Q: Would you give us an overview of the history and mission of the fund?
The idea for this strategy arose from the late 1990s, when many investors were chasing stock market returns without any appreciation for the risks they were taking. The goal of this strategy has been to generate mid- to high-single-digit yield and total return over a rolling five-year period, with as little risk as possible.
The strategy has evolved, along with our investment research team, establishing our core competency in business analysis and valuation. In 2008, it began to focus exclusively on U.S.-dollar-denominated corporate bonds, becoming a high-conviction, low-risk, high-yield strategy that has excelled in difficult markets and generated strong risk-adjusted returns over complete market cycles.
Bill Zox has been hands-on with the fund since its inception in 2002 and became the lead portfolio manager in April 2008. Co-portfolio manager John McClain joined the firm in mid-2014.
Q: How does your fund contrast with its peers?
We maintain a common sense approach to investing, with three key strategy differentiators. The first focuses on capacity, preserving our ability to generate strong returns for our clients. Capacity is estimated to be between $1 billion and $2 billion for this fund; currently it’s a little above $500 million in the strategy.
The high-yield market structure presents opportunities for a fund our size to be nimble in taking advantage of opportunities. We want to preserve our ability to invest in smaller deals where we feel the market is highly inefficient and protect our clients when we make an investment mistake and need to sell an issue.
Our second key differentiator is our long-term thinking. There are times to make money and times to focus simply on not losing money, so we judge ourselves over rolling five-year periods. The fact that we aren’t beholden to daily, monthly, and quarterly returns enables us to better exploit opportunities.
The third differentiator is how we’ve committed substantial resources to our research effort. We now have 43 research associates, analysts, and portfolio managers who all adhere to the same investment philosophy.
Our analysts’ narrow focus enables them to dig more deeply into companies than our competitors can, which is especially useful in high yield, where many companies have minimal coverage on the sell side and are potentially misunderstood, or not followed, by the buy side.
We try to gain an information advantage over other managers, with the majority of our performance in the fund coming from credit selection.
Q: What is your investment philosophy?
Every strategy here—equity and fixed income—adheres to the same long-term, intrinsic value investment philosophy. We see corporate bonds as an interest in a business, not pieces of paper traded on a short-term basis.
Focusing on corporate bonds priced at a discount to intrinsic value is our best way to reduce risk and generate returns. It’s our margin of safety, and it is contrary to the commonplace assertion that higher returns only come with taking higher risk.
We also believe that, over long periods of time, the price of a publicly traded security tends to revert to intrinsic value, but at any point in time the price may be well above or below that intrinsic value. Our job is to apply our intensive research to invest in undervalued securities. The high-yield corporate bond market in particular is a smaller, less efficient market, prone to dislocation, and offers frequent opportunities to invest in undervalued securities and generate attractive risk-adjusted returns.
Q: Why do you promote value investing?
Long term, economics dictate outcome. Markets are efficient in the long run, just not necessarily so at any point in time. When you are involved in these markets on a day-to-day basis, a small trade, like a million dollars, can dramatically reset the price of a corporate bond in a way that has nothing to do with economic fundamentals.
There are a lot of ways to generate performance. Sometimes, the simplest ideas are the best. We prefer to stay within our core competency as business valuation experts, to hit our objectives with as little risk as possible. Fundamental intrinsic value investing is a good way to do that.
Q: How does your investment philosophy shape your process?
People and philosophy drive our process. Over 90% of our investment professionals are located right here, on the same floor, streamlining communication, a significant asset when the market moves in the blink of an eye and opportunities arise abruptly.
We are vigilant in adopting best practices and avoiding industry mistakes, aligning our incentives with client objectives. For example, portfolio manager incentive compensation, based primarily on achieving investment goals over rolling five-year periods, is mainly paid in company stock or fund shares that can’t be sold for five years.
Both our structural advantages and process have been carefully designed to accomplish two things. First, if we find a bond that we know and like, at an attractive price, we take a meaningful position in that bond, in either the secondary or new issue markets, regardless of index weight.
Second, when volatility spikes and liquidity comes out of the high-yield market, we want to be in a strong position to provide liquidity to the market, earning that extra compensation for our clients rather than paying to take liquidity. In other words, when there are forced sellers in the market, we want to be ready to buy, and when buyers are desperate to put cash to work, we want to sell, to boost performance.
The most distinctive part of our structure is our capacity discipline. We are committed to close the strategy before we become too large to execute it. Most of our competitors sell when there are forced sellers because their clients are redeeming at the same time, or they’re trying to beat a benchmark over the short run.
All of our fixed income portfolio managers also do their own trading. Providing liquidity to an illiquid market means we have to move fast—there’s no time to communicate instructions to a dedicated trader.
Finally, since we don’t manage against any index, we don’t have to chase an overvalued index, putting us in a strong position to take advantage of an undervalued market.
Q: What is your research process?
We spend our days scouring our investable universe of cash corporate bonds, both investment grade and high yield, for opportunities. We focus on alpha generation, not simply covering an issuer because it’s in our benchmark.
We concentrate on businesses and issues we can analyze, assess, and value, and model our expectations over the next five years. If we see an opportunity in a company’s longer-term fundamentals and cash flow, we commit significant capital to it. If we can’t get comfortable with a business, we won’t own it.
We also look at conventional debt metrics, like debt to capital ratio, capitalization, free cash flow yield, and interest coverage, and tailor them to our holistic view of a company’s capital structure. We analyze individual bond structures, including covenants, tenor, and position in the capital structure, to identify the bonds that best maximize risk-adjusted returns.
We assess the enterprise value of a business. If we have a view on what the equity is worth, that’s our margin of safety starting point.
Our first priority, however, is return of capital from businesses we partner with. We insist on understanding management in terms of how they are compensated, their historical track record, priority for future free cash flow, whether we can trust them, and if they’re good capital allocators.
We assemble a list of companies, about 100–200 issuers we know well and actively monitor, and build up required rates of return for each respective bond. We speak with management whenever necessary, follow quarterly reporting, and look for events and catalysts that might change our estimation of the intrinsic value of the business.
Our valuation and conviction shapes our position sizing, our largest weightings equating to our highest-conviction ideas on a risk-adjusted basis. And when we buy an issue, we continually monitor and retest our thesis, always asking how we might be wrong, or what we may have missed in our analysis.
Q: Can you illustrate your research process with an example?
Let’s look at Popular, Inc., known as Banco Popular, Puerto Rico’s largest bank. Banco Popular represents three basis points in the index but over 4% of our fund for much of the last year.
Near the peak of the high-yield market, in late June of 2014, they issued a 7% coupon, five-year maturity, non-callable bond (which is a very favorable structure to us) with relatively low duration and no call or extension risks. At that time, the high-yield market’s yield was about 5%, generating about 200 basis points premium over the market.
Now, even though Puerto Rico has been mired in recession for most of the past decade, Banco Popular has continually increased capital levels and asset quality since the financial crisis and has over a 16% common equity tier-one capital ratio, about as high as you get in banking.
Popular has a very large deposit share, in the mid-40% range, a dominant level that U.S. banks are generally not permitted to approach. The bank today has excess capital, we believe conservatively measured, of $1.5 billion. This is a $450 million issue, with over $400 million cash at the holding company level available to pay off this maturity in less than three years.
We believe the risk is much lower in this bond than the overall high-yield market. It traded down, into the low 90s in the summer of 2015 to last spring, based partly on Puerto Rico’s fiscal situation, despite its limited impact on the bank’s capital position, and subsequently on weakness in the high-yield market, when everything was trading down.
In the low 90s, the bond was generating roughly a 10% yield, so the absolute yields were attractive and comparable with the high-yield market. Currently, the bond is trading at a premium to the issue price.
Since issuance, the high-yield market has compounded by about 2%, so this 7% coupon is now trading at a premium to par, with high single-digit returns in a 2% or so high-yield market.
We have been the number four shareholder of this bank for a number of years, so we know the bank and its management team extremely well, but because it’s still just a three basis point position in our index, that creates opportunity for us relative to other large managers who wouldn’t even look at it.
Q: How do you construct your portfolio?
It stems from our bottom-up fundamental analysis. Any sector overweights and underweights relative to an index come from finding good opportunities at the issuer level, not necessarily taking a macro view on whether we want to be overweight or underweight in given sectors.
Our position sizing derives from our highest-conviction analysis and our discount to intrinsic value. We typically own 40 to 80 issuers and try to select the best bond in a company’s capital structure. Currently, we have 62 issuers in the portfolio, with 70 bonds total.
Our primary benchmark is the Bank of America U.S. Corporate and High Yield Index. It’s not a common benchmark, and while it represents our opportunity set, it has no impact on portfolio construction.
The index is mainly constructed of investment-grade bonds, with a yield around 3%, with about a five-year duration, whereas we currently invest mostly in high yield, with about a 5% yield and three-year duration.
Q: How do you perceive and manage risk?
To us, risk is the permanent loss of capital, but we also aim to minimize longer-term drawdowns. We limit CCC-rated exposure to 10% of the portfolio and limit issuer, industry and sector exposure.
Our most important risk management tool, however, is our intensive research—we consistently test our investment theses to avoid defaults and overvalued bonds.
Our capacity discipline is another important risk management tool. When we realize we’ve made a mistake, or if a bond is no longer undervalued, we want the ability to get out of the position, so we rarely own more than 10% of a bond, and we will close the strategy before that limitation becomes a problem.
While we do not shy away from short-term volatility, our intrinsic value philosophy, absolute objectives, intensive research, and long-term time horizon have allowed us to generate strong Sharpe ratios.
