Q: What is the history of the fund?
The idea for the fund was born over time. In 2010, the Global Value Team decided to apply its value-based, long-term, bottom-up investment approach to develop an income- oriented fund. The financial crisis that started in 2007 caused interest rates to plunge to historically unprecedented levels, both from central bank policy and ongoing deflation fears and investor flight to safety. This undermined traditional approaches to generating a meaningful stream of income, whether from bank accounts, government bonds, or even investment grade debt.

We wanted to offer a fund with income generation that stayed true to our core investment principles, including our focus on risk and downside protection. While it was very typical for us to own stocks in our portfolios with above average dividend yields, and we have historically made episodic investments in credit and fixed income, we felt we needed to add to our fixed income capability to create a strong fund platform.

The fund was launched in May 2012, and is managed by two members of the Global Value team and two members of our Credit Team, who are also portfolio managers of our High Yield Fund. We are supported by 19 equity and credit analysts.

It has two investment mandates: generation of current income and long-term growth of capital. It’s similar to an endowment fund in that we want to grow the capital base in real terms while producing meaningful distribution streams.

Q: How does the fund differ from its peers?
First, we follow a bottom-up investment approach—no top-down calls on asset classes. Instead, we look across asset classes, sectors and geographies for securities that we believe combine value and income. Our asset allocation is a reflection of where we are finding these individual opportunities.

We are also flexible. As a tool, to gauge our risk profile and expected returns, we suggest to our investors a benchmark of a 60/40 mix of the MSCI World Index and the Barclays Capital U.S. Aggregate Bond Index, but we do not rigidly adhere to those indices. This gives us the flexibility to move from equities to credit to other forms of fixed income, and to use cash and gold as well.

We accumulate cash when value investments are scarce and deploy it when values become available. Gold bullion and gold mining stocks represent a potential hedge against extreme macro economic events or geopolitical circumstances, like Brexit, which put pressure on risk assets.

While we understand investors are currently yield-starved and looking for high investment income levels, we won’t risk exposing capital to potential loss in this environment purely to generate income. We avoid instruments sometimes found in other income funds like mortgage REITs, which we view as highly levered equities, which can be extremely sensitive to movements in interest rates.

Similarly, we avoid equity-linked notes, where you basically monetize a stock’s volatility, selling the upside and converting it into some kind of manufactured fixed income instrument that registers for accounting purposes as income but exposes the fund to a stock’s downside risk potential. While those instruments generate yield, they do not align with our underwriting approach.

Q: What is your investment philosophy?
We have a bottom-up process. We seek to avoid permanent capital impairment and invest with what we believe is an appropriate “margin of safety”, an appropriate discount to intrinsic value. Being benchmark-agnostic allows us to avoid parts of the market where valuation becomes too aggressive, like the tech telecom internet boom, financials in 2007–2008, and, more recently, emerging markets, before commodities collapsed.

We focus on downside protection. By investing at what we calculate as a 30% to 50% discount to our estimate of intrinsic value, if our valuations are off even by 25%, we still have a potential cushion against capital impairment.

Q: Would you explain how your investment strategy reflects these principles?
One of the fund’s strengths is a time-tested, sound investment approach, without top-down calls. We think about the macro economic environment, but focus on the business behind the security, its quality, and the durability of the assets underpinning it. We look for hidden assets and liabilities and may appraise different segments of the business in different ways.

Portfolio turnover, while generally low for our funds versus the industry, is a little higher for this fund, about 30%, because of somewhat higher turnover on the credit side. We are judged on long-term results, enabling us to bear short-term pain where there are unresolved risks or other negative factors weighing on a security, but where we see long-term value in the business that the market will come to recognize.

We invest the time necessary to understand a business before we invest because we often hold it for five or ten years. We visit companies around the world. As a fairly large platform in global value, we make significant investments, often positioning us a top-five shareholder. This gives us good access to the company and management team, who welcome our tendency to hold positions for the long term.

By prospectus, we need only be 80% invested in income-producing securities in normal markets, so we focus on equities with above average dividend yields ranging from 2% to potentially double-digit yields.

Beyond high yield and corporate credit, we have a developing focus on sovereign debt, particularly in emerging markets. The fund’s historic exposure to emerging markets has been small, but now that many of those markets have come under pressure, we may assume more significant exposure. We own the sovereign debt of Mexico as well as Singapore, and are considering other countries. We now have a sovereign bond analyst on the team to assist us.

Historically we have had little exposure to CCC-rated securities—while not prohibited, it is not an area of emphasis for the fund.

Q: What is your research process and how do you look for opportunities?
We do basic fundamental credit research such as determining a company’s ability to generate free cash flow by breaking down the balance sheet and examining the company’s positioning within the industry.

Free cash flow is one of our investment metrics. Ideally, a company will generate enough free cash between now and maturity to pay off its bonds. The leverage of the company speaks directly to the margin of safety. If something is highly levered, it doesn’t take much for the company to be forced into restructuring, possibly based only on what happens in the overall economy.

Below-investment-grade credits are generally weaker companies lacking dominant market share. We try to determine their resilience in different economic environments and whether we believe there exists the ability and willingness to repay debt when due. In certain cases, we speak with management prior to investing.

In the new issue markets, there are calls and net road shows, which provide considerable information and access to management.

In fixed income, if it is a short maturity where we feel the company clearly has the ability and willingness to repay that security despite the underlying business being weak and, if we are only looking to invest for three months or so, it may prove an appropriate investment.

Q: Can you provide any examples of your security selection?
In fixed income, ACCO is a company that provides primarily U.S.-based office supplies and generates good cash flow. It levered up to make a strategic acquisition about five years ago, an acquisition that did make sense, but management has since de-levered by as much as two turns. What attracted us was that the company generates free cash and management was intent to de-lever and acted on that.

Operating earnings and cash flow are more important to us than accounting earnings, which are subject to distortions.

One example on the equity side, from our top ten holdings, is Mandarin Oriental, a leading luxury hotel operator. We think it’s an undervalued security. With a market cap of less than $2 billion, it is smaller than the rest of our top ten. Mandarin owns a number of hotels in gateway cities, and the hotels’ real estate value significantly exceeds the company’s market cap. Most of the company is owned by Jardine Matheson, an Asia-based holding company, which is also in the fund.

Moreover, the growth part of the business is a hotel management business, which earns high margin fees, particularly in the Far East and China. The strategy is to boost the Mandarin brand among the tourist class without extending capital or assuming any financial risk. The combination of real estate value and growth prospects for the management company is attractive, as is the stock’s 4% dividend yield.

Q: What is your portfolio construction process?
Diversification among equities is a priority. No position typically exceeds 200 basis points, so we are not concentrated. It is a broadly diversified portfolio with a focus on downside protection that provides exposure to different asset classes, different geographies, and may also include allocations to cash and gold. As of June 30th, it held 111 equity securities and 53 fixed income positions.

Equities represent just over half the capital, with roughly two-thirds being foreign equities, across all geographies. It is more a factor of where we find opportunities. One important sleeve is in Asia, outside of Japan, but we also have significant exposure to Europe, and some to emerging markets.

Our fixed income side is about 65% to 70% domestic.

On the equity side, our buy discipline is to invest where we believe there is an adequate “margin of safety” in the business and we are attracted to the quality of the business and the price of the business.

We pay close attention to the potential for dividend cuts. While we do not necessarily target growing dividend streams, we seek reliable, sustainable dividends. The possibility of a dividend cut might not deter us if we believe we can obtain an attractive income from the investment, but we want companies that have sufficient internal cash flow and balance sheet strength to pay dividends, to return capital to shareholders without resorting to debt. Many of the companies we own return capital both through income generation and share buybacks, which support dividend growth on a per share basis.

When we have achieved—or the market price already reflects or exceeds—our estimate of intrinsic value, even though it may still be a quality business, we will sell if we can invest in other more attractively valued businesses. We will also sell if the complexity of the business changes, our judgment of the business was not accurate, or if the competitive landscape changes in a way that no longer encourages us to expose our capital that way.

On the fixed income side, something could become fully valued, or priced at a level where we are no longer compensated for the associated risk. There might be a change in management, capital allocation policy, or the level of leverage they are willing to accept. It could also be that management has become more aggressive regarding acquisitions or overall expansion of the business. If we feel there has been a change in investment thesis we will examine it to see whether we should sell.

Q: How do you define and manage risk?
Risk management is embedded in our process. To us, risk is permanent capital impairment—not volatility. Seeking to avoid that permanent impairment drives everything we do. We manage risk from the bottom up. If we do a good job as far as our underwriting on both the equity and fixed income sides, that minimizes losses over time and reduces the overall risk profile of the portfolio.

We have systems that provide reports regarding concentrations, and we focus more on portfolio liquidity on the fixed income side now because, since the financial crisis, certain regulatory changes have shifted market liquidity.

On the equity side, we analyze the strength of a company’s balance sheet. Even a good business, if stretched, can pose a permanent capital impairment risk to its investors through equity dilution or, worse, bankruptcy.

Our diversification also helps to mitigate risk. That includes having cash and gold in the portfolio, because gold typically appreciates in environments where companies and the economy are under pressure, or where markets become volatile.

We are mindful not to direct our capital too much toward one area or theme where investment performance is likely to be highly correlated. The four of us manage as a team, rather than individually, and constantly look to identify sources of risk to the portfolio across all of our holdings.