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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.”
A: Our contrarian approach doesn’t mean that we are deep value managers who buy beaten-up securities. Instead, we look for companies that fit in the high-quality bucket but may be temporarily out of favor. We look to add value through the length of our outlook, because we are truly long-term investors.

We purchase quality companies at a discount but, at the end of the day, we look for companies with secular growth. That differentiates us from the deep value realm.

Q: How is your research team organized?

We regard ourselves as generalists and the analysts cover a wide variety of industries and sectors. We meet companies across the spectrum in different sectors and industries and we also gather input from competitors and suppliers. Although we have a dedicated team, we also leverage the broader investment team at CIBC Atlantic Trust, which has a lot of experience with companies that have moved through the lifecycle, as well as with suppliers and competitors in the entire market cap spectrum. So, there is utilization of resources throughout the company.

Q: What is your investment approach in the fixed-income market?

We regularly project sector returns, utilizing different asset classes in different parts of the world, and we use that input in our research and portfolio construction. In that process, we incorporate different assumptions, such as analysis of the monetary and credit cycles, including their current stage and direction. As a result, we assign a category, which could be late-stage easing, early-stage easing or late-stage tightening, for example.

The stage of the monetary cycle frames the biases for fixed income risk drivers like duration, yield curve, allocation, credit allocation, and bond structure. Volatility and liquidity are also important components in selecting securities with or without embedded options.

The credit cycle analysis is another important part of our macro process. We build models to project defaults for speculative-grade companies through the credit cycle. We incorporate inputs, which track the quality and the use of supply in the high-yield market. We also track macro indicators that have proven to be predictive of future credit quality. On that basis, we develop an outlook for defaults and compare that outlook against what the market has already discounted.

With these two frameworks, we develop biases within our portfolios, which lead us to tilts in duration, yield curve allocation, and credit exposure. Within those parameters, we apply screens similar to the ones on the equity side, but with focus on risk-adjusted bond valuation. We examine the universe of mid-cap and large-cap issuers of corporate bonds, and up and down the coupon stacks within the securitized markets. We look at all the securities that are fairly priced for the level of risk assigned to them.

We use third-party rating services in the risk process, but we don’t exclusively rely on them. For example, when we look at a corporate credit, we will check the rating from a third party provider, but we’ll also examine the fundamentals, the cash flow, the free cash-to-debt ratio, and a variety of profitability and balance sheet metrics. For publicly traded companies, we look at the implied volatility in the equity market and incorporate it in a risk score for the screening process.

Once we have a list of candidates, we undertake fundamental and traditional cash flow analysis, which helps to determine the ability and the willingness of the company to meet coupon and principal payments going forward.

Q: Would you explain your due diligence process on the equity side?

On the equity side, when we compare two similar companies, free cash flow yields are crucial, but they don’t tell the whole story. Often a company with higher cash flow yield may be a potential value trap.

Within our free cash flow methodology, we make important adjustments to the traditional free cash flow yield. We spend a lot of time analyzing capital expenditures and a company’s use of excess capital. Based on our estimates and the available company guidance, we break down the maintenance and the growth Capex. By separating the two expenditures, we can focus on the maintenance Capex to see how much cash the company really generates before its growth decisions. In other words, we look at the company on a core level and we can compare companies at that level, even if they are in different sectors or have different capital structures.

The second layer of analysis is about how much growth in capital expenditure we expect. While some companies spend a lot on growth, others spend very little and return that capital to shareholders via dividends or buybacks. That’s why looking at straight free cash flow yield can be misleading, while our adjustments enable us to compare apples to apples.

So, attractive valuation is important, but we want to see some level of growth as well. We spend a lot of time analyzing the capital allocation decisions of the managements. We may tolerate lower free cash flow yield if the company has substantial growth prospects and reinvests that capital into the business.

Q: Could you give is some examples that illustrate your approach?

As I mentioned, we make projection for defaults in the high-yield corporate bond market based on quality, supply, use of supply, yield curve shapes, bank loans, surveys, etc. These inputs led us to expect lower defaults in the coming six to 12 months. We recognized that the market for high-yield corporate bonds discounted these lower default rates.

When we evaluated the risk-adjusted or loss-adjusted yield of high-yield against investment grade corporate bonds and dividend-paying equities, we saw a risk-adjusted advantage to improving the credit quality of the portfolio. So we sold some high yield bonds and deployed the proceeds into investment grade bonds and dividend paying stocks.

Q: How do you assess the willingness of the management to pay dividends?

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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