09/03/2014

For Equity Growth, Rufenacht Seeks the Fiscally Responsible

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If the equity markets have had a nice run since 2009, it’s been even better for Aquila Three Peaks Opportunity Growth Fund. For the five-year period ending on June 30, the S&P 500 Index returned a cumulative 120% while Aquila Three Peaks Opportunity Growth Fund had a cumulative total return of 148% based on the public offering price. The annualized total return over the period placed the Fund in the top 21% of its Lipper Mid-Cap Core category. We recently spoke with the fund’s co-portfolio manager Sandy Rufenacht about fiscally responsible companies, how long the equity bull market might last, and his unique approach to stock investing that incorporates his expertise in the high yield bond market.

Would you give us an overview of the fund?

It’s an equity fund that seeks growth by investing in what we believe to be the most fiscally responsible publicly-traded companies that are making positive balance sheet actions.

We’re looking for the same kinds of companies we seek in our companion strategy, the Aquila Three Peaks High Income Fund:  companies demonstrating their fiscal responsibility by paying down debt and generating the free cash flow to do so—cash flow that ideally is earmarked for debt paydown through covenants.

When these companies start paying down debt, generally speaking, good things happen to their stock. We’re agnostic about “growth” and “value” stocks, and we’ll invest across all capitalizations from small to large.

How do you find these fiscally responsible companies?

The universe of companies we consider comes straight from our high-yield bond research, which at any given time includes 70 to 80 publicly-traded companies that are committed to paying down debt.

The search for fiscal responsibility generally rules out industries that are dependent on the economic cycle: steel, paper, chemicals, autos, restaurants, retailers, and airlines. When the economy is doing well, the management teams of companies in these industries tend to think the good times will last and they end up levering up the balance sheet at the worst time—at the top of the cycle, usually around the time the Fed is beginning to raise rates to slow the economy. It makes intuitive sense to add leverage when the economy is doing well, but a company may end up with an over-leveraged balance sheet.

Does your selection process end there?

That’s just the beginning. To find the potential winners, we have to know these companies almost better than their own management. That includes an intimate knowledge of the three main financial statements—the balance sheet, the income statement, the statement of cash flow. But it goes way deeper. For example, we might call a former secretary of the company’s board and ask, what was the CFO’s attitude toward debt when you worked for him? We want to see fiscal responsibility in their DNA.

That gets us to the portfolio of stocks we have a high conviction about. But our process doesn’t stop once a stock is in the portfolio. We’re vigilant about monitoring whether they have sufficient free cash flow. We stay very much on top of them. It takes an enormous amount of research, onsite visits, and time.

This isn’t a conservative strategy, but I think our very careful and constant research is a conservative approach to equity investing.

So you get at equities through the high-yield door, so to speak. How does this give you an edge over other equity managers?

I believe our unusual analytical approach helps us understand companies better and helps us know a little earlier than most when to buy and when to sell.

At Janus Funds, where I once worked, I made a discovery that has defined my career: I saw that high-yield analysts were quicker to realize when to buy and sell equities—quicker than the equity analysts. Why? I think it’s because most equity analysts are focused on revenues, whereas in the high-yield world we’re focused on EBITDA (earnings before interest, taxes, depreciation and amortization). Among other things, EBITDA is better than revenues at helping you understand a company’s ability to pay down debt.

The Fund has done well in this bull market. How will you keep up the pace?

We’ll continue doing what we’re doing. Our process doesn’t change with the economic or market cycle. The better question is, have equities had their run, and is it time to shift to more conservative investments?

From our vantage, equities are still the place to be. The Fed has forced investors into riskier asset classes—hence the run-up in equities. Even with a lot of money still on the sidelines, even with continued fund outflows, even with occasional scares, there simply isn’t much of a payoff in less risky investments. Yet.

When will equities lose favor to less risky asset classes? When the Fed starts raising interest rates. Until recently, it’s been a tepid, almost fragile economy, despite the Fed’s stimulus. But I think that’s changing. I think things are better than GDP growth or employment numbers indicate. Whether you’re in Las Vegas, Phoenix, Austin, San Diego, Miami, New York, there are construction cranes again. Things have rebounded quickly. The Fed has accomplished its goals. It’s going to happen.

I don’t know when it will happen. Nobody does. But we have what I think is a dependable leading indicator. In our experience, high-yield bond yield spreads tend to widen before a major turn in the equity markets. So we watch high-yield spreads very carefully.

Can you dial down the fund’s risk in that scenario?

Yes. We’ve written into the prospectus an ability to invest up to 30% of the portfolio in high-yield securities. Historically, high-yield bonds are lower-risk (in terms of volatility) than equities. And we tend to invest on the more conservative end of the high-yield bond spectrum, because of the research-intensive approach I outlined earlier.

By monitoring the tone of both the high-yield and the equity market, looking for the types of leading indicators that we’ve seen in previous market cycles, we would seek to adjust the fund portfolio – ideally, ahead of other market participants.

Before investing in one of the Aquila Group of Funds, carefully read about and consider the investment objectives, risks, charges, expenses, and other information found in the Fund prospectus. The prospectus is available here, from your financial advisor, or by calling 800-437-1020.

Mutual fund investing involves risk; loss of principal is possible.

Investment Considerations for Aquila Three Peaks High Income Fund: Investments in bonds may decline in value due to rising interest rates, a real or perceived decline in credit quality of the issuer, borrower, counterparty, or collateral, adverse tax or legislative changes, court decisions, market or economic conditions. The Fund’s portfolio will typically include a high proportion, perhaps even 100%, of high-yield / high-risk securities rated below investment grade. High-yield corporate bonds generally have greater credit risk than other types of fixed-income securities and may be especially sensitive to economic and political changes or adverse developments specific to the company that issued the bond. The return of principal for the bond holdings in this fund is not guaranteed.

Investment Considerations for Aquila Three Peaks Opportunity Growth Fund: An investment involves certain risks including market risk, financial risk, interest rate risk, credit risk, and risks associated with investments in highly-leveraged companies, lower-quality debt securities, foreign markets and foreign currencies, and potential loss of value.