A Fundamental Approach to Relative Value
First Investors Total Return Fund
Rajeev Sharma, Sean Reidy
Author: Ticker Magazine
Last Update: Jun 04, 8:35 AM EDT
|One of the core advantages of balanced portfolios is their ability to capture the upside and protect the downside, adjusting the allocation between equity and fixed-income holdings in a timely fashion. Rajeev Sharma and Sean Reidy, portfolio managers of the First Investors Total Return Fund, complement this flexibility with a steady focus on company balance sheets and relative value, with the objective to achieve long-term total return with a moderate level of investment risk.
ďWith our ability to adjust the portfolio allocations based on the latest valuations, we have the opportunity to capture the upside when markets are going strong and, when things start to get scary, to offer investors downside protection.Ē
Q: How has the fund evolved since its inception?
When the First Investors Total Return Fund was launched in 1990, its aim was to invest in a mix of stocks and bonds. Since its inception, the objective of the Fund has been to achieve high long-term total return with moderate investment risk. That objective still exists today, but the tools and the allocation capabilities have changed over time.
Today, more asset class selection is available in the fixed-income world. When the Fund was launched, our typical fixed-income allocation would include corporate bonds, municipal bonds, U.S. Treasuries, and mortgage-backed securities. Today, we are able to look at other asset classes, such as asset-backed securities, collateralized loan obligations, and collateralized mortgage obligations. In addition, we recently added a high-yield sleeve to the Fund which can allocate up to 10% to high yield corporate bonds.
On the equity side, the Fund has historically been a multi-cap core fund, employing the strategy of growth at a reasonable price. But as we transition forward, the mix is evolving more towards large caps, based on our bottom-up, fundamental analysis and stock selection process.
Currently, 50% to 70% of the Fund is allocated to equity and at least 30% to fixed income. Rajeev Sharma has been managing the fixed-income component since September 2017, while Sean Reidy took over the equity portion in April 2018. Foresters Investment Management Company, Inc (FIMCO) is the Fundís investment adviser and Muzinich serves as a sub-adviser for the high yield portion of the portfolio.
Q: What is the advantage of investing in your fund?
The Fund is suitable for new investors because it provides a balanced allocation to both fixed income and equities, while the portfolio managers adjust these weightings based on the current market environment. For instance, if valuations become frothy on the equity side and good value opportunities are difficult to find, we can adjust the equity allocation downward and invest more of the Fundís assets in fixed income. Alternatively, if equity markets appear to be attractively valued and we believe we can find better returns in stocks, we can increase the equity exposure of the Fund.
Initially, the Fund was developed to introduce first-time investors to a concept that many may not have been familiar with, namely understanding downside risks and by extension, participating in the potential upside presented by the marker. The goal was to provide a balanced return. Thatís the genesis of the Fund. With our ability to adjust the portfolio allocations based on the latest valuations, we have the opportunity to capture the upside when markets are going strong and, when things start to get scary, to offer investors downside protection.
Q: What are the core beliefs that guide your investment philosophy?
One of our core tenets is the focus on strong balance sheets and free cash flow generation. We look for companies that generate excess cash flow over earnings. This approach improves the risk profile for the fund. We also look for companies with improving returns on invested capital and growing margins. Through our valuation process, we aim to buy companies at a discount to our price target to lower the risk and mitigate the downside.
We emphasize cash flow per share instead of earnings per share because earnings can be more easily manipulated than cash flow within the GAAP framework. Through our diligent research and careful analysis, we estimate the true earnings power of the companies in our investment universe based on the cash flow they generate. After that step, we then come up with valuation based on EV/EBITDA, or discounted cash flow. Once we establish company valuations, we try to buy them at a discount.
We avoid financial risk and companies that we consider to be overleveraged or donít produce enough cash flow to run their business. We look for effective management of inventories and receivables and a proven return on invested capital. Once we have identified companies that we consider out of favor or underperforming and purchase them for the Fund, we set individual milestones that we expect these companies to achieve over the course of time.
Q: What is the rationale behind your asset allocation model?
Asset class allocation is based on relative value. The process begins with an assessment of relative value of the asset classes. Then, within those asset classes, we look for the sectors and the securities that offer the most value.
Having the ability to now invest in high yield bonds gives the Fund an opportunity to explore an asset class that has over the past few years outperformed investment grade asset classes. The anticipation is that allocation will provide a higher yield to the portfolio and the potential for greater total return. We will be able to better explore relative value amongst an increased number of asset class choices
Q: What is your investment process?
On the fixed-income side, we start with a top-down macroeconomic approach. We look at the direction of interest rates and the market conditions. We establish a view on duration, credit ratings and relative valuations of several different asset classes. Next, we look at the strength of each specific issuer relative to the current credit cycle.
This type of fundamental approach is rigorous and involves examining securities at the issuer level. In addition, the shape of the yield curve will be a significant factor in our investment process. For instance, if a 30-year corporate bond is trading at the same spread as a 20-year corporate bond, we would rather own the 20-year bond in order to eliminate a portion of the credit and duration risks.
On the equity side, we invest in U.S. stocks and some American Depository Receipts of foreign companies. The process begins with quantitatively screening our issuer universe, in which we eliminate highly leveraged companies and companies with a market cap of less than $500 million. We look for companies that are growing their cash flows above their earnings and prefer companies with an increasing dividend yield or dividend growth.
Once we have eliminated any companies that failed our screening criteria, the residual is our target list. At this point, we work with our team of sector-specific analysts and, together we come up with price targets (or the private market value) for each stock. We thoroughly complete our due diligence and read all the 10-Ks and 10-Qs regulatory filings to eliminate the noise within GAAP accounting standards and to estimate the true earnings power of each company. We eliminate companies that appear to massage earnings to meet short-term expectations. We want to buy companies that have strong fundamentals without using GAAP, which, in our opinion, makes earnings appear better.
Also, we talk to company management before we make any investment decisions to get a clear understanding of the business and its competitors. We favor companies that are near the top of that particular industry in terms of competition.
In the next step of our investment process, the analyst pitches the idea to the portfolio managers, who usually play devilís advocate, and try to essentially punch holes in the investment thesis. At FIMCO, portfolio managers need to approve the idea before the stock is bought for the portfolio.
There is also an ongoing maintenance effort surrounding these ownership stakes. We participate in all conference calls and meet with the management in our NY office at least once a year. We also visit the companies to get a better visual understanding of their businesses. We also talk to third-party researchers to confirm our thesis. Our price target is managed on a quarterly basis to make sure that the original investment thesis is still on track. Once the investment thesis has played out or when the valuation has become too high, then the stock becomes a sell candidate.
Q: Could you give some examples that illustrate your research process?
Through our investment process we found a new corporate bond issue, Magellan Midstream Partners, a distributor of refined petroleum products. It came to the market with an attractive spread against the 10-year U.S. Treasury. First, we evaluated the attractiveness of the sector from a top-down perspective. At the time, it had a very favorable spread, so we researched the name with our credit analyst and considered the credit metrics along with the long-term contracts that the company had in place. We found it to be a stable credit, with leverage that was lower than the average for the master limited partnership (MLP) space.
Additionally, the company had low commodity price exposure, which was also a positive factor. We were comfortable with its ratings (Baa1 and BBB+) at the time. When oil started to rebound, we purchased the security. On a relative value basis, the credit made sense and the bond performed well in the portfolio. If our relative value analysis determined that the credit wasnít attractive and the valuation was not appealing, we would have avoided the issue, even if the issuer displays strong financial metrics and ratings.