Greg Carlson: Hi, I'm Greg Carlson, and I'm an analyst with Morningstar. I'm joined today by David Giroux, the manager of T. Rowe Price Capital Appreciation.
David, thanks for being here.
David Giroux: It's my pleasure.
Carlson: Just as a word of explanation, David was our Allocation Fund Manager of the Year for 2012, and the fund does receive a Gold Analyst Rating from Morningstar.
David, perhaps we can get an update on what you've been doing with the fund lately. First of all, it closed to new investors at the end of June.
Giroux: Yes, that's accurate.
Carlson: Can you talk about what prompted that?
Giroux: I think we were getting significant inflows for the last two or three years. I think it's very, very important to make sure that those flows, while they were not an impact in the short term, we were worried that if that level of flows were to continue for three, four, five years in the future, it could impair our ability to invest in things like high yield, to invest in mid-cap names, again three, four, five years down the road. We took an attitude, and T. Rowe took an attitude, that protecting our existing clients was more important than growing the strategy.
Carlson: And indeed in the few months since fund closed to new investors it's gone from strong inflows to fairly flat.
Giroux: Relatively flat, absolutely, which we feel good about.
Carlson: Preserving your flexibility.
Carlson: Let's talk about what you have been doing within the portfolio. I know back in the March-April time period, you picked up some growth stocks as they corrected, and you generally are not a big investor of growth stocks per se.
Giroux: You are right. In that April-March timeframe, we saw a number of names, especially in growth side, get hit. We used that weakness to initiate a couple of companies that traded at maybe a little bit higher multiples than we've historically bought--Twentieth Century Fox, we bought Liberty Global, and we also bought Visa. Actually all of those companies are really attractive on a longer-term basis. Their valuations had come down from 9 times EBITDA to 8 times EBITDA for Liberty Global, and a 25 times multiple, to a 20 multiple for Visa. So we felt very, very good that the valuations were at the low end of their historical trading range. We felt very good about their long-term prospects.
Carlson: Maybe you can touch on a couple of things that have exited the portfolio as well.
Giroux: Earlier this year we let our Nestle exposure go, as it revalued back up to toward the high teens to 20 multiple. We let General Mills out of the portfolio. We had some concerns on a longer-term basis about the staples space and what's going on in the center of the store, and the multiples with staples continued to be very high, relative to history and on an absolute basis, the fundamentals in staples companies are typically pretty poor right now. So we actually feel much better about utilities on a relative basis to staples today.
Carlson: Can you talk a little bit more about the consumer staples environment and what's been going on there.
Giroux: I think if you think about it from a very, very high level, you are seeing more shoppers spend more and more of their dollars on the outside of the store versus the center of the store--that's fruits, vegetables, dairy, juice drinks, and less in the center of the store. As a result of that, the companies that sell into the center of the store, which have historically grown volumes in the U.S. at 2% to 3% pretty consistently over time, their growth rates have come down.
In addition to that trend of trying to eat healthier, you are seeing another trend of people wanting more organic options. So whether it be the General Mills products or Nestle's products being knocked off by organic offerings--not only in the Whole Foods of the world or the Sprouts of the world--but in Kroger and Safeways of the world. So their business is under pressure on a secular basis on multiple dimensions. And their valuations really haven't corrected relative to history. So we feel very good about having a pretty bit underweight in staples, relative to where we think are better risk-reward situations with utilities.
Carlson: Overall within equities, the weighting of the overall portfolio is around your neutral position, maybe a little below that.
Giroux: We would characterize it as about 300 basis points underweight normal. We normally talk about an equity weight of 61% to 62% on a net basis given our option exposure. Today we're about 58%-59% equities, and that's really driven by a concern about market valuations being elevated, high expectations in the market, and maybe some concerns simply about earnings growth next year probably going to disappoint. All of those things make us a little bit more concerned about the equity market. If the equity market were to correct another 10% from where we are today, we'd probably be moving more toward a neutral level in our equity exposure.
Carlson: That option exposure is just covered calls essentially?
Giroux: It's all covered calls, exactly.
Carlson: And that position has increased somewhat as volatility in the market has increased.
Giroux: We basically doubled our covered call exposure as volatility has increased, really in the last month or so.
Carlson: Meanwhile, the fund obviously invests in fixed income as well, and it will hold cash. You've got some interesting fixed-income positioning as usual.
Carlson: Leveraged loans, something we don't see in lot of allocation funds.
Giroux: Our leveraged loan exposure, probably in the last year, has dropped down from almost 10% of the portfolio to more like 4% to 5% of the portfolio, just because a lot more of the new loans that are being issued are coming without covenants, which we don't invest in for the most part. So that's really reduced that leveraged loan exposure.
In addition, we have increased exposure to what I call the highest quality BBs, the safest BBs, what we call money good bonds, that even if company went through another '08 or '09 cycle, we think that they would still be money good. A lot of these companies we think potentially could be investment grade in the future--like Range Resources or MarkWest or Targa. So that high-quality BB bucket, from a valuation perspective, looks very attractive. It's actually the only asset class, if you will, where spreads are today above the 25-year average. I see equity markets trading at a premium to its 25-year average on a multiple basis. Investment grade is trading at a premium to where it's historically traded, but BBs are somewhat attractive on that metric.
Carlson: And meanwhile within leveraged loans, you've actually sold some winners as well.
Giroux: We have. Our big position, which we've talked about in the past, was Dunkin' Brands. Dunkin' Brands tried to reprice their loan at an uneconomical for us spread level, and we chose to let them have our leveraged loans back at par. These leveraged loans have traded down pretty materially since that happened. So that was actually one of the biggest drivers in going from 10 to 4, because that was over 2% of our assets.
Carlson: Meanwhile, the fund did not own Treasuries essentially for a number of years due to low yields. You went back in last year but that position has come down some.
Giroux: Yes, at the end of last year, when the 10-year approached 3%, we thought the risk-reward, especially relative to cash, was somewhat attractive, especially given the downside protection that Treasuries usually offer in market downturns. Now as the 10-year Treasury has gone from 3% all the way to 2.3%, or even little bit below, today, we have pulled that exposure back more very recently, where we've gone from 6%-7% of the portfolio in Treasuries today to more like 1% or 2% of the portfolio in Treasuries.
Carlson: And meanwhile cash sits in a relatively bigger position.
Giroux: It had been earlier this year, when it had risen to the high single digits, but given some purchases we made more recently in the BB space, our cash position is down to about 6% of our assets today, as opposed to 9% or 10% earlier in the year. And we've actually taken advantage of this market correction to get equity exposure up a tiny bit as well. But we're basically mid-single digits in cash today versus high single digits in the past.
Carlson: Which is basically where you like to be, right?
Giroux: It is, Mid-single digits cash makes a lot of sense for us on a long-term basis.
Carlson: Over the course of your now eight-year tenure, you've actually had quite a bit of cash over time, at times because of the lack of fixed-income opportunities.
Giroux: That's true. I think the reason is being able to buy more BBs, where you are really earning 4% to 5% kind of yields, you are not taking a lot of credit risk ... we feel very, very comfortable with the underlying credit risk, as well as the duration is usually inside five years. So you are taking a little bit of interest rate risk, but not a lot of interest rate risk, if you think about it over a three- to four-year basis. So we feel very good about the ability to earn that kind of mid-single-digit return without taking a lot of credit or interest rate risk.
Carlson: Thanks for your time, David.
Giroux: It's my pleasure.