Capital Appreciation through Quality and Diversification
Value Line Capital Appreciation Fund
Cindy Starke, Liane Rosenberg
Author: Ticker Magazine
Last Update: Mar 23, 4:25 PM EDT
|Seeking capital appreciation and income, the Value Line Capital Appreciation Fund is an asset allocation fund that at year end 2017 was 85% invested in equities and 15% in bonds and cash. For equities, the fund mainly looks to own leading growth businesses with secular growth drivers, unique market positioning and competitive advantages. On the fixed-income side, the fund focuses on income, liquidity, and improving credit metrics. For portfolio managers Cindy Starke and Liane Rosenberg, the ultimate goal is to achieve a diversified portfolio that emphasizes the best return-generating ideas.
ďWith equities, our goal is to create superior longer-term capital appreciation for investors through longer-term ownership in a diverse group of leading growth companies. On the fixed income side, it is about relative value and enhancing investment income.Ē
We like to own stocks for the long term, but we constantly pay attention to fundamentals potential and competitive threats. When a business becomes unsustainable, we would typically see a slowdown in the sales or earnings growth rate and a deterioration in margins.
In GrubHub, we see a business thatís fast growing and continues to gain strength through innovative new partnerships, acquisitions, and scale This market will never be as big as Facebookís but it still is very large with an estimated $200 billion spent by consumers on takeout.. With over 50% market share, GRUB has a lot of room for future growth with 2017 gross food sales coming in just under $4 billion dollars. Although the stock has been volatile, the company is producing strong results. The management team has shown forward thinking and we are encouraged by their recent moves and decisions.
Q: Could you give us an example of a bond holding?
When we started looking at XL Group Ltd, the global insurance and re-insurance company, we saw that it hit a very rough patch around 2008, like many in the industry, due to an aggressive investment style. A new chairman, Mike McGavick, came in and started to restructure. While the stock had been beaten up, the company had a well diversified product line and a global presence. They had seasoned managers in both the insurance and the investment businesses. The new chairman was able to leverage the many strengths that were in place while leading to solid performance for the XL bondholders.
This has been a very long-term holding for us. After it acquired Catlin Group several years ago, the size of the combined entity substantially increased. The company was better able to compete with some of the larger industry players. The most recent development was the purchase of XL by AXA, giving the bondholder another win as the bonds tightened on the news.
Q: What is your portfolio construction process?
On the equity side, we have a bottom-up portfolio construction process. Our benchmark is the S&P 500 Index. For the overall portfolio, we use a blended benchmark, which is the 60/40 (S&P 500/ Bloomberg Barclays US Aggregate Bond Index).
We own a diversified portfolio of approximately 60 companies. We feel this gives us adequate diversification and at the same time allows us to build a Fund that can outperform the Index and our peers. The Fundís positions are not equally weighted, and instead are sized based on what we view as the likely risk and return of each company. With that, our biggest position recently was around 5% and the average position size typically ranges from 1% to 3%. Recently, we had roughly 30% of the Fund invested in our top ten positions. Our strategy is to focus on the best ideas that we hold, but also to maintain a diversified portfolio.
We canít own more than 25% in any industry and we tend to be overweight or underweight the Index in different sectors. Since our process is fundamentally driven, as we look for businesses with the best prospects for longer-term sales and earnings growth, we tend to have higher exposure to sectors like consumer discretionary, healthcare and information technology. On the other hand, we will be out certain sectors where we donít find any worthy longer-term growth opportunities. For instance at the end of 2017, the fund was not invested in materials, utilities and telecom services.
On the fixed-income side, we start with the index. Our exposure to U.S. Treasuries is about 17%, which is a significant underweight relative to the benchmark. We have a similar overweight in corporate bonds. Our exposure in the securitized sector is neutral vs. the Index.
We view setting the Fundís risk appetite as a starting point, which includes both interest rate and credit risk. Once we establish the sector exposure, we start looking for individual credits and we set a duration target relative to the index. In general, we donít deviate more than six months from the index duration in either direction.
Last year we had large exposure to energy, particularly refiners and exploration, and that did well for us. We were heavily invested in BBBs, but are moving towards higher quality in 2018, as spread widening has been more pronounced in the lower-quality names.
Q: How do you define and manage risk?
We believe that the best way to reduce risk is to own a diversified, yet focused portfolio of high-quality and fast-growing companies for the long term. We know our companies well and focus on understanding where their businesses are going in the long run. If a companyís business fundamentals deteriorate, we will sell it, but if their growth prospects remain attractive, we will remain invested.
Another way we control risk is by owning companies with business models that we understand. We find itís a lot easier to understand companies with secular growth drivers than the very cyclical ones, because there are many factors the companies cannot control and we cannot predict. Through our fundamental research process, we make sure to understand the downside and upside potential of every stock we own.
Another element is right sizing the positions based on the risks and opportunities we see. Companies with the best risk/return are usually at the top of the portfolio, while those that may be growing faster but present higher risk, would be smaller positions in the Fund.
Our portfolio is diversified through an assortment of unique and strong businesses. With roughly 60 holdings, we have built a diversified fund, which tends to be less risky because of its large-cap and high-quality bias. Overall, risk control on the equity side comes from selecting companies with secular growth drivers, strong balance sheets, good management team and positions that do not depend strongly on the economic environment.
In the fixed-income universe, we favor large liquid issues, or benchmark issues, to mitigate the liquidity risk. We donít own a lot of private placements because of the execution risk. We focus on credit risk and look for diversification within the credits. We analyze each credit to see how shareholder friendly this company has been. We wait for better entry points in terms of spreads.
Interest rate risk is harder to control within a fund. We donít ĒhugĒ the benchmark, but we also donít stray too far away from it. So, the key risk controls in fixed income are maintaining liquidity, monitoring credit metrics, and watching the spreads or relative value.
The worst-case scenario, of course, is the loss of capital. Since we donít buy the lowest rated high-yield bonds that are more likely to go bankrupt, loss of capital is a small risk for us. We are concerned more about underperformance, which would happen if our bonds widen more than the bonds in the index or the bonds of our peers. Our goal is strong steady performance relative to our Index and to our peers.
Q: What lessons did you learn from the financial crisis of 2008-2009?
If there was a lesson to be learned, it was about the value of liquidity. We own fixed-income issues that tend to be large public benchmark issues. Theyíre generally more liquid than some older issues with fewer bonds outstanding or those that are private placements.
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