Our goal for convertible portfolios is to provide long-term capital appreciation and income and to outperform the Merrill Lynch All Convertible Index over a full market cycle with less volatility.
Transamerica Investment Management, LLC ("TIM") Convertible Securities can be categorized as a fundamental and research driven approach to investing in growth companies that have market capitalizations in excess of $500 million. Convertible securities often provide the conservative investor with opportunities not found in the equity or fixed income markets.
Our philosophy is to invest in a number of high quality companies with superior business models exhibiting catalysts for positive change, which can result in rapid growth in earnings, revenue and discretionary free cash flow. Significant emphasis is placed on prudent and visionary management teams with past records of success that act in the best interest of shareholders.
Our team-oriented investment decision-making approach emphasizes in-house research and seeks to limit non-systemic risk. Our investment culture is based on the combination of peer scrutiny and ultimate individual accountability.
Using our economic and interest rate outlook as well as our credit analysis, we continuously monitor and project the outlook for both the bond and stock markets. Evaluating these markets plays a significant role in the valuation of convertibles. By analyzing the bond market, we are able to form conclusions about attractive yield levels in both the new issue and secondary markets. Because changes in the investment value (straight bond value) of a convertible are a principal determinant of downside protection, this analysis is vital. The closer a convertible is priced to its investment value, the lower the sensitivity to changes in the underlying equity. Having completed our interest rate review, we concentrate our analysis on the equity market.
We believe that value can be added when we identify at an early stage positive changes affecting a company that 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. It may also be positive fundamental changes occurring within an industry or a company such as a management-related change.
The entire team also reviews economic indicators and events occurring in each of our analyst's respective sectors. We then synthesize our conclusions into an outlook on the economy, what type of growth is to be expected and what portions of the economy will drive that growth, within the capital markets.
Our capitalization strategy is a by-product of our investment philosophy. We tend to favor mid to large cap companies. The investment team focuses primarily on growth companies with market capitalizations in excess of $500 million at the time of purchase. This universe has remained consistent over time.
Original research is the core of our investment process and has added value over time. Our team-oriented process emphasizes in-house research and seeks to control or limit non-systematic or business risk. Our dedicated and highly experienced equity research team is complemented by a large group of credit analysts.
The generation of "new ideas" starts with an eclectic group of sources including: new issues, industry contacts, trade shows, industry specific conferences, trade and general media, quantitative screens and, on a limited basis, Wall Street research. A manager or analyst then identifies a company or group of companies that may be positively impacted by change. We look for secular change, driven by evolving demographics, politics or economics; as well as fundamental change, involving an industry cycle, a product cycle or a management transition. After this initial review, promising "ideas" are presented to the entire management team to determine which concepts merit further investigation.
Companies that warrant further investigation are contacted and a meeting set up with senior management by several members of our research team. Meetings and interviews with managements allow the research team to identify the companies best positioned to benefit disproportionately from change; generally those with superior business models, proven managements and businesses that are producing substantial free cash flow.
TIM's philosophy is to invest in a concentrated number 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.
In meeting with management teams, 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 management teams with a history of success and that act in the long-term best interest of shareholders, particularly through effective allocation of capital.
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.
Financial statement analysis is focused on companies that are experiencing a substantial increase in discretionary cash flow. Through proprietary analysis of financial statements, we look at the sustainability of a company's cash flow and reconcile it back to its earnings. Discrepancies between operational cash flow and net income can often warn of underlying problems. Preferred companies exhibit positive 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 growth potential at the most attractive prices/valuations. We want to make sure we do not overpay relative to a company's intrinsic business value and/or projected growth rate or relative to alternative investments within an industry. Proprietary valuation models (DCF-based) are built for every company considered for investment and form the basis for our valuation judgments.
Research includes a "Porter's 5 Forces" analysis which reviews entry barriers, competition, threat of substitutes, bargaining power of buyers and suppliers and rivalry among competitors.
Research documentation will include a business discussion, an earnings model which reflects historical and expected financial performance and a quantitative analysis of the security's potential risk-reward characteristics.
Companies not eliminated from fundamental research are presented to the Investment Team for review. Group evaluations ensure that the reasoning and analysis behind each recommendation is solid and defensible and the securities ultimately selected truly fit all criteria and controls.
We have developed a methodology and process which constantly monitors all convertibles that are eligible for consideration. Included in the statistical analysis are comparisons of the issue's current yield vs. premium over conversion. This relationship enables us to judge the relative attractiveness of convertible issues and provides us with a basis to compare new issues with the universe. We also plot investment premium vs. conversion premium, which enables us to consider convertibles that can perform with either the stock market or the bond market.
The final security selection is a result of the compilation of all fundamental analysis. To ensure that our downside risk expectations are not exceeded, we invest primarily in high quality convertibles that have predictable investment values. The average dollar weighted rating of the securities in our portfolios is BB. To enhance upside potential, we seek convertibles that have long call protection either through non-call provisions or issues selling at discounts. To enhance protection of capital, we seek convertibles that provide immediate sinking funds, shorter maturities, or mandatory "put" features. Our primary risk control mechanism is our rigorous evaluation of a company's competitive position, business model, management team and valuation (i.e., minimizing non-systemic risk and maximizing credit worthiness). All portfolios are well-diversified, and will generally consist of 40 to 60 securities (with an average holding representing 2.5% of the portfolio). A typical individual position size at purchase is 1% - 3% and generally doesn't exceed 5% at market value. No more than 35% of the portfolio can be invested in any one broad sector for the particular portfolio's benchmark. TIM's Convertible Securities portfolio is managed with the objective of generally remaining fully invested. Cash levels are typically in the 1%-5% range, rarely rising above 10% or below 1%. All accounts are monitored on an on-going basis by the portfolio manager responsible. The number of portfolios assigned to a portfolio manager varies depending on the size of the portfolios. Client restrictions and guidelines are documented, and if possible, quantified on our portfolio accounting system. Compliance with client guidelines is reviewed on a regular on-going basis by the portfolio manager and Compliance Department.
The sell disciplines we use incorporate several factors, including: conversion or call of the issue, 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 if management is changing strategy in a questionable way or not meeting operating objectives. The research group also formally reviews all holdings which have declined 25% from cost or trailing twelve month high.
TIM's equity trading desk is staffed by experienced professionals. Traders and portfolio managers work together to establish priorities at order entry and if necessary, during the execution process. Portfolio managers review trade tickets at the end of the day and all trade tickets are reviewed the following morning by the investment team. TIM's Best Execution Oversight Committee monitors trade execution costs on a quarterly basis.
TIM's dedicated trading group has developed an extensive network of brokers, and, due to our firm size and trading volume, is able to leverage negotiations for best execution purposes. We attempt to keep commissions as low as possible. While the traders do their best to minimize market impact while executing orders, the ultimate decision on execution lies with the portfolio managers where opportunity costs may outweigh short-term market impact costs.
Our internal research is presented at our weekly research meetings as well as monthly at our strategy meetings. Weekly meetings tend to focus on brief updates of news items affecting our holdings while monthly meetings tend to cover more comprehensive reports such as buy or sell recommendations. Internal research is easily accessed by everyone through e-mail and voicemail. TIM has offices in Los Angeles with a daily exchange of information among the entire investment and research staff. 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.