MARK FREEMAN – FINDING INCOME WITHOUT TAKING UNDUE RISK – Transcript 11/22/2013 #1022

CONSUELO MACK: This week on WealthTrack: Where can you find income in a low yield world without taking on too much risk? Morningstar favorite Mark Freeman of Westwood Income Opportunity Fund shows us where he is finding that illusive income catch, on the next Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack.  Don’t fight the Fed is a long-held investment maxim because over the years it has frequently worked.  But in recent months it has seemed like a particularly difficult rule to follow because no one has been quite sure what the Federal Reserve is going to do next. We do have a pretty good indication of how Federal Reserve Chairman-nominee Janet Yellen feels however. In testimony before the Senate Banking Committee, the current Fed Vice Chairman cheered the markets by saying that although progress has been made since the financial crisis and recession  “unemployment… is still too high, reflecting a labor market and economy performing far short of their potential.”

Wall Street’s conclusion:  The Fed’s unprecedented quantitative easing program of buying $85 billion worth of mortgage and treasury bonds a month is not going to slow, or in Fed lingo,  “taper” anytime soon which will keep a lid on long term interest rates. As for short term interest rates which the Fed has kept near zero since December of 2008, no one is even talking about when those will be  raised — think a couple of years or more according to the Washington analysts at Cornerstone Macro.  There is a heated debate going on about the wisdom of the central bank’s policies however.  Larry Fink, the CEO of Blackrock, the world’s largest money manager recently said the Fed’s policy is contributing to “bubble-like markets” in both the stock and bond markets as investors search for higher income and returns.

If you ask any investors, especially retirees what their top investment concerns are, the answers will include income and market volatility, caused in part by these novel Federal Reserve policies. Finding income without taking undue risk has been a constant theme of ours on WealthTrack and this week’s guest has a successful track record of doing both.

Mark Freeman is Chief Investment Officer at Westwood Holdings Group. He succeeded now-retired Great Investor Susan Byrne at that job in 2012. Among his many responsibilities, he is Senior Portfolio Manager of the Westwood Income Opportunity Fund, which he launched in 2005. The conservative allocation fund is a Morningstar favorite because of its “attractive total return with moderate risk”

I began the interview by asking Freeman how his search for income opportunities has changed during these years of low interest rates and low bond yields.

MARK FREEMAN: That’s a great question and when I think back about it over the last several years, the way it’s changed is ultimately it’s not really from a process standpoint or ultimately in terms of what we’re looking for, but what has really changed is, where do you find it?  And I look back, and if you look at, say, the top level across our asset allocation, that’s what’s changed, and that asset allocation reflects where we’re finding those opportunities that offer income but also growth, but again, it’s not static. It doesn’t stay in just one part of the market, and the fixed income market is a perfect example.

 

CONSUELO MACK: So let’s talk about how your asset allocation has changed, because right now more than 50% of the portfolio in the fund is in stocks, you know, common stocks or, what, preferred convertibles or preferred stocks, and so traditionally that’s a heavier weighting than you would normally have.  Correct?

 

MARK FREEMAN: It is on a historical basis. Matter of fact, at the beginning fixed income was roughly 45%.

 

CONSUELO MACK: You mean in the beginning in 2005 when you started the fund?

MARK FREEMAN:  For the mutual fund, for the strategy… Exactly right, because again, that was a time and a place where we could actually find attractive opportunities in fixed income, and so now if you fast forward to today, and we all know what’s happened in terms of interest rates and them being at extremely low levels today, you know, our fixed income exposure has come down rather significantly. We’re probably now in the mid-teens in terms of fixed income exposure, but at the same time our equity exposure has really done the opposite. It’s gone from roughly mid-teens to, as you mentioned now, in the roughly high 40 percent of the portfolio.

 

CONSUELO MACK: You are a new face to our WealthTrack viewers. I’m delighted to have you here. Your predecessor, Susan Byrne at Westwood Holdings, who is now retired, was not a new face, but I’d love to know what your investment objectives are with the Income Opportunity Fund and also talk to us a little bit about process as well.

 

MARK FREEMAN: Sure.  Let me kind of, as you said, let’s take a step back and kind of give you a little bit of history of the strategy.  So when we started it, we started it because our clients were coming to us because of what had taken place in the bond market, and rates had fallen rather dramatically, and they were saying, “look, there’s got to be something better out there, a better alternative to the return profile that we’re seeing in fixed income,” and so we said, okay, that’s great, but what they were also saying was that we want a better return profile, but in many ways we still want the volatility profile or the low volatility profile that fixed income investors had typically experienced. And so ultimately what they were saying is like we would like to earn an attractive total rate of return but with an acceptable, i.e., low level of overall volatility in the portfolio.

 

CONSUELO MACK: Right, and low level of volatility compared to the stock market.

 

MARK FREEMAN: Absolutely. Certainly even less than a pure equity type of product, because at the time that was really the traditional mindset, and really that was really from a product offering. That’s all there was. You could either have fixed income or you could go into “equity income products” which were basically just dividend-paying stocks, but they still had the same volatility profile as roughly the equity market, and so that really wasn’t a suitable solution for what those investors were asking for. So we literally just took a blank sheet of paper and said, “Okay, how do we solve this problem?” And ultimately tried to come up with a solution, and the income opportunity strategy was the end result, and so ultimately we said, “Look, how do we do this?” We’ll use income-producing securities, and we’ll use those from up to eight different asset classes. So that gives us the diversification, but I think what’s also important to understand is, what is the role of income? Why is income so important, and I think everyone understands it from the return standpoint. Okay, here’s the yield and everyone has cash in hand, and you can get that, but it’s also very important on a total return basis.  It gives you a nice foundation. If you can add two, three, four percent yield and then add a capital appreciation component, you then generate on a total return basis what I think is a pretty attractive overall total return profile.

CONSUELO MACK: Speaking of low risk, and lower risk than the stock market, so when I look at your portfolio today, for instance, with more than 50% in stocks, how do you avoid the risk that you’ve got in stocks?

 

MARK FREEMAN:  Well, I think there’s a couple of different ways. One reflects Westwood’s philosophy in terms of the type of companies that we invest in, and those are companies that are what we perceive to be as very high quality. They have strong balance sheets. They’re generating high levels of free cash flow. So when you look at those metrics, typically those are companies that tend to have a lower volatility profile, certainly less so than those companies that, say, have no earnings or let alone pay dividends or maybe they have distressed balance sheets. And so really our investment philosophy is really the starting point that takes us in that direction in terms of limiting volatility.

 

The other thing, are the types of names themselves. I mean, we’re in some of the traditional areas if you look at, say, consumer staples. That would be one area.  They also tend to have a lower overall beta, if you will, than the market. We have used names in the utility space even though that’s a little bit less attractive than it has been, but I think ultimately what it gets back to are just very high-quality companies that are generating high levels of free cash flow, and again, that dividend yield itself provides an important valuation support in many cases, and so look.  The other thing I would just mention is that when we talk about volatility, by definition there’s two parts of volatility. There’s upside volatility and downside. My phone has never rung even once with anyone complaining about upside volatility. They only care about the downside part, and so that’s what we focus on and things like quality, dividend yields, providing the yield support, valuation support, those all come into play when you care which is on the down side.

 

CONSUELO MACK: So the upside volatility portion of your portfolio, which is actually quite high now in your stocks, and I’m looking at your top holdings, so Novartis, Pepsi, General Mills, GE and  J & J, they’ve all had big run-ups in recent months.

 

MARK FREEMAN: They have.

 

CONSUELO MACK: Nearly 30%or above, so how do you assess their valuations now, and your portfolio traditionally has a pretty low turnover. You hold stocks on average five years, so how do you address the valuations now in the stock portion of your portfolio?

 

MARK FREEMAN: Well, ultimately you go back to your process, and a fundamental part of our process is that every security that we own has a price target, and so we are constantly looking at and evaluating that individual security on ultimately what is the upside, which is the reward, versus what is the downside, which is the risk, and so ultimately we want to continue to make sure that in the portfolio we have a group of holdings that we feel have an attractive reward to risk profile, and the other thing is that, as you mentioned, look, many of these securities have had very strong run as has the broader market from there, so we’re very conscious in terms of, well, where are we in terms of valuation, and so when a security hits its price target, it’s sold, and then we go out and we’ll look for another opportunity. It doesn’t necessarily have to be an equity. It can be anywhere in terms of the various eight asset classes that we use.

 

CONSUELO MACK: So speaking of, you know, you’ve got price targets on your stocks, and when I’m looking at the asset allocation of your portfolio, again, you’ve got about 20% in cash. And recently the CEO of Blackrock, the largest asset manager in the world, Larry Fink, mentioned that he felt that the market was in bubble mode, that certain aspects of the market were in bubble mode. Do you feel that way as well? Do you think that there is some really frothy parts of the market that are of concern to you?

 

MARK FREEMAN:  The short answer is yes, but let me explain that.  You know, I certainly respect Larry’s comments, because obviously he sees the market very well, but I think what I would note is that in his comments he was not purely focusing on, say, equities. He was focusing on what I think was also a very, very critical component, and that was actually the fixed income or the credit market, and I think that that often tends to get lost in terms of, okay, well, look. We always talk about valuations in equities, but if you ask the average person, “well, what’s the valuation in fixed income?” Most people wouldn’t know, and i think what he was trying to highlight is that there are some parts of the fixed income market that are appearing stretched or, as he referred to it, have some bubble-like characteristics, and of course, I think there’s some parts of the equity market where you could certainly debate whether some of the valuations are justified from there, but I think in a broader sense what his message was, was giving where we are from a rate environment, given where we are in terms of quantitative easing, it’s time for investors to be on guard and to be on the lookout for those areas where there are potential excesses and, more importantly, not be there.

 

CONSUELO MACK: One of the things that you told me in a pre-interview is one of the things that you’re doing at Westwood is that you look at where not to be …

 

MARK FREEMAN: … exactly right.

 

CONSUELO MACK: … is as important as where to be. So again, looking at your portfolio in the Income Opportunity Fund with, what, 11 percent in the bond market, clearly you’ve decided that the bond market is not a place you want to be.

 

MARK FREEMAN: Exactly right.

 

CONSUELO MACK: Why?

 

MARK FREEMAN: … not in a meaningful way, and the reason why is that ultimately I think it would probably be helpful to understand in terms of, well, look, how do we get to those various allocation levels? And so how we get there is through our bottom-up fundamental process, and at Westwood, I’m fortunate to work with an extremely talented, hardworking group of analysts, and the reason why I mention that is because it is the idea flow that is coming from our bottom-up fundamental process, and those analysts looking across their areas of coverage that generates, that tells us where to be, but it also tells us in terms of the lack of ideas coming from those areas, it tells us where we don’t want to be. And so that has worked well for us. We do not walk into the meeting and say, “Okay, we want 48%in equities. Let’s go find them.” To me, that’s not the best way or suboptimal way to do it.  How we do it is we look at where are the best opportunities coming from the areas that we cover and also talking to the analysts and saying… They will say, “look, I’m just not finding a lot of opportunities here.”  Well, why?  It’s typically because of things like valuation from there. So that’s what ultimately drives that, but to your point, I would much rather want to know where I don’t want to be versus… It’s great to know where you want to be, but it’s really important to know, well, here’s where I don’t want to be, because again in terms of volatility and downside protection.

CONSUELO MACK: So Mark, how treacherous is the bond market for individual investors?

 

MARK FREEMAN:  Ultimately what I would say is that this is, when I look across the fixed income and the credit market landscape, this is not a time to be trying to stretch for that incremental yield, because the incremental risk that comes with that is typically significantly higher than the compensation you’re receiving for that slightly more additional yield.

 

CONSUELO MACK: Right, so don’t want to be in low-quality debt. Don’t want to be in high-yield debt necessarily.

 

MARK FREEMAN: I think one needs to be cautious in those areas when you look at absolute yield levels there and also the underlying assumptions and specifically in terms of what are investors assuming in terms of loss ratios going forward. The assumptions are fairly aggressive I would say.

 

CONSUELO MACK: So one of your themes that you also told me about previously was that you don’t want to own Fed-dependent securities.

 

MARK FREEMAN: Exactly right.

 

CONSUELO MACK: So along those themes, what are other Fed-dependent securities that you’re avoiding?

 

MARK FREEMAN: You know, ultimately when I say Fed-dependent, I mean in terms of dependent on the Fed and their policy of quantitative easing. Okay? I don’t know when the Fed is going to eventually end quantitative easing. Quite frankly, I’m not sure if the members of the Federal Reserve know when they’re going to do so, but i do think that this is a prudent time for investors to start thinking about, well, what types of securities do i want to own that are not dependent upon the quantitative easing programs that we’ve had for the last several years? What quantitative easing is very effective at is influencing valuations, and you see that directly through the level of interest rates and ultimately valuations for all asset classes. The single most important variable are interest rates, and quantitative easing significantly influences or artificially depresses the level of interest rates which then has an impact on valuation. So what i would say is that if you’re looking at securities, then let’s not look at and focus on securities that are dependent on valuation support, i.e., multiple expansion. Let’s look at those securities that can stand on their own from an earnings standpoint, because if quantitative easing goes away, and even if interest rates stay low, you’re going to want to be in those securities that ultimately can still benefit, and the way they benefit is that they’ll be able to produce respectable earnings growth.

 

CONSUELO MACK: So let’s talk about some of the themes that you are investing in, and one of them is energy, you know, energy production in the U.S. and energy self-sufficiency. So give us some examples of how you’re investing in that theme.

 

MARK FREEMAN: I think that even though it is very widely discussed and perhaps understood, I think it’s still relatively underappreciated, especially on the domestic level, and that’s ultimately what we’re talking about, and so not just in energy but what it means to the broader economy, to continue to move towards self-sufficiency, and so we view this not as a process that’s going to play out over one quarter, two quarters or three. We view this as a process that is going to continue to play out over the next several years, and so we’re looking for companies that are going to directly benefit and participate in that. I mention master limited partnerships. That is one type of company that is really in the middle, literally and figuratively, of that process, because the ones that we focus on are referred to as midstream master limited partnerships. You have upstream which are the companies that bring the oil and gas out of the ground. You have downstream which are the refineries. Well, the mid-streams, those are the ones who own the pipelines and the storage, and they help get the commodity, oil and natural gas, to the refiners.  They are the toll collectors of the energy world, and so what they provide to us is a nice yield but then also the abilities as those volumes grow, that distribution growth will also continue.

 

CONSUELO MACK: And what’s a vehicle, a master-limited partnership that you’ve been invested in in the fund?

 

MARK FREEMAN: Well, there are several. Kinder Morgan is one of the largest players.

 

CONSUELO MACK: Really well known.

 

MARK FREEMAN: Very well known. Enterprise product is another very well known, so we’re sticking to what we feel are the highest quality names in that segment of the market, but you don’t have to stay just there. You can actually do it through equity exposure in names that are participating.  One name, Occidental Petroleum is a name. There’s really kind of a very interesting structure. It’s really going through a transformation, if you will, and we think that what you’re left with at the end is going to be very attractive to investors.

 

CONSUELO MACK: So here’s a company that’s shrinking and that you mentioned to me. I mean, they’re selling off their international operations. They want to focus on Texas and California production…

 

MARK FREEMAN: Exactly right.

 

CONSUELO MACK: …which strikes me as, gee, that sounds high risk. We’ve been there before, and it can really hurt you, but you’re saying it’s a good opportunity.

 

MARK FREEMAN: I think so. I think when you look at Occidental specifically in terms of what they want to do and where they want to be, as the CEO mentioned, he said, “we want to become smaller and less volatile,” and what they’re doing are focusing on their highest quality assets, and so when they sell, their plan is to sell a portion of the Middle Eastern assets there. That’s going to generate a very sizable component of cash which they’ll be able to return to shareholder. They’re also paying down debt, so the balance sheet is in order. They’re also looking at other assets to sell off, specifically their mid-continent assets, but ultimately it’s what are you left with and then what you’re left with are the California and Texas assets which are very high quality, and ultimately from the energy what you want to see is, well, what does production growth look like, and those are assets that are generating we think very attractive levels of organic production.

 

CONSUELO MACK: So I have to ask you about one other holding, and that’s General Electric. So tell me how that figures into your portfolio.

 

MARK FREEMAN: We feel like this is a time now for GE in terms of how they’re positioned, and specifically it’s on the industrial side. So GE has two components. Okay, there’s GE Capital which is the financial part of it, and then there’s ge the industrial side of it, and ultimately from our perspective, if you own GE, you’re owning it for the industrial side, and that’s what’s most highly …

 

CONSUELO MACK: So just write off GE Capital?  No, no, we can’t.

 

MARK FREEMAN: No, no, no. You’re right. You don’t want to just write it off. That would be a negative outcome, because there’s still value there, but I think ultimately it is about shrinking that part of the company which then in turn allows them to focus on what we feel is the more value-added part of the company which is the industrial side, but to your point, you may say, “well, what does this have to with energy?” If you actually look in the various segments on the industrial side, it’s the energy component that is the fastest growing and will be a very significant contributor both in terms of revenues and earnings going forward.

 

CONSUELO MACK: Last question that we always ask our guests, you know, what’s the One Investment we should all have in a long-term diversified portfolio? What would you have us own?

 

MARK FREEMAN: I think there’s kind of a checklist, if you will, in terms of what do you want to own there. You want to own a company whose end markets are growing, so that helps your top line. You also want to own companies that have room for margin improvement which then flows through to the bottom line, and then back to the quality aspect. You want to own companies that have solid balance sheets, which gives them financial flexibility. They’re not dependent on the Fed and maintaining lower interest rates. They’re generating high levels of free cash flow, and ultimately what we also want to see are companies that then are willing to commit and say we’re willing to take those high levels of free cash flow and return it to shareholders either in terms of a dividend or a buyback.  So if you take top line, bottom line and then buyback through that, that’s a pretty powerful combination, long-term combination for earnings growth.

 

So to answer your question, a company I think that tracks and checks those boxes is Covidien, so back in the health care space. It’s a medical technology and product company, and if you look across it and say, well, okay, top line, what do they have going for them there, one is which is that currently right now it’s only about 13%of revenues coming from emerging markets, but those markets are growing at about 15% a year. So over the long run, that’s an area that eventually will be able to be a material contributor to their overall growth. The other part of it is that if you look at it, they provide surgical products, and if you look at overall surgical procedures, they’re growing about one or two percent a year. However, what they really focus on, are what are called minimally invasive procedures.

 

CONSUELO MACK: Huge growth. Right?

 

MARK FREEMAN: Exactly, exactly right, and so that’s really their niche play, and so that’s going to come through, and then on a broader basis I would say this. If you look at health care usage in the U.S., right now we have roughly 160 million individuals participating in the system. We know what the affordable care act estimates are. We’ll probably add another 20 million, so that’s a long way of saying we think usage is going to go up, so we think that’ll help in the top line. They have room for bottom line improvement, and then last what I would mention is that management recently committed they were going to return 50% free cash flow back to shareholders in terms of either dividends or buybacks.  Right now, the dividend payout ratio is about 30%. It gives you about a two percent yield. They’ve signaled that they’ll go to 35%. The rest they can use for buybacks from there, so if you put all of those together, what we get is roughly about a 10% organic earnings growth, and then what they’ve also done very successfully is gone out and made small acquisitions of products that they can then utilize through their distribution system which then also adds to earnings growth. So that, kind of in a summary way, I think that gives you the characteristics of a company that would make for a long-term holding.

 

CONSUELO MACK: All right, and the kind of company that you own at Westwood Income Opportunity Fund. So Mark Freeman, thanks so much for joining us on WealthTrack, delighted to have you for the first time.

 

MARK FREEMAN: Thank you. It was my pleasure.

 

CONSUELO MACK:  At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term.  This week’s Action Point is:  Start taking some money off the market table.  We have seen a big multi-year run up in both stock and, until very recently, bond prices.  Several of the Great Investors we have talked to recently, both on camera and off- Yacktman Funds’ Don Yacktman and fpa Crescent’s Steven Romick come to mind- are sitting on cash because they see very few undervalued investment opportunities. And what they do own is very high quality. They would rather be safe than sorry and have cash to deploy when the market corrects, which it inevitably will do.

Next week during pledge drives on public television stations, we are going to revisit our classic active versus passive investing debate with Vanguard’s Daniel Wallick and Gerstein Fisher’s Gregg Fisher. And just in case WealthTrack is pre-empted on your local television station, we will have an additional Extra feature, a web-only interview with last week’s guests. Morningstar veterans Christine Benz and Russel Kinnel will discuss the best and worst mutual fund products and share more of their specific fund recommendations. You will find them on our Extra page. In the meantime, have a very happy Thanksgiving and a joyous Chanukah.  We hear that the next time the two holidays will coincide will be in the year 79,811 so we better enjoy this one! And, of course, make the week ahead a profitable and a productive one.