Q: What is the history of the company and the fund?

At the end of 2001, William Garvey, our founder and chief investment officer, a fixed income portfolio manager nearing the end of his tenure at Ashland Management, suggested to clients he could generate higher returns without significant risk increases by adding small “yield” exposures with MLPs (master limited partnerships), REITs (real estate investment trusts), and dividend stocks to their intermediate bond portfolios. 

When they agreed, Hilton Capital Management was founded, to add a small growth element to an intermediate bond portfolio while keeping risks as close to the original mandate as possible. After 15 years, we still hold true to this original philosophy.

Our benchmark is 60% Bloomberg Barclays Intermediate U.S. Government/Credit Index and 40% S&P 500 Index. The standard deviation of that benchmark has been around 6% over a few market cycles, the volatility level we want for our clients. 

At the outset of Hilton Capital we shifted from all fixed income to include a small but increasing equity allocation. In early 2007, through 2008, we migrated to a lower-risk position as credit spreads were widening. Early in 2009 we modestly increased our equity positions and by late 2010 approached 50% equities. By 2013 we increased our equity allocation to nearly 60% which was the highest level of risk assets in the history of the firm. About a year ago we pulled our equity exposure down to around 35%, shifting into mostly fixed income and lower-risk assets, anticipating that future returns in the equity markets could be muted compared to what they have been. 

The fund has now grown to about $67 million, and firm assets are about $950 million. 

Q: How does the fund differ from its peers?

Unlike most managers, we are risk-minded over return-minded— primarily focused on how much money we can lose if we are wrong. We seek a higher Sharpe ratio. If we assume the intermediate bond index has a 3.5 standard deviation, we take ours to maybe 5.5 and generate well in excess of two more points of return for those two more points of standard deviation. 

We let the upside take care of itself while we look for favorable risk/reward situations, not only at the individual security level but, once the portfolio is constructed, in how the holdings interact with each other. 

We aim to drive between 6% and 8% annual return over a complete market cycle, including the down cycle, correction, recovery, and mature phases, which we have succeeded in doing over two complete cycles since the beginning. We tell our clients we cannot control the upside, but we can control the downside by maintaining a good handle on the risk we take. 

Compounding drives wealth creation. It’s what generates returns. You don’t have to work as hard on upside if you avoid significant drawdowns. Other managers tend to hug their benchmark. We don’t. 

We seek relatively consistent volatility, not tracking returns on the upside but striving to deliver 6% to 8% over a complete cycle. 

Q: How do you define your investment philosophy?

We believe dividend-paying companies with income-generating strategies are a consistent way to compound wealth. The decisions they make related to mergers and acquisitions, divesting businesses, or capital expenditure are influenced by that quarterly dividend payment, and they typically have a higher return on invested capital threshold over those not paying dividends. And they tend to make better decisions over market cycles. 

We want income to be a large portion of total return because it is reliable, reduces volatility, and is not subject to market whims. 

Primarily, instead of trying to grind out an annual return, by avoiding the large drawdowns that happen seemingly every seven to 10 years, and capitalizing on drawdowns by having the wherewithal to invest into risk assets, is how we create client wealth.

When the market declines, that’s when the likelihood of future returns increase. When the market increases, that’s typically when expected returns decline. If you’re fully invested all the time, you miss those opportunities. We focus on long lead-time changes in the market, what we think the future expected returns are in risk assets, and position accordingly. 

To do this, we typically hold 8% to 10% cash in the portfolio, so that when opportunities arise we can take advantage of them. Our return sets incorporate that high level of cash. I hear consultants say that holding cash earns zero and is a drag on performance. I disagree. For instance, suppose there is a 35% chance of a 20% market correction, the subsequent probability-adjusted bound is a 7% return potential on my 10% cash position. 

The best possible wealth creation points in a cycle are when we’re emerging from recessions. Multiply the probability of a negative event by the severity and assume you will capture some of that—we’ve done a good job of that overall. 

Being a tactical income fund means shifting between fixed income and equity securities over market cycles. We take more risk when opportunities are numerous and less when limited opportunities exist. Being tactical means trying to achieve the correct relative positioning of portfolio risk over a complete market cycle, not focusing on the quarter-to-quarter reflexes as our peers often do. 

Q: What is your investment strategy and process?

We are a macro, top-down-driven firm. Macro outlooks drive our appetite for risk. In a bountiful market, we are more apt to add risk; in a tight market, we reduce risk. 

We have vast experience understanding broad markets, i.e., commodities, interest rates, global fixed income, and currencies. Some see macro as licking your finger and holding it up to determine which way the wind blows, but we see it as considering the changes at the margin and determining whether those changes are dramatic enough for us to necessitate a change in our risk taking. 

The yield space and the types of securities we own—dividend-paying equities, preferred securities, REITs, BDCs (business development companies), closed-end funds, convertibles, emerging market debt—is not an overwhelming universe. We know the companies, we track them; we follow the progress, and the changes, before deciding what to add to the portfolio to improve the fund’s risk/reward characteristics. 

We’ve been overweight in certain asset classes, and when the volatility profile of an asset class ramps up uncomfortably, we reduce positions. We evolve our forecast by continually bouncing ideas off each other and debating what is important. There are no surprises, no ideas out of left field.

If expected returns in the market are lowering or we are uncertain, we dial back risk. If we think the markets appear strong for at least the next 18 months, we increase risk. These are multiyear changes, not quarterly, done well in advance, with often more than an 18-month outlook. 

The biggest concern we have is a sustained sharp spike in inflation, most likely as the result of a spending monetization infrastructure boom, where governments around the world invest in massive infrastructure projects concurrent with companies deciding to invest in capex, capital expenditures, to increase production. But if you look at capex as a percent of corporate profitability, it is trending lower—they’re not investing in new plants and equipment; they’re issuing debt and buying back stock, reducing capital. 

Rampant inflation would require a systematic change in the way the central banks view their main role, and we don’t see that occurring. Maybe 2% of our portfolio is now in U.S. Treasuries. We have a lot of highly rated floating rate and corporate debt. If we’re wrong, and rates do shoot up, we’ll adjust, but we manage to the markets we’re in, not the ones we “hope” might come.

Q: What is your research process?

Our macro approach means we have discussed ideas weeks—months—before any initial purchase. We lay out the business model and hold detailed discussions about the strengths and weaknesses of a particular security and what we think the risk/reward structure looks like over various timeframes. 

We start with how much money we might lose if we are wrong, and then examine the reasons why we might be wrong. If we become comfortable with that, we typically buy the security, particularly if we expect any downside to be reasonable, all to avoid excess downside. 

We avoid binary outcome stocks—stocks that need an upside catalyst or feature a downside catalyst. We do not own biotech companies or deep cyclical types of stocks. 

We target needs-based stocks in sectors like food processing, energy, transportation, real estate, and financial services—services companies want and people regularly need—not companies that make burritos or yoga pants or the next hot technology product.  

We might wait for a certain price target, or until after earnings are released, or if the company does a secondary where it is a little more liquid before we buy. 

When a new name gets introduced (assuming we are not upping our lowering our risk assets), it must offer a better risk/reward than a current holding for the swap to happen. This also holds true for fixed income securities. There is a lot of relative value that occurs inside the portfolio, not relative value in the traditional sense but relative value to the other names we own. So if ABC has a 2-to-1 risk/reward ratio and XYZ a 3-to-1 risk/reward, there is a good chance XYZ will replace ABC in the portfolio. 

Q: Do you look for stocks in certain market cap sizes?

The portfolio is all cap. We’ll buy $100 million market cap stocks and a $400 billion market cap stock. 

We typically do not invest in smaller companies unless we meet the management team face to face to understand their goals, because they determine capital allocation which drives the return profile of the company. 

We ask them a number of questions: What is the highest return on capital investment you could make? What is your threshold? What do you think your cost of equity capital is? What about the cost of your debt capital? How do you evaluate different types of projects, and what is your return threshold? What would your return threshold be for an acquisition? How do you feel about what this other company has done? 

We use examples and ask their opinions on their competitors. We want to know them as capital allocators and be comfortable with their decision-making process for one primary reason—if we understand how the management team makes decisions, then we can get comfortable with the security’s downside, because when times get hard, we want to predict the decisions these management teams will make, to avoid surprises. 

If they make a decision counter to what we expect, we follow up to understand their motivation. We sometimes have uncomfortable conversations. We’re not here to be friends with them. It’s about taking care of our clients—they come first. 

Q: What is your portfolio construction process?

Asset allocation is important, because we focus on the role each security plays in our portfolio. We want positions that offset the potential embedded risk of others. 

For example, we have many yield stocks, and because of compression in the yield curve, we have some duration-like risks in the equity portfolio. Since 2013, when we saw it spike to 3% in the 10-year and how our portfolio reacted, we added conservatively managed community banks in good geographies. We met with the management teams, often multiple times. These banks benefit from higher interest rates, have decent dividend yields, and relative valuations are attractive. These became a core holding for us because they offset a lot of our interest rate risk and provided diversification and risk reduction in our portfolio. 

We shied away from large cap banks. They have large asset pools that not everyone understands, and the regulatory risks are almost unknowable, preventing us from getting comfortable with their downside, whereas we could become comfortable with the downside of a smaller cap bank, with a more granular asset portfolio. 

A large part of our equity holdings are not traditional dividend stocks. We have a lot of lower-yielding financial services companies that benefit from higher rates. We have some that are higher growth, stable names in the portfolio that most traditional managers who want to accomplish the same things we do simply don’t own. We intentionally pulled our fund’s yield down from 5% to about 4.3% in the last 18 months, not because we think rates are going to significantly increase but because higher rates represent a risk in our portfolio. Going back to our mandate, we want a consistent standard deviation experience and construct our portfolio accordingly. 

We do not target specific sector weightings. Our portfolio is fluid. The individual names, particularly equities, are chosen because they enhance the yield without adding significant incremental risk. 

Q: You said a year ago you began lowering equity exposure. How is the portfolio allocated now?

Currently, we are 33% equities and 67% cash/fixed income, largely defensively constructed. Over a cycle we expect a low of no less than 25% equities and a high of no more than 60%. 

We have a few names we like that we won’t likely sell, as long as we remain comfortable with their risk/reward ratio. The rest we wouldn’t have a problem selling. We have probably 3.5% MLPs—master limited partnerships—about 8% REITs, and about 23% dividend-paying common stocks, with about 6% of that in community banks.

Most of our fixed income exposure is high-grade corporate debt, although we do own some closed-end funds. They are a spread product, mostly floating-rate bond portfolios. And we have about 18% to 20% in preferred stocks. A lot of those are trading above their call prices and have a bit of duration. We tend to buy higher-coupon preferred securities and accept the call risk while at the same time reducing the duration risk. 

Because of the proliferation of ETFs and passive strategies in the preferred space, we remain cognizant of which names we own appear in the indices and which do not, because those can become big risk factors. For instance, when people really like preferred securities and there are massive inflows, like this year, a lot of the index names outperform the non-index names. 

Conversely, we need to focus on when rates spike, because we are risk-averse and the non-index preferred securities tend to hold up better in that environment. 

Q: How would you describe the ideal security for your strategy?

The perfect security for us is one with a 4% yield, with 5-10% capital appreciation upside, having a relatively low payout/leverage ratio, and a low beta. If I could find 50 securities like that, we would own all of them and call it a day. But there are plenty of decent companies with relatively high payout ratios that can sustain a relatively high dividend. We are fine owning those. 

Dividend growth is important, and can sometimes—although not always—be an important contributor to return. It always boils down to how it fits in to our portfolio and achieves our mission. We are not particularly valuation sensitive. 

Q: How do you define and manage risk?

Risk to us is the volatility present in the portfolio over a market cycle. Tracing a line from where we started in 2001 to today, we want it to remain as consistent as possible. 

Yes, you can lose money investing with us; we are not a risk-free shop. But we try hard to drive that blended benchmark standard deviation volatility experience. That is the risk we take and the type of portfolio we want to create over a market cycle. 

If you had to choose two options, portfolio A or portfolio B, each with a total expected return of 8% you might think it doesn’t matter which you choose. But what if portfolio A has a standard deviation of 20% while portfolio B’s standard deviation is 6%? The decision quickly becomes clearer.

Investors make bad decisions when volatility is introduced, often selling at bottoms. We want to drive a consistent volatility experience, and keep them invested over the long run. A reduced volatility profile leads to better decision making over a market cycle. We manage risk every step of the way within every security.

Q: Are there any specific tools that you use?

We have an internal risk management matrix in which we list every equity security in our portfolio and normalize its historic volatility. We look for relative downside performers on a multiyear risk-adjusted basis. When a certain threshold is met on a risk-adjusted security, relative to the broad market and its peer group, it turns red on the quantification tool and we discuss it. We ask ourselves what we might be missing. Why is this security performing this way? If we don’t have a good answer, we sell it, without hesitation. 

In terms of metrics, we generally use enterprise value to EBITDA, more than we use price to earnings (P/E), as it’s just a cleaner, less oversimplified way to use debt and total capitalization to account for earnings generation. 

Dividend payout ratio is also important. We love to own names with the ability to raise dividends. We prefer low beta, unless the correlation of that security is inverse to our portfolio—a security can have a high beta if it helps counteract some of our risk elsewhere.

We look at the balance sheet, preferring not to take excess leverage risk because of the greater downside when a company relies too heavily on debt funding—issues like rollover and capital markets risks—but if we’re positioned for a multi-year bull market, we don’t have a problem buying leveraged companies. It does require we do second derivative work on capital markets funding abilities, but we’re okay with that. 

Generally speaking relative value is an important benchmark for us across the board when we select names.