Balancing Yield and Capital Appreciation

Katie Reichart: I'm Katie Reichart with Morningstar. I'm here with Clare Hart, manager of JP Morgan Equity Income and a panelist on the Active Equity Challenge Panel.

Thanks for being here.

Clare Hart: Thanks for having me.

Reichart: We've been seeing a tremendous amount of money moved from actively managed funds to passive. How does your fund maintain an edge?

Hart: What's really important for us, what really helps me I think when I go to market, is that we've got, at JP Morgan, a deep pool of analysts that really help us. When I go to market and I'm going to buy or sell a stock, by definition, there's somebody on the other side of the market that knows better than I do about the stock. But I know going to market that our analysts are very good at cash flow and earnings, and so I can feel confident in buying or selling a stock that I've gotten really good information behind me. The analysts are dedicated, lot of experience, and they're very good at what they do. It helps me do my job better, because we've got all those analysts behind us.

Reichart: And meeting company management, too.

Hart: Meeting company managers is very important to us. I know people say in the world of Reg FD, "How do you get anything out of management?" Quite frankly, before the world of Reg FD, we didn't get anything inappropriate out of management teams, anyway. What's really important to me, the reason I like meeting with management teams is, I like to look them in the eye. These are the people that I'm going to invest with. These are the people that I'm going to take my investors' money, and hand to them, and trust them to run their businesses.

The way I trust is, trust but verify. Look them in the eye. See if I agree with the way they think about investing. Talk to a CFO. See how they talk about spending the capital, not just what they print in a press release, but you talk to them. You ask the questions, and sometimes it's just visceral. You hear the things that make sense to you, or sometimes you hear things and say, "OK, that could be an appropriate strategy in the market, but I'm not comfortable with that. That doesn't suit my strategy, so I can't really own their stock." You learn that in the conversation with management teams.

Reichart: You run an equity income fund, but you've traded lately in some yield-heavy sectors, such as REITs and utilities. How do you balance yield with other considerations?

Hart: Yield is one of the things we look at, but this strategy, the way I run it, is always yield plus capital appreciation. If I look at how much we have in utilities now, there is a time--and I've run this strategy at the firm for 15 years--there is a time in the past 15 years that I've had 10% of the portfolio in utilities. That's certainly not the case now, which really gets to your point around we care about yield. But it has to be yield attached to a stock where we think we're going to make money in terms of the capital appreciation.

I would say the property REITs, in particular, and the utilities are not two of my favorite sectors right now. But I would say, never say never. If the valuations come in a bit, there will be a time to own those sectors. We could sit down a year from now, and if the valuation has given us a chance, we will buy those names, because they're great companies in there, terrible business models, very smart management teams, pay their dividends. We have no concern over coverage, so to speak. It's just potentially what we see in terms of the overvalued equity that keeps us on the sidelines.

Reichart: Financials have had a really good run, so where are valuations today?

Hart: I would say financials is one of those sectors where, on the margin, you're right. There's the fundamental piece that the market has known about for forever that rates are going to rise. Rates have actually started to rise now, so that's starting to come into the stock. But what the market wasn't really expecting, I think, was the unexpected presidential outcome we had back in November. That has really expanded the multiples.

On the margins, financials for me now is more of an area I look at from the valuation lens, and I'm thinking carefully around where might we need to take money out. Is there a different financial that we might own instead? Again, we haven't gotten to the point where we are aggressively moving out of those names, but we're trying to be sensitive around valuation. That's a sector, again, we've made a lot of money, so we're watching. We're careful.

Reichart: Your turnover is pretty low, but with valuations stretched broadly, where are you seeing other opportunities nowadays?

Hart: The valuations are--I'm not really sure, stretched. It's definitely an environment where I would say your company had better have a plan, and it's not just showing up in the market so that everybody makes money. It's not one of those kind of markets.

What's really important to us is finding companies where, again, incrementally they can make their own luck. Similar to the financials, right, make their own luck. It just so happens we got paid a lot more because of the election.

I'd say within specific sectors, industrial is an area, we've moved money around. It's not on the whole moving more money into the industrials, but being valuation-sensitive, taking money out of some of the names we've actually had for a while and made a lot of money in. We think the valuations are worth paring back, and we're moving into different names.

I think within healthcare, it's really fascinating all the news that goes on with the Affordable Care Act. I think it makes some of the managed care names even more interesting, so that's an area that we're looking at. Then even within retail, there are pockets of retail, not necessarily the consumer department stores, but other parts of retail where we think there could be good opportunity.

Reichart: Clare, thanks for being here.

Hart: Thanks for your time.

Reichart: For Morningstar, I'm Katie Reichart.