Barron's: How Pimco is Wading into Stocks

By SIMON CONSTABLE
The trickiest part of investing—and the most important—is determining the right mix of stocks and bonds. When investors think of Pimco, it’s usually with regard to the bond side of its portfolio. Yet its stock funds have done remarkably well.
Enter the $820 million Pimco Dividend and Income Builder fund (ticker: PQIZX). This three-year-old fund is a hybrid stock-bond fund. Despite the considerable experience his firm has in fixed-income investing, manager Brad Kinkelaar runs a fund (with three other managers, including the firm’s new chief investment officer, Dan Ivascyn) that’s heavily skewed toward stocks—its target mix is 75% equities, 25% bonds. “It could be confusing,” he says.
As of year end the fund was even more heavily invested in stocks: some 92%, with just 8% in fixed income. Nearly half the portfolio is in U.S. stocks, with about 40% in foreign shares. The mix is driven by the fund’s focus on income. “It’s a competition for capital, rather than an allocation of capital,” Kinkelaar says. Clearly, stocks are winning that competition by offering higher yields than bonds these days. Kinkelaar looks for stocks that are undervalued, which of course lends itself to a higher-yielding portfolio. But Kinkelaar emphasizes companies that are in good financial shape and are expected to increase their dividend payout. The fund yields 2.5%.
Through January, the fund has returned 11.1% per year since its inception in December 2011—beating the 10.8% average annual return of its weighted benchmark, which is 75% MSCI All Country World Index and 25% Barclays Global Aggregate. That outperformance comes with a high hurdle: The fund’s fees, at 1.57%, are higher than the average world-allocation fund, according to Morningstar, and the fund comes with a hefty upfront 5.5% sales charge.
Kinkelaar co-managed the Thornburg Investment Income Builder fund (TIBAX) for six years, which consistently outperformed in that time. Prior to that, Kinkelaar was an associate portfolio manager of two other Thornburg funds.
Casting a wide net for undervalued or out-of-favor stocks has led to an eclectic portfolio. One of the fund’s larger holdings, Target (TGT), at 2.8% of the portfolio, is another example of the portfolio managers pouncing on an opportunity to get something of quality at a discount. In late 2013, Target suffered an enormous security breach, plaguing the firm with negative publicity.
The managers asked themselves, “Will Target still be in the headlines for security breaches” in two or three years? They didn’t think so, and took the stock’s two-month, 12% plunge as an opportunity to buy shares in a company that would continue to grow.
Target also announced it will shutter all of its Canadian operations, which had weighed on performance. Without the northern drag, the company should see earnings growth of 40% to 50%, even better than the double-digit growth Target has traditionally seen.

KINKELAAR’S LARGEST STAKE
 in a sector is in financial-services stocks; 25% of the portfolio is invested in this sector, far above the 15% for the category average. If not the poster child for a financial institution crippled by the housing crisis, the U.K.-based Lloyds Banking Group (LYG) was certainly a contender. “It went through a troublesome period that required government investment,” Kinkelaar says, but he bought the stock last year because he liked the bank’s “very conservative” approach relative to its competitors. Lloyds is “one of the more conservative” banking firms in terms of how it does business, and Kinkelaar says the bank is undervalued. It’s trading at a mere 1.1 times book value, a deep discount to similarly structured Scandinavian banks trading at two to three times book value. Kinkelaar sees that gap being narrowed in favor of Lloyds trading higher.
Likewise, Kinkelaar thought the market was missing something in assessing Colony Financial (CLNY), a mortgage real estate investment trust, or REIT. “Like most mortgage REITs, it has benefited from lower interest rates,” says Kinkelaar. But there is a bigger story: The company has a large investment in residential real estate, for which it wasn’t getting any credit, he explains. “As they put the properties out to lease, their ability to grow yield increased,” he says. The stock yields 5.9%, and the stock has rallied more than 10% over the last year. Kinkelaar says the firm should increase its earnings as much as 20% this year.
The bank has also shored up its balance sheet, and based on that will soon be allowed to pay dividends, says Kinkelaar. The bank was rescued by a government bailout in 2009. He sees a dividend of 3.5% to 4% in 2015, rising to 5.5% next year.
THE FIRM’S OUTLOOK for bonds is evident in its tiny allocation, though the fund uses some derivatives instead of buying the bonds outright. Co-manager Alfred T. Murata, does see some value in mortgage-based securities, especially those not backed by government-sponsored enterprises such as Fannie Mae or Freddie Mac. These securities make up slightly more than half the fund’s fixed-income allocation.
These bonds have some protection if the economy falters and borrowers default, because the loans are secured on the properties. Currently, he says these securities trade at a hefty discount, about 70% of face value, because they were issued during the heady days of the housing bubble. But that also means there is the potential for big gains if the real estate market improves more than expected, says Murata. Even the worst-case scenario, he adds, would give a return of 4%. 
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