Stocks Attractive on a Relative, But Not Absolute, Basis

Greg Carlson: Himy name is Greg Carlson; I'm a fund analyst with Morningstar.

I'm joined today by the winner of Morningstar's very first award for Allocation Fund Manager the Year, David Giroux of T. Rowe Price Capital Appreciation.

David, thanks for joining me.

David Giroux: Pleasure to be here.

Carlson: Now we should probably start by talking about the strategy of your fund, because there are number of moving parts here.

Perhaps, you can go through them. The fund typically invests the majority of its assets in stocks, but there are other sub-portfolios, if you will, that are involved?

Giroux: Sure, Greg, we are a multi-asset-class strategy. Like you said, stocks are always at least half the assets of the strategy, but in addition we'll buy fixed-rate bonds, investment-grade bonds, high-yield bonds, floating-rate securities like bank debt or Ginnie Maes. In addition, we do some covered-call writing from time to time.

The strategy really has three main objectives: We want to generate good, risk-adjusted returns year in and year out, we want to preserve capital over a three-year basis, and over a full market cycle, we need to generated equitylike returns with less risk and that of the overall market.

Carlson: Right, and the benchmark there being the S&P.

Giroux: Yes.

Carlson: Well, maybe you can review for us just briefly what did well in 2012 for the fund? It obviously had a very good year relative to its category?

Giroux: Well, Greg, I'd say a couple of things went right for us last year. A lot of our floating-rate instruments did well. We had a big bet in Sprint in our fixed-income that did well. TRW, Delphi, some of our auto suppliers did well, Disney had a good year. Thermo Fisher, which was our largest holding last year, did very, very well. So, really equities and fixed income both did quite well for us.

Carlson: Drillingdown little more, I think you mentioned Cooper--that was a company that was taken out at the premium for you?

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Giroux: Cooper Industries was acquired by Eaton, basically mid-year. It was a name that we've always thought was a likely takeout candidate, but we thought the fundamentals at Cooper were very, very attractive by themselves. Cooper is a great example of something we do every year, which is we try to find companies where we think there is some free optionality, where there's a potential for being taken out down the road, where the market is not pricing in that option. It's almost a "free optionality," if you will. So it seem like every year, we have a Cooper or an El Paso or a First Data that gets taken out and adds 20, 30, 40 basis points to the fund's performance.

Carlson: But you are not necessarily betting on a takeover; it's more just the fact that these are companies that are in pretty good shape and trading relatively cheaply.

Giroux: We don't want to ever pay up that option. Obviously, if we paid up for it, it wouldn't be free. And in the case of Cooper, it was a name that we thought over a long period of time created a lot of value, and Eaton stepped forward and paid a big premium for the stock--about 30%--premium and lot of us recognized that upside earlier.

Carlson: And within the fixed-income sleeve, I know leveraged loans have been a significant contributor for the fund.

Giroux: Yeah. Leveraged loansare still around 40%of all of our fixed-income assets. We like leveraged loans because of the top of the capital structure, which means even in a difficult economy, they tend not lose a lot of money. Their floating rates, if rates go up, you get extra income to compensate you for that. So we really like leveraged loans as a very attractive risk-reward characteristic asset class in the marketplace.

About half of our fixed-income exposure is floating rate in nature, and our effective duration on our fixed-income portfolio is roughly about two years, so we are very concerned that rates could go higher, and we've positioned the portfolio for rates to go higher.

Carlson: I guess, we should mention here that leveraged loans are generally rated high yield, but you are generally focusing on companies that do have a very good chance of paying back their debt.

Giroux: Yes. The attractiveness of leveraged loans is, if you think about the capital structure, you have equity, you usually have subordinated debt, you have senior debt, and then you have leveraged loans, or bank debt, if you will. So you'd have to destroy a lot of value before you can actually pierce that leveraged loan value, if you will. That's why they tend not lose a lot of money, even in bankruptcies per se. That's why they are so attractive.

Carlson: And your biggest position there has been Dunkin' Brands.

Giroux: Dunkin' Brands, which obviously owns Dunkin' Donuts, is a very, very safe … it's a franchise model. It's an asset where the equity trades for 14 to 15 times EBITDA. Only levered through the banks at 5 or 6 times. So a lot would have to go wrong for Dunkin' to not to get paid back in full, if you will. And we'll earn about a 4% yield along the way.

Carlson: Now, you're not necessarily making asset allocation shifts, trying to time different asset classes. But at the same time, it seems a shift did help the fund last year. Earlier in the year, you had an above average-exposure to equities.

Giroux: Yes. We talked about sort of a normal equity exposure around 61%-62%. Earlier in the year, we were a little bit higher than that. As the market rallied, we took that down; the market came off a little bit in November, and we actually added back to that, so we are right around that average of 61%-62% today.

And I think the point you raised is a good one. Typically, when there's fear in the marketplace, when there's blood on the streets, if you will, when people are very fearful of the next data point, we'll typically step up and add to equities, put more risk in the portfolio. And when people are complacent, when stock markets are hitting 52-week highs, you'll usually see us pull back. We tend to be a little bit counterintuitive, if you will, on that side.

Carlson: Right. And that feeds into a little more talk about your current positioning. The fund has been very light on Treasury bonds, lately. I know that you would like to own those, but you just simply don't find them attractive at this point.

Giroux: They are just not very attractive. You are earnings below … you are earning a negative real yield. If you think about it, a 10-year at 1.8%, inflation probably is going to be 2%-2.5%. You are going to actually lose money on a real basis in Treasuries.

I think people think about Treasuries as low-risk investment, and that may be true from a credit perspective, at least hopefully, but at the same time, if rates were to go from 1.8% to 2.8%, you're going to lose 5% over the course of a year. If rates went from 1.8% to 3%, you could lose a midteens kind of percentage. So, there is a lot of risk if rates go higher. So you have an asymmetric risk-reward that is quite negative with Treasuries today.

Carlson: Besides leveraged loans, the rest of the fixed-income portfolio consists largely of short-term bonds?

Giroux: Yes, it's either short-term investment-grade paper or short-term high-yield paper, for the most part.

Carlson: The fund also has a double-digit cash take at the moment, too?

Giroux: Yes, I agree. We will always have a little bit more cash than that of the average mutual fund, and that really goes back to that second objective I mentioned earlier of capital preservation.

We want, if you give us a dollar today, no matter how bad the market is, we'd be able to give you back that dollar in three years. So, we do think about capital preservation, and we're always going to hold a little more cash as a result of that.

In addition, we always want a little bit of extra capacity in case that the market were to roll over, so we can put that money to work really quickly, and I don't want to have to sell fixed-income securities first to do that.

Then the other thing I'd just say is, the opportunity cost of holding cash today is quite low, given how low rates are. So, we feel very comfortable having a double-digit cash position. Over a long period of time, we'd hope to have that lower, but right now, with not a lot of asset classes looking particularly attractive, with the S&P 500 near a 52-week high, there is a little bit of complacency in the marketplace, so we're going to hold a little bit more cash.

Carlson: Now one area of the portfolio that was much bigger in the past was the exposure to convertible bonds, and that's dropped quite a bit.

Giroux: Unfortunately. We love convertible bonds. We like the long-term risk-reward characteristics of the convertible market. The challenge is the convertible market has really shrunk. Companies that used to issue convertibles have now chosen to either not issue convertibles because of some accounting changes, or they have chosen to issue high-yield debt, because rates have come in, or they have chosen just to do straight equity. So there is very little new convertible issuance, and what new convertible issuance we do see is typically in small-cap companies, which have a lot of volatility. Our historical preference to own convertibles in the mid-cap and large-cap names. There is very little issuance in mid-cap and large-cap convertibles today.

Carlson: That's similar in some ways to the equity portfolio, where you have invested primarily in large cap, or what we might call blue-chip names?

Giroux: Yes. I think we tend to invest in average to above-average companies that typically don't have secular challenges. So, yes, you would see that the average market cap is well into the large-cap area, if you will.

Carlson: So to sum up, the equity portfolio is somewhere around its historical weighting. The bond portfolio is below average, but it's not that you're bullish on stocks really, it's just, relative to bonds, they're perhaps a little more attractive.

Giroux: Greg, I think you said it well. I think … equities are attractive on a relative basis, relative to bonds, because bonds are unattractive, but stocks on an absolute sense are not a compelling value right here.

Carlson: So, keep your expectations in check is what I'm hearing?

Giroux: I think that's fair. I think that's a fair conclusion.

Carlson: Well, thanks very much, David.

Giroux: It's my pleasure.