Q:  What is the history of the firm and fund? A : Madison has been managing both fixed income and equity portfolios since 1974. We manage portfolios for a number of different client types through a variety of vehicles, primarily separate accounts, open-end mutual funds and closed-end funds. In the equity component of our firm we have a team of 15 portfolio managers and analysts. Of that group 11 are chartered financial analysts with, on average, over 20 years of experience. We are structured by strategy in teams around products such as: mid cap core, large cap core, large cap value, and large cap growth as well as the covered call strategy. The overall equity group works collaboratively sharing resources and ideas, but the suitability of each investment idea is ultimately up to each lead portfolio manager of each strategy. For the covered call group, I am a co-manager of the strategy, responsible for the day-to-day management of our covered call funds. Frank Burgess is the co-manager of the strategy and also the founder of the firm. He was really the driving force behind developing the covered call strategy here at the firm back in the early 2000s. I have been involved with the strategy since its inception in 2004. In total, we manage over $310 million in the covered-call strategy across three different funds. Two of them are closed end funds, while the third, the Madison Equity Income Fund (MENYX), is an open-end mutual fund version of the strategy. Q:  How has the covered call investment strategy evolved over the last decade? A : Covered call strategy has been around for a long time. It is a non-complex conservative strategy that has been time tested and has been used for many years, even if not used broadly. In recent years, the strategy has been made more available through the advent of closed-end funds, and more recently, open-end mutual funds. Essentially the covered call strategy involves purchasing an asset, whether it is a stock or a collection of stocks in an index derivative. The manager then pre-sells the asset at a pre-determined price for a fixed period of time. That will naturally limit the upside in owning that asset, but there is also an advantage that comes from the proceeds or premium from selling the call option. This regular income adds to the downside protection of the strategy. In 2002 an index was created to track the performance of a passive covered call strategy. That index was created by the Chicago Board Options Exchange. The CBOE S&P 500 BuyWrite Index (BXM) uses the S&P 500 as the asset and models the sale of 30-day call options against the Index; calls which are just out of the money. That 30-day option is renewed every 30 days, providing a benchmark for how a passive version of the strategy would perform. Once that index was created a number of studies were performed that concluded that the strategy in general delivers, over time, index-like returns but with less volatility. This provided the impetus to make the strategy more widely available to all investors and was the precursor to covered call fund launches. In 2004 we launched the first closed-end fund that had a covered call strategy as its base strategy. At the time it was called the Madison/Claymore Covered Call Fund. It is now called the Madison Covered Call and Equity Strategy Fund (MCN). In 2005, we came back and launched another closed-end fund called the Madison Strategic Sector Premium Fund (MSP) and that differed slightly from the original fund in that it had a little narrower sector focus in the underlying investments. Finally, in late 2009, we launched the Madison Equity Income Fund as an open-end mutual fund version of the strategy. As we proceed I’ll be focusing on this fund in our conversation. Q:  What are the three ways of implementing covered call investment strategy? A : The overall objective of the fund is to provide a consistent total return and, secondarily, a high level of income primarily through option premiums and realized gains on the underlying securities. It has a relatively high distribution rate so it has garnered some attraction given the current low yield environment. We seek to produce a healthy quarterly distribution on the fund and that primarily comes from option premiums we collect throughout the year and any realized capital gains from the underlying securities that we distribute as well. There are essentially three broad ways to manage a covered call strategy. The first one is to be a passive equity investor, which is to purchase an index or ETF derivative, or a group of ETFs based on indices, and then passively manage the option side of the portfolio by selling index options against your ETF or index investments. So it is passive on the asset side and passive on the option side. The second way of implementing the strategy is to be an active equity investor. That is to own a portfolio of stocks and then cover the portfolio on the option side with index options that cover the whole market, being an active equity investor and passive option investor. The third way is to be active on both sides. That is to actively manage a stock portfolio and then actively manage the option side of the portfolio, not using index options but individual equity options where you can match the characteristics of the options to the individual securities that you have in the portfolio. One of the primary benefits to that is that the premiums we can achieve on equity options are typically larger than the premiums that you can achieve from selling index options so you have an immediate benefit from the amount of money you are collecting. That is the way we manage our strategy. Q:  What is your investment philosophy? A : Our covered call philosophy was an offshoot of what we have been doing here at Madison on the equity side of our business since the 1970s. The underlying strategy is to be a high-quality, bottom-up equity investor. Our focus is on high-quality companies with strong balance sheets, excellent competitive advantages, strong free cash flow generation, and high consistency in profitability, high return on equity and invested capital. Then we look for management teams that not only have a great deal of experience but have a good track record in allocating capital in a shareholder friendly manner. Finally, we like to buy companies at valuations that are attractive relative to their long term growth rates. It is very much a fundamentally driven bottom-up investment philosophy. Many refer to it as growth at a reasonable price. It is really in our DNA here to invest with the idea of participating in strong markets but more importantly protecting when markets become more challenged. That really provided the foundation for our equity approach within the covered call strategy as well. It really was a natural extension of how we feel about investing in the markets. Selling call options against the high-quality portfolio adds an additional layer of protection. We are able to participate in the upside but provide an even higher level of downside protection through the addition of the option strategy. Q:  What is your investment process? A : We start off with a quantitative screening process, which just simply eliminates some of the companies that we would not have a high level of attraction with. From our perspective, with the covered call team, we really start out with market caps of greater than $3 billion. From a characteristic standpoint we are typically a large cap oriented strategy but we can have up to 35% of the fund in mid cap stocks, which we would classify as anything under $10 billion. We screen for various quantitative issues such as high debt levels since we want companies with lower debt liability. We seek a higher return on invested capital, consistency and stability in earnings and cash flow growth, strong long-term earnings growth and positive cash flow generators. Once we are past that quantitative stage we focus on fundamental bottom-up investment research. We gather information from a variety of sources. We clearly take in all of the information that comes from companies in terms of financial statements and commentaries. We have direct communication with companies, either by phone or direct meeting, where we can meet on premises or at various conferences with management teams. We will spend a fair amount of time at conferences, not just focusing on companies, but getting a good feel for industry dynamics. We read industry journals, street research, et cetera, with a goal of understanding the business better and their long-term success, and gaining a high level of conviction before we make that ultimate decision to invest. Once we have gotten through the information gathering stage we really focus on trying to get a very strong understanding of what we are looking for with the business model. Many of the things that we look for are geared around competitive advantage; market leadership, pricing power, and brand superiority. What you will find in many of our portfolios is that we have a large number of market leaders, companies that will survive downturns that will have strong competitive advantages for years and years to come. We want companies that have a great degree of financial flexibility and that typically comes from high free cash flow generating companies where ultimately companies have the flexibility to internally finance their growth and enhance returns through shareholder friendly activities, such as increasing dividends and buying back stock. These types of companies typically have stronger balance sheets because they have the free cash flow to pay down debt to reasonable levels and not let debt be an anchor to a business. Once we have a very good feel for the business model, we then spend a fair amount of time trying to assess the management team and its track record. Finally, if we are comfortable with the business model and the management team, we move onto the valuation part of our process. This essentially utilizes a number of different valuation techniques. We are strongly focused on free cash flow and discounted cash flow analysis. We are trying to project cash flow going forward based on our internal assumptions of the business. We also compare that with other industry comparables, such as price-to-cash-flow, price-to-book-value, price-to-sales and enterprise value to operating earnings, to get a picture of where we are trading today relative to historical trends or averages. If we were to stop the process there we think we would have a high-quality, solid equity portfolio with good forward growth and a high level of safety. On top of that we add the option side of the portfolio. We utilize individual equity options rather than index options, because the premiums are higher and we can tailor the characteristics of the options directly to our view of the individual equity holding and/or our view of the overall market in general. Q:  Typically, what kind of options or covered calls will you be looking to write? A : Typically we will be selling out-of-the money call options so that we can participate at least to a certain degree in the upside potential in the stock. How much out of the money we will go will be determined by our view of the upside potential of the stock and our view of the overall market. As an example, if we feel that a stock is coming up towards what we feel is the upper end of its valuation range, then we would be more conservative with the option strategy and possibly sell an option that is very close to the money. In doing that we would gather a much higher premium to provide more downside protection in the event that the stock declined. On the other hand, if we felt that we were holding a position that had a fair amount of upside potential, we may sell an option that is further out of the money so that we can participate more on the upside. The offset to that is we would accept a lower premium on the option for doing that. We are balancing our view on the stock, and the characteristics of the options, so that we are maximizing what we feel is the total return potential of the combination of the stock and the option positions. On top of that, if we feel the market is overly expensive and we want to get conservative, we will sell options that are closer to the money to provide more protection. If we feel that market is not fully valued and has room to run then we would sell further out of the money as well. It combines our view of the stock and our view of the overall market. In general, what we are trying to accomplish here is taking a longer-term strategic view of the underlying stock, and managing the option portfolio to a shorter-term tactical view of what is moving the stock over shorter periods of time. Typically, we are selling options between 30 days and 90 days out into the future so we are impacted by some of the shorter term movements of the market and of the stocks, but ultimately we are interested in owning stocks that we would like to own for a significant period of time, in excess of 18 months, and hopefully quite a bit longer than that. Q:  What kinds of companies meet your research process? A : An example of one of the holding in Equity Income is United Technologies, an industrial company, a relatively recent purchase in the fund. This has been a company that has been followed here for quite some time and we know the company quite well. It has many of the characteristics that we look for from a business model perspective. United Technologies is a large industrial conglomerate. In most of the businesses that it operates it has market leadership. It has strong brand recognition through many of its holdings, such as Otis Elevator; Carrier, in the air conditioning and heating space; Pratt and Whitney, with aircraft engines; Sikorsky Helicopters; and most recently an acquisition, Goodrich. It also has a commonality across most of its businesses in that they have large installed bases, which leads to a high degree of recurring after-sale revenue. This helps to smooth out some of the cyclicality in many of these industrial businesses. This also provides consistency in returns. They also have an internal management system that drives continuous operating efficiency across all of its business units. That limits cyclicality; it improves margins and often leads to higher return on invested capital than its competitors. From a business model perspective we found United Technologies to be very attractive while trading at a reasonable valuation and it was purchased into the fund. From an option perspective, we felt there was real upside so we wanted to participate as much as we could. However, at the time of purchase we were concerned about the level of the markets and the probability of a pullback at some time in the near term. We wanted to be more cautious because of the overall market environment with our option-writing program. In the case of United Technologies we sold an option that was approximately 2% to 2.5% out of the money so we were not necessarily participating in a lot of a short term upside, but we received a fairly hefty premium for doing that to give us a greater degree of downside protection in the event that the market entered a challenging period. Another recent addition is DirecTV, which again met all of our criteria. DirecTV had a significant market leadership as a satellite TV provider. DirecTV is the largest pay TV service provider with over 20 million satellite subscribers in the U.S. The U.S. part of its business is a steady but slower growth and high cash generating business, with additional growth coming from its Latin American subsidiary where penetration rates for satellite TV are significantly lower than the U.S. with a very long runway for significant growth. The management team there has been very solid for a long time. It used to be run by John Malone and he still owns a lot of stock in the company. As is typical with a John Malone media property, DirecTV tends to generate a lot of free cash flow, and often has used that cash to repurchase shares which we believe is a major plus in returning capital to investors. Fundamentally we think DirecTV demonstrates a good growth profile, is backed by a strong management team, and we were able to buy shares at a price deemed attractive. Similar to the United Technologies story, despite the fact that we like the long term nature of DirecTV, our cautiousness on the overall market has led us to sell options that are somewhat tighter to the money. We sold options that were 2% out of the money to protect against any short term correction. We will reevaluate those options a couple of months down the road. Q:  How do you decide the amount of call options coverage you write? A : Overall, from a portfolio standpoint, we can change the amount of the portfolio exposure that is covered by options. Typically the fund will have between 70% and 80% of the equity exposure covered by call options. But, when we are concerned about the market valuations, that coverage through options can go right up to 100%. When we are less covered and we want to participate more in the upside, and we think the market is cheap, we can bring that down to the 60% to 65% level so the fund has more upside potential. We are constantly readjusting the coverage of the overall portfolio and we do the same thing individually stock by stock. Q:  What is your portfolio construction process? A : We typically operate a concentrated equity portfolio. The range is 40 to 70 individual holdings from the equity perspective so it is relatively concentrated. We have always felt that it is important to place more capital in your best ideas and we certainly do that here. The majority of the portfolio, at a minimum of 65%, has to be invested in large cap companies and a maximum of 35% in mid cap companies. We can also invest up to 15% in foreign securities where available. We tend not to have as much exposure in sectors where volatility is typically low: Consumer Staples companies, Utilities and Telecom Sector companies. The portfolio will be slightly skewed from a sector perspective toward areas where we can find very high-quality companies that meet our criterion but have somewhat higher volatility so that we can get better option pricing. The fund has historically had more concentration in the Technology Sector, the Industrial Sector, Healthcare, Consumer Discretionary, and to a lesser degree, Energy. Here is where we typically find a combination of perceived quality with option pricing potential. To diversify our option exposure per holding we will sell not just one option against the complete equity position, but we may have multiple options against the same stock position. For example, we could have 50% of the position at a strike to a certain expiry date, another 25% at a different price with a different expiration date, and the rest of the 25% at another strike price and expiration date. So we are diversifying our option coverage of each holding as well. If we average two options per security, then we could have 80 to 140 option positions in the portfolio at any given time. The result is a concentrated stock portfolio with a diversified option coverage on top. Q:  How do you define and manage risk? A : There are many ways to define risk in any investment process and there are a lot of quantitative ways to measure risk. We think about risk as the downside potential on the equity holdings. We see the options as the risk reducing part of the portfolio. One key risk is making an error on the equity side of the portfolio and that is why we spend so much of our time understanding business models and then using the discipline of valuation so that we are increasing the margin of safety we have on the underlying security. We gauge our risk by the ability to protect capital. We are happy to be approximately right in a rising market so that we can capture at least a health percent of that rise. More importantly, we do everything thing we can to avoid following the market in a steep decline. We do that through the valuation discipline to get that additional margin of safety we believe exist in solid companies and then laying on that additional layer of protection provided by call income. We do not quantify the risk so much as it is infused into all of the parts of the process as we manage the portfolio. We are living right now in a yield-challenged environment and there is no question that this strategy can create a significant amount of income. We seek to produce a regular, quarterly distribution on the fund. When you are looking at zero percent interest rates on the short run and just over 2% in 10-year treasury yield, many investors might look to a covered call strategy as a fixed income alternatives. While the potential income is attractive we would caution investors to look at this as more of a total return product because the underlying investment of the funds is stocks. The performance of the fund will be most correlated with the stock market, particularly should stocks decline deeply, well past the margin of safety provided by the call income. Even though this process and this strategy has historically created a significant amount of income and as such, is very attractive in this environment, it really fits into an investor’s allocation not so much as replacing fixed income, but a way to participate in equity markets in a cautious manner.