The objective of the Transamerica Investment Management, LLC's (TIM) High Yield Fixed Income product is to achieve superior returns relative to peers and to outperform benchmarks such as the Merrill Lynch All High Yield Master Index over a full market cycle.
Transamerica Investment Management, LLC's (TIM) High Yield portfolio management style uses fundamental and credit research to capitalize on misvaluations in the least efficient portions of the fixed income markets. The investment focus is on total return, investing primarily in debt instruments and convertible securities with an emphasis on lower quality securities. Strategies in security selection, sector weightings, and duration and term structure management are all critical to generating excess returns.
TIM's thorough and unique credit research results in a portfolio of high quality companies with superior business models which exhibit unrecognized catalysts for positive change. This optimizes the prospects for rapid growth in earnings, revenue, and discretionary free cash flow, an improvement in credit metrics, ratings upgrades from the rating agencies, and price appreciation. Significant emphasis is placed on the sustainability of the business model and prudent and visionary managements with past records of success which act in the best interest of debtholders.
TIM's team-oriented approach emphasizes in-house research and seeks to limit non-systemic risk. Our entrepreneurial investment culture is based on a powerful combination of ultimate individual accountability in conjunction with aggressive peer scrutiny, which results in transparency throughout the entire process.
TIM believes that it is essential to gauge the outlook for the economy, Federal Reserve policy, interest rates and the investment environment when managing fixed income portfolios through the economic cycle. This focus assists us in the management of sector allocation, duration and portfolio term structure. Other factors considered in this analysis include the political environment and its potential impact on fiscal policy, taxes, regulation, foreign trade, consumer confidence, entrepreneurial risk-taking, and the outlook for corporate growth.
We also assess the demographic changes which can influence demand for products and services and the outlook for growth in our major trading partners, in order to capitalize on longer term, secular changes in the economy. The entire team also reviews events occurring in each of our analyst's respective sectors. We then synthesize our top-down and bottom-up conclusions into an outlook for specific sectors within the economy and for the economy as a whole. This process culminates in a quarterly investment outlook publication summarizing Transamerica's view on the economy and current investment opportunities.
The portfolio team will generally take a moderate duration position against their benchmark (the Lehman Aggregate or Lehman Gov't/Credit benchmark) in accordance with their view on the economy The objective is to primarily add value via individual security selection and to use maturity/duration positioning as a secondary source of return. Changes in the duration of the portfolio are typically not altered on a frequent basis, but rather only when the investment team determines such a change to be consistent with significant changes within the macro-economic environment, including inflation expectations. Historically, changes in portfolio duration positioning occur 1-2 times per year, with duration positioning constrained to +/-10% of the benchmark.
Yield curve analysis and management is another source of added value in TIM fixed income portfolio management. Our economic and Fed policy outlook results in a yield curve strategy to capitalize on anticipated changes in the shape of the yield curve.
We believe that active sector allocation (between US Government, corporate, mortgage-backed, asset-backed and convertible bonds) is an important source of excess returns. Sector allocation decisions are driven primarily by cyclical factors, such as our economic and interest rate outlook, secular factors, such as demographic change, and technical factors, such as supply and institutional demand, which is calibrated against valuations in each sector. Reviewing historical yield spreads and comparing them to our outlook for a given sector assists us in determining the relative attractiveness of a given sector. Our mortgage-backed securities strategy is determined by our outlook for the yield curve, interest rate volatility, and our interpretation of secular trends in the mortgage-backed market.
Each analyst is required to recommend a weighting (i.e. underweight or overweight) on the sectors they cover in accordance with their outlook for relative fundamental performance. Inputs assessed in making this determination include the economic outlook, input costs, pricing power, capacity utilization, global competition, as well as near term financing needs. Our outlook for specific industry sectors assists us in the search for improving credits in beneficial environments.
Original and proprietary research is the core of our investment process and has added value across asset classes and through time, for over 20 years. Our team-oriented research process emphasizes in-house research and seeks to control or limit non-systematic or business risk. In addition to a dedicated and highly experienced fixed income research team, our portfolio managers (who are analysts as well) also have access to a large group of equity analysts.
We believe that we add value when we identify early stage positive changes affecting a company or a sector, which the market has yet to discern. This groundswell of change may be a result of long term secular trends such as changes in demographics or technological advances, or more fundamental changes occurring within a company, such as a management-related change.
The generation of Ònew ideasÓ starts with a top-down assessment of the economic cycle in conjunction with a view on which sectors will likely lead the economy, and which sectors are undergoing unrecognized positive change. Change may be secular, driven by evolving demographics, politics or economics. Or it may be fundamental, involving an industry cycle, a product cycle or a management transition. After this initial review, promising ÒideasÓ are presented to the entire management team to determine which concepts merit further investigation.
Companies which warrant further investigation are generally contacted and a meeting is set up with senior management by several members of TIM's research team. This team will frequently consist of both debt and equity analysts. Through these meetings and interviews with management, the research team identifies the companies best positioned to benefit disproportionately from change; generally those with superior business models, proven management teams and businesses that are producing substantial free cash flow.
In conjunction with an unrecognized catalyst for positive change, we seek to invest in companies with sustainable, competitive, defensible business models. Our experience has shown that fundamentally unsustainable business models present one of the greatest sources of long term credit risk for a corporate bond. Since stock underperformance can be an early warning sign of a failing business model, we monitor stock performance closely as part of our analytical process. This similarity in research focus and focus on share performance results in synergies with our equity team.
TIM's philosophy is to invest in a portfolio of companies that offer distinct and sustainable competitive advantages (5-10 years) over their competitors. Many of these companies maintain dominant market share yet have transparency of their operations. We also prefer to invest in companies that demonstrate organic growth (instead of growth through acquisitions), recurring revenue models and an operating business that benefits from incremental unit volumes and can bring those incremental unit volumes to the bottom line. Because it takes time for unrecognized positive change to impact credit ratios and to become fully recognized, a by-product of our process is very low turnover.
In meeting with managements, the evaluation includes a determination of their vision, culture, incentive plans, strengths and weaknesses, the company's product lines, distribution capabilities and product pricing. Our goal is to invest in companies that have managements that are experienced, prudent, and visionary, have a history of success and act in the long-term best interest of debtholders, particularly through the effective balancing of shareholder and debtholder interests.
Our fixed income analysts, working with our equity analysts, attend industry conferences and sit in on conference calls to gain additional insights into the financial intentions of company management. Management is often more frank with equity analysts with regard to their plans for share repurchases, dividend increases and leveraged recapitalizations, actions which are harmful to debt-holders. Through time we have found that the soundest, most sustainable business models result in outperformance for both equity and debt-holders. This aspect of our philosophy results in synergies between our equity and debt research teams.
Independent sources such as customers, suppliers, and competitors are used to verify or cross reference facts and information derived from company management interviews. These meetings and discussions can also add a different perspective to the merits of an investment idea.
Our financial statement analysis process seeks companies which are experiencing a substantial and sustainable increase in discretionary free cash flow. Through proprietary analysis of financial statements, we look at a company's cash flow and reconcile it back to its earnings. To the extent that the two have diverged through time, further investigation is merited. Sometimes this is a result of efficient use of capital, but at other times this may be a warning sign that the business model is unsustainable, or at the extreme, there may be financial fraud. We seek companies which exhibit highly predictable revenue and earnings growth, strong balance sheets and demonstrate high returns on equity and assets.
Critical to the investment process is the identification of companies exhibiting the highest credit improvement potential at the most attractive price. We want to make sure that we don't overpay relative to a company's intrinsic risk or relative to alternative investments within an industry. The relative valuation process involves a comparison of a specific credit to other credits with similar levels of risk, or of similar industries and ratings, calibrated with its prospects for credit improvement. When a corporate bond is purchased, a valuation target and thesis for improvement is presented by the analyst, with the target valuation stated either in terms of other credits of lesser risk, or credits in similar industries with higher credit ratings. Because the corporate bond market is less transparent and dealer-driven compared to the stock market, each analyst has to sit on the trading desk to assure that relative valuation does not occur without real-time market information.
All TIM bond portfolios are well-diversified with respect to issuers and sectors, and will generally consist of 40 to 70 securities (with a corporate issuer representing less than 2.0% of the portfolio). A typical individual position size at purchase is 1-3% and will not exceed 5% at market value. No more than 55% of the portfolio can be invested in any one broad Lehman sector and industry weightings are limited to 15% of the portfolio as defined by Lehman's industry sub-sector breakdown. TIM's High Yield portfolio is managed with the objective of being fully invested, with cash levels typically well below 5%. Derivative securities are not used in the management of this product.
CMS BondEdge is used to measure duration, convexity and yield by sector and to insure that portfolios remain within any predetermined parameters for credit quality and industry concentration. Proprietary models monitoring credit exposure by portfolio provide another level of analysis. Because we believe that there is no substitute for fundamental research, computer and optimization models are not used in the construction of portfolios.
Finally, a dedicated compliance department reviews overall processes on an ongoing basis, and monitors all portfolios. Client restrictions and guidelines are documented and quantified on TIM's portfolio accounting system. Compliance with client guidelines is reviewed on a regular on-going basis by the portfolio manager and the compliance staff.
Our sell discipline includes several factors, including: the realization of the original investment thesis, an issue matures or it's tendered, identification of a better idea, overvaluation relative to TIM-determined fair value and as compared with other like securities, a deterioration in company fundamentals, or a change in the original investment thesis.
Portfolio Managers and analysts sit on the trading desk and generally trade for the portfolio they manage. TIM's dedicated trading group has developed an extensive network of brokers, and is able to leverage negotiations for best execution practices, due to our organization's size.
Our internal credit research is presented at our daily and monthly research meetings. Monday meetings tend to focus on a review of the ongoing economic outlook, investment strategy, and positioning, while Monthly meetings tend to cover more comprehensive reports such as buy or sell recommendations. TIM's entire investment team convenes daily by conference call to go over economic indicators, news impacting our holdings, and new investment ideas. This daily call culminates in a trade review of all trades which took place in the institutional portfolios, a process which ensures full transparency on an ongoing basis. TIM's extensive peer review process also incorporates daily internal meetings/conference calls involving the Chief Investment Officer, portfolio managers and analysts of all investment classes.