Where Equity and Fixed Income Opportunities Can be Found

Equity Allocation

With the economy bolstered by a strong consumer in 2019, would you please discuss which portfolio holdings may benefit?

The consumer continues to be strong as evidenced by a favorable U.S. jobs reports and an increased labor force participation rate. We believe this backdrop combined with low inflation and low interest rates is a positive environment for equities.

The Fund’s holdings in Apple and Visa, in our view, are particularly advantaged by a strong consumer.

•Apple has $90 billion in net cash on its balance sheet, and it is growing its services business that has a recurring revenue component. In the past two years, Apple bought back $60-70 billion in stock per year and has grown its dividend 34% annually on average since it was initiated about seven years ago. The company has reduced the outstanding number of shares by about 30% since 2010. Even though it has returned a significant amount of capital to shareholders, Apple still generates about $50-60 billion in free cash flow annually.

•Visa is currently generating around $12 billion in free cash flow per year. Over the past year, the company repurchased $9 billion in shares. Since 2010, the company has reduced the number of shares outstanding by 24% and has also grown its dividend by 26% annually.

Would you please comment on merger and acquisition (M&A) activity?

On a year-over-year basis as of December 2019, the number of M&A deals is down about 13%. We believe the Federal Reserve’s rate increase in the fourth quarter of 2018 created uncertainty, which tempered M&A transactions in the beginning of the year. Throughout 2019, deal activity accelerated, particularly in the Healthcare, Technology, and Financials sectors, and the value of deals in the U.S. last year was actually up 6%. Yet, buyers remained disciplined, which we view as a positive sign as it suggests the M&A market could continue to grow.

Looking ahead to 2020, we believe deal activity could continue within the Technology and Financials sectors due to the high levels of excess cash on their balance sheets. Technology companies have about 25% of their total assets in cash, and Financials companies have 14% of assets in cash. Conversely, the sectors with the lowest amount of cash are Real Estate, Utilities, and Energy.

In the current low rate environment, it makes sense for management teams to deploy capital through M&A transactions, share buybacks, and/or return some of the cash to shareholders via dividends. In addition, there is potentially a tremendous amount of purchasing power from private equity, with approximately $770 billion of cash on the sidelines. We believe a portion of those assets will be used towards M&A activity in 2020.

What do you look for when seeking companies for the Fund’s equity portion?

We seek high-quality companies run by managers who think and act like owners and that have sustainable competitive advantages, strong balance sheets, and higher returns on capital. As a result of this focus, the portfolio is priced at a discount with higher cash flow generating abilities and less leverage than the S&P 500 Index. As of 12/31/19, the portfolio had a pre-tax return on capital of 20.3% versus 13.5% for the S&P 500. Our net debt to earnings before interest, taxes, depreciation and amortization (EBITDA) is 1.4x compared to 1.8x for the S&P 500. In terms of valuation, the Fund’s equity sleeve enterprise value to EBITDA was 13.2x compared to the S&P 500’s 14.0x.

What holding exemplifies these qualities?

We purchased Charles Schwab Corp. prior to the announcement that it would acquire TD Ameritrade. Even prior to the acquisition and cutting trade commissions, Schwab had been a leader in lowering costs for investors. While Schwab has a best-in-class platform and over $4 trillion in assets, the combined companies possess strong synergies and an ability to weather tough economic cycles. In addition, we had seen insider buying for the first time in a long time, which we believe signaled management’s confidence in the company. The company also announced a $4 billion share repurchase plan in January 2019.

Fixed Income Allocation

What is the relative attractiveness of the U.S. fixed income market?

We believe the U.S. has the most liquid, safest, and highest-yielding fixed income market, making it particularly attractive to investors around the world. Among developed markets, the U.S. currently offers the highest yield. At almost 1.90% as of the end of December 2019, the 10-year U.S. Treasury is about 200 basis points higher than a 10-year German or Swiss government bond, 180 basis points higher than the French and Japanese equivalent, and 100 basis points more than the 10-year U.K. bond.

U.S. investment grade corporate bonds, high-yield bonds, and bank loan debt also currently offer the highest yields in the developed world. Therefore, we believe U.S. Treasurys and other debt instruments are well supported in today’s market.

Would you please discuss your thoughts on the direction of interest rates?

We expect rates to remain around the same levels in 2020 and over the next decade. The Federal Reserve’s stance is significantly different than it was at the end of 2018. At that time, the Fed’s planned rate increases were out of line with future inflation expectations, the strong dollar, flat commodity prices, and a lack of wage growth. We correctly predicted that the Fed would not increase rates, which it announced in early 2019. The Fed’s change in stance generated significant returns in 2019 for many equity and fixed income investors as the riskfree rate was cut almost in half.

The Fed’s view is that there is a possibility of one rate hike in 2021 and one in 2022. However, rather than focus on future rate increases, investors should focus on the current market that appears to support risk assets. Fundamentally, the U.S. economy appears strong as it is growing at the same rate as inflation, commodity prices are weak, and the U.S. is at full employment.

Where are you finding the greatest risk/reward opportunities?

We seek high-quality, fixed rate bonds with an average credit quality of A by Moody’s, holding primarily Treasurys, agencies, and investment grade corporate obligations. Among these securities, we believe investment grade corporate credit will continue to outperform other investment grade debt.

The portfolio can invest up to 10% of its fixed-income assets in non-investment grade obligations to enhance yield. On a risk-adjusted basis, bank loans, preferred stocks, and high-yield bonds appear to be the most attractive. Particularly with bank loans, they have underperformed in 2019 relative to other fixed-income assets and, since they are out of favor, appear to be attractively priced.