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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: That’s a key part of our process and of the analysis of each company. When a company commits to paying a dividend, this is perceived as a long-term commitment and signals confidence in the future cash flows of the business. We make sure the company has a comfortable dividend payout ratio, given the underlying fundamentals and the business risk, so a mild downturn would not put the dividend at risk. In our screening process, we look for companies with dividend yield above the market and a healthy level of the dividend payout.

Overall, the absolute dividend yield is less important than that ability to maintain and grow the dividend yield. By investing in fundamentally strong companies with growing revenues and growing market share, we invest in companies that should be able to grow their earnings and cash flow throughout a cycle and, ultimately, grow their dividend as well.

Q: What is your portfolio construction process? How important is diversification?

Diversification plays an important role in portfolio construction. In reality, for every security there is a risk that our expected outcome wouldn’t play out. Other risks are not well known at the time of purchase. Diversification helps to reduce the cumulative risks in the strategy, including the security-specific idiosyncratic risk.

The strategy is diversified by the number of positions and the weight of each position in the portfolio. We are also diversified across industries and sectors as we have exposure to all 11 sectors of the Global Industry Classification Standard.

We use a blended benchmark, which is 60% S&P 500 Index/ 40% Bloomberg Barclays U.S. Aggregate Bond Index. We definitely deviate from the index in terms of sector weights. Our relative sector weights are a function of our bottom-up security selection process and we may have zero exposure to some smaller sectors in certain cases.

We are cognizant of the benchmark in terms of the limits to position sizes and sector weights. In the equity part of the portfolio, because of our focus on income, over time we tend to have an overweight in sectors like financials and be underweight in sectors like technology.

A multi asset class portfolio tends to carry more idiosyncratic risk from equities but is balanced by the availability of fixed income securities. We diversify to reduce some of the idiosyncratic risk. We also take into account interest rate risks, so we diversify across the yield curve and look at duration as a key metric of risk control.

Due to the focus on income, we know that we’ll have more credit risk within the fixed income portfolio. We balance some of that risk with higher duration and high quality components.

Typically, we hold about 30 to 40 individual corporate bonds. That’s adequate to maintain diversification in the broader scope of the portfolio and to get exposure to, in our view, the best ideas in the market.

Q: What is your view on risk? How do you define and manage it?

Risk does have a negative connotation in the equity world. However, in many instances what initially is considered a risk, later develops into an opportunity. The opportunity arises when the risk for a sector to underperform is reflected in the price and the future outlook. Then we can begin hunting for out of favor opportunities that may be approaching a positive inflection in fundamentals.

We view risk multi-dimensionally. At the highest level is the risk for loss of capital and we mitigate that risk by investing in companies, which are not in secular decline, but generate excess cash flow, have experienced management teams and reasonable valuation. In that way we try to mitigate both the fundamental and the valuation risk.

From the perspective of portfolio construction, there are risks at the security, sector, industry, and factor level. We aim to be always aware of the risks we take and to have a reason for being over or underexposed to any type of risk.

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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