Balancing Portfolios Through Diversified Asset Classes
Leon H. Loewenstine
TWST: Let's start with an overview of RiverPoint Capital Management.
Mr. Loewenstine: RiverPoint Capital Management is an independent investment adviser registered with the SEC and has just over $1.2 billion in assets under management. We offer our clients customized investment portfolios based on their risk tolerance, income needs and growth expectations. The majority of our clients are individuals and families, but we also work with a lot of local not-for-profit organizations. Our minimum account size is generally $1 million in assets. In addition, we also have significant expertise in the wealth management area and will work with our clients on estate and tax planning, insurance, charitable and education planning. We do not sell any commission-based products and do not charge for this service, so we are able to truly be a partner for our clients and be totally objective. We also work with accountants and attorneys in making sure these needs are being adequately addressed on a regular basis. We're also very active in the community. All the portfolio managers at RiverPoint serve on nonprofit boards. We believe it is important to support our community and to give back to our city.
TWST: You are Chief Investment Strategist and Managing Director, as well as one of the Portfolio Managers of the RiverPoint's large-cap Classic Value Strategy. Would you please explain the firm's investment philosophy and strategy to us?
Mr. Loewenstine: We have three primary strategies at RiverPoint: Growth and Income, Dividend Strategy, and Classic Value. These strategies allows us to meet all of the needs of our clients from the most conservative, dividend strategy, to the most aggressive, Classic Value. Our growth and income strategy is geared for a lot of our individual clients who want a customized portfolio for growth but also realize income is an important part of their needs or objectives. Our Classic Value Strategy intended for our clients with a higher risk tolerance is ranked in the top 6% in the PSN database of large-cap value managers on a national level. We're proud of our success in that strategy.
In terms of our Large Cap Value Strategy and approach, it's a relative value strategy. It's not just buying cheap, depressed stocks, but companies that we believe are out of favor for short-term reasons or undervalued relative to their peers or the industry. Some of the reasons these stocks may be out of favor include economic reasons, restructurings, manufacturing recalls or simply the sector's out of favor.
TWST: When screening stocks, what is the process RiverPoint uses?
Mr. Loewenstine: We do our own research and use two software programs as the first stage in screening stocks. One is called Baseline, which screens over 10,000 companies. We will screen the Baseline universe based on market cap of $1 billion and up, and then breakdown the result by sector and rank those companies in the sector from cheapest to the most expensive. We will use different metrics for this ranking for each sector. From this screen, we will look at the five to 10 cheapest companies and begin more fundamental research. We will pull the 10-Q and assess the company's risk and competitive position relative to its peers and the sector. Then we ask what the future looks like for the company and when do we think the market will realize that undervaluation.
We are generally willing to hold a stock for two to three years until this value is realized. Our portfolios will generally hold 30 to 35 positions, which we believe offer the best risk/reward scenario. We will control risk through diversification by sector and cap individual positions at 5%. We also use another program called Holt. This program ranks stocks based on returns on invested capital and is a good program to confirm our estimates of fair value. That's the process we go through in screening stocks. It's extensive and cumbersome, but it's something we really enjoy and it's worked well.
I'll give you an example of a company that we bought not too long ago. It's a sector that Warren Buffett became interested in after we did. The industry is the railroad business. I am not sure why he did not buy what we bought, but we own the most efficient rail company in North America in Canadian National Railway (CNI). We bought the stock after doing our homework on the company. It was clear, in our opinion, they were the most efficient operator and best managed. And that wasn't being recognized, in our opinion, by the marketplace. Then once Warren starting talking about the industry, the stocks took off. We were early and glad we were. It's nice to be ahead of the curve in situations like that and to see your thesis get supported by someone of his stature. That's an example of the kind of work we do. We compared Canadian National to Burlington Northern (BRK-A) to Norfolk Southern (NSC) to Union Pacific (UNP), and we felt that they had the most consistent earnings history of any company. They had a strong balance sheet, and they were shipping a lot of commodities down from Canada into North America. And they showed us that from a margin standpoint and efficiency, they were the best at what they did. That's just one example of how we would rank companies in the sector and then make our decision.
TWST: RiverPoint includes master limited partnerships in its investment portfolios. What makes MLPs attractive?
Mr. Loewenstine: Usually we wouldn't use the MLPs in our value strategy. We use it as part of our total portfolio strategy. What we like about MLPs is that they pay very high dividends and are very tax efficient. Most pay 6% to 8% and some more. They are really not dividends - if you will - they are really distributions because you are a partner not a shareholder. As a partner you don't own shares of stock. You own an interest in the partnership, and the partnership doesn't pay taxes. Those distributions are generally treated as a return of capital. So you don't pay tax on those distributions until you sell the investment or you've recovered 100% of your costs. In addition, they can serve as a hedge against inflation as many operate under contracts that allow them to raise prices annually in line with the Producer Price Index plus 1.2%. As inflation goes up, so does the fee they charge.
Another kicker is the fact that there is an ongoing demand for more infrastructures to move oil and gas through the country based on new energy discoveries. So besides just having a high yield and being tax efficient, you also have organic growth in the 3% to 5% range annually. Does it get any better than that? Last and most important, they've continued to significantly outperform the S&P 500 and most equity indexes over the last three, five and 10 years. Fortunately, we've been investing in MLPs since close to their inception, and it has really helped our client returns. We continue to think it's a great area to invest today as well.
TWST: The firm also invests in bonds. Is the bond-investing philosophy different from the stock-selection philosophy?
Mr. Loewenstine: Absolutely. Unlike stocks, you do not invest in bonds for growth but income. Bonds are intended to provide a certain level of income to your clients and stability in the portfolio. Since most of our clients have balanced portfolios, they will have an allocation to stocks, bonds, MLPs and other alternatives. The allocation to bonds will vary from client to client. Once the appropriate allocation is established, then the bond portfolio is structured. We generally tend to use a ladder approach of one to 10 years, but have recently reduced that to one to five years and added long-term bonds called trust preferreds.
Some advisers will use bond mutual funds. We tend to avoid them except in certain situations such as global bonds, floating rate bonds, TIPS or other niche areas. The reason we do not use bond funds, in general, is because you have no fixed maturity and cannot control the quality of the holdings. In addition, if interest rates rise and the bonds fall in value and other mutual fund holders decide to sell their shares forcing the mutual fund manager to raise cash, then you will have to realize a loss on the bonds sold. That loss is shared by all mutual fund shareholders.
Because we haven't been in a rising interest rate environment in a while, most investors do not understand the risk they take on in most bond funds. That is why we generally hold individual bonds. You can hold an individual bond until maturity and be relatively assured of getting all of your money back with interest. Then to capture more income, we have purchased trust preferreds, which are long-term bonds which pay 6% to 7%.
We do own an international bond fund called the Templeton Global Bond Fund, which has been a consistent five-star performer by Morningstar with relatively low fees. The reason we own the Fund is to hedge exposure to a weak U.S. dollar, and it pays more income than we can get in U.S. bonds. The Fund pays about 5%, and I think it has an average maturity of less than five years. At this point, with the yields where they are, you've got to do your work to know where the real opportunities are. You do add incrementally more risk in taking on a bond fund, but we think global bonds, international bonds, can make sense over a three- to five-year period.
TWST: You mentioned portfolio balance. How does RiverPoint create a balanced portfolio?
Mr. Loewenstine: Because most clients want to reduce risk or volatility if possible and may also have a need for income, a balanced portfolio makes the most sense for them. What we try to do in structuring balanced portfolios is focus on the correlation of returns of different asset classes. We want to add asset classes that have a lower correlation to each other. Large-cap stocks have a correlation of one to themselves, so if you start from there and you say: "Okay, in structuring a stock portfolio, where do I add value with less risk or volatility? If I go to midcap stocks, they have a correlation of like 0.9, and small-cap stocks have a correlation of about 0.8. So even though I diversify, I really haven't reduced my risk significantly." When you go to international stocks, now that correlation will begin to drop. And I think for international stocks today, they're somewhere around 70% correlated to large-cap individual stocks.
Other areas with a lower correlation are MLPs, REITs, commodities and bonds. The lower the correlation, the greater the ability to smooth out the volatility of investment returns. This is why we include stocks like BHP Billiton (BHP) in our portfolios. BHP is based out of Australia and is the largest mining company in the world. Commodities have about the lowest correlation to stocks, next to bonds, of any other asset class. Not surprisingly, BHP has been one of our best-performing holdings over the last five years.
TWST: Are there certain sectors right now that you believe give more opportunity than others?
Mr. Loewenstine: When the market goes down, unfortunately the correlation for a lot of stocks like in 2008 can often become one. I do think there are certain specific companies that offer tremendous value, but I also think you can make that case almost on a sector basis as well. Technology, industrials, energy and materials would probably be the four sectors that offer the most upside in a recovering or growing economy.
However, if we are going into a recession, you don't want to be in those sectors. It is a hard call right now. We do not think we are going into a recession, but if Europe does not get their act together, they could force a worldwide recession. Until we get more clarity, it is probably best to be a little more cautious but stay balanced. You want to have some exposure to industrials because if Europe resolves their problems, industrials and energy stocks will likely lead the market higher, and staples and utilities will lag badly. On the other hand, if they don't get their act together, staples and utilities are likely to be the best performers. It's just to hard to call right now so we are staying balanced and focused on solid high-quality dividend-paying stocks like Emerson Electric (EMR) with a 3.2% dividend, Rogers Communication (RCI) with a 4% dividend and Verizon (VZ) with a 5.6% dividend.
Technology also looks cheap and Marvell (MRVL), a chip company, is at 10.4 times earnings, has a historical growth rate of 40%, has a projected growth rate of 16%. They expect to earn a $1.44 this year, and the stock is at $15. Marvell normally trades at 29 times trailing earnings. If we ignore that and we say what we think fair value is 15 times earnings, the stock offers 50% upside. We're not trying to use ridiculous multiples for future valuations. But if you can buy a stock at one time its growth rate - and we think Marvell can grow at 15% to 16% a year, and I can buy that stock at 10 times earnings right now - I've got a great stock, and I'm going to make a lot of money. That's what we're looking at right now when we look at technology in particular.
You could put a number of other companies in that same category. When you go to industrials, you're seeing a very similar story. Another great story is Johnson Controls (JCI). It trades for less than 10 times 2011 estimated earnings and is projected to grow 15% a year for the next five years. The stock normally trades at 13 to 15 times earnings. That is 30% to 50% undervalued. So you get an opportunity to buy a company at less than one time its growth rate. Occidental Petroleum (OXY) is another company at an absurdly cheap valuation at eight times earnings. OXY is one of the best-managed and most successful energy companies in the last 20 years. Oil has come down a bit from the high $90s to low $80s, but they are still printing money at $80, and oil will go higher as the economy recovers.
TWST: How do you manage risk in the portfolio?
Mr. Loewenstine: We try to control risk a couple different ways. One is capping sector weights, so you're adequately diversified by sectors. Second, we cap individual position sizes at 5%, so on average we'll have about 40 names in a portfolio and the average position size is about 2.5%. The third way you control risk is by making sure the balance sheets of the companies you own are clean and not overly leveraged. We generally do not invest in companies with a debt-to-capital ratio over 50%, with the exception of utilities, telecom and other companies with more predictable and consistent earnings growth.
We also control risk by not overpaying for the growth of the companies you own. The greatest risk to most stocks is investing in companies with unsustainably high growth rates. They tend to be the worst-performing stocks over long periods of time. Netflix (NFLX) is a good example. It was trading at over 50 times earnings just a few weeks ago. Does anybody believe Netflix was going to continue to grow in excess of 30% plus a year? Netflix recently announced earnings were going to be soft, and they were losing some subscribers. The stock has gone from $300 to $132 today. That's what happens if you don't buy companies at reasonable valuations, so you really need to try not to overpay for growth. Don't chase the herd. Don't get caught up into that greed mentality. Be disciplined and be skeptical of what everyone else is buying. Being a contrarian is usually much more rewarding than chasing the herd.
Health care stocks are an area right now where everyone is skeptical, so take a look and see if there are some winners or survivors, and you will probably do very well. One example may be Merck (MRK) with a 5% dividend and trading at eight times earnings. The company is strong financially, has a decent pipeline and no one expects anything. Even if the future growth rate is only 5% to 6%, if you are getting a 5% dividend that equals 10% to 11% a year with low risk, that is just one example of where you may find some value.
TWST: Is 2011 going to end up similar to 2010?
Mr. Loewenstine: I hope so. In our opinion, we think the probability is that the year will end in positive territory, as long as Europe does not blow up. I don't know that we're going to see a 2010 15% kind of return, but I think we could go from where we are at negative 8% to negative 10% to positive territory. Again, it will be contingent upon two factors. One is resolution of the European debt crisis, and the second is that the supercommittee steps up and passes something in the neighborhood of at least $1.5 trillion to $2 trillion in spending cuts. If they do that, then they can begin to restore some confidence in Washington that these guys are serious about cutting spending. If you can get those two things done then the market really could surprise a lot of people on the upside.
TWST: Thank you. (LMR)
Leon H. Loewenstine
Managing Director & Chief Investment Strategist
RiverPoint Capital Management
312 Walnut St.
Cincinnati, OH 45202
(800) 548-1625 - TOLL FREE
(513) 421-5948 - FAX