Q: How has the fund evolved since its inception?
When the First Investors Total Return Fund was launched in 1990, its aim was to invest in a mix of stocks and bonds. Since its inception, the objective of the Fund has been to achieve high long-term total return with moderate investment risk. That objective still exists today, but the tools and the allocation capabilities have changed over time.
Today, more asset class selection is available in the fixed-income world. When the Fund was launched, our typical fixed-income allocation would include corporate bonds, municipal bonds, U.S. Treasuries, and mortgage-backed securities. Today, we are able to look at other asset classes, such as asset-backed securities, collateralized loan obligations, and collateralized mortgage obligations. In addition, we recently added a high-yield sleeve to the Fund which can allocate up to 10% to high yield corporate bonds.
On the equity side, the Fund has historically been a multi-cap core fund, employing the strategy of growth at a reasonable price. But as we transition forward, the mix is evolving more towards large caps, based on our bottom-up, fundamental analysis and stock selection process.
Currently, 50% to 70% of the Fund is allocated to equity and at least 30% to fixed income. Rajeev Sharma has been managing the fixed-income component since September 2017, while Sean Reidy took over the equity portion in April 2018. Foresters Investment Management Company, Inc (FIMCO) is the Fund’s investment adviser and Muzinich serves as a sub-adviser for the high yield portion of the portfolio.
Q: What is the advantage of investing in your fund?
The Fund is suitable for new investors because it provides a balanced allocation to both fixed income and equities, while the portfolio managers adjust these weightings based on the current market environment. For instance, if valuations become frothy on the equity side and good value opportunities are difficult to find, we can adjust the equity allocation downward and invest more of the Fund’s assets in fixed income. Alternatively, if equity markets appear to be attractively valued and we believe we can find better returns in stocks, we can increase the equity exposure of the Fund.
Initially, the Fund was developed to introduce first-time investors to a concept that many may not have been familiar with, namely understanding downside risks and by extension, participating in the potential upside presented by the marker. The goal was to provide a balanced return. That’s the genesis of the Fund. With 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.
Q: What are the core beliefs that guide your investment philosophy?
One of our core tenets is the focus on strong balance sheets and free cash flow generation. We look for companies that generate excess cash flow over earnings. This approach improves the risk profile for the fund. We also look for companies with improving returns on invested capital and growing margins. Through our valuation process, we aim to buy companies at a discount to our price target to lower the risk and mitigate the downside.
We emphasize cash flow per share instead of earnings per share because earnings can be more easily manipulated than cash flow within the GAAP framework. Through our diligent research and careful analysis, we estimate the true earnings power of the companies in our investment universe based on the cash flow they generate. After that step, we then come up with valuation based on EV/EBITDA, or discounted cash flow. Once we establish company valuations, we try to buy them at a discount.
We avoid financial risk and companies that we consider to be overleveraged or don’t produce enough cash flow to run their business. We look for effective management of inventories and receivables and a proven return on invested capital. Once we have identified companies that we consider out of favor or underperforming and purchase them for the Fund, we set individual milestones that we expect these companies to achieve over the course of time.
Q: What is the rationale behind your asset allocation model?
Asset class allocation is based on relative value. The process begins with an assessment of relative value of the asset classes. Then, within those asset classes, we look for the sectors and the securities that offer the most value.
Having the ability to now invest in high yield bonds gives the Fund an opportunity to explore an asset class that has over the past few years outperformed investment grade asset classes. The anticipation is that allocation will provide a higher yield to the portfolio and the potential for greater total return. We will be able to better explore relative value amongst an increased number of asset class choices
Q: What is your investment process?
On the fixed-income side, we start with a top-down macroeconomic approach. We look at the direction of interest rates and the market conditions. We establish a view on duration, credit ratings and relative valuations of several different asset classes. Next, we look at the strength of each specific issuer relative to the current credit cycle.
This type of fundamental approach is rigorous and involves examining securities at the issuer level. In addition, the shape of the yield curve will be a significant factor in our investment process. For instance, if a 30-year corporate bond is trading at the same spread as a 20-year corporate bond, we would rather own the 20-year bond in order to eliminate a portion of the credit and duration risks.
On the equity side, we invest in U.S. stocks and some American Depository Receipts of foreign companies. The process begins with quantitatively screening our issuer universe, in which we eliminate highly leveraged companies and companies with a market cap of less than $500 million. We look for companies that are growing their cash flows above their earnings and prefer companies with an increasing dividend yield or dividend growth.
Once we have eliminated any companies that failed our screening criteria, the residual is our target list. At this point, we work with our team of sector-specific analysts and, together we come up with price targets (or the private market value) for each stock. We thoroughly complete our due diligence and read all the 10-Ks and 10-Qs regulatory filings to eliminate the noise within GAAP accounting standards and to estimate the true earnings power of each company. We eliminate companies that appear to massage earnings to meet short-term expectations. We want to buy companies that have strong fundamentals without using GAAP, which, in our opinion, makes earnings appear better.
Also, we talk to company management before we make any investment decisions to get a clear understanding of the business and its competitors. We favor companies that are near the top of that particular industry in terms of competition.
In the next step of our investment process, the analyst pitches the idea to the portfolio managers, who usually play devil’s advocate, and try to essentially punch holes in the investment thesis. At FIMCO, portfolio managers need to approve the idea before the stock is bought for the portfolio.
There is also an ongoing maintenance effort surrounding these ownership stakes. We participate in all conference calls and meet with the management in our NY office at least once a year. We also visit the companies to get a better visual understanding of their businesses. We also talk to third-party researchers to confirm our thesis. Our price target is managed on a quarterly basis to make sure that the original investment thesis is still on track. Once the investment thesis has played out or when the valuation has become too high, then the stock becomes a sell candidate.
Q: Could you give some examples that illustrate your research process?
Through our investment process we found a new corporate bond issue, Magellan Midstream Partners, a distributor of refined petroleum products. It came to the market with an attractive spread against the 10-year U.S. Treasury. First, we evaluated the attractiveness of the sector from a top-down perspective. At the time, it had a very favorable spread, so we researched the name with our credit analyst and considered the credit metrics along with the long-term contracts that the company had in place. We found it to be a stable credit, with leverage that was lower than the average for the master limited partnership (MLP) space.
Additionally, the company had low commodity price exposure, which was also a positive factor. We were comfortable with its ratings (Baa1 and BBB+) at the time. When oil started to rebound, we purchased the security. On a relative value basis, the credit made sense and the bond performed well in the portfolio. If our relative value analysis determined that the credit wasn’t attractive and the valuation was not appealing, we would have avoided the issue, even if the issuer displays strong financial metrics and ratings.
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 FEMA’s need for trucks to support relief efforts, there’s 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 doesn’t 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 firm’s 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 don’t 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 company’s 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, it’s 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 it’s the Bank of America Merrill Lynch U.S. Corporate, Government and Mortgage Index.
Q: How important is a company’s dividend-paying ability on the equity side?
It’s 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 company’s 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 don’t 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 don’t 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.
