PIMCO's New Pathfinder Fund Finds a Familiar Road

PIMCO EqS Pathfinder , the renowned bond giant's first foray into actively managed equities, is less than a month old, but this is one newbie with a solid story behind it. Its managers, Anne Gudefin and Chuck Lahr, were poached in late 2009 from the esteemed Mutual Series group. They'd been running  Mutual Global Discovery (TEDIX) and other funds that practice a strict value discipline and maintain a real aversion to downside risk. Gudefin and Lahr demonstrated that risk-averse approach toward the end of 2008, when they made the decision to put more than a third of their previous fund's assets into cash, and then let that amount rise to nearly 50% in early 2009--bold decisions that limited the fund's losses as the market tanked.

Since then, of course, many global stock markets are up more than 50%, and the bargains of a year ago are fewer and further between. Given Gudefin and Lahr's strong performance record, their value leanings, and the current market environment, we were eager to hear from the managers. Are they finding great opportunities to populate their new fund? Or would they maintain a high cash level?

The Basics
Gudefin and Lahr will use a three-pronged approach at Pathfinder, just as they did at Mutual Series. The bulk of the portfolio will be composed of stocks from around the world that the managers consider undervalued. But they will also engage in merger-arbitrage deals and buy distressed debt. On the currency front, they'll maintain a flexible hedging policy.

So far, Gudefin and Lahr have hired just one analyst, who comes with a background in merger arbitrage. They plan to hire two or three more. They say they'll make much use of PIMCO's impressive fixed-income and macroeconomic research, though it's not clear how applicable that bigger-picture research will be, considering the fund's bottom-up strategy.

Staying Disciplined
"Do we have less cash than in December 2008?" Gudefin asks rhetorically. "The answer is yes. But we always want to keep cash on the side to invest when things are happening. That's more true than ever." Gudefin cites the recent Gulf of Mexico oil spill as an example of a reason to keep dry powder, saying the markets are "overpricing the consequences of this oil spill."

PIMCO won't yet give specifics on the fund's holdings, but Lahr alludes to a roughly 20% cash level today. The 2008-09 period aside, that's on the high side for Lahr and Gudefin's strategy.

While that could suggest that they're finding cheap stocks tougher to come by, they say it's also a function of the fact that they only have hired one analyst so far. "It's not the case that a lot of ideas are getting shot down because of risk right now. As people come on board, [we] expect to deploy more, but in keeping with the discipline," says Lahr.

Lahr says that he and Gudefin--who consider themselves analysts, as well--have thus invested by sticking with what they know. Lahr's background is in analyzing global financials, while Gudefin had an emphasis on consumer goods companies and energy. More specifically, tobacco names, such as British American Tobacco (BATS), and food and beverage stocks, including Danone (DANOY), had long been well represented in Mutual Global Discovery. On the financials side, Lahr favored non-U.S. financials, though as that sector has gone through crisis over the past few years, the makeup of Lahr's holdings has changed. As for energy stocks, Gudefin has favored oil-services firms.

Although new analysts might mean more ground is covered, it's tough to imagine the portfolio's characteristics being much different than those of Mutual Global Discovery on Gudefin and Lahr's watch. That said, two costly holes currently could be technology and health care. Although these haven't been big parts of the portfolio historically, high-quality large-cap tech and health care are historically cheap and thus could mean some missed opportunity here.

It's Yesterday Once More
Judging by Mutual Global Discovery's historical portfolios and Lahr and Gudefin's approach, a couple of points emerge. One, there's that margin of safety--valuation is critical. Two, they value cash return. That's clear from their emphasis on dividend yields, like those offered by big tobacco, for example.

Gudefin still likes the tobacco names even though they weren't among those that were crushed in the market correction between 2007 and 2009 (and also aren't among the biggest winners in the rebound). She says tobacco companies are trading at "10 to 12 times earnings and with dividend yields of 5% to 6%. Some have reached some all-time highs recently, but they continue to give very good returns to investors." In particular, she says British American Tobacco, while above its peak in 2008, is still not expensive because the company has continued to grow the business over the past couple of years and has vast emerging-markets exposure. Some of the tobacco firms that sat atop Mutual Global Discovery on Gudefin and Lahr's watch include BAT,  Imperial Tobacco (ITYBY), and  Lorillard , all of which are wide-moat stocks with comparatively high free cash-flow yields.

Gudefin has also been a fan of Seadrill, a company that she first bought in 2006's second quarter--not long after it was created. "It was a high-risk company for several reasons. The management maneuvered successfully through these different pitfalls, and Seadrill is now one of the largest rig operators," Gudefin says. She also says the story isn't over, citing a trend toward ultradeep offshore drilling.

Gudefin does recognize that she has to factor in the price of oil in Seadrill's position, as well as those of other oil-services stocks. She explains how her price discipline can work in the fund's favor. "In the summer of 2008 when oil prices reached an all-time high, we trimmed the position in Seadrill around the NOK 140 level to buy it back in Q4 2008 below NOK 60. Volatility may continue to present these types of opportunities in the future," she says.

Something Old, Something New in Financials
Lahr remains committed to Deutsche Borse (DBOEY). He explains that the structural move toward trading derivatives on exchanges, as well as the fact that volatility in markets is increasing, benefits the exchanges. "It doesn't take much of a shift there to see pretty substantial growth," he says. "People normalize earnings on banks and lots of other industries--nobody seems to want to on exchanges. Then there's a solid dividend yield without even throwing in the optionality of regulatory reform."

But Lahr also sees new opportunities in financials in some of the banks. Whereas he thinks some regional banks aren't as cheap as they were at the beginning of 2010, he does like smaller, subregional banks and community banks. Of the big banks, he says many have priced in too much good news. But he thinks  Bank of America (BAC) is incredibly cheap: "This is a bank with probably $2.50 to $3.00 per share in normalized earnings power. Its capital position is pretty solid. You have real leverage to an improved consumer, but at the same time you are not relying on an acceleration in consumer spending. You also have a fair amount of exposure to capital-markets activity. And a steep yield curve--it allows banks to surf the yield curve."

What to Expect
Investors here can expect certain behavior from PIMCO EqS Pathfinder. During rip-roaring rallies, its valuation sensitivity will likely keep it behind peers. But the fund should perform relatively well in times of market strife--just as Mutual Global Discovery has. Patience on the part of shareholders will be a necessity, as the strategy can go through dry spells. But at Mutual Global Discovery shareholders were rewarded for that patience, for the fund has notched strong long-term returns. Meanwhile, Pathfinder's expense ratio, which includes a waiver for a portion of its management fee, should run at 1.24% initially, according to its prospectus. (Its no-load D shares will also have a 1.24% expense ratio.)

There are other risks, however. As noted, the investment-management infrastructure is still incomplete--more analysts still need to be hired. There's also the possibility that PIMCO's top-down thinking starts to shape the portfolio, rather than the bottom-up stock-picking that has worked so well, but this development seems unlikely. Finally, there's the potential that the managers become overwhelmed with cash. This isn't an issue at this point, because most mutual fund flows have been going into bond funds. Currently, the fund is still tiny. But when interest returns to equities, PIMCO's large number of fixed-income fundholders could shift a lot of money into Pathfinder, which could cause difficulties for the currently small operation.