The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
How does the Fund’s quality bias factor into the overall investment strategy?
Our strategy is predicated on the belief that above-average profitability is an accurate measure of quality, and that quality can be objectively measured and durable. Surprisingly, the concept of what constitutes quality can be controversial and inevitably varies widely as do results among the asset class. We believe that profitability is a reliable indication of quality, and observe that it is occasionally undervalued by investors.
Profitable companies are rarely “on sale.” Yet, at almost any given moment, some segment of our quality universe is out of favor. We seek to exploit the opportunity of investors' fickle attitude towards quality by identifying high-quality companies trading at a reasonable valuation with identifiable catalysts that we believe could drive relative outperformance over the following 12 months.
One of the other unique attributes that sets our strategy apart from others in the category is our focus on valuation. We pay a lot of attention to valuation. Our goal is to ensure that we are buying value and not just buying quality, which is different from having a value bias. Warren Buffet has said "Price is what you pay, value is what you get." We look for ‘value’ by investing in quality companies whose securities are trading at a reasonable price.
Investors often flock to deeply cyclical companies while markets are rising with the hope that profitability will soon follow. In uncertain times, the opposite is true and quality becomes expensive. By using valuation as a barometer, we seek to avoid factor and style exposures that can become overvalued and tend to mean-revert over time.
Has the Fund’s quality emphasis impacted performance in our current environment?
First, let’s take a step back. At the start of the year, the Fund’s equity allocation was 68%. There were indications that growth was slowing and the economic outlook was increasingly uncertain. As a result, it seemed prudent around mid-January to reduce equity exposure. We took equity down 5%, allocating to treasuries.
Within the fixed income sleeve of the portfolio, 63% was allocated to treasuries. This shows how we were thinking about the world and positioned for the coming year. We also had reduced credit exposure, as spreads for corporates had narrowed and we thought the risk/reward was no longer as attractive.
We were relatively well positioned for what was to come in February and March, especially on the fixed income portion of the portfolio. As the economic impact of the COVID-19 pandemic became more apparent, we further reduced the equity sleeve to about 55% of the total portfolio weight, which is where we ended the quarter.
Early in the second quarter, the market rebounded remarkably from the March lows when the market seemed to be indiscriminately selling off. We saw this as an opportunity and added to existing names as well as invested in new quality companies we believe will perform well over the long term. Our equity allocation now is back over 60%. At the same time, the fixed income portion of the portfolio today is comprised of approximately 33% treasuries with roughly 10% non-investment grade securities.
The market ran towards high quality companies, resulting in valuation spreads increasing to levels that are historically significant. The relationship between the most expensive quintile of stocks relative to the market average blew out to a 4.5 standard deviation level in the March period. Currently, that relationship stands at around 2.5 standard deviations.
However, markets appear unwilling to adopt a value or pro-cyclical bias, resulting in a sustained level of wide valuation dispersions. We are increasingly looking for ideas that have more of a cyclical bias and could be better positioned to perform as economies reopen. Within fixed income, we continue to see non-investment grade as an attractive area. Investment -grade credit spreads have narrowed and seem fairly valued. By contrast, treasuries currently appear to be overvalued.
Are there environments where this approach has struggled?
Yes. The first is when equity underperforms fixed income over an extended period of time as we tend to hold more equity exposure than our benchmark. While we will adjust our allocation during periods of significant equity contractions, we don’t attempt to tactically adjust allocation, preferring to ride through the volatility if we see evidence the economic backdrop is on solid footing.
The second setting is when we see momentum characteristics where the market is led by a narrow band of expensive stocks. Our valuation discipline naturally causes us to avoid or limit exposure to these types of names that could lead to underperformance in this type of market environment.
Across economic cycles and irrespective of market moods, we seek to maintain an emphasis on finding high quality, growing companies whose securities are trading at a reasonable valuation with visible catalysts to drive relative outperformance over the next 12 months.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This informa¬tion is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. The views are current through July 1, 2020, and are subject to change at any time based on market or other conditions.
Risk Factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fixed-income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. The lower-rated securities in which the Fund may invest may carry greater risk of nonpayment of interest or principal then higher-rated bonds. In addition to the risks typically associated with fixed-income securities, loan participations in which the Fund may invest carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loan participations may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. The Fund’s emphasis on dividend-paying stocks involves the risk that such stocks may fall out of favor with investors and underperform non-dividend paying stocks and the market as a whole over any period of time. In addition, there is no guarantee that the companies in which the Fund invests will declare dividends in the future or that dividends, if declared, will remain at current levels or increase over time. The amount of any dividend the company may pay may fluctuate significantly. In addition, the value of dividend-paying common stocks can decline when interest rates rise as fixed-income investments become more attractive to investors. This risk may be greater due to the current period of historically low interest rates. The Fund typically holds a limited number of stocks (generally 45 to 55). As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a large number of securities. The value of a security believed by the Fund’s manager to be undervalued may never reach what the manager believes to be its full value, or such security’s value may decrease. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.