Q: Would you give an overview of the fund?
The Transamerica Strategic High Income Fund was launched in March 3, 2014. Thompson, Siegel & Walmsley LLC (TSW) is our sub-adviser.
In the aftermath of the 2008 crisis, investors approached us seeking lower volatility, more downside protection to the equity market, and higher income generation, which prompted the genesis of this strategy.
Because TSW manages both equity and credit, we believed these objectives could be achieved by investing across the entire corporate capital structure, from common equity to preferreds to the corporate debt of the companies we analyze. By combining these three asset classes, we determined the fund could generate high current income but with much lower volatility.
We move between these asset classes based on relative value while continually holding true to our primary income objective. The fund’s gross current yield is just over 5%, and today approximately 57% of the asset is invested in common equities, 35% in high-yield credit, and 8% in preferred stocks.
The fund’s assets under management are about $139 million and additional $60 million managed outside of the fund, for a total of $200 million in the strategy.
Q: What is the objective of the fund?
Income is our primary objective, followed by strong risk-adjusted returns derived from selecting securities which will perform well within the portfolio. Managing income at the portfolio level grants us the ability to actually hold non-dividend paying equities and make up for their dearth of income in the high-yield and preferred spaces.
The management of both equity and credit under one roof is a key differentiator of the fund, as it gives the portfolio management team the ability to toggle between dividend-paying equities, high-yield bonds, and preferred stocks. This allows us to actually choose which part of a company’s capital structure to invest in.
If we think an equity is fully valued with little upside, we would look at its preferred equity or high-yield debt. Regardless of whether we are considering an equity or credit investment, we feel that balance sheet analysis plays an important role.
Q: How do you define your investment philosophy?
Leonardo da Vinci has been credited with saying “Simplicity is the ultimate sophistication,” and we truly believe in that statement. The marketplace has become quite sophisticated over the last 10 years, but we believe keeping this product extremely simple and understandable is the best way to serve our clients.
Income can be derived in many ways, and often involves derivatives and leverage – two things we don’t do. The income generated within this fund is quite organic and most of our names are recognizable.
It’s crucial that our clients understand what we are doing in a granular fashion. This is why we stay true to the corporate capital structure of primarily domestic companies – the fund doesn’t invest in residential or commercial mortgage-backed securities, or in emerging market debt.
Q: What is your investment process?
Our investment process comprises our macro view, strategic allocation among our three sleeves, and fundamental analysis on every name that goes into the portfolio.
We begin by determining how much risk we want to take given our current macroeconomic view. Determining where we are in the economic cycle helps us determine the fund’s weightings.
Strategic allocation starts by deciding where we want to be from an equity standpoint, and then the balance of the portfolio is filled with high-yield and preferreds based on the relative value between them. If we see better value in high yield, the weight of preferreds may actually be zero.
Next comes security selection, where we are truly fundamental investors. We prefer to invest in companies that are cheap on a cash-flow basis and have positive catalysts that are sustainable over long periods.
Our focus on cash flow also holds true on the credit side. When investing in a company’s credit, we prefer it have positive cash flow, moderate leverage, and strong interest coverage and asset coverage ratios. We are biased toward higher-quality, high-yield bonds, and look most closely at the B and BB space because CCC-rated bonds have far less attractive risk-adjusted returns.
Lastly, because the fund’s primary objective is income, we look at income at the portfolio level, where we can make up for the loss of income from non-dividend paying investments through allocations to credit and preferreds. Owning equities without dividend yields allows that sleeve of the portfolio to have a much higher beta than traditional income-oriented products. While income is the fund’s primary objective, holding equities that don’t pay dividends means we are also concerned with total return, albeit at a secondary level.
Q: How do you go about your research process?
To narrow the investment universe, we use a four-factor screen which identifies companies that are cheap on a cash flow basis with sustainable catalysts.
On the equity side, our fundamental analysis revolves around sustainable and growing cash flows. It is very beneficial when management teams come through our office. We can ask them pointed questions concerning their balance sheet and credit metrics, questions they would not expect from an equity-only shop. Again, it really plays into the benefit of us managing both bonds and stocks under one roof.
Additionally, we have a broad array of relationships on the Street, so sell-side research comes in quite frequently. That’s more informational in nature – on an industry or particular companies. Decisions about whether a company is investable or not are made internally.
At the portfolio level, we target income in the range of 3% to 5% above the S&P 500 Index’s dividend yield. The reason the S&P dividend yield is used as a target is because the strategy is more correlated to equities than it is to fixed income.
When looking at credit, we never rely on third-party ratings agencies; actually, one of our goals is to identify companies that are mis-rated. To us, attractive companies are those that generate positive cash flow, can cover their interest, and have strong asset coverage metrics because these things highlight downside protection at the corporate level. We look to protect capital in periods of stress, increasing the profitability we get paid back as bond investors.
Our ideal investment is a B or BB company that has financial metrics in the BBB range and is being overlooked by the market.
From a diversification standpoint, we limit equity investments to companies with market caps of $3 billion and larger. Because our high-yield and preferred allocations can go to companies smaller than that, the fund is diversified not only up and down the capital structure, but also across the market-cap spectrum.
Q: Can you give a couple of examples to illustrate your process?
One of our credit investments, a general contracting firm called Tutor Perini Corp, has been owned by our small-cap group for a while and illustrates how we work together to find higher-yielding securities that benefit our shareholders.
Tutor Perini focuses on large-scale, complex projects like Hudson Yards in Manhattan and the Alaskan Way Viaduct in Seattle where there’s not much competition from smaller players. Its stock got beaten up after a government contract resulted in some cash flow not coming in on time, and the company and its principals parted ways. In coordination with our small-cap equity group, we were able to understand that despite all this, Tutor Perini should be able to improve its cash flow.
In addition, in November 2016, Los Angeles County voters approved $120 billion in transportation improvement over the next 40 years and Tutor Perini received a contract from the county’s Metropolitan Transportation Authority. This led us to view Tutor Perini as having an improving credit and cash flow story with strong industry fundamentals.
Another example is our recent investment in Lowe’s Companies, Inc., the home improvement retailer. We wanted a bit more exposure to home improvement, where we see a number of strong industry drivers over the next few years.
Here in Richmond, the housing market is hot and it is in many places across the country. When prices rise in a hot market like this, consumers are more willing to borrow or spend on home improvement than they have been in previous years.
This should contribute to improving earnings for both Lowe’s and Home Depot Inc. Though we’ve owned Home Depot for a long time, the relative valuation gap between the companies made Lowe’s more attractive.
Lowe’s pays a 2% dividend, which is fairly low in the income space, but it has a great total return profile – we think this $73.00 stock can go to $90.00 or $95.00. Had we invested in a utility, the yield would be 4%, so the 2% income yield that we give up by investing in Lowe’s will be made up in the high-yield and preferred portions of the portfolio.
This exemplifies our belief that there is strategic value in combining these three asset classes to drive returns.
Q: How do you construct your portfolio?
The portfolio construction process is determined by our view of where we are in the macroeconomic cycle, so we start by assessing whether corporate profit or GDP is increasing, monetary policy is easing, and if there are tailwinds at our back to invest in equity. If it’s a good time to invest in equities, we will allocate more to that sleeve.
Because the fund is primarily driven by income, a maximum of 60% can be allocated to equity; currently we are near the high end of that range. The balance is then split between high yield and preferreds based on relative value; right now, the fund is 35% high yield and 8% preferreds. We have been as high as 18% to 20% preferreds but have pared back because of their higher correlation to interest rates and our belief that rates will rise in the medium term.
The process is quite fluid. Unlike many funds, which manage sleeves separately and don’t know what the others are doing on an intraday or inter-day basis, we can look at relative value not only within the sleeve but across the sleeves as well.
For example, if we wanted to reduce the portfolio’s risk and take the equity allocation from 57% to 52%, we could do that in five to seven trades. From there, we could go into a high-quality, high-yield bond – perhaps a BB or an investment-grade preferred stock – and actually increase the yield of the portfolio almost instantaneously, going from the current yield of about 5.2% on a gross basis to 5.6% – and we could do it all with one team.
From a portfolio construction standpoint, this is important. As we look at each sleeve every day, we may start to see softness in the high-yield market over a course of a week and equities reaching new highs. We would take that as an opportunity to pare back our equity exposure and lower the risk of the portfolio.
In terms of diversification, our position sizes are the biggest risk reducer. We can’t own more than 5% of any one security, though our actual position sizes are usually far lower than that. The fund is limited to plus or minus 10% relative to the index per sector. In our benchmark, the S&P 500, financial services are 19%, so we can invest between 9% and 29% in that sector. This provides ample opportunity to add value not only in name but also in sector selection.
Q: What are your views on risk? How do you manage it?
During portfolio construction we analyze how much risk to take. For every name, we believe we ought to be paid commensurate with the risk we are taking.
Remaining cognizant of risk is crucial, so we track our exposures diligently, looking daily at empirical returns at the portfolio, sleeve, and name levels.
Introducing high yield and preferred stocks to a core equity mandate reduces volatility and creates an attractive risk-return profile.
Income generated in the high-yield space acts to moderate the return profile, minimizing the peaks and troughs, allowing us to win over long periods of time.
