Q: What is the history of the fund?
Tributary Balanced Fund was launched on August 6, 1996, as a traditional balanced fund that holds both individual equities and fixed-income securities. Initially, the equity side of the portfolio was managed by the value team, but in 2001 the growth team took over. The fund’s adviser is Tributary Capital Management, LLC, a wholly-owned subsidiary of First National of Nebraska, Inc.
Tributary Capital Management can be characterized as a niche player. Over the years, we have gravitated to asset classes that, we believe, can add alpha and superior risk-adjusted returns. The biggest fund within the complex is the Tributary Small Company Fund. Other funds include a mid-cap growth fund and three fixed-income funds. Although we don’t have a dedicated large-cap fund on the equity side, we don’t ignore the large-cap space. The Balanced Fund takes a multi-cap approach to the equity portion fund.
As of March 15, 2018, the Tributary Fund complex had assets under management of $1.35 billion.
Q: What differentiates your fund from its peers?
First of all, this is an actively managed fund. One of its advantages is the multi-cap approach, which leads to fewer constraints in stock selection. We have a bottom-up, opportunistic view in analyzing companies. Instead of deciding whether the market looks cheap on a small or mid-cap basis, we go through a screening process to find companies with a rising profit outlook and valuation discounts. If mid-caps are cheap, we’ll find plenty of companies in the area through our bottom-up view. Our advantage is that we are not looking at a particular area of the market.
This is an institutionally managed process, both in equity and fixed income, which we deliver through a retail channel. It actually uses the principles of institutional asset management in the entire process, from asset allocation to security selection.
Q: How would you describe the core beliefs that drive your investment philosophy?
The objective of the fund is to provide capital appreciation and income through tactical asset allocation and security selection. A unique feature of the fund is that we invest with both absolute and relative return objectives. The asset allocation parameters are 25% to 75% of stock allocation, with a minimum of 25% in fixed income and cash. Historically, we have drive alpha through security selection and controlled the portfolio risk through diversification.
We aim to invest in quality companies with improving fundamentals relative to the peer group. We utilize a concept called profit outlook, which looks at the next 12 month earnings of companies within their respective industries. We look for companies that are outperforming their industry in terms of sales, earnings, and cash flow. Also, we look at the quality of the businesses, the return on capital, and the strength of their balance sheet.
The next step is looking at absolute valuations and valuations relative to its peer group. In essence, we buy high-quality companies that have superior or rising profit outlook at either below average or average valuations. The consistent application of this valuation discipline typically leads to a growth bias.
In terms of diversification, we invest in all the economic sectors with a focus on companies that fit our discipline. We find many opportunities in areas that are not usually perceived as growth areas, such as utilities and consumer staples. The emphasis is on the company fundamentals and profit outlook, combined with the valuation discipline in our stock selection process.
Q: Could you explain your tactical asset allocation process?
The tactical asset allocation is a multi-factor model, which emphasizes three areas. The first area is establishing a view of the global and the U.S. economic outlook. From our perspective, global growth is expected to continue at similar to 2017 levels or better. We believe that in 2018 the U.S. economic growth may be faster because of the tax reform benefits. That view favors stocks over fixed-income securities.
The second factor is the profit outlook. We assess the outlook for corporate earnings in the U.S. and internationally over the next 12 months.
The third factor is relative valuations of cash, fixed income and equities. We examine this factor on the basis of equity risk premium. Over the last years, stocks were trading at a modest discount to bonds. However, after last year’s performance and returns, they are less of a bargain. So, we started to pull back our overweight in stocks, which we were favoring for the last 8.5 years.
Overall, our weightings vary based on earnings and valuation. In the case of great earnings and a cheap stock market, our equity allocation would be in the 65% to 70% range. When we expect corporate earnings to go down significantly based on our economic view, we would become more conservative and underweight stocks. We will continue to monitor market conditions for both earnings and valuation opportunities as interest rates rise.
Q: What is your research process on the equity side?
We utilize a third-party platform for our stock selection and run daily screens to monitor the portfolio and to generate new ideas. When a company reaches its full valuation, we typically trim the security. Our metric based screens look at each company from the perspective of relative profit outlook and valuation, both absolute and relative. In essence, we look for the companies that fit the expected earnings growth and the valuation targets.
The fundamental analysis begins with screens on debt levels and coverage, operating margin and return on capital trends. Significant changes to the business from mergers and acquisition activity are also important. We look at the sustainability or the factors that would help a company’s revenue and earnings to continue to outperform their peer group.
We do an internal company report, which is partially based on screens, Wall Street research reports, company earnings, earnings calls transcripts, etc. before we decide to add a stock to the portfolio. The research report is presented to the equity team, so there is an opportunity for all team members to ask questions and to do additional research.
After the research process is completed, we determine if the stock will be added to the portfolio and what would be the appropriate weighting from a risk perspective. The higher risk securities typically receive lower weightings in our process.
Q: What is your buy and sell discipline?
In general, in the equity portion of the Fund, we start buying companies at 0.5% to 1.5% of the portfolio. The allocation can vary based on the market cap of the company.
According to our sell discipline, we would sell a stock if it becomes expensive, if we don’t see the upside any more, if fundamentals deteriorate, if downside risk increases, or if we no longer expect the profit outlook of the company to outperform its peer group.
Q: Would you highlight the steps involved in your research within fixed income?
In fixed income, we manage to the Barclays U.S. Intermediate Government/Credit Bond Index. Our security selection process combines a top-down view with a bottom-up approach. We start with our views on the economic cycle, the Federal Reserve policy, the changes in monetary policy, and the likelihood for interest rate hikes.
Our screening process involves looking at relative valuation from a duration or yield perspective. We analyze the opportunities in corporate spreads, structured products, asset-backed or mortgage-backed securities. The process varies for the different types of securities but in the end, similarly to the equity approach, we create a fundamental credit review and a research report that’s presented to the fixed-income team.
From a corporate standpoint, the emphasis is less on the expected profit outlook and more on the strength of the balance sheet and the consistency of the cash flow. For example, if a company has just made an acquisition, its debt may have been downgraded and spreads could have widened. However, if the business generates solid cash flow and the management is focused on bringing the leverage back down to the target level, we would be interested. That would be an opportunity if the company manages to deleverage its balance sheet, credit ratings improve and spreads tighten. That’s an example of a corporate bond that we would include in the portfolio.
On the mortgage-backed securities front, we tend to perform more analysis of the collateral than our peers to make sure that we have a thorough understanding of the assets. We need to be comfortable with the credit risk that we take.
In corporate bonds, our average credit rating is usually anywhere from BBB to AA-. Unlike some of our peers, we don’t stretch for yield. Although we can invest in high yield, our high-yield exposure is typically quite low. Overall, the portfolio is constructed as a core fixed-income portfolio with limited interest rate and credit risk.
Another differentiating factor is that our fund doesn’t have international exposure in fixed income, while international bonds represent about 10% of that universe. We may look at some international companies if they have a significant U.S. presence or trade in the U.S.
Q: Could you give us some examples that illustrate your process?
In the fourth quarter we added Waste Management, Inc., an industrial company. We didn’t have exposure in the area, but we were trying to diversify our holdings. The company met our criteria in terms balance sheet strength, return on capital, industry leadership and growing profit outlook as it has been consistently growing its revenues and earnings. It operates in a very fragmented industry, where some consolidation is going on. We saw the market opportunity from a price perspective and added the stock at the end of 2017.
Another example is Activision Blizzard, an interesting company within the gaming technology space. The industry is fairly consolidated, with a few strong players. More importantly, as distribution changes and becomes increasingly based on the Internet, the industry favors the existing companies in terms of continuing sales growth and margin expansion. We believe Activision Blizzard is benefiting from that trend. The company has a number of other drivers and a sustainable profit outlook. The stock has done quite well since we purchased it in November.
Q: What is your portfolio construction process?
Our benchmark is 60% Russell 3000 and 40% Barclays U.S. Intermediate Government/Credit Bond Index. Due to our multi-cap approach, we use a broad U.S. market index. In terms of our risk matrix, diversification is important both in stocks and bonds.
We typically hold about 70 to 80 individual equities. We have constrained individual stock exposure to 5% and sector exposure to over 10% of the Russell 3000. We look at a range of 75% to 125% of the benchmark.
The goal of the portfolio construction process is to be diversified and to drive alpha through stock selection. Our sector bias is consistent with our view of the global economic growth. But while we may have small overweight positions in some cyclical sectors like technology, industrials, and financials, we’ll still have exposure to REITs, consumer staples, healthcare and some of the more defensive areas of the marketplace.
On the fixed-income side, we typically hold around 65 bonds with full position size of 1%, or even less for some BBB credits or BB bonds. Currently, our largest holdings are government securities.
On the equity side, actively managed funds usually have significant international exposure; right now it is about 23% of the assets. We invest only in few international companies that are headquarters in the U.S. Our international exposure currently is 1% to 2%. Of course, we are interested in international growth and emerging markets, like China and India, but we achieve that exposure primarily through U.S. specific companies that benefit from the synchronized global growth.
When we construct the portfolio, we look at active weightings relative to our index. Large-cap companies typically have larger weightings in the portfolio. For companies like Apple, which we currently own, the weighting in the portfolio can be 3% to 4%, while a small-cap company with small weight in the index, would be closer to 1% in the equity portfolio.
Q: How do you define and manage risk?
We start with absolute risk as we look for opportunities and some capital preservation. This is not an all-equity fund and our exposure of 25% to 75% in fixed income helps to mitigate the risk of losing value in a downturn. Although our benchmark is 60% stock and 40% bond, we have the ability to have lower equity exposure than the benchmark. During 2008 and in the beginning of 2009, our equity allocation was less than 50%.
Diversification is our primary risk control within the two major asset classes of stocks and bonds. We have constraints on sector and individual position exposure and we aim to provide higher returns with less risk within each asset class.
On a volatility-adjusted basis, the higher-risk companies receive lower active weightings. That’s an integral part of our portfolio construction process from a risk management perspective.
On the fixed-income side, a key focus for long-term outperformance is preservation of capital. That conservative view drives the portfolio construction of the bond part of the portfolio. We don’t invest much in high yield and the high-yield bonds that we do hold, are expected to be upgraded. Also, we avoid taking substantial interest rate and credit risk.
The overall risk management, the portfolio construction and the diversification, are important components of the fund.
