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Quality, Cash Flow and Relative Value for Income
Author: Darlington Musarurwa
Last Update: May 24, 1:47 PM EDT

In an environment of extremely low interest rates, income becomes a key component of total return. The CIBC Atlantic Trust Income Opportunities Strategy balances a portfolio of dividend paying equities, fixed income, and non-traditional hybrid securities of debt and equity. With a disciplined approach towards valuation, portfolio managers Brant Houston and Gary Pzegeo look for quality companies with predictable cash flow.
“Clients and investors were searching for more income and we felt that income was going to be a key component of total return for a long time.”
Q: What is the history and objective of the strategy?

The CIBC Atlantic Trust Income Opportunities Strategy, launched in March 2012, is a multi-asset-class income investing strategy. We invest in both debt and equity, aiming to find attractive opportunities in income producing securities. The objective of the strategy is to generate high level of current income and long-term capital appreciation.

The strategy was established not only because of the expertise of CIBC Atlantic Trust in both equity and fixed income, but also because of the period of extremely low interest rates. Clients and investors were searching for more income and we felt that income was going to be a key component of total return for a long time.

On the equity side, we focus on dividend-paying stocks. We carefully balance the absolute level of dividend yield with the ability of the company to sustain and grow that dividend over time. In other words, we would trade high dividend yield for dividend growth.

The nature of dividend investing implies owning more mature, moderate-growth companies, which generate cash flow in excess of their needs for funding growth. Within such strategies, equities exhibit less growth than the S&P 500. We don’t expect the equity part to outperform a robust bull market, but we invest in historically high quality, mature companies with high returns on invested capital, high margins, strong cash generation and market leading positions. Many of our positions are defensive in nature and provide downside mitigation.

On the fixed income side, we cycle in and out of different sectors based on our outlook and valuation. The fixed income component looks across the yield curve. Within the U.S. markets, we also invest in higher-income securities when that’s appropriate.

Q: What is the basis for your allocation decisions?

We view the capital markets in three broad categories. The first category is equity, which can range between 30% and 70% of the portfolio. The second category is traditional fixed income, which can also receive an allocation of 30% to 70%. We’ve called the third basket non-traditional income, which includes hybrids of the first two categories, like preferred stocks.

The investments in the third category exhibit characteristics of both debt and equity. They can be more rate sensitive than equities, but will certainly have the cash-flow dependencies of dividend-paying stocks. In that category, we may include certain types of fixed income that are less sensitive to interest rates, such as floating rate debt and bank loans. We may include option strategies that may generate income. This third basket, the non- traditional income sector, we feel is our main differentiator in the broad category of balanced strategies.

We make allocation decisions based on the macro inputs of our internal asset allocation committee, but we also look up and down the capital structure of specific issuers to decide on relative value. We consider specific companies both from the bond and equity perspective to analyze the relative value of their securities.

We may like the fundamental nature of their business but may differ on the relative value of parts of the capital structure. So, there’s a micro component as well. Before we include an investment in our portfolio, we evaluate the debt and the equity of the issuer within the scope of investments.

Q: What core principles guide your investment philosophy?

We believe that high-quality companies with above-average, sustainable cash flow characteristics should outperform the broad market over a full market cycle. That’s why we focus on cash flow on the equity side. Our core belief is that cash flow and quality are the most important investment components. For us, the ideal candidates are strong companies with sustainable recurring cash flows and which have exhibited at least a modest level of growth.

We view equity as a function of the future cash flow of a company and a function of the market’s confidence in the growth of that cash flow. We focus on companies with high recurring revenues and stable to expanding margins, because we believe that this approach lowers the risk for a dramatic change in the company’s fundamentals.

Our focus on cash flow is also reflected in the valuations. We buy reasonably priced companies and our valuation discipline helps to mitigate valuation risk. We have a disciplined approach towards valuation and a contrarian approach when entering and exiting positions. We closely monitor our holdings and we exit companies when valuations become too rich and when the likelihood of achieving our total return expectations diminishes.

Cash flow and quality are the two drivers both on the equity side and on individual corporate bonds. Regarding fixed income, our investment philosophy is consistent with equities. There may be different opinions on the same company in different parts of the capital structure, but that is rarely connected to cash flow as part of the assessment. If a company is a good cash flow generator, that’s certainly positive from the bond standpoint as well.

Q: What is your investment process? How do you generate ideas?

On the equity side, we generate ideas through screens, attending industry conferences, meeting with analysts and company managements. We cast a wide net to generate ideas. We use our quality filter on the investable universe and narrow it down to several hundred companies that fit our quality requirements.

Once we’ve narrowed down the universe through our quality filter and after we have identified the quality names, we do valuation work and examine metrics based on free cash flow. At that point, we often meet with management teams and do further research. If the valuation isn’t currently attractive, then we will wait for a better entry point. In certain cases, we may watch a company for years before we actually invest in it.

Q: Could you explain the contrarian part of your investment strategy?

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Sources: Data collected by 123jump.com and Ticker.com from company press releases, filings and corporate websites. Market data: BATS Exchange. Inc