.
Benz: Speaking of large positions, Vanguard Primecap Fund’s top holding is Eli Lilly. It appears that you’ve owned it at least since 1986, which is as far back as our holdings data go. You’ve made good money in it, but in each instance from 1986 until late 2000, and then again from 2002 until now, it took quite a while for the investment to pay off. Can you walk through the lifecycle of your investment in Lilly and why you stuck with it amid prolonged underperformance at times?
Mordecai: Well, it’s nice of you to pick one of our winners. We invested in Eli Lilly in the early 2000s, and this one’s a good example of how the market’s obsession with the short-term caused the stock to be undervalued relative to the long-term potential. The company at that time was undergoing a meaningful patent cliff, namely with Zyprexa and Cymbalta going off patent, and that was depressing near-term earnings. At the same time, the company was investing heavily in R&D, well above the industry average as a percentage of revenues. And because R&D is expense, that also was depressing earnings. So, both of these factors made the stock look expensive on a price/earnings basis compared with their competitors. But we felt the market was missing the long-term potential based on a robust early-stage pipeline of products that were being developed to treat all kinds of unmet needs, including diabetes and metabolic disease, cancer, autoimmune, and neurodegeneration diseases. So, this is a great example of the market being focused on the short term. Depressed earnings due to high R&D spend and upcoming patent expirations, and not on the long term—a rich early-stage pipeline of therapies and clinical trials.
Eli Lilly built strong capabilities and know-how, with its investments in the incretin space, which first yielded Trulicity and later Tirzepatide, which are better known by their brand names of Mounjaro and Zepbound for diabetes and now weight loss, and they also have a drug, a very important drug, for Alzheimer’s. This positioned the company to be in a leadership position when the science in these two large disease states began to break. These investments have now resulted in two of the largest potential revenue opportunities in the history of the industry. But to be honest, it took the patience of Jobe. We believed Lilly’s beta amyloid thesis for Alzheimer’s—are you ready for this?—going all the way back to 2010, and the first phase 3 failure occurred in 2012. So, it will have taken 12 more years to get approval for their Alzheimer’s therapy.
So, to summarize, we stuck with Lilly through periods of underperformance, and also as the stock began to outperform, because we believed the company had a strong management team, a sound strategy, they prioritized R&D investments through good times and challenging times, had prudent capital allocation—especially with respect to business development—and they continued to build know-how and capabilities in areas where they had a high probability of winning.
Ptak: I wanted to stick with Lilly. In last year’s annual report to shareholders, you wrote that—I’m paraphrasing here—that you expect Lilly to quadruple earnings by the end of the decade. I would think that estimate reflects the likeliest of a range of possibilities, some less rosy, maybe focusing on those less optimistic scenarios. What are the biggest competitive or operational risks to Lilly meeting the potential you see for it? And how did you come to conclude those risks were less likely to come to materialize?
Mordecai: This is a great discussion, Jeff. And if you were to sit on one of our morning meetings, this is something that we talk about quite often because it’s such a big position for our firm. So, the less-optimistic scenarios involve mainly the disappointing sales of the diabetes obesity franchise, which we talked about, or if the launch of their Alzheimer’s drug goes poorly. In the metabolic franchise, specifically, the largest risk to a revenue potential, it would include insurance coverage, limiting access to the drug, which we think is small, but possible; the success of Novo, which has a competing drug, and Lilly drawing new competitive entrants. So, we’re already seeing Amgen, Pfizer, AstraZeneca, a few others that are developing drugs, but they’re quite a bit behind. And then probably the biggest one would be some unexpected new safety signal that casts a pall on this class of drugs.
The most important factors in making us feel comfortable with all these risks are the strength of the clinical profile of the drugs and continued R&D progress. The drugs have proven to be transformative in patient lives, and so far, the safety profile of the drugs is similar to what was seen in the clinical trials, with millions of patients now on drug. Lilly has continued to innovate and is leading in the next wave of incretin innovation with its GGG drugs, which are demonstrating now 25% weight loss, and an oral GLP-1. This has the potential to ensure that Lilly will retain dominant share going forward, as well as extending the duration of the franchise past the potential generic pressures out a decade or so from now. In Alzheimer’s, we believe the progress that the existing class of drugs has, so 30% improvement against placebo for a devastating disease, or in a large market opportunity, despite some of the initial controversies. Lilly’s commercial ability to build big markets, as well as their credibility in the Alzheimer’s area, give us confidence that a major revenue opportunity will materialize. In addition, efforts to go earlier in the disease—so they’re going to be moving toward prevention studies—as well as continued R&D and other Alzheimer’s mechanisms, could offer improvements upon these first-generation efforts.
Benz: I wanted to just ask about your position size there. Eli Lilly recently accounted for almost 11% of Vanguard Primecap Fund’s assets. It appears that you’ve been reducing your stake in the shares, but it has run up so much in price that it’s become the largest position the fund has ever taken in a single stock, according to our data. So, can you talk about position management in the context of your Eli Lilly stake? And, more generally, how you decide how much leash to give a name that has rallied as strongly as Lilly has in recent years?
Fried: It’s a great question, Christine, and my answer probably won’t be very satisfying. Like some of my earlier responses, we don’t have an algorithm for it. Each situation needs to be weighed on its own merit. But like most attributes of the fund, what you see is the net result of five independent decision-makers. So, for Lilly to be 11% of assets, it essentially means that the five portfolio managers have independently chosen to hold on average 11% of their assets in Lilly. It’s not a decision that we make as a group. But when people look at Lilly, it’s consistent with what we talked about with respect to Adobe. We evaluate it today in the context of the next five to 10 years, and we see a compelling and unprecedented opportunity, as Al described. I won’t go through the whole thesis as Al did it pretty comprehensively, but to sum it up, we see the weight loss drug opportunity in the U.S. alone, that is, at well in excess of $100 billion, and we believe Lilly will have the majority market share. Additionally, as Al mentioned, the company should have an Alzheimer’s drug on the market this year. It will be one of only two drugs serving a huge currently untreated market. We think this opportunity is in the tens of billions of dollars. So, these two product categories alone, if they pan out, would more than justify the current valuation without any consideration for a very large, broad, and deep portfolio that they have outside of the obesity and Alzheimer’s categories.
Mordecai: To put this into context as to how big those numbers are, Lilly’s current sales run rate is about $30 billion. So, when Joel talks about $100 billion, you’re talking about more than quadrupling the size of the company in terms of sales, and these are products which have incredible gross margins, upward of 90%.
Ptak: If I may, I wanted to ask a more general question about position-sizing and do so in the context of the “Magnificent Seven” stocks. If I’m not mistaken, I think that you own each of the seven stocks in Vanguard Primecap—I could be wrong about that—and I think that you’ve owned them for quite some time, but your recent weighting was about a third of the market. So, can you talk about how your appraisal risk informs position-sizing and why in some of those cases you haven’t sold the names outright? And I do know you’ve been very helpful in pointing out that these are individual manager and sleeve-level decisions, and so that’s going to dictate to a particular degree, but I wasn’t sure if you could go beyond that in explaining your weighting in these seven stocks, which have been so scrutinized, I suppose.
Fried: Absolutely. As you might imagine, Jeff, we’ve had many conversations about the Magnificent Seven. So much of the performance over the last few years has been concentrated in the Magnificent Seven, and so not owning them has been a real handicap to performance. But if you think about the Magnificent Seven today, they comprise 28% of the value of the S&P 500. We’ve never seen that kind of concentration before. We’re talking about seven stocks with a combined market value of greater than $10 trillion and revenues approaching $2 trillion. At some point, the law of large numbers kicks in. We think the market assumes that this group of companies will grow revenues at a compound annual rate of at least 10% over the next five years. This would imply the seven stocks increasing revenue by about a trillion dollars in five years. That’s an extremely high bar in our opinion.
To maintain their current multiples, this would require the market value of the Magnificent Seven increases by more than $5 trillion in five years. Could it happen? Sure. Is it likely? We don’t think so. When companies are this large and this profitable, it inevitably invites competition, especially in technology-based industries. And in our experience, creative destruction is undefeated.
I’ll give you an example that has always stuck with me. It was fairly early in my career. In the early ‘90s, Walmart was the dominant retailer. It offered the lowest prices and the broadest selection of goods. It had massive scale advantages. It parlayed its strength in discount stores, into warehouse stores and grocery stores. It was a classic example of a virtuous cycle. Every growth fund owned the stock. The consensus growth projections of Wall Street analysts, if realized, would have resulted in Walmart owning the majority of retail sales in this country. It was really difficult to imagine how Walmart could be dethroned. Then, out of the blue, came the internet and then came Amazon. Let me be clear. The Magnificent Seven are excellent companies with wide moats, wonderful prospects, and fortresslike balance sheets. But in our view, they’re priced accordingly. As you observe, we continue to own positions in several of these stocks, but our dramatic underweighting reflects our caution.
Benz: I wanted to ask about another position, not a big position, but in Vanguard Primecap Fund, you hold online security firm Splunk. It’s a newer holding and it’s smaller than most of the companies you own. It looks like you initiated your stake in early 2021 and progressively added to it on weakness through late 2022. The firm occupies an interesting niche, but it doesn’t look cheap by traditional valuation measures. Can you talk about what gives you confidence that you’ve bought at a price that affords a decent margin of safety?
Mordecai: Going back to the genesis of this position, this is an example of how we benefit from our access to senior management teams, not only of the company itself like Splunk, but also of companies in a wide range of industries. So, when we met with companies from all sectors, but especially in the financials, we heard again and again how important cybersecurity was going to be and how each of them expected to spend more in the future on cybersecurity. So, it was an area of interest for us for quite some time.
Splunk correlates, captures, and indexes real-time data from which it creates alerts, dashboards, and so on, which are a critical part of cybersecurity and IT operations. We’ve owned Splunk in some of the funds prior to 2021, but it’s true that we only started buying in the Primecap Fund in early 2021. Regarding the weakness that you talked about, Splunk’s financial metrics were noisily distorted for a period of multiple years as it navigated several simultaneous product and business transitions, so the shares did not look inexpensive on those misleading metrics, misleading in our opinion. But the company’s valuation generally looked fair to cheap on our view of normalized, post-transition numbers. We also believe that the persistent bear case around Splunk, share loss to competitors, was incorrect, creating a dislocation in the shares that we could take advantage of. We more than doubled our position in the Primecap Fund in 2022 when the shares declined during that widespread bear market that we had, but when we could see that our thesis was playing out and that the management changes were further bolstering our conviction in Splunk’s product and business execution. So, more recently, Christine, you probably saw on the news, Cisco also came to the long-term conclusion that we did for Splunk and announced plans to acquire the company, I believe it was in September, for $28 billion, and we think the deal will close in the third quarter of this year.
Ptak: I have a couple of more questions for you. One, you own a smattering of stocks that aren’t based in the U.S. Most of your holdings are based here in the U.S., but a few aren’t, and that’s true of your positions, I should say, Vanguard Primecap Fund’s stake in Chinese e-commerce giants Alibaba and Baidu. You don’t do macro. That much is very clear, but sometimes I have to imagine it’s inescapable. These were positions the funds entered in 2014 and 2020, respectively, if I’m not mistaken. How do the thesis then, at those times, compare to the thesis now, and to what extent does it hinge on assumptions about the posture of the Chinese government and regulators toward firms like these?
Mordecai: Our thesis for owning Alibaba and Baidu has evolved over time, Jeff, but its core remains the same. These are two of the most important technology companies in China, and both will play a critical role in China in both the shift to a consumption-driven economy, which is very important to the Chinese, and also the digital transformation, including the use of artificial intelligence to boost the productivity of the country. What has evolved in the thesis is the risk of government regulation, as well as this more recent slowing macroeconomy in China. We acknowledge both of these factors. However, our job is to assess if they’re being discounted in the stock price, and it’s our assessment that they are, and overly so. The S&P 500 is trading at around 20 times earnings, but Alibaba and Baidu are trading at single-digit price/earnings multiples, with both trading at only 5 times earnings ex-cash.
Regarding the Chinese regulation, China has benefited from cheap labor versus other countries for years, in part, due to decades of a one-child policy. They’re going to have a shortage of labor, and labor isn’t as cheap relative to the rest of the world anymore. So, they’ve got to figure out a way to grow the economy internally. Therefore, China is dependent on companies like Alibaba and Baidu to achieve its objectives of strong economic growth and less dependency on other countries.
A couple of things specific to each company. Alibaba has struggled more than we anticipated to maintain its market share in e-commerce in China, but we believe share loss is slowing and that a renewed focus will enable stabilization. The company maintains the leading cloud platform in China, and we believe this will eventually be a much larger and more profitable business. On Baidu, they’ve been investing in artificial intelligence for over a decade. We believe it will be a much larger company as this technology leadership translates into revenue growth in its cloud, robotaxi, smart device, and mobile ecosystem group. And again, to summarize, both of these companies are trading in single-digit price/earnings multiples.
Benz: You’ve become keepers of the culture at Primecap. When you decide your time is up at the firm and you have to prepare the next generation of leaders to take the mantle from you, what is it that you’ll underscore to them about what is most critical to ensuring that they uphold the firm’s culture in the way that you and your partners have?
Fried: It’s a great question, Christine, and an important one. We’re really proud of the culture we’ve created at Primecap. We think it’s unique, and we think it’s a true point of differentiation. It’s not just how we approach investing, it’s how we run the firm, and the tremendous respect we have for the individual. I believe preserving the culture is paramount to the continued success of Primecap. Fortunately, the next generation of leaders already fully embody the Primecap culture. As I mentioned in my opening comments, Al and I have worked with Mohsin and James for over 20 years. The next group of leaders we’ve worked with, on average, about 15 years. They all already live and breathe Primecap. Culturally, we feel pretty confident that Primecap won’t miss a beat when we’re gone. Culturally, that is.
Ptak: Joel and Al, this has been a really interesting discussion. Thanks so much for sharing your time and insights with us. We’ve enjoyed chatting with you.
Fried: It’s our pleasure.
Mordecai: Thank you very much. I want to express again what Joel said at the beginning. We really appreciate Morningstar’s dedication to educating our shareholders. As we mentioned earlier, we don’t usually talk to the press. We make an exception for Morningstar because we feel that your job is not to promote us, but rather to educate our shareholders, which we think is an extraordinarily important function. We want to thank you all and the whole Morningstar team for that.
Benz: Thank you so much. That means a lot to us.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
You can follow us on Twitter @Syouth1, which is S-Y-O-U-T-H and the number 1.
Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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