To many investors, management shake-ups, investor pessimism and disappointing earnings are good reasons to sell a stock. To Tom Bastian, they’re signs that it may be time to take a second look.

“We like to buy companies when they are attractively valued, under-earning and unloved,” says the manager of the Invesco Equity and Income Fund. “But there also has to be a catalyst for change and the potential for revaluation.” That catalyst might take the form of a new CEO or management team that promises to shake things up for the better, a shift in growth prospects for a sector or an improvement in earnings expectations.

With the market appearing to settle into a slow-growth environment after several bullish years, says Bastian, “the broad sector opportunities have been exploited. From here on, it’s a stock picker’s market.”

Even with good stock picking, it can take a while to see gains from stocks that others are ignoring or selling, and at times the underdog status of the fund’s holdings has held it back. In 2011, for example, a large position in struggling financial stocks contributed to the fund’s finish in the bottom half of Morningstar’s moderate allocation category. More recently, a top 10 position in Avon Products has hurt performance as the company struggles to boost sales.

But as the fund’s 21% annual turnover rate shows, the 49-year-old Bastian is a patient investor who is willing to wait several years for an investment thesis to pan out. For the most part, picking laggards before they catch up with the rest of the pack while avoiding market hot spots has worked to the advantage of investors in this $12 billion fund. In 2004 and 2005, for example, it had a much smaller stake in the financial sector than most of its peers because Bastian felt the stocks were too richly valued and over-loved by investors. In 2008, the decision to tread lightly helped the fund fall about 10 percentage points less than its peers. He continued accumulating attractively valued financial stocks between 2009 and 2012. At 20% of assets, financial companies now represent the fund’s largest sector.

“Over the last couple of years, financial services companies have been repairing their balance sheets and building up capital,” he observes. “At the same time, the regulatory environment has also become increasingly clear. The stage is set for higher levels of return of capital through dividends and stock buybacks. We think investors will be pleasantly surprised.” Stocks he hopes will deliver such surprises include JPMorgan Chase & Co., Citigroup, Morgan Stanley and Marsh & McLennan.

Splitting The Pie
As a moderate allocation fund, Invesco Equity and Income divides its assets among stocks, bonds and convertible securities. Equity exposure, which consists mainly of large-cap U.S. stocks, typically ranges from 60% to 65% of assets, but has been as high as 68% since Bastian took over as manager in 2003. A current equity allocation of about 65% of assets reflects a cautiously optimistic view of the stock market, and the relative attractiveness of stocks versus bonds.

“The market is no longer as inexpensive as it once was, but we also don’t think it’s particularly expensive,” he says. “Over the near term, government wrangling over the budget, the prospect of tapering, debt ceiling issues and uncertainty in China and emerging markets all point to continued volatility. On the other hand, strong corporate balance sheets and a European recession that appears to be bottoming are positive signs. Our intermediate and long-term view is one of cautious optimism. While we see slow growth in the stock market, we also believe we can continue to find good ideas.”

One of Bastian’s more recent “good ideas” is General Motors, where the fund established a small position in the second half of last year. “GM is attractively valued, and while it is under-earning relative to its peers, it also has a cleaner balance sheet,” says Bastian. “It has a significant exposure to Europe, where the economy is hopefully troughing, and auto sales are improving in the U.S. as well.”

The fund also initiated a small stake in mining company Freeport-McMoRan Copper & Gold last year after investors reacted negatively to the high cost of an energy company acquisition. Bastian bought the stock after meeting with management helped convince him that the company would be able to shed some of its debt from the transaction and improve its balance sheet.

Top 10 positions include Morgan Stanley. When Bastian added it to the fund in 2012, the stock was selling at just 0.5 times book, compared to over 6 times book value at its peak. Costs associated with a consolidation with Smith Barney, purchased from Citigroup, also hurt operating margins, which weren’t as strong as those at the firm’s brokerage industry competitors. With the consolidation completed, Bastian believes margins will improve to a point that is more in line with the rest of the industry.

At 13% of assets, health care represents the second-largest sector weighting. Medtronic, a leading medical device maker, was added to the portfolio in 2011 when overspending led to deteriorating profits and a drop in the stock’s price. Bastian says the company, which has significant international operations and a solid product pipeline, has new management that is streamlining operations and reducing costs.

In the technology sector, Bastian likes software and information storage giant Symantec. He started buying the stock in early 2013, after a series of 19 mergers and acquisitions over five years hurt profitability. He believes shareholders will be rewarded as a new CEO focuses less on M&A and more on operations.

Two areas where the fund has treaded lightly are energy and materials. Bastian believes that while valuations in the energy sector are attractive, companies need to pull back on expenditures before he’ll consider moving in more aggressively. He’d also take another look at materials if recent cutbacks in expenditures help earnings.

Bonds usually weigh in at 15% to 20% of assets, and the current allocation stands at about the midpoint of that range. Because Bastian views the bond sleeve of the portfolio as more of a buffer for stability and income than a growth play, most of that part of the portfolio is invested in high-quality government and corporate securities.

The duration of the bond side of the portfolio is about five years, compared to about six years for its benchmark, the Barclays government credit index. “By shortening duration, we are better able to meet the challenge of a rising-rate environment,” he says. “I don’t have a time line for when rates might rise. But bonds have had a 30-year tailwind of falling rates, so I do believe it’s highly likely that rates will go up over the next few years.”

Bastian believes the sizable convertible bond side of the portfolio differentiates the fund from its competitors, which have just a small presence in the hybrid securities, or none at all. By contrast, Invesco Equity and Income typically has 15% to 20% of its assets there.

“As an asset class, convertibles are overlooked and underappreciated, but to me they play an important role in a portfolio,” he says. “Because they are income-producing bonds, they provide protection on the downside. At the same time, the conversion feature offers the opportunity to participate on the upside. And in a rising-rate environment, historically convertibles have done well compared to straight fixed-income investments.” He likes to buy the bonds close to par value or at a discount, which “provides decent bond characteristics that allow the securities to grow into their equity sensitivity over time.”

Right now, convertibles account for only about 11% of assets, a relatively small stake for the fund. Bastian explains that many of the convertibles issued several years ago have been called by issuers, and he’s put some of the money into equities. “As opportunities present themselves, we have capacity, and intend to move more money into the convertibles market,” he says.  

As he searches for those opportunities, the fund continues to maintain a stake in existing convertible positions such as bond insurer MGIC Investment Corporation. The firm, which insures individual mortgages and provides an insurance wrapper for mortgage-backed securities, managed to withstand the housing crisis by issuing new equity and convertibles. With many of its competitors fallen by the wayside, Bastian feels the company is well positioned to grow with an improving housing market.

Health insurer WellPoint, another convertible bond holding, fell out of favor several years ago after poor policy pricing led to disappointing earnings. With a new CEO at the helm, Bastian feels the company is better prepared to reprice policies to more profitable levels and improve profitability.