A Fundamental Approach to Relative Value
First Investors Total Return Fund
Rajeev Sharma, Sean Reidy
Author: Ticker Magazine
Last Update: Jun 04, 8:35 AM EDT
|One of the core advantages of balanced portfolios is their ability to capture the upside and protect the downside, adjusting the allocation between equity and fixed-income holdings in a timely fashion. Rajeev Sharma and Sean Reidy, portfolio managers of the First Investors Total Return Fund, complement this flexibility with a steady focus on company balance sheets and relative value, with the objective to achieve long-term total return with a moderate level of investment risk.
ďWith our ability to adjust the portfolio allocations based on the latest valuations, we have the opportunity to capture the upside when markets are going strong and, when things start to get scary, to offer investors downside protection.Ē
Q: Could you also give us an example on the equity side?
A relatively new name in the portfolio is Schneider National, a provider of truckload, intermodal and logistics services. We found it attractive for several reasons. First, the initial public offering was priced at a discounted valuation to existing trucking names. Second, due to a new industry regulation concerning electronic logging devices, the service was limited in its hours of operation. As a result, some companies were struggling and a number of the smaller, mom-and-pop carriers unfortunately went out of business. With the recent disruptions of hurricanes and FEMAís need for trucks to support relief efforts, thereís been a huge spike in shipping costs.
Schneider has its own in-house platform, which gives it a competitive advantage in terms of pricing. It doesnít need much capital expenditure at this time which means better earnings and cash flow for the firm. It also is not overly leveraged and takes advantage of pricing in the marketplace. Since there has not been much new capacity in this market, the company is still selling at a discount to its competitors.
With that background, we found the valuation, the earnings and the sustainable, long-term thesis to be very appealing. Schneider is actually a bigger player in the spot market and has a degree of pricing power. Before it went public, it was the largest independent private shipper. Pricing power still remains high and a number of the staples companies have shared that their shipping costs are rising.
It is important to note that we look more closely at earnings growth than to earnings multiples, because if we know that earnings will grow, we think the firmís multiple will take care of itself over time. Once most analysts recognize that a company is growing its earnings at 15% or 20% annually, they will assign the correct multiple. So, we donít try to guess the future multiple, but we try to calculate the earnings and the right valuation.
Q: Do you set price targets in the process?
Analysts set a 12-month price target on a stock but the portfolio manager aims to see the potential valuation over the longer term. We look at a companyís valuation from different perspectives. If we view a company as a potential leverages buyout target, we estimate the price if the company were to go private or if there was a strategic acquisition. Although our multiples are based on earnings and cash flow, we analyze each company from different angles to avoid the mistake of selling our winners too early.
We need to keep in perspective the company outlook in two or three years if the current earnings and cash flow trends continue. Would it buy large or smaller-sized competitors that excess cash? In our disciplined approach, we go through that process each time to determine valuations in the short and long term.
Q: What is your portfolio construction process?
We try to build an equity portfolio that is as broadly diversified as possible, seeking value in every sector of the market. The Fund typically holds between 120 and 130 issuers.
Our largest positions tend to be companies that, in our opinion, are selling at the biggest discounts to their intrinsic values because these are the issuers with the most upside and alpha generation potential combined with the most limited downside. Over time, as the valuation gap shrinks and these names start to realize their full value, our sell discipline kicks in and we reduce risk by selling the names that are closer to full value.
For the fixed-income portfolio, the diversity of the asset classes is important, but we are diversified even within our asset classes. For example, we can buy different levels of coupons within the mortgage-backed securities allocation. Within the corporate bond allocation, by investing across different sectors and subsectors, we are able to avoid concentration risk. Traditionally, the biggest risks for fixed-income securities are interest rate and credit risks, but even within credit risk, itís important to avoid concentration. The Fund has roughly 200 names in fixed income, and security selection is extremely important.
For the equities, the benchmark is the S&P 500 Index, while for fixed income itís the Bank of America Merrill Lynch U.S. Corporate, Government and Mortgage Index.
Q: How important is a companyís dividend-paying ability on the equity side?
Itís a key part of the process because the added return of dividends is essential for outperforming the market over time. We focus on companies that generate cash above their needs to run their businesses. These are firms that obtain the best capital allocation from management. We want to see an alignment of company management and shareholders r that can be evident through either stock buybacks or by growing the companyís dividend.
We favor companies that can calculate the best returns on their own invested capital. It could be accomplished via buying back their own stock, returning it to shareholders or making acquisitions.
Currently, the yield of the Fund is about 2.1% on the equity side, which is greater than the yield of the S&P 500, so we tend to gravitate towards companies with growing yields.
Q: How do you define and manage risk?
With our investment approach, as we mentioned earlier, the two biggest risks are credit and interest rate risk. These risks go hand in hand when we decide on the asset allocation, the specific issuer and the security selection. We constantly look at our rate exposures and the internal interest rate calls. The short end of the curve is more vulnerable to Fed action, while the intermediate to longer duration is more impacted by the economy risk.
Corporate credit risk is another important factor in our process. We know that certain sectors are more vulnerable to changes in the economy or even to headline risk. This year, we expect mergers and acquisitions (M&A) activity to rise and, as a result, many sectors will be negatively impacted. The spreads on some secondary issues may widen and their prices cheapen, indicating that M&A risk is another consideration for fixed-income investors.
Staying within fixed income, there is also liquidity risk which needs to be monitored on a continual basis. We manage it by identifying which issuers are eligible for index inclusion and then we populate the portfolios largely with those issues. We try to hold liquid assets that we can buy and sell easily
On the equity side, our risk management begins with a quality assessment of each holding in our portfolio and rigorous, bottom-up fundamental analysis. The company-specific risk is outlined in our new idea process, in which we try to eliminate companies with downside risks. We avoid highly leveraged companies or those that rely on the marketplace to fund their growth because we donít want to assume any financial risk. Instead, as we stated earlier, we focus on the companies that generate significant cash flow. Buying stocks at a discount to their private market value also diminishes risk.
Diversification is the key component of managing the portfolio risk. We have limited the individual security exposure to 3% and we donít overweight sectors by 25% or 30%. The focus on dividend-paying companies that generate excess cash also helps to mitigate the market risk as such companies tend to outperform in down markets.
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