Conventional investment wisdom doesn't seem to sit well with Margaret Patel, manager of the Evergreen Balanced fund.
"I am not like a lot of balanced fund managers who hug their benchmarks and whose funds stay closely correlated to a particular index," she says. "This fund is a true diversifier."
Founded in 1935, Evergreen Balanced had been following a fairly traditional balanced fund path before Patel took over in June 2007 by focusing on large companies and taking its investment cues from its benchmark index, the Standard & Poor's 500. But where many balanced fund managers stray a few steps from an index's holdings or industry weightings, Patel roams her universe, the Russell 1000 Index, from its $450 billion market cap top to its $2 billion toe in search of stocks in industries she believes will outpace the economy. She starts her analysis with top-down industry themes, then drills down with fundamental analysis of specific stocks.
Like her management style, some of her views about sectors and companies that will remain buoyant in the face of economic pessimism defy traditional wisdom. She believes industrials, considered to be particularly sensitive to economic downturns, are not as vulnerable as many people believe. "Economically sensitive industries continue to do well, particularly those positioned to take advantage of capital expenditures by businesses. People seem to think that these companies are highly cyclical, but I haven't found that to be the case lately. Companies have plenty of money to invest and are still in the process of improving their efficiency and environmental standards." Basic materials companies should also benefit from a continued infrastructure build-out of power plants, municipal facilities and other nonresidential construction.
She also contends that defense company holdings such as Raytheon will thrive regardless of whether a Democrat or a Republican gets elected to the White House, or even if the war in Iraq winds down. "There is a multi-year expansion cycle that is focusing on substituting technology for manpower, rationalizing and decreasing labor costs, and aerospace units will benefit from new cycle for passenger plane development," she says.
But she isn't as confident about consumers keeping their wallets open and is staying away from sectors such as restaurants, retailers and automobiles. "I don't want companies with low barriers to entry that will have trouble raising prices and are vulnerable to a slowdown in consumer spending," she says.
The fixed-income side also reflects a departure from the balanced fund norm, which typically consists of a mix of government, mortgage-backed and high-quality investment-grade bonds. Patel views bonds as a way to pick the best place in a company's capital structure, maximize the fixed-income side's total return and get some interest to boot.
The walls between the equity and bond side are more fluid than they are with many balanced funds, and cross-pollination of ideas between the two asset classes is not that unusual. If she likes a company but thinks its bonds are a better choice than its stocks, she will invest in line with that conviction.
"Instead of broadly diversifying the fixed-income side without any focus, I look for the parts of the bond market that have the best risk-reward characteristics," she says. "It's a more dynamic approach that links the equity and bond portions of the fund." She estimates that over the long-term approximately 20% to 40% of the fund will be in fixed-income securities, depending on which asset class looks more attractive. Stocks recently accounted for roughly 73% of the assets, followed by corporate bonds at 12% and convertible securities at 8%.
The fixed-income side has a hefty dose of higher-yielding, below-investment-grade securities. The convertible bonds offer the chance at a higher yield and better downside protection than the stock offers, while still capturing about half of the equity's upside potential. "What I'm looking for is above-average income from the bond side so that I'm not married to stocks that pay high dividends," she says.
The strategy has allowed the fund to maintain a decent level of income and still migrate into mid-cap stocks, which often have lower dividend yields than larger companies. About half of the assets on equity side of the portfolio recently consisted of names with $50 billion or less in market capitalization, with about 20% of assets in companies with market capitalizations of under $10 billion.
Shareholders should not view the fund as a way to generate high income, since Patel anticipates that its yield will be roughly on par with that of the S&P 500 Index. Instead, the attraction here is "capital appreciation potential and the flexibility to invest in a broad range of companies, securities and market capitalizations."
Fund Remodel
The fund's investment strategy represents a departure from the form it took before mid-2007, when Patel took charge with what she calls "a mandate to restructure the fund."
Under the previous manager, Walter McCormick, Evergreen Balanced had focused squarely on its benchmark and had invested mainly in growth companies with very large market capitalizations. The fund fell behind many of its peers as the market favored small- and mid-cap stocks, and lagged its Morningstar moderate allocation category average for six of the seven years from 2000 through 2006. In McCormick's last report to investors, dated March 2007, he noted that "our security selection within the equity sleeve of the portfolio was suboptimal," and cited a premature migration to large-cap stocks of stable growth companies as the major culprit.
Patel changed the equity investment universe to the Russell 1000 to include some mid-cap names and increased the presence in industrials, which now represents the fund's largest sector universe at 14% of assets. The bond side saw retooling as she trimmed the former manager's Treasury, mortgage-backed and investment-grade corporate bonds. At the other end of the risk spectrum, she eliminated positions in emerging market bonds as well as lower-quality, small-company names.
She replaced many of those securities with "borderline credits," an area of expertise she honed at her previous position as the manager of Pioneer High Yield Fund, where she worked for eight years before joining Evergreen. Patel believes that bonds slightly above or below investment-grade quality, issued by "solid companies with positive cash flow," present the best risk-reward balance in the fixed-income spectrum at this point. They offer a relatively high yield, can benefit from an improvement in the economy or a credit upgrade, and are less sensitive to rising interest rates than Treasuries or high-quality bonds. She admits that while capital appreciation potential is moderate, the bonds could get a push if yield spreads between Treasuries and lower-quality securities narrow.
General Cable Corp. represents 5.5% of assets and is the fund's largest holding. Patel owns both the company's "straight" bonds, which have a yield of 7.3%, as well as its convertible bonds, which have a modest 1% yield. The stock pays no dividend. "This is a high-quality company even though the bonds only have a B+ rating," she says. "Investing in the bonds is a way to benefit from strong growth trends and get some income as well," she says.
The fund also expanded its reach as Patel increased the number of holdings when she took over, from about 75 to more than 208 by the end of September, reflecting her emphasis on industries and sectors rather than staking large claims in individual securities.
Among the holdings she decided to hang on to were large technology stocks such as Microsoft and Cisco Systems, which have an "insurmountable lead position and should benefit from business capital expenditures and continued consumer spending on technology products." Information technology, the second biggest sector weighting, accounts for 13% of assets.
Despite headlines trumpeting the dangers of expiring patents, she also has maintained a presence in pharmaceutical holdings such as Bristol-Myers Squibb and Pfizer because they are restructuring, rationalizing, developing new drugs and acquiring companies with cutting-edge products. And health care equipment and supply companies such as Thermo Fisher Scientific, the largest company in the sector with the broadest product line, will get support from research expenditures earmarked toward improving health care processes and diagnostic capabilities.
The mix of McCormick's old holdings with Patel's newer additions gives the fund a very different flavor than it had a year ago. Morningstar analyst Andrew Gogerty notes while Patel's addition is a plus to the firm "investors now must decide whether the fund's new profile still fits in their overall portfolio." He observes that an increased exposure to mid-and small-cap stocks comes after a sustained run compared with larger-cap stocks. Patel counters that the fund still owns a number of large company growth stocks left by her predecessor that she intends to keep. Exposure to companies with less than $2 billion in market capitalization "is next to nothing, and the mid-sized companies in the fund have a sustainable path of higher earnings ahead of them."
