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Walsh: Evaluating Risks Is Key in Defensive Equity Investing

Walsh: Evaluating Risks Is Key in Defensive Equity Investing

Alex Bryan: For Morningstar, I'm Alex Bryan. We're at the sidelines of the Morningstar Investment Conference. Today, we had a panel discussing defensive equity strategies, looking at defensive equity from a couple of different angles ranging from active to passive. Joining me I have Meggan Walsh, who is the manager of Invesco Diversified Dividend. She has been the manager of that fund since 2002.

Meggan, thank you so much for joining me today.

Meggan Walsh: Thanks for having me, Alex.

Bryan: Meggan, you pay a lot of attention to risk when you think about building your portfolio. Can you talk a bit about your process and how you build risk management into your selection approach?

Walsh: I'd probably point out first and foremost our valuation framework, which as you know, we do a fair amount of work around building sensitivity analysis to our financial models and particularly, around the more cyclical stocks that we are considering for inclusion in the portfolio. More broadly, across the full market cycle, we are looking to identify companies that have the wherewithal and the discipline to grow the return of capital but also equally important to grow the returns of capital. Ideally, we are identifying companies that earn their cost of capital in excess of cost of capital of a full market cycle.

Bryan: When you say return of capital, you mean return of capital back to shareholders in the form of dividends and buybacks?

Walsh: Yes, exactly. Net share buybacks as well as growth of dividends.

Bryan: One thing that you do that I think is kind of interesting is, as a way of checking yourself is if one of your holdings goes down by a certain amount below where you first purchased it, you have a second analyst to play the devil's advocate role to make sure that you are still on board with the investment thesis. Can you talk a bit about that and how that helps protect you on the downside?

Walsh: That again is something we have embedded since inception in 2002. Really, for our process, you mentioned, it's more than 15% below our cost basis. It's temporarily reassigned to another analyst for a fresh set of eyes, both on the investment thesis but also on the two or three most important drivers of our financial model. I believe that all investors have investor biases. We are looking to avoid value traps or increased conviction in names that we may have just been a little bit early on. Then most importantly, we want to help the investors learn through their own mistakes and just don't want to make the same type of mistakes ideally a second time.

Bryan: Your incorporate that learning into your process going forward?

Walsh: We do.

Bryan: One of the points that you brought up during our panel discussion was that every market cycle is a little bit different and the risks that drive the market can be different from time to time. In the financial crisis, you were worried about off balance sheet liabilities. What types of macro risks are you concerned about now?

Walsh: There's a fair amount of them given that we are so late in the cycle, nine years into the profit cycle. Probably the most obvious one that I think about the most is the risk of misallocation of capital. We've seen record M&A, both in our portfolio, the most I've seen since I've managed the product, but also more broadly across the market. I think in an era of easy money, it's easy to make these deals look accretive. I think that will prove to be transitory a few years from now. Then probably the operating leverage and the financial leverage would be other risks that we are really digging deep into on the balance sheet.

Bryan: Being so late into this market rally, I imagine it's harder to find good opportunities, good values. Where are you finding those opportunities today?

Walsh: We are still finding some pretty good value. I would say, again, we are looking for those companies that have the flexibility to control their own destiny when things get a little bit tougher. Again, ideally, companies that have higher degrees of predictable free cash flow generation. I'd say there's some select industrials that are going through portfolio optimization and some changes within their portfolios that we think will increase their full cycle returns on the business that we find attractive here.

Also, within the energy sector, particularly around the utility companies, the conglomerate utility companies, we think some of the energy assets are underappreciated there. Then finally, within consumer, we do think there is not going to be an across-the-board Armageddon within the consumer stocks. We are digging deep in there as well.

Bryan: Consumer defensive or cyclical?

Walsh: I'd say consumer cyclical but also a few on the defensive side. Where we've seen margin pressure the most is more on the consumer defensive side, but also of course, in the retail stocks as well.

Bryan: Interesting insights. Thank you for sharing them with us today.

Walsh: Thanks for having me.

Bryan: For Morningstar, I'm Alex Bryan.

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