70% Equity/30% Fixed Income Allocation
What changes were made to the weightings in the portfolio?
We are enthusiastic about an allocation shift to 70% equities as we believe they offer a greater total return potential compared with fixed income securities currently.
For the equity portion of the portfolio, we are long-term investors in high-quality companies. Therefore, we allocated the increased funds across all our current holdings.
The fixed income allocation reduction from 40% to 30% resulted in exiting the most expensive Treasury, investment grade corporate, mortgage-backed, and core-plus holdings while retaining what we believe to be the highest-quality holdings. The result is a smaller, but higher-quality, fixed income allocation.
Would you please discuss the recent outperformance of value-oriented stocks over growth?
Growth stocks have primarily outperformed value stocks for the past decade but we saw a leadership change in the fourth quarter of 2020 for two primary reasons:
1. The Election. The election was resolved and, despite the administration’s attempt to call the results into question, Joe Biden is now the President. Perhaps the biggest surprise was the lack of a blue wave with Republicans picking up seats in the house and narrow Democrat control in the Senate. This reduces the prospect of many of the tax and fiscal policies that would have come from a Democrat sweep, which is probably positive for the market.
2. The Availability of the COVID-19 Vaccine. The approval and swift distribution of vaccines lifted sentiment around an improving economy.
Prior to these events, only a few stocks, including the FAANG stocks and those benefitting from the “COVID trade,” participated in the market’s rise. Looking to 2021, there may not be as much concentration in stock performance. If the economy continues to strengthen, it should help a broader range of companies, including beaten-down cyclical stocks, outperform.
Notably, two factors that drove the market more recently have been volatility and valuation metrics, including price-to-book, cash flow yield, and price-to-sales. Conversely, quality-focused metrics, such as return-on-equity, profits, stability, growth, and size, were not rewarded, producing an environment that does not favor our investment process.
How is the Fund positioned if value stocks continue to outperform in 2021?
We are not a typical value manager as we focus on quality, i.e., less levered companies with sustainable, competitive advantages, high return-on-capital businesses, and run by shareholder-friendly management teams. As a result of this focus, as of 12/31/20, our companies:
1. Generate cash at a higher level relative to the market. The equity portion of the portfolio had a return on capital of 19.9% vs. the S&P 500 Index's 12.9%.
2. Maintain lower leverage. The Fund's net debt/EBITDA was 1.4x compared to the S&P 500's 1.9x.
3. Are attractively valued. The Fund's EV/EBITDA was 15.9x versus 18.0x for S&P 500.
We believe by focusing on these criteria, our portfolio will be able to outperform over a full market cycle with less risk.
Would you please comment on merger and acquisition (M&A) activity?
Following a relatively slow year for M&A activity in 2019, transactions plummeted during the COVID-19 shutdown, with deal activity in April 2020 about 80% lower than at the same time in 2019. While a few of the Fund’s companies have made acquisitions, such as Charles Schwab’s acquisition of TD Ameritrade, in general, our holdings have characteristics that make them attractive acquisition targets due to their higher return on capital, low leverage, and greater stability of cash flows compared to peers.
Going forward, the deal environment looks positive for 2021. Some companies with higher debt levels may look to delever or divest businesses. In addition, with roughly $1.5 trillion of cash, private equity firms may put some money to work in this continued low interest rate environment.
Would you please discuss a few of your highest conviction holdings?
Brokerage firm Charles Schwab was added to the portfolio in the third quarter of 2019. As a low-cost provider, Schwab has been an incredible asset gatherer, in our opinion. We believe it has one of the most competitive product offerings in the industry and is currently taking in $2 in assets for every $1 that flows out. With $4 trillion in assets, it recently completed its acquisition of TD Ameritrade, increasing the company’s asset base even further.
During the market turmoil in spring of 2020, Schwabs’ corporate cash balances increased. Over time, Schwab has been a strong allocator of capital and has scale advantages as well. Additionally we saw insider buying during the market rout in April which further increases our confidence in the company.
Another company in which we have a high conviction is Texas Instruments. It has a strong balance sheet, with a very low net debt to EBITDA. It is a high capital return business, with returns on invested capital of approximately 30%-40%. The company has a long product cycle and a healthy demand for its products, allowing management to fully operate its factories, even during slow periods, which helps the company maintain margins.
Texas Instrument’s management team is shareholder friendly as the company has increased its dividend at a 22% annual rate for the past 10 years while shrinking its share count by 23% over the same period.
A recent 2020 purchase is STORE Capital, a triple net lease real estate investment trust (REIT). The company receives store-level financials of its properties and works with middle-market companies to gain greater negotiating power. Among its diversified portfolio are restaurants and gyms affected by the government-mandated shutdowns. This exposure caused the market to speculate that it would cut its dividend, but the company actually raised its dividend by 3% in the third quarter.
Fixed Income Allocation
What is your view on short- and long-term interest rates?
We believe interest rates will remain not just lower for longer but lower for a lot longer. The events of 2020 have extended this outlook longer than previously anticipated. Short-term interest rates remain near zero, while rates at the longer end of the yield curve hover around 1.5% to 2.0%, resulting in a steeper yield curve.
One of the biggest changes in this new era of monetary policy is the Federal Reserve’s increased importance on average inflation targeting. This attempt to generate between 2.25% and 2.50% inflation on a sustained basis has been an unobtained goal for over 20 years. While inflation may reach north of 2% as early as 2021, we do not anticipate conditions will be present for a sustained level.
What’s driving the demand for fixed-income investments?
The current market environment has led investors to realize that products which generate meaningful income are scarce, and could become even more scarce. For example, the Barclays Capital Intermediate U.S. Government/Credit Index returned 6.4% in 2020, yet the return has mostly been price appreciation and not income generation.
We believe the U.S. continues to offer both the highest quality and greatest liquidity within the global fixed income market. Although currently suffering from “financial repression,” which is the state in which the yield on a security is less than the rate of inflation, U.S. fixed income securities remain more attractive compared with any of the $18 trillion in negative-yielding fixed income securities in circulation globally.
Where are you finding the best opportunities in the fixed income market?
We believe high-yield bonds, preferred equities, and certain floating-rate bank loans offer the most attractive opportunities. Although often considered by investors to be “riskier” assets, the anticipated post-COVID economic recovery combined with supportive monetary policy conditions from the Fed should help to create a backdrop against which these assets are well-positioned to outperform.
However, due to their lower correlation to equities, many investors should continue to diversify their portfolio with high-quality bonds. For example, when the S&P 500 Index declined in March 2020, high-quality bonds increased in value.