Fran Radano of North American Income trust on how he beats the index by taking active bets with a focus on cash flow.
A passive storm has hit the active fund management industry over the past decade, with a growing army of self-directed investors choosing to accept the returns produced by stockmarket indices.
Big reductions in management fees over the past seven years or so, with some index funds and ETFs now costing just a tenth the price of an active fund, have been one key driver towards passive.
Another is that many investors in actively managed funds have ‘defected’ to passive funds after being disappointed by the chronic underperformance of their active holdings. Added to that, as various pieces of research over the years have shown, the majority of active funds fail to bring home the bacon with any consistency.
To put the rapid growth of passive funds over the past decade into context: in the UK retail fund space before the financial crisis in 2007, the amount held in tracker funds was a mere £29 billion, which at the time represented 6.3% of total assets under management. At the end of March this year, the amount held in trackers stood at £194 billion, which represents a 16.1% share of the total.
In the US, the growth of passive has been even greater, with passive funds now accounting for 45% of all US stock-based fund assets, up from 25% a decade ago. As Money Observer has highlighted over the years, the US stockmarket is a tough nut for active fund managers to crack, due to its position as the biggest and most widely followed market in the world.
Fran Radano of Aberdeen Standard Investments, manager of the North American Income investment trust, acknowledges that “there are 30 or 40 analysts covering every large cap US company, so it is hard for investors to get an edge”.
Therefore, to stand out from the crowd, active fund managers need to do something different to set themselves apart – otherwise, as Radano points out: “Investors will choose Vanguard to do my job for free. I have got to beat free, and the only way to do this is through being active and taking active bets that deviate away from an index.”
In fact, under its former guise prior to 2013, the North American Income Trust was known as Edinburgh US Tracker, and it tracked the S&P 500 index. But its move to change tack and adopt an actively managed remit with a focus on dividend-friendly US businesses has paid off. Since Radano and co-manager Ralph Bassett took over management of the investment trust at the end of June 2015, it has delivered a share price gain of 91% (to the end of May).
Outperfoming its rivals
In contrast, the S&P 500 index – which is not its benchmark index (the Russell 1000 Value is used) but is the main index to compare active fund management performance for US fund managers – has delivered 76%. This is all the more notable given the trust does not hold the non dividend-paying tech stars that have lit up the index over that period. As the chart below shows, over the same time period, the trust has also comfortably outperformed rival investment trusts that invest in US shares.
Radano says: “We look for shares yielding between 2% and 4%, but more importantly dividend growth needs to be mid to high single digits each year. For the trust, growing the dividend is vitally important, but for me personally the main aim is to beat the Russell 1000 Value index.”
Outperforming its peers over the past four years
In the main, the portfolio combines defensive shares such as consumer staples businesses with cash-generative growth companies. The portfolio is concentrated, with just 41 names, but Radano (who makes most of the day-to-day decisions on the portfolio) keeps an eye on how the fund’s weightings compare to the index in order to ensure he is comfortable with the risk level of the portfolio. Radano and Bassett are also able to hold fixed income securities and use options to dampen volatility and add income for investors.
Overall, as Radano points out, holding a collection of dividend-paying companies is a more conservative approach than investing in purely growth-focused businesses. But, he adds, there are traps to avoid stepping into, one being that some businesses overstretch themselves by maintaining or increasing dividend payments to keep shareholders sweet.
“We like companies that pay dividends, so long as it’s not a constraint on their capital,” he says. “Ultimately, we avoid businesses that are over-distributing, which is why we pay particular attention to how a business is allocating its cash flow.”
He adds: “After all, earnings are just an opinion, but cash is a fact. Therefore, we think it is important to meet management teams and sit across the table to understand their business culture and their drive. We want to see sufficient cash being generated to pay a dividend and have money also left over to reinvest back into the business.”
Banks are now striking this balance, according to Radano. Three years ago he started to build up exposure to financials from less than 10% of the portfolio; they now account for 25%. He mainly owns stakes in regional US banks, as they are subject to less regulation and red tape. But he recently snapped up shares in Citigroup, which he says had become too cheap to ignore.
“If there are interest rate increases (in the next couple of years) then bank share prices will benefit, although my expectation for 2019 is for rates to remain where they are given that inflation is low at 2%.”
Disagreeing with the doom-mongers
The continued good health of the US economy, which is enjoying one of its longest expansion phases in history, will also help underpin the performance of bank shares and indeed will also be a great influence over how the trust’s US-centric performance will fare in the coming years.
Although first and foremost a stockpicker, Radano disagrees with the doom-mongers who believe the US economy is cooling. Those fears were heightened earlier this year with the inversion of the bond market’s closely watched yield curve, which has in the past been a harbinger of a recession around the corner.
“We feel that US macroeconomic indicators have improved for the most part: jobless claims continued to trend at very low levels; small-business optimism rose; and most importantly, in our view, the initial first-quarter 2019 GDP growth reading was above 3%, exceeding expectations,” he comments. Moreover, on the ground, corporate results are largely coming in ahead of consensus expectations, so therefore “forecasts for an ‘earnings recession’ now seem somewhat misplaced.”
By extension, he does not foresee an imminent end to the 10-year-long run enjoyed by the US stockmarket over the past decade. In that context, he also argues the rise of share buybacks by US companies, which has helped boost their share prices, is “overstated” and is not a major concern.
However, critics point out that moves by companies to buy back their own shares could have unintended ramifications, as they are ultimately prioritising earning per share each quarter over investment in the long-term future of the company.
Fran Radano in six
1 My best investment was...buying 100 old baseball cards off a neighbour for $5 a long time ago….but the share example would be Rockwell Automation. The oil market was beginning to seize up at the end of 2015 and any business that had any exposure to the energy market was given an energy-like valuation. After having Rockwell on our watch list for several years, we initiated a position in January 2016. The stock immediately dropped by nearly 10%, despite the fact that half of its business mix involves stable end markets in consumer healthcare and the like. We were subsequently vindicated when oil prices rebounded and the share was properly re-rated as a best in class automation provider.
2 My worst investment and lesson learned...buying a micro-cap stock for myself based on a recommendation without properly doing my own research.
3 Alternative career would have been...a left-handed air guitarist, if such a career existed.
4 In my spare time I like to...play paddle tennis in the winter, paddleboard in the bay in the summer, and enjoy a pint 12 months of the year.
5 The one thing I would like to see change in financial services is...for participants to volunteer in their spare time to increase financial literacy among youth and others wishing to learn.
6 Do you invest in the fund…unfortunately I cannot without having to hire a full-time accountant, given the tax ramifications for US citizens. I attempted to move nearly my entire Aberdeen retirement account when I took over management of the fund in summer of 2015, but the tax, record-keeping and other red-tape hurdles of being a foreign investor were insurmountable.