Featuring:
Peter Vanderlee
Managing Director & Portfolio Manager
ClearBridge Investments
Market risks remain elevated as higher interest rates and other financial conditions slow economic activity. But with a diversified portfolio of high-quality income producing equities, investors may find downside protection and upside participation at typically lower risk and volatility than the broader market. Learn about the benefits and potential opportunities of income equities from Peter Vanderlee, Managing Director at Franklin Templeton affiliate ClearBridge Investments, and Portfolio Manager of LMP Capital and Income Fund, ticker SCD.
The LMP Capital and Income Fund, ticker SCD, seeks total return with an emphasis on income by, under normal market conditions, investing at least 80% of the sum of its average daily net assets in a broad range of equity and fixed income securities of both U.S. and foreign issuers.
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Podcast Transcript
CEFA:
Welcome to CEF Insights, your source for Closed-End Fund information and education, brought to you by the Closed-End Fund Association. Today we are joined by Peter Vanderlee, Managing Director with ClearBridge Investments, as well as Portfolio Manager of LMP Capital and Income Fund, ticker SCD. ClearBridge is an affiliate of Franklin Templeton. Peter, we are happy to have you with us today.
Peter Vanderlee:
Thanks. Glad to be here and thanks for having me.
CEFA:
Peter. In managing SCD, your portfolio is focused on income-oriented equities to target total return with an emphasis on income for investors. Can you discuss the investment strategy for the fund and how the components of this strategy complement each other?
Peter Vanderlee:
SCD provides a broad-based portfolio that can invest in a range of equity and fixed income securities, including stocks, MLPs, REITs and fixed income. We seek to achieve an attractive total return with an emphasis on income. Now in practice, this translates to a diversified equity portfolio with investments in high quality dividend paying stocks, energy MLPs, publicly traded REITs and business development corporations supplemented by mandatory convertible securities.
We typically invest in companies that have attractive dividend profiles and we favor companies with strong balance sheets, companies that generate a lot of free cash flow and have a leadership position in a sector and have the ability to not only maintain the dividend, but also provide dividend growth over time. We invest in energy MLPs, we invest in publicly traded REITs. We also can own a select few business development corporations, which typically finance small and midsize companies and can distribute high and attractive income streams to their shareholders. Finally, we can invest in convertible preferred shares which provide an attractive income stream while retaining exposure to the performance of the underlying stock.
CEFA:
As a multi-asset strategy, you have a broad range of opportunities in the fund›s investment universe. What is your process to evaluate this investment universe to develop a workable set of potential investments?
Peter Vanderlee:
We begin with a broad universe of around 1,200 securities, and there we look at the overall attractiveness of equity income asset classes and we evaluate the overall attractiveness of common stocks, MLPs, REITs, BDCs, convertible securities, preferred stocks on an absolute basis and relative to each other. We can also invest in corporate bonds, but for a long time the environment for equities has been strong compared to corporate bonds as many bonds were not providing much income. Now we seek companies with strong balance sheets, sound business strategies, good management teams and attractive income streams in the form of current yield and the prospects for income growth over time.
We look for secular and cyclical growth opportunities, looking at evolving trends as well as economic conditions to determine which trends are actionable. Now from there, we conduct a more in-depth fundamental analysis to narrow down the universe of potential investments. We examine, for example, the company's competitive position in its sector, the risks and opportunity the company faces. We look at the strength of the management team that's in place. From a financial standpoint, we analyze the strength of the balance sheets, the debt profile of the company and other liabilities a company may have such as pension plans.
Of course we analyze the dividend profile in terms of its track record, its ability to maintain the dividend or better yet grow it over time. We also assess the company's ability to generate free cash flow to sustain that dividend. Then finally we perform a rigorous valuation analysis using a variety of metrics, free cash flow yield, enterprise value to EBITDA, price to earnings, price to book, among others, to see which securities are the best candidates to be included in the portfolio.
CEFA:
How do you then make specific security selections and allocate those positions as you build your portfolio?
Peter Vanderlee:
Yeah, in that last step, we construct a portfolio where we seek diversification across various asset classes and sectors. So we'll put emphasis on secular growth themes and also overweight cyclical growth themes and look at individual position sizes to manage those as well and typically capping those individual position sizes at 5% at cost.
CEFA:
What are the key factors or events that would lead you to sell a particular portfolio security or significantly change your portfolio allocation?
Peter Vanderlee:
Our sell strategy is the inverse of our buy strategy. One event that could lead us to sell or trim our position is that we're seeing or anticipating a material change to our investment thesis. This could, for example, be due to the company making a large transformative acquisition or to underlying changes that are occurring in its industry and competitive landscape that can worsen the company's prospects. Another reason for a sale or trim can be that we determine that the company is experiencing deteriorating financials. For example, if we see that a company is taking on more leverage or generates less free cash flow, or if we see that a dividend is at risk, we may sell or trim.
A third reason for a trim of sale is that the company has experienced strong stock performance. If we assess that the risk-reward at the current stock price is no longer compelling, we may decide to trim or sell. Now, in that case, our investment thesis has come to fruition or the stock is ahead of itself and we may decide to take some money off the table to look for opportunities elsewhere.
CEFA:
How has the SCD strategy performed through the recent periods of volatility in 2022 and 2023? How did the portfolio adjust as you were going through these periods?
Peter Vanderlee:
In terms of performance in 2022, 2023, in most of 2022, we outperformed significantly as our energy overweight was rewarded in a tight environment for most commodities. We're also underweight communication services and consumer discretionary sectors where high multiple growth stocks sold off in a rising rate environment. Being underweight, those sectors helped us and we were underweight those sectors as we did not see compelling risk-reward given that many stocks in those sectors were selling at very high multiples with low free cash flow.
Now the fund exhibited positive absolute returns thus far in 2023, but we did give back a bit of outperformance in the first quarter of 2023 as market trends somewhat reversed. In terms of portfolio adjustments in the period, on the margin, we added to financials and industrials, seeking a little bit more positive exposure to higher interest rates and economic sensitivity as supply chain problems from the pandemic eased. We added a bit more financials exposure also during this period, especially in the first quarter of 2023 as banks sold off and we think there is some good quality to be captured there.
Within IT, we largely focused on managing our semiconductor exposure. Semiconductors are late in the cycle and we exited a few positions and trimmed a few others. We made some minimal changes to our energy positioning, although as some exploration and production companies sold off in early 2023, we did buy ConocoPhillips capitalizing on an opportunity to add a high quality company at an attractive price in our view. Among the REITs, we trimmed exposure to communication towers in 2022, but we added some back in the early part of 2023 as prices had corrected and interest rates look to have peaked or at least close to have peaked.
CEFA:
Peter, the Federal Reserve has been aggressively raising interest rates. Inflation has been high and economic growth has slowed. We also have significant geopolitical tensions as well as some issues in the banking sector that have added to volatility. Where do you see the investment markets currently and what is your outlook for the rest of 2023?
Peter Vanderlee:
Market risks remain elevated as a result of the slowdown in economic activity due to higher interest rates and overall tightening financial conditions. The U.S. housing market is showing weakness, a result of higher mortgage rates and weakening fundamentals. We continue to expect the Fed to stay hawkish for the time being, although most of the increases of interest rates are likely behind us. Inflation expectations continue to be above 2%, still above the long term stated goal by the Fed. Corporate earnings are under pressure with demand showing signs of weakness.
Outside of pressures in the economy from the housing market, there are also other sectors that are showing signs of strain, most notably financials where pressure on the select few banks such as Silicon Valley Banks, Silvergate Capital and Signature Bank is reverberating throughout the sector increasing volatility in its wake. Regional banks, which often rely on deposits from a funding standpoint have been punished, especially those who invested in long-term bonds leading to unrealized losses in their held to maturity portfolio and causing a duration mismatch with their short-term deposits.
The jaw dropping stock declines we witnessed in many regional banks are reminiscent of the falling dominoes that we saw during the global financial crisis. Though our exposure to regional banks was nonexistent, we continued to follow developments closely to guard against possible contagion risk. For now, our assessment is that contagion and the risk of contagion to other parts of the banking system or the market is broadly low, although investors' nerves are frayed and things can evolve at very much a lightning speed.
CEFA:
What challenges does this environment present to income-oriented investors or investors seeking portfolio diversification?
Peter Vanderlee:
Our assessment is that the environment remains challenging for risk assets such as common stocks in the short term. In the long term, we continue to be comfortable owning high quality companies with sound balance sheets, lots of free cash flow, leadership positions in our sectors, attractive dividend yields and dividend growth potential.
CEFA:
We have talked about SCD having a broad range of potential investments. How do you see active management across this range of potential investments contributing to addressing the challenges this market environment presents?
Peter Vanderlee:
In terms of exposure to dividend paying stocks, we continue to favor companies that are leaders in the sectors, that generate lots of free cash flow and have solid balance sheets. These companies are typically less cyclical and exhibit lower volatility due to the high-quality, strong balance sheet and attractive dividend. In terms of our exposure to energy, we remain opportunistic and tactical in managing through the high level of volatility in the energy market. The market has been adjusting to the supply shock with Russian output much lower than before. We continue to emphasize balance sheet strength, asset footprint diversity and quality, and carefully assess our holdings with an eye towards managing successfully through the short term disruption and thriving in the long term.
We continue to believe that in the long term, midstream companies and MLPs will continue to represent an attractive investment opportunity. In terms of REITs, the commercial real estate market recovery has been slow as higher interest rates and associated real estate borrowing costs are putting pressure on real estate asset values and REIT share prices. We continue to emphasize those REITs with strong balance sheets that are operating in sectors that have significant long-term secular growth trends.
CEFA:
How is the SCD portfolio currently positioned and where are you seeing the best opportunities in this market?
Peter Vanderlee:
We maintain our overweight to energy, especially towards energy MLPs, which exhibit a lot of stability in the cash flows they generate as their contracts are typically long duration and do not depend on the price of the underlying commodities such as crude oil or natural gas. The companies we own tend to have these predictable cash flow streams which tend to grow over time as many of the contracts are indexed to inflation. Also, we look for companies that have strong balance sheets so that they can withstand tougher economic environments, including recessions, and for companies with strong distribution or dividend profiles.
Further, a good part of the distributions we receive from our MLP holdings is comprised of a return of capital, which is advantageous from a tax standpoint. Finally, though many of our energy MLPs issue K-1 tax forms, the fund, SCD, provides our investors with regular 1099 simplified tax reporting. We are also overweight in utilities and own a diversified set of utilities, including companies with exposure to renewable energy such as Brookfield Renewable Energy Partners. NextEra Energy, Inc. is also a name that we own, and we also own natural gas exposure through our holdings in CenterPoint, Sempra Energy and Suburban Propane Partners.
We are underweight in consumer discretionary as we are concerned over a weakening economy that can translate into fewer discretionary purchases. As you might expect, we are also underweight information technology where many companies do not exhibit strong dividend profiles, although we do have a healthy exposure to high quality technology companies that are operating as leaders in growing markets, examples include Microsoft, Apple, Broadcom, and Qualcomm, which are all holdings in the portfolio.
CEFA:
Peter, how do you see an allocation to a strategy focused on income-oriented equities best positioned in an investor's diversified portfolio, and likewise for an investor that is more income oriented?
Peter Vanderlee:
An allocation to income producing equities can provide an investment trifecta of sorts. First, it provides income, which can supplement savings or a lack thereof and help meet cash and spending needs. Second, it can provide income growth, which is especially important in high inflationary environments such as the one we're in today. Third, it can provide capital appreciation over time, which helps build wealth. The strategy can be especially valuable during periods of market turbulence or down markets. This is because high quality income oriented strategies provide downside protection stemming from the dividends they pay and from the quality assets they typically own.
Further, during upmarkets, the strategy tends to participate providing additive return. So in a diversified portfolio of high quality income producing equities, you can get downside protection and upside participation typically at lower risk and lower volatility compared to the broader market. These are desirable investment characteristics. Especially if you look at income opportunities more broadly like we do, you can arrive at an eclectic mix of high quality securities and asset classes that exhibit low correlations to each other and that provide attractive current income while preserving the potential for capital appreciation.
Let's not forget that even though bond yields have risen, they are still low by historical standards. I have to mention that because we can, and at times do invest in fixed income. But today, many stocks continue to exhibit low dividend payout ratios by historical standards and we believe there's room for dividends to grow over time, providing investors with the potential for income growth, which is something regular bonds typically do not provide as the coupon is fixed.
CEFA:
Peter, thank you so much for taking the time to share your thoughts with us today.
Peter Vanderlee:
Glad to be here and thanks for having me.
CEFA:
We want to thank you for tuning into another CEF Insights Podcast. For more educational content, please visit our website at www.cefa.com. This material is not and is not intended as investment advice, an indication of trading intent or holdings or the prediction of investment performance. All fund specific information is the latest publicly available information. All other information is current as of the date of this presentation. All opinions and forward-looking statements are subject to change at any time.
ClearBridge disclaims any responsibility to update such views and or information. This information is deemed to be from reliable sources. However, ClearBridge does not warrant its completeness or accuracy. This presentation is not intended to and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any security, product, investment advice or service, nor shall any security, product, investment advice or service be offered or sold in any jurisdiction in which ClearBridge is not licensed to conduct business and or an offer, solicitation, purchase or sale would be unavailable or unlawful.
About the CEF Insights Podcast
Presented by the Closed-End Fund Association (CEFA), the CEF Insights Podcast provides investors with closed-end fund education, insights, and perspectives. The CEF Insights Podcast is available on CEFA.com, Apple Podcasts, Seeking Alpha, Spotify, and other leading podcast platforms.