Equity and Income Opportunities in a Higher Interest Rate Environment

Equity Allocation

What surprised you the most about the equity market so far in 2023? 

The strength in equities driven by better-than-expected economic growth and the excitement around the potential benefits of artificial intelligence (AI) have been the biggest surprises this year. 

In addition, the anticipated recession has not happened yet despite the Federal Reserve’s increases totaling over 500 basis points in the federal funds rate. 

Notably, in 2023, growth companies have significantly outperformed value stocks with the difference most exaggerated in the large-cap area of the market. For the first six months of the year, the large-cap Russell 1000 Growth Index rose 29.0% versus a 5.1% increase in the Russell 1000 Value Index. Much of the outperformance can be attributed to seven stocks that drove the majority of the return of the broader market.

Would you please discuss the valuation of the equity portfolio relative to 2022 and the current market?

The Fund’s equity portfolio currently trades in line with the overall market. On an EV/EBITDA basis, both the portfolio and the S&P 500 Index trade at 14.8x trailing 12 months results as of June 30, 2023. Given the portfolio’s overall higher quality based on higher pre-tax returns on capital, and lower leverage ratios, we believe the Fund’s equity holdings look attractively priced.  

At the end of 2022, the portfolio was trading at 13.9x on an EV/EBITDA basis. Even though the portfolio is currently trading slightly higher, the relative valuation has improved as the equity sleeve is now in line with the S&P 500 while it traded at a slight premium valuation at the end of 2022.

With a focus on companies with lower leverage, higher levels of free cash flow, and higher returns on capital, what areas of the market look appealing?

Our goal is to own companies with sustainable competitive advantages that can compound high returns on capital for many years. We look to establish positions in attractive businesses regardless of sector classification and hold them for the long term. Given that viewpoint, we see opportunities across many areas of the market, including the consumer sectors, financials (excluding banks), 
and information technology sectors.  We believe businesses with quality attributes and solid fundamentals will lead to strong risk-adjusted returns over the longer term. 

What are recent additions to the portfolio?

In the second quarter of 2023, we initiated a position in Republic Services (RSG). The company maintains the second highest market share behind Waste Management in the North American waste services market. The company’s competitive advantages stem from the ownership of numerous landfills and transfer stations and cost advantages via route density. RSG leverages a large network of collection routes and transfer stations, which move trash from commercial, industrial, and residential markets to landfills.

Operating margins have been in the high teens. Volume growth is slow and stable, and is largely driven by population growth. Margins may improve over time via higher pricing and route density, and industry consolidation in recent years has led to better pricing. 

Although the company’s net debt/leverage ratio is roughly 2.8x, it maintains financial flexibility. Cash flow generation has been consistent and will likely be used for reinvestment in the business, acquisitions, dividends, and share repurchases. 

We also initiated a position in chemical company Albemarle (ALB), underscored by its recent insider buying by executives.

Over 80% of EBITDA is driven by the Energy Storage business, and strong demand for electric vehicles has been driving demand for lithium. ALB is also the world’s second largest producer of bromine, a chemical used in flame-retardants for electronic devices. Greater demand for servers and automobile electronics should drive growth while, conversely, demand from TVs and laptops may decline.

In terms of operating cash flow, a meaningful amount will be spent to expand capacity in the lithium business while remaining cash flow will likely go toward debt reduction, increasing the dividend and occasional share repurchases. The company maintains a strong balance sheet with net debt/EBITDA of less than 1x.  

Fixed Income Allocation

What are your expectations regarding the Federal Reserve actions for the rest of 2023?

As expected, the Federal Reserve increased the fed funds rate by a quarter percentage point to a target range of 5.25% to 5.5% in July. Following this rate hike, we believe there may be a small chance the Fed will raise rates one more time before November 2023 since core inflation and employment data has remained strong.  

Notably, 2024 is an election year so the Fed will likely want to stay out of the limelight next year. Therefore, the terminal rate should become clearer in the next three months.  

While the market had priced in 3 to 4 rate cuts earlier this year following the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank, we do not expect a reduction in rates for the remainder of this year.

What changes have you made to the fixed income portfolio over the first half of 2023?

With higher yield opportunities in other areas of the fixed income market, we made numerous changes in the portfolio. 

Previously in 2022, we had reduced our exposure to high yield credits. As we entered 2023, in an uncertain environment with many investors expecting a material economic slowdown, we further increased the quality in the portfolio. These moves included purchasing high-quality investment grade bonds and Treasuries, reducing the preferred stock allocation from 6.8% down to approximately 3.5%, and selling the Fund’s 2.5% position in business development companies. 

As of the end of the first half of 2023, we believe the portfolio is higher quality with less risk. The Fund’s duration has held steady, near the Bloomberg U.S. Intermediate Government/Credit Bond Index’s duration of 3.8%. 

Overall, we believe the current environment is providing attractive yields for fixed income investors. 

Would you please comment on the direction of the yield curve for the rest of 2023?

The 10-year Treasury has been below the two-year yield for more than a year, the longest since 1980. With the unemployment rate below 4% and year-over-year U.S. inflation around 3%, we believe the yield curve will remain inverted for the foreseeable future. Further, we haven’t seen any material distress in interest-rate sensitive areas of the economy despite the Fed’s 5.25% increase in the fed funds rate in 16 months.

As 2023 comes to a close, we could see longer yields come down a little lower. While there is more opportunity for short-term yields to move, investors do not receive as much appreciation as they do on the longer end.