Investing Insights: Here's to 35 More Years

Editor's note: We are presenting Morningstar's Investing Insights podcast here. You can subscribe for free on iTunes.

***

Kunal Kapoor: So, Joe, we're getting together because 35 years ago you had a little idea, and we're gonna talk about how you took that little idea and made it into what Morningstar is today, and Don, we're gonna focus a lot, too, on the research side, and how pivotal that's been because you had such a strong hand in shaping that, and the outcomes that many investors had. So I'm looking forward to this conversation because I think not only does it allow us to reflect, but also to look ahead. So Joe, how did you come up with the name Morningstar?

Joe Mansueto: So, when I was looking to name the company, I remembered a book that I read as a first-year student at the University of Chicago, "Walden," by Thoreau, and I often tell the story of when I first read that. It was my first quarter at U of C, and I read this very powerful book, and the conclusion of "Walden" is very powerful, and I'm wondering, how is Thoreau gonna end this book? And so I'm up on the fourth floor of Regenstein Library at the University of Chicago, and I get to that last line: "The sun is but a morning star," and I still remember reading that line, pausing, putting the book down on my lap, and I look out over the quads, and the snow is falling, it's the end of the quarter, and I think to myself what the hell does that mean? 

I had to think about it for a bit, and, I mean, it's something that's been around as long as the sun. It's still in its infancy. It's about rebirth. It's a very positive statement, but that line stuck with me, and that book meant a lot to me, and it was all about independence, thrift, self-reliance, and those were all great qualities for a company to embody, and so when I was thinking of a name I really liked those qualities, and so the name hearkens back to "Walden," that last line, and it just had a very positive, optimistic sound to it: Morningstar.

Kapoor: They're also great qualities for investors in some ways when you sort of think about that angle.

Mansueto: Yeah, the independence, self-reliance. Think for yourself. March to your own drummer.

And so, from that you also created what is now a ubiquitous logo, and so what's the connection between the naming of Morningstar and the creation of the logo?

Mansueto: Well, after having a company you need a logo, and so I didn't know a lot about design, and so I did research, and I would look at various designers who were out there, talked to a lot of people, and I read a book that really resonated with me. It was by Paul Rand, called "A Designer's Art," and I recommend this book to you if you have not read it, and Paul, as you may know, designed the IBM logo, the old UPS logo with the package, the Westinghouse logo, and he approached design, what I liked about the book, he approached design from a fine arts perspective. A lot of designers came out of, brand identity designers, came out of the marketing/advertising world, and it was more of a trade, but Paul Rand came at it from this fine arts perspective, and so it took me a while to track him down. The first person I called in New York, when I asked how do I get a hold of Paul Rand, said, "Oh, he died a number of years ago," and so I persevered, and I finally found him in Weston, Connecticut, and I called him up and said I admired his work. I wanted to have him design the Morningstar logo, and he was, one-man band, there was no assistant or anything. He just, "Urgh, I'm very busy. "Call me back in a month."

Don Phillips: I died 10 years ago, huh?

Mansueto: Yeah, he didn't mention that. It almost sounded like he was not far away, but he was very gruff, and I thought, this is kind of odd customer service, but I called him back in a few weeks, and I got the same treatment: "Urgh." Then he said, "Send me a letter," and so I wrote him a long letter, how important this company was to me. I admired his work. I really wanted him to create our logo, and I called him back after I sent the letter, and still: "Oh, I'm too busy, too busy." 

Then I said what if I fly out and meet with you? Then he changed 180 degrees, and he later told me that made all the difference, the willingness to fly out. He says he gets calls all the time from people wanting him to design their logos, and he only did a couple projects a year, so he's very selective in who he took on, and so I remember flying out there. 

It was Superbowl Sunday in January, and it was a bitter cold day, and I stayed at the White Plains, New York hotel. The next morning I drove out to Weston, Connecticut, and I spent a wonderful morning with Paul in his home. He had a beautiful home in Weston. Floor-to-ceiling glass facing a wooded lot, and it was snow on the ground, and his wife would come in often and fill up our coffee, and it was a surprising morning. 

I didn't know what he would wanna talk about, but he just wanted to talk about art, and he showed me all the art in his home. Talked about design, what idiots the people at IBM were and how they mismanaged the whole design program there. He designed a logo for Ford that didn't get accepted because the wife of the chairman didn't like it.

But he had amazing anecdotes. He was a great storyteller in addition to design, and so I'm wondering when is he gonna start to ask me about Morningstar? And so, towards the end of the conversation, it was around lunchtime, and he said, "Well, Morningstar, "you've got an M, and an S, and an R, and a T," said, "I'll call you when I finish. "I'll let you know," and I said, OK, that's fantastic. I just have two requests, Paul. The first request is that I want the logo and the name to be one thing, like Coca-Cola. I don't want a mark plus the name. I regret that now, but any case that's what I wanted, and he kind of hemmed and hawed, and said, "OK," and then the second thing I wanna ask you is that you've done all this great work: IBM, all these fantastic companies. You've worked with Steve Jobs with the NeXT logo, and they're all terrific, but this company is really, really important to me, Paul, and I really want you to promise me you'll do your best work ever. 

He kind of growled about that, and so then we're walking out, and he said, "OK, I'll call you when I'm done," and then we're walking out to my car, and I think I should ask him how much is this gonna cost? I have no idea. I'm a scrappy young entrepreneur, so I said, Paul, I hate to ask the great artist, but how much will this cost? And he kind of looked up at me, and he said, "What are your revenues?" I said they're a million dollars. He said, "That'll be 50,000, half up front," and I said, fine, and I knew instantly, you amortize that over a period of time--

Phillips: What a bargain.

Mansueto: What a bargain, and so I fly back to Chicago, and I wait, and I wait, and I wait, and I know from reading his book, A Designer's Art, he gives advice to clients: don't bother the artist. Let the artist work, and so I was hesitant about calling him up, and our head of marketing was saying, hey, we're designing a catalog. We need that identity, and so finally I just couldn't take it. After about six weeks I called him, and I said Paul, how's it coming? He said, "Oh, I'm glad you called, Joe. I've just solved the logo. I've just finished it yesterday. I went down a wrong path. I filled up books with star logos, with Morningstar with a star in it," and he said, "Then I remembered where the name came from: 'The sun is but a morning star,' and so a rising sun, and as soon as I had the rising sun, I got it like that." 

Then, just to wrap up the story, the way he presents his work, you don't go meet with him. He sends you a book, and he kind of walks through kind of where you are currently, and then at the end is a gatefold with the new logo, and it had the logo, and on this book that he hand-made, he put a note on it. He said, Joe, here's my best work ever--with 11 letters, Paul Rand.

Phillips: Why do you regret telling him, or putting that constraint on him that you wanted the word to be the logo?

Mansueto: Well, what I didn't realize, in the digital world that we live in today, a mark separate from the name is very nice to use on, say, a smartphone. When you wanna go small, you think of the Apple logo, just that apple, you can use it digitally in ways that I didn't dream of back then, but it was mainly for the digital world, where if you're on the App Store, just have a little mark is very useful today when it wasn't back then.

Kapoor: That's right, that's right. So, you've got a name, you've got a logo, and now we need to kind of forge our identity a little bit more. So, Don, what came first: the star rating or the Style Box?

Phillips: Oh, the star rating. I mean, the star rating was, Joe had that already in the Mutual Fund Sourcebook, which he'd been putting out for maybe a year and half, two years when I joined. I joined for the first publication that had sort of analysis in it. It was when we moved to the one-page reviews that went into a binder, and so the star rating was already there, and then the Style Box came about as... We were always trying to improve the pages. 

Every time a new issue came out we wanted it to be better than the one it replaced, so we wanted to have new data, we wanted to have new information, we wanted to have analysis on a higher number of the funds each time, so sort of this constant improvement, and I think from the beginning that was one of the things that advisors saw in what we were doing. I mean, they might have looked at what we were doing and said, okay, look, this isn't perfect, and if you look at some of the early issues we put out, half the pages had no analysis on them, over half, but people saw that, well, one, we were really trying, and that we were constantly getting better, and people give you a lot of credit if you do that.

Kapoor: Yeah, yeah, and to me, both of you could just talk about the insights behind the star rating and the Style Box, because they both seem, well, they are iconic in many ways, and yet they're relatively simple insights into how to take complex topics and present them in a way that's digestible to the average investor, advisor, however you think about it.

Mansueto: Yeah, I can start with the rating, and so if you went back to the early '80s, fund companies marketed themselves, really, solely on total return. You open up the newspaper, I've returned 65% over three years, I returned 125% over five years, and it was return, return, return, return. I knew, having gone to business school, about the concept of risk-adjusted returns, so to really evaluate a return you need to understand the risks that were assumed to achieve that return. 

You may have two funds, as you know, that, say, each earned 10% per year over a decade, but one gets there like that, and one gets there in a steady, step-wise progression. Those are two different funds for two different types of investors. They've earned those returns in different ways, and so I thought I really wanted to highlight kind of the risks as well as the return into one measure, and the idea is you want the most return for a unit of risk, so a risk-adjusted return, so I wanted to take all those returns and adjust them for risk, so I made a couple tweaks. One tweak is just load-adjusting the return, so what the investor actually received. So often the return is whatever it is, but you pay a 8.5% load to buy it. At the time, loads were pretty ...

Kapoor: Commission

Phillips: It was common, yeah.

Mansueto: ... were very common, and then the other tweak was on the risk measure. The standard academic way of doing it is volatility, and I thought, well, upside volatility's good. Let's leave that, take that out, and just the downside volatility, the risk of losing money, so load-adjusted on the return, and then the downside volatility measure for the risk, and then I can compute this return for a unit of risk measure, essentially a Sharpe ratio, if you've gone to business school. So it was a tweak on the Sharpe ratio, and then, did that over three, five, and 10 years for the various universes. Then just created a bell curve, and those in the top 10% got five, and etc., and that was really the genesis, but it was the idea of the returns aren't really telling the whole story, and in one measure, just to have a simple rating, and then to use stars to make it more accessible. 

I still remember the first time I saw stars next to a fund name it was jarring because I was used to seeing statistics. Working as an analyst, it was just numbers and charts, but to see stars, which I associated with restaurants or something, next to funds, it looked fun, and it was like, wow, and it just, it was captivating for me.

Kapoor: When did you know that you had connected with people because it resonated in such a meaningful way?

Mansueto: With the rating?

Kapoor: Yeah.

Mansueto: It took a while. I think we had to build credibility, and I give Don and the team of analysts a ton of credit. They built that credibility, having the voice, the analyst team writing about the rating, explaining it. Just putting it out there didn't happen overnight. It's like, who's behind that? There's lots of ratings. We weren't the first rating. Don remembers CDA, other firms would have numerical ratings, magazines rated. There were all kinds of, Forbes had a rating.

Phillips: Bull or bear market ratings, and--

Mansueto: Yeah, there was a lot of ratings, but I think the analyst team really gave it credibility, and the writing about it, explaining it fund by fund, and it really then connected with people, but that took time.

Kapoor: What about the Style Box?

Phillips: Well, that came out of talking to financial planners. It really came from the ICFP retreat in Rhode Island, and I think one of the key things we did there is we were asked to go and present there, so I went out and gave a series of presentations, but I also just hung around and talked to the advisors, and it's amazing--people will tell you the right things to do with your business if you're just smart enough to be quiet and listen to them. I was hanging out with them and hearing about problems they were having, and I remember one advisor in particular saying, "My client is dying to buy a gold fund. We only have one fund in their portfolio," and said, "I can see adding a gold fund, but it should be the seventh or eighth fund that we add, not the second. How to explain that we haven't covered all of the work in the equity space with just one fund?" 

There was a gentleman at the same retreat, Tom Ebright, who worked with Chuck Royce, who was doing a presentation where he talked about a four-box matrix. He said, "You shouldn't just think of equity managers. You should think of large-cap or small-cap, and then you should think of growth or value." It was a very shrewd thing for Tom to do because there were about 2,000 funds out at the time; 1,800 were large-cap, so if he gets you to think large and small he's eliminated the majority of his competition. But then, in the small-cap, the vast majority of small-cap funds were aggressive growth funds, and they were very focused on high growth. There were really only about 20, 25 small value funds, so Tom whittled down his competition from one in 2,000 to one in 20 just by getting you to think this way. 

I took it a little further by adding the blend and the mid-cap, and Tom wrote me a real nice note when it came out. He said, Don, that's a better mousetrap. I think the key thing is that you just, both the star rating and the Style Box took a whole bunch of complex information and made it accessible, and one of the things we settled on is that if you just have a table of numbers you're really only gonna communicate with a very limited audience. I think it's a classic mistake Wall Street makes. They think they're educating people, and what they're really doing is just befuddling them, throwing all these numbers. If you've got a Treynor ratio, and Sharpe ratio, and it goes out to six decimal points, it's really hard to get grounded and understand what you're doing. 

We decided if you have a table of numbers, and you can turn it into a paragraph, you begin to widen the circle a little bit, but if you can turn that paragraph into a picture, that's where you really begin to impact behavior, and you connect with investors, and you get people to behave differently. 

One of the things I've really come to realize over the years is that if you're in the information business or the investment business, we're really in the behavior-modification business: Keeping people from doing the things that sabotage their returns. Both the star rating and the Style Box took a whole bunch of complex information and made it accessible. 

How many people can look at a list of holdings and say, oh, gee, these seem to be more the names a value manager would favor versus a growth manager. For the average investor that was just inside baseball that you just couldn't make sense of. The Style Box, it fit a lot of needs. It helped you understand how two managers might use the same term, but it had slightly different implications. 

Prior to this, you had names in the industry that were very poetic, things like Magellan, or Windsor, or Janus, but you had to be an inside player to know that Janus was a growth-oriented investor and Windsor was value. The ordinary investor couldn't know that they occupied different places in the portfolio, and were actually complementary to each other, perhaps. 

This was a tool that sort of empowered investors and helped them make sense of a lot of different disparate information and take control of it, the same way the star rating did. Before that you had fund companies choosing the time period, and maybe even the methodology that was most favorable to them, and now, all of a sudden, the investor had control over the information, so it was a big power shift, I think.

Kapoor: The other piece that both of you touched on a little bit was just this notion of how investments were advertised and potentially the impact we had on changing the way people thought advertising should work so that it was, I think, more appropriately presented to the investor. But we also had our fair share of run-ins, shall I say, with folks on this side, and you had a famous incident yourself, or infamous, depending on your perspective. Maybe you wanna talk a little bit about that.

Phillips: Well, I wrote a commentary called Lies, Damned Lies, and Mutual Fund Advertisements, and it was based on an advertisement I just thought was very misleading. It was a full-page ad in The Wall Street Journal. It used to run top to bottom, and it said, Has Anything Like This Ever Happened Before? It had five boxes, and it had number one, number two, number three, number four, number five, and at each of them it had a name of one of these different funds from this fund group. 

The reality, what happened, it acted like they had the top five funds in the universe, but they had one fund that was number one in one category; another fund that had three share classes, which made it two, three, and four in a completely separate category; and I think the fifth fund was even a closed-end fund. They had to go outside the U.S., or outside of the open-end universe, to get this. 

I wrote a commentary and pointed out that there isn't a quarter that goes by that Fidelity couldn't construct such an ad with all of their sector funds. If you just said, OK, let's do healthcare funds, or just these small, little slices. So, anyway, the fund company didn't like it. They sued me. It was a big thing in the industry, but fortunately, ultimately we got it kicked out of ... finally someone read it in the California Supreme Court, and they said that the fund company pointed all these things they didn't like about the commentary, but they couldn't point to a single thing that wasn't true. They said truth remains the ultimate defense of libel. 

It was a harrowing year, year and a half. It was a tough time, and they were suing us for much more than the company's revenues, and they were suing me personally on top of that. It's one of those things that what doesn't kill you makes you stronger, and it was a fight that was worth fighting, because after this they made a whole bunch of changes to mutual fund advertising rules. 

The different regulatory organizations came in and they helped clean that up a lot, and so mutual fund advertising got much better. I mean, used to have funds advertised just on the basis of yield with no total return numbers. I mean, you talked about adding risk to return, but sometimes they were sold just on the basis of yield without talking about the risk or the potential erosion of capital that you might get, and some companies, or some funds, you may remember, would return capital to inflate their yield, and then they would include that in the numbers that they advertised or went out and talked about, so the playing field has gotten a lot cleaner, and I think Morningstar was a catalyst for some of those improvements.

Kapoor: That's right.

Mansueto: That's amazing how heavy-handed fund companies can be at times. I mean, we've had companies, as you both know, who've canceled contracts with us because they've not liked what our analyst group had read. I think we all take a lot of pride in knowing we've never wavered, and we'll take lawsuits, we'll take canceling contracts, as long as we believe in what we're saying. If we've made errors in our analysis we'll correct them, but if not, we'll stand by it. I think Don and team were very courageous in kind of fighting those fights for many years.

Phillips: Another angle you could look at that is that the industry, also, in the long run, has been quite responsive. They've addressed the concerns that we've raised, and they've done things, on the whole, that are right for investors, and we've seen improved behavior, so ...

Kapoor: The investor is much better off today than they were 10 or 20 years ago, right?

Phillips: The industry responded in a positive way, and then investors got smarter largely because I think the independent advisors were very demanding. They said treat us like institutions. We want better disclosure. We want to make good decisions on the part of our clients, and that improved behavior throughout the industry. You kind of got this virtuous circle going, and again, we didn't single-handedly cause these, but I think we were part of the trend, and the catalyst for many positive--

Mansueto: I think those fund company behaviors were more the exception than the rule. I mean, I think, most part, fund executives got it. They liked what we were doing and they were supportive. I mean, the case that you just went through, it was a bad actor, and that person was later expelled from the industry, correct? And barred from the industry.

Phillips: But the person was on the ICI's Board of Governors at the time, although someone later told me--

Kapoor: Meaning the Investment Company Institute.

Phillips:Yeah, Investment Company Institute, yeah. Someone later said, well, we did that just to kind of rein that person in. It was better to keep an eye on her than to just let her go off and do whatever she's doing.

Mansueto: It's like having Al Capone in prison so you can keep an eye on him or something.

Kapoor: Joe, I get a lot of questions about one of the legacies you've left me, which is how we operate as a public company. I have to say--

Mansueto: Sorry about that.

Kapoor:I 'm very thankful about it, and I never get tired explaining about it. Why don't you talk about our whole process of coming public: why it was different, and how we do things differently, and why it's so important who we are and how we think investors should engage with any company.

Mansueto: I think we did something a little different there, and it's an interesting story, so when we went public, first of all, we didn't have to go public. We had one outside investor, SoftBank of Japan. We had plenty of money in the bank, no debt, profitable, but SoftBank wanted to exit at one point. They had 20% of our shares, so when we went public we just swapped SoftBank for the public. We didn't raise new capital. 

When we figured out how to, or decided to do that, the next step is how do you go public? And so we started with a traditional underwriter, Morgan Stanley, and doing a traditional what's called book-building process, the traditional IPO. Then, in the middle of it, Google went public, and they used this auction format, and that instantly appealed to us. It really seemed to align with the ethos of Morningstar. It was about transparency, lower cost, equal access. Because traditional IPO process, the so-called book-building process, the underwriter typically allocates shares to their favorite clients. If it's a so-called hot IPO, the small guy doesn't get any allocation. It's the big, institutional investors. 

That never really felt right to us, but once we came across the auction method, it really seemed, again, to fit perfectly with the values of Morningstar. We went to Morgan Stanley. We said, we'll still use you as the underwriter, but we really wanna use this auction format. They said no, and here are 500 reasons why it's a bad idea. They went to all the board members, talked to them all, but we stuck to our guns. We said, no, we really wanna do the auction method. 

They said, well, if you really wanna do that, we're not your underwriter, so we said, OK, you're not our underwriter, and we went to WR Hambrecht out on the West Coast, who was the leader in auction IPOs. They underwrote us, and it worked out remarkably well. We still did a road show, Don and our CFO, Martha Boudos at the time, the three of us spent two weeks traveling around the U.S. and probably 70, 80 meetings with all kinds of investors. 

The interesting part is at the end, the pricing meeting, which is really often a big debate and discussion about how to price the shares, took all of five minutes. Because in an auction it's where supply meets demand, so we wanted to sell 7.5 million shares. That's the supply. The demand curve goes like this, so at a low price there's a lot of demand; at a high price there's little demand. Where those two lines meet, that's the clearing price, so we wanted a price between 17 and 19. Those two lines met at $18.50 is where we could sell the 7.5 million shares. It took five minutes. We went to The Slanted Door, had a nice dinner in San Francisco right after that, and so it all worked remarkably well. There was no pop after the first day, that you sometimes see, which indicates the offering was mispriced, and so it worked like a charm ...

Kapoor: If there was a pop, it would be mispriced.

Mansueto: If there was a pop, I'm sorry, yeah, if there was a pop, it was mispriced. It was very efficient in that instead of charging 7%, which is what Morgan Stanley, it's a bit of a cartel, they all charge 7%. Hambrecht charged us 2%, so we saved 5% on $140 million offering, so that's $7 million we saved SoftBank. The irony is they wanted us to use Morgan Stanley and use the book-building process, but we kind of forced the auction, which they didn't really care for. We saved them a lot of money, but we really wanted to help, maybe, get auctions off to a good start, maybe see them proliferate, because we think it's a better way for investors--this equal access, lower cost, transparent pricing, and so that was the genesis of the auction format.

Kapoor: We don't do earnings estimates. We don't talk to analysts.

Mansueto: Yeah, as you know, we have a lot of different approaches to being a public company, but you're right. We don't do forecasts or guidance. We don't do conference calls. The idea is to keep the management team focused on building the business, creating great products, staying close to our customers, not out catering to Wall Street, trooping around, meeting with institutional shareholders to the detriment of individuals who don't get that same information. Let's get everybody the same information. You can put a question in writing. We answer all the questions once a month, post it on our website, so equal access to information, but keeps the overhead low on management.

Phillips: I remember during the road show there were a lot of money managers trying to get us to change those policies. I remember one in particular saying, my whole spiel to investors is that I really get to know company management really well, and I've got this inside track on what's happening. He goes, I can't tell them that with you because they can see that you only answer my questions the same as you do everyone else's. and he would say, Well then, because of that, I'm not gonna buy your stock, and trying to put pressure on us to change those policies. 

I think that your leadership, saying, no, we're not gonna do this. These are the terms that we're doing this, was really important because you end up with the shareholder base that you deserve. I think we've ended up with a terrific shareholder base of people that, if they're paying attention, they can really get to know the company. Kunal, your new shareholder letter really goes out and explains the philosophy behind this, and that's what you want are long-term partners in the business.

Kapoor: That's right. I often tell other shareholders this very line about getting the shareholder base that you deserve based on the way that you engage with them, so I love the shareholder base that we have, and they've been with us for a long run.

Phillips: The same thing's true in the fund industry. I remember John Templeton said, "Those who get rich very quick are the same one who get poor very quick." You see that with fund companies, that they advertise on yield or short-term performance, they attract the most fickle investors, and then as soon as the performance isn't hot, or the yield sinks, the investors flee. Again, it's do you wanna be in the business for short-term gains or for long-term trends?

Mansueto: I think a nice thing is our behavior internally did not change once we went public in 2005. The way we were before 2005 is the same after 2005. Only life change for our CFO was to comply with all of the SEC guidelines and Sarbanes-Oxley. Other than that I think it's business as usual for everybody. 

I remember, we got a taste, when we did this road show, I remember meeting with Ron Baron and his team. They probably covered 5% of our business in an hour. They had so many questions, and this was one investor, and if you had to do this every quarter, and then, as you say, they turn over the investors, it would take an unusually large amount of time to spend educating one-on-one investors versus doing it for everybody all at once. It's been a very efficient thing, and so it's made being a public company, really a nonevent.

Kapoor: Yeah, yeah, yeah, it's great.

Phillips: One of the disappointments, to me, is that more people haven't followed with the auction process. I mean, Google did it. We did it. There was a little bit of a trend, Google and us. It's just such a good idea, and it'd be wonderful to see more companies embrace this and follow that. I'm glad we did that. It's one of the things that I'm very proud of.

Mansueto: I think the big underwriting firms are very skilled in talking people out of it, and our business is investing, so we understand it more than an average company that's making bricks or whatever. They trust a Goldman Sachs or whoever. You're the expert. Tell me what to do. I don't know Wall Street, but since we're in the investment business, I think we can take a stand moreso than most.

Kapoor: That's right.

Phillips: I guess we saw some of that when we were on the road show. I remember there were some IPO newsletters and stuff, and there were industry insiders saying, oh, there's no interest in this deal. It's not gonna come out. If it prices, it'll price way below the range. We knew that the book was building over the thing, and things were going just fine, but if you just read from the outside, these so-called experts were saying, no, it was gonna flop. You realized that they were being fed that line by some of the traditional interests that didn't want to see this thing work.

Mansueto: That's very true.

Phillips: Morningstar's primarily grown organically, and you describe it as sort of a bootstrap operation in that we've sort of just reinvested heavily throughout the years, but we've also made a number of acquisitions that have really been key to our growth, and can you talk about some of those that really stand out for you, Joe, that were transformative in Morningstar's history?

Mansueto: We've been fortunate to have a very profitable business for many years, and we've chosen to take the bulk of those funds and reinvest them back into the business, either in terms of opportunities that we see for new product creation, ideas that we have, or acquisitions. We've done a fair amount, and the acquisitions we've done, typically we know how to build product, create databases, so it's a build-or-buy decision. If there's a capability, a company, a person, a team, that's on the road map where we're going anyway, if we can buy that capability versus rebuilding it, creating it de novo, it sped us up along the path we wanted to go to anyway. 

When I look back on our history, there are a couple that stand out, I think. When we acquired the S&P international fund business, what used to be called the Micropal business. Standard & Poor's bought a company called Micropal, that was really what Morningstar and Lipper were in the U.S., outside the U.S. We approached S&P about buying that. It was not on their focus area of ratings and indexes. They agreed to sell it to us, and it really gave our international business a real boost, and it really increased the size and scale of that business. That business went from really not making money internationally to being nicely profitable, and gave us scale, a lot of media relationships. 

That went, Kunal, you worked, I know, on that integration, which was not easy, so thank you. That stands out. 

I guess the other one I would mention, I could mention a lot of them, would be Ibbotson, really getting us further into the advice business, the managed-account business. Ibbotson was a real leader in advice, asset allocation advice, principally. That was Roger's core, Roger Ibbotson of Yale, core expertise. He had taken that knowledge, that expertise, and created an investment consulting business, as well as the managed-account business, and those were two businesses that we brought in that increased the capabilities and size, and scope of our institutional consulting and management business. Then our burgeoning 401(k) management business. Then we also got some tremendous people, people like Tom and Zorick are still here. A lot of the former Ibbotson people are still here Those two kind of stand out for me.

Phillips: Kunal, as you became CEO, Morningstar made its biggest acquisition ever, PitchBook, and you had been involved in that for some time. You'd been our board member at PitchBook. I think it's an incredibly gutsy move to make the biggest acquisition just as you're moving into the CEO role. My hat's off to you for having the courage to do that. Could you explain a little of that relationship, and why that's worked so well for Morningstar?

Kapoor: One of the things as, a value investor, that I sometimes have to check myself on is that people never like to sell their businesses at value prices. Don, the reality's like acquisitions are hard to do, our own research, others' research show that they destroy a lot of value. I think we're all like students of that reality, and conservative, appropriately, when it comes to thinking about them. 

I particularly worry with acquisitions just about the impact on our culture, and so I often think about if some firm was to come in to Morningstar, would the culture mesh? I think there were two things that we all agreed upon with PitchBook. One was that the cultures were fantastic and would mesh well together. John had built a really terrific organization, John Gabbert, and one could see exactly that they shared the values of Morningstar. 

The other is, I think, just a simpler insight. We're all investors. We all look and have portfolios, and we look at other investors' portfolios. You referenced looking at what your clients are doing, and the reality is more and more of our wealth management and asset management partners started to say they're investing in private equity and venture cap. When you look at x-raying an entire portfolio, not having that segment seemed like a miss on our part. 

Fast forward to today, and I think it's fair to say that it's gonna move to the mainstream as in private equity and venture cap investing, in probably a way that even we had not anticipated three years ago. I think it's definitely the case of being thoughtful about where the investor portfolio's going, and then being true to your own principles and culture as you bring another organization in. It's not always the case, but those I think are good guiding principles.

Phillips: One of the things that's really excited me the last couple of years is what we've done around ESG and sustainability. It reminds me of the the early days of Morningstar, where we're really changing behavior, and people get excited about this, and there's a passion and energy, and the creativity to what we're doing in this area. 

Can you speak a little, I think, Joe, you maybe were a catalyst for starting this when you went to a conference that we hosted in Amsterdam. I think you saw some of the royalty of Amsterdam get up and talk about this, and it seemed like that sort of was a catalyst for your enthusiastic support of this.

Mansueto: I remember that conference, and I spent some time with Queen Maxima, I believe her name is, of the Netherlands, a really remarkable woman. One of her passions was financial inclusion. How do you get people who don't even have bank accounts into the financial system? 

They've done some really remarkable work in Africa and just getting more people who can partake in the financial markets, whether it's just banking services, or ideally becoming investors, and getting more people to take advantage of that, and that was a spark. A lot of other people, Steven Smit and others, have done a lot of phenomenal work. 

The idea of people wanna align their investments with their values. Do you wanna invest in a tobacco company, or an arms manufacturer, or a company that's harming the environment in some way? That's very important, especially to younger people. I sound like an old person, but they're important to me, too, but millennials, especially, wanna invest along with their values. It's a wonderful trend in that people are thinking like owners. I'm not just delegating, but I'm owning a piece of a company, and do I wanna be in this business? It's creating that owner mindset, and it's really wonderful to see. 

I know personally I don't really wanna own a tobacco company. I wouldn't feel good about rooting that company on to sell more cigarettes and getting more people to use tobacco products., I totally understand that you wanna invest according to your values, and ask yourself what business do you wanna be in? You are an owner, and so it's a very powerful trend. 

We're in a unique spot to really bring some transparency and visibility to how your assets are invested, when otherwise it's very opaque to really understand a portfolio, what these companies do, how much exposure. I may have initially greenlit, but there's a big team of people, and credit to Kunal, and everybody who's been involved in this effort, because it's just, I think, really resonated with advisors and their end investors in a very large way.

Phillips: Really, since we keep with the sort of themes we've been talking about at Morningstar, about helping people make informed decisions. You're not telling what to do, but helping them understand what they're doing and the impact. 

Kunal, you've really made this, brought this right to the core of Morningstar, and made this very central to what we're doing. Why have you done that? Why is that important to you?

Kapoor: I think there's a few things. One thing maybe that we haven't talked a ton about is just the entrepreneurial spirit that we value within Morningstar, and part of the story is that an individual within Morningstar, Steven Smit, really was the spark behind this, and kind of drove it. We love when individuals or teams can just bring an idea and drive it because they have a passion for it, and see things before others see it. I would say Steven saw this in ways that everyone else in the organization is only now coming along and appreciating, and so that was ...

Phillips: Didn't Buffett have the one-question job interview: Are you a fanatic?

Kapoor: Yeah, exactly.

Phillips: Steven was a fanatic about this.

Kapoor: He was. He still is a fanatic, but there's a couple other things that I'd point to that I think are important. Joe told a story at the outset about risk being something that, when Morningstar started was maybe not in the mainstream. Today, when you're building a portfolio, people don't even think about whether risk is incorporated or not because the assumption is that it is. 

I think 10 years from now ESG's gonna be very similar in that it'll just become a natural part of the way a portfolio's built, because I think we're entering this age of portfolio-ization, where technology's enabling, really, anyone to build a portfolio in a manner that's unique and resonant with them. Particularly what I like about it is chapter 1.0 of this movement, which was called SRI, or socially responsible investing, was all about exclusion. You don't like the gun manufacturer, so you could leave it out, or you don't like a company that's polluting, so you could leave it out. You don't like a company that's doing something in healthcare, you could leave it out. This, as an ESG, is all about inclusion. What is your view of the future, and as an investor, how do you wanna think about it? 

Our recently launched carbon index is, for example, most people, when they first hear about them, assume it's about leaving out companies that, say, are polluting. That's not really what it's about. It's simply about the fact that if you have a view that we are transitioning to a low-carbon world, what are the companies best positioned to thrive in that world? And guess what? That includes companies in the oil patch. It's really about inclusion, and reflecting views, and trying to make a portfolio more personal and more resonant, and hopefully, one that leads to outperformance because of a view that you have It's a form of active management if you think about it in that way.

Phillips: It's great that we're giving this information to investors, but sometimes we, as you mentioned earlier, we step on some toes and upset some people, and we had an issue recently. We do a global fund investor experience, grade what's the situation like in different countries around the world for investors. We gave a poor mark to the Indian fund industry in terms of their expenses, which caused a bit of a rebellion in that market. In fact, a number of fund managers are threatening to boycott our conference. You were there for that conference. What was that situation like, and what's it like being the CEO of the company when you have to defend your analysts?

Kapoor: I think it's easy to defend our values. I think that's very clear. I think we've always said when you go into business with us you're going into business with our values. I think that's clear and obvious. 

I do think, though, that as we grow in other parts of the world where the investing culture is more nascent, where investors maybe have not had the victories that they've had here in the U.S. and elsewhere, those chapters are being written. 

I still remember the day I got the call from the head of our business in India, and candidly, I think he was nervous. They had never experienced anything like this, and in the social media age it kind of became personal. There were formal attacks over social media, personally at him and others on our team. I still remember saying, well, it's really fine. You should stand your ground. 

I think just those simple words gave them a lot of confidence because just as you said, my first question was, is the data correct? And the answer was absolutely. Well, if the data's correct then stand your ground. It was hard, and even when I went to India with Jeff Ptak, who leads our manager research, we met with folks who were upset. We heard them out, but nobody ever said, just like in your example, that what you're saying is factually incorrect or untrue. 

The beauty of it was financial advisers showed up in droves, and so we had our largest conference in India last year. As if for further validation, fees in India are actually a little bit more regulated than they are in other parts of the world, and so the regulator in India essentially caused everyone to push their fees down as a result of our report. I'd say that there's still some hard feelings, and I think that's the nature of it, but the investor won, and that's where we wanna be.

Phillips: It's interesting when you get whole organizations sort of clamoring together and working against you. We've had similar situations in New Zealand and Canada. One of the things, or the question I remember posing to one of those entities was are you defending your industry's worst qualities or are you advancing their best ones? And this woman said, when you put it that way I kind of look at it a little differently.

Kapoor: Sometimes the reality is it takes longer to win when you're independent, when you take a pro-investor view. It's easy to cut corners and try to be short-term profit-minded. I think even around the world it's not just organizations at Morningstar that have won in our business, it's firms that have generally done the right thing, right. If you look at the firms that you admire around the world in our business, it maybe took them longer to get to where they are, but they get to a place where people understand their value, and then they just take off. It's no wonder that some of the largest asset managers today are the ones that had lower fees, a long-term view of things, great disclosure practices. They've won, and I think that that's a good lesson.

Phillips: Ultimate, if the investor doesn't win ...

Kapoor: Yeah, transparency wins.

Phillips: no one wins.

Kapoor: Yeah.

Mansueto: Even though that was very difficult in India, I would suspect that that'll go a very long way in building our brand and reputation in India. Once you take a hard stand like that, and advisors, investors, individuals see us taking all that fire, and we're sticking to our guns, it builds such credibility and such trust. 

I think that's how we've built trust over 35 years is those kinds of situations, and it's not done for that purpose. It's done to do the right thing. I think the end result is it creates this unusually strong brand and reputation, integrity, and in this age, where people compromise all over the place in life, it just stands apart in a very shining example kind of way. Credit to you for making that stand.

Phillips: It's about gaining respect, not about winning friendship or cooperation, near-term cooperation. It's are you, in the long term, earning the respect of the people that you're doing business with? 

One of the things that I remember, a number of fund firms that we had issues with in the early days, they didn't like things that we wrote, as some of these executives started having kids going to college and then graduating from college. They started recommending them to work at Morningstar. They'd call me up and say, "Don, my daughter, she's real idealist, and she's really super smart, and I couldn't think of a better place for her to be than Morningstar." 

I'm like, you used to hate us. You used to call me up and tell me how wrong we were about all these issues. They're like, Yeah, yeah, yeah, but for my daughter I want the best, so that was one of the things where you knew we'd kind of earned some respect.

Kapoor: It's true, it's true, and we have a lot of fights, still on our hands on behalf of investors. The big one that I think about now, I think in many ways on investment data we've come a long way, but I think investor data is the next big frontier. We're all, today, awash in data, and we're all sharing lots of data, and so different firms have loads of access to investor data, to financial transactions. 

How firms deal with that data is gonna be very important, so we've taken a very strong stand on privacy that we're only gonna share data that the investor or the advisor has asked us to share, and that the investor is the owner of their own data. Whereas other firms are choosing to monetize this data in ways that I think ultimately most people are gonna say they're uncomfortable with. I think the next generation of transparency's really gonna extend to personal data and how that's actually ultimately used to help investors. I'm not sure that most firms in the space are actually thinking about helping investors per se, as opposed to finding a path to profitability.

Phillips: I like that. It's the other side of the coin. It's sort of investors' rights. For a long time we've talked about investor's right to know certain things about their investments, but this is also the investor's right to protect certain things about their own information.

Kapoor: Yes, exactly.

Mansueto: That's very analogous to the trouble Facebook got into taking people's data. They thought it was entrusted to Facebook, and here they sell it, and expose very private information. I think having that same high ground that, say, maybe Apple is doing in the tech sphere, in our sphere of really protecting people's rights is the absolute right thing to do. I feel really good, and I think that just really jibes with the ethos of Morningstar.

Phillips: Goes back to that long-term view of the sun being but a morning star.

Kapoor: That's right.

Mansueto: Last year we took a big step. We launched our own family of mutual funds, which I believe surprised many people. Is it the referee becoming the player? You wouldn't think a rater of funds would have its own family of funds. I know we have very good reasons for doing that, but do you wanna talk about that? I think it did surprise some people, and why would we launch our own family of funds?

Kapoor: I think probably the untold part of that story is it took us a decade to figure out exactly how to do it, because we certainly wanted to take it very seriously. It's been a long and I think thoughtful path there. I think it actually mirrors the way financial advisors have changed the way they work with us. There used to be a time where financial advisors solely wanted to build portfolios themselves. We wanted to help them do that, and so it was our data, our software, our research that helped them build portfolios. 

As advisors have grown larger, gotten more clients, are managing more money, doing more activities for clients, they've increasingly asked to start to outsource the investment management piece. When we first got into investment management, I think around 2001 or so, in terms of building portfolios for advisors, we essentially started to use third-party funds. 

As our offering has grown, though, we've wanted to, obviously, lower the cost, and one of the challenges when you're using third-party funds is that there are a lot of embedded expenses in there related to distribution costs, for example, that we just don't use and take advantage of. So essentially investors in our portfolios were paying a tax that they didn't need. The way to eliminate that was to simply move that layer away. 

We've launched our funds essentially to lower costs, and that's exactly what's happened by a meaningful amount. I'm really proud of what we've done, because we've done it with a really independent board. More than 75% of the board is independent. Our chairperson is independent. If you'll look at the disclosures, they are as good as any. We actually explain what custodial fees are and what we're paying there, which may sound a little esoteric, but surprisingly it's esoteric, which is why people don't disclose it, but it's meaningful. We've gone even further in terms of disclosing how we use people's data, and even sent a notice recently to all investors explaining how their data is used and our privacy standards. 

We're gonna do this in a way that embodies our values and embodies the way that we think funds should be built the right way. We've got a lot of inspiration, both from our values and the ways others have done it. I think we're gonna really make a lot of advisors and their clients very happy.

Mansueto: So, these funds power manage portfolios, they can lower the costs, but we don't sell these funds outside of managed portfolios.

Kapoor: We don't. We think they're best presented in a portfolio, so as opposed to selling them on a standalone basis. We're really trying to think about investing on behalf of others in a goal-based, outcome-based way. One of our specialties, you referenced Ibbotson, the roots of all of that is around portfolio-building, asset allocation. That's another one of our strengths beyond manager selection in and of itself.

Phillips: I think kind of like a next phase of Morningstar. Morningstar started, people bought bad funds. I mean, John Rekenthaler's done some research into this, but money was almost as likely to go into a very expensive fund as an inexpensive fund, or one with mediocre performance, or versus good performance. Today that's not the case at all. Almost all of the money goes into the least expensive funds and the better performing funds. 

I think that's one of the things that Morningstar shining a light on this industry has helped do, is that money doesn't go to bad funds anymore, but people still assemble poor portfolios. They buy what they wish they'd bought three years ago, and they end up with portfolios that don't really have the diversification, that aren't forward-looking. To me that's the cutting edge, and it's where Morningstar's going is how can you help advisors and help clients get into portfolios that better meet their goals and objectives?

Kapoor: People have the right intentions, but they're not getting the right outcomes, and we wanna make sure that that last mile is as successful as the journey to it.

Mansueto: We've already talked a bit about PitchBook, a big acquisition for us. Do you wanna talk more generally about the convergence of public and private markets? Companies, obviously, are staying private much longer; Uber, well it's about to go public, but Airbnb, there's a whole host of unicorns. Staying private doesn't have the same, maybe, stigma for some venture-backed companies that it had a long time ago, and they're seeing more and more benefits to staying private. Now we're covering both private, public, they're coming together. You wanna talk a little about that?

Kapoor: One of the benefits being that they can get a better valuation in the private markets, as recent examples have shown. 

I think the reality is that capital is arriving, in the U.S. in particular, in different ways and from different sources. It has given rise to an age of fantastic innovation, and much of that innovation has taken place in the private world, where you have companies building businesses overnight almost, it seems, and they become household names in ways that we have not seen before. Those are the headlines, but I also think that there's a story that a lot of public companies are often being taken private so that they can be retooled, made stronger, perhaps be run more efficiently, and then being brought public again. 

I think that line is kind of blurred between what's a public company and what's a private company, and if you're an investor, used to be you might be able to open up a Morningstar report and you could look at 15 years of history, and see what had happened to a company over that time. I know that's how Joe spent his weekends.

Mansueto: True.

Kapoor: In some ways it's harder to tell that story now because companies have different life cycles that they go through, and one of the things I hope we're gonna be able to do is actually connect that. If you've seen some of our recent research on some of the companies coming public, say, in the ride-sharing space, we're starting to do that, and tell this comprehensive story. Who knows--the company may be private, it may go public, and may go private again, and have many avatars in that way. 

I wanna make sure Morningstar can position the investor for success by telling the investor that full story. Otherwise the picture is incomplete. In my mind we're shining a light and kind of making that path clearer. I would just say, Joe, that as much as we've put a bright light on the public markets, and successfully done that, we're only starting our work now on the private side, and starting to look into how companies are built, how they're funded, how returns are reported. It's a unregulated space, no one's really rocked the boat there. I think we're definitely going to be very thoughtful about making sure that investors are winning in that space as well.

Mansueto: That's pretty cool. Right now we can track the whole life cycle of a company from the seed round, angel investing, venture-backed, IPO, public, then as you say, maybe back to private again, back to public. We have that whole arc. I don't know anyone who's doing it in a fundamental research way like we are.

Phillips: Even if there are times when you can't invest in that company, it has an impact on its industry and the other players that are in that, so if you wanna be an informed investor you really need to know what's happening behind the door sometimes.

Kapoor: If you wanna think about autonomous cars, and the impact on Ford, and Fiat Chrysler, and GM, you're gonna look at the private set, so not just Tesla.

Mansueto: That's great. It's brought a whole new audience to Morningstar, the people who invest in that are typically not the audience we've addressed, so it brings a whole separate sphere of investors into the fold, which is great.

Kapoor: Thank you both for joining me today. I never get tired of listening to both of you. I think so much of an organization's history, and the stories are so critical to its future. I think we should all be memorializing all the good things we've done and take inspiration from them, because they have such a big part in our future as well. Thank you both.

Mansueto: Sure. It's one of our favorite topics to talk about.

Kapoor: Let's not do this in 35 years again. Let's do it sooner.

Mansueto: Any time.