Get ready for rising rates

By Vikram Barhat | January 17, 2014 | Last updated on January 17, 2014
5 min read

Vivian Lo aspired to be a professional traveller.

The vice president and portfolio manager of Aston Hill Asset Management Inc. may have traded her backpack for growth and infrastructure funds, but carving out a career has proven an off-the-beaten-path adventure.

Following a four-year stint in the equity research department of CIBC World Markets, she joined Aston Hill in 2007. She now co-manages $601 million in five funds.

She holds an MBA from the Schulich School of Business at York University, and a BComm from the University of Toronto. Lo, who has extensive experience in managing investments in equities, high-yield bonds, convertible debentures and preferred shares, got her CFA in 2006.

How do you pick investments?

Being style-agnostic helps me switch between growth and value philosophies to reflect where I think we are in the current economic cycle. I consider cash an asset class and a significant part of how I view total return, 50% to 70% of which is targeted to come from dividends and cash coupons.

Marrying macro themes to rigorous fundamental analysis helps me identify companies in growth industries that have solid management teams and balance sheets. I employ a top-down, bottom-up approach. Our model of portfolio construction imposes no restrictions in terms of asset classes or geography.

How do you evaluate asset classes?

I run balanced funds where the allocation mix is determined by relative value in different asset classes. The funds I manage all pay distributions and yields vary across funds. The Aston Hill Growth & Income Fund pays three cents per month per unit, or about 5% yield per annum. In equities, we look mainly for dividend growth companies with attractive valuations.

For fixed income, I look to the U.S. high-yield corporate bond market ($1.5 trillion), which provides a large universe of investment opportunities compared to a much smaller Canadian market ($15 billion to $20 billion). Some bonds I currently like include NGL Energy Partners, a diversified U.S. energy infrastructure company, with an annual coupon rate of 6.875% maturing in 2021; Crescent Resources, a private U.S. real estate company with a 10.250% coupon maturing in 2017; and Stackpole International, an autoparts manufacturer with a 7.750% coupon maturing in 2021.

How are your picks doing?

The Aston Hill Growth & Income Fund just reached a three-year number of +11.1%, outperforming our benchmark by 6.3%, with significantly lower volatility.

This outperformance isn’t attributed to only security selection. It is more the flexibility of shifting weights in different asset classes and sectors. In 2011, we increased the cash weighting and high-yield exposure significantly while reducing direct energy exposure in favour of energy infrastructure and REITs. In 2012, when valuations of high-yield bonds started to shoot up, we slashed exposure and raised direct U.S. equity exposure in sectors such as consumer discretionary and industrials to participate in the U.S. recovery. In Canada, we increased weight in REITs and energy infrastructure, and in companies with greater U.S./international exposure, which further contributed to the 2012 outperformance. We continued to increase direct U.S. equity exposure in 2013 by adding consumer discretionaries and industrials, and introducing financials.

The fund was down more than 100 basis points only 5% of all its negative days, versus 25% for the S&P/TSX Composite Total Return Index, the fund’s benchmark. The fund has outperformed its benchmark about 80% of the time in their negative months. Over the past few years, though, the exposure to high yield and U.S. equities has increased significantly, relative to Canadian content. As a result, the appropriateness of using the TSX as a benchmark will be re-evaluated.

Any opportunities you’ve missed?

An example would be Walgreen Co., when it missed Q2 earnings and the stock was down over 12%. I thought valuation would fall further as it was still trading at a valuation higher than its historical range. As I waited, the stock jumped on rumour of an activist taking a stake in the company and subsequently on the announcement of increased dividend.

Lesson learned. Timing the market is tough. I should’ve bought a small position to start with.

What are your short- and long-term global outlooks?

Near term, I expect volatility in the financial markets to pick up again in the first quarter of 2014 as political issues resurface in the U.S. The Fed tapered in December 2013, as economic data suggested the U.S. economy is performing better. I expect interest-rate- sensitive securities, including high-yield bonds, to be more volatile.

We’ve been positioning the portfolio for a rising interest rate environment by increasing exposure to industries that benefit from a rising rate environment, such as U.S. financials (Bank United, TriState Capital, Prudential). We also added exposure to cyclicals, including industrials (Boeing, PPG) and consumer discretionary (Ford, Starbucks, AutoCanada, Foot Locker and Alimentation Couche-Tard). I’ll also be overweight equities versus high yield and underweight government and high-grade bonds.

I’ve been shorting the five-year Canada bond since mid-2012, and still do, as a hedge against interest rates.

It’s an inexpensive way to protect the fund when rates move higher. Longer term, I expect continued improvement in U.S. economic fundamentals: stronger housing, jobs and manufacturing data.

Elsewhere, there are signs of Europe stabilizing and repairing itself, but structural issues remain within the region. Emerging markets—Asian markets specifically—will be challenged to shift from investment-driven to consumer-driven growth.

What are your controls for short- and longer-term risks?

When a security is down between 7% and 10%, we review the position and revisit why we liked the story. If the story has changed, we sell the stock and consult analysts to see what changed. If it hasn’t, I review the original analysis and determine if the valuation is cheap enough for us to buy more.

I also use simple option strategies like buying protective puts or writing covered calls.

Where are the wildcards?

Trading liquidity isn’t an issue for a smaller fund and they can easily trade without being a significant amount of daily trading volume. Brookfield Family of Companies and Boyd Group Income Fund are two examples of such opportunities. Individually, most Brookfield companies trade on average 160,000 shares a day and have higher dividends than the parent company, Brookfield Asset Management.

Boyd Group Income Fund, which operates collision repair shops in Canada and the U.S, has a strong balance sheet with minimal debt and offers a dividend yield of 1.7%.

Both are examples of companies I’m able to easily invest in with a smaller fund.

What currencies do you hedge against?

I actively manage a hedge against the U.S. dollar. Our primary focus is on picking good stocks and bonds independent of currency. However, in order to dampen volatility, we hedge between 80% and 100% of the U.S. dollar-denominated portfolio.

What’s your cash limit?

There’s no limit on cash but I wouldn’t go higher than 20%. Right now the weighting is around 10%, up from as low as 4% this last spring, as I wanted to reduce some exposure and have extra cash in case we saw a buying opportunity going into year-end.

Geographic dispersion Enlarge Rebalancing asset class weightings

Vikram Barhat is a Toronto-based financial writer.

Vikram Barhat