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Investing in Value-Creating Opportunities

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TWST: Please start with a brief history of Herndon Capital Management and an overview of your firm today.

Mr. Cain: Herndon Capital Management was launched back in 2001 by Atlanta Life Financial Group, and we started managing money in 2002, just now celebrating our 10-year anniversary being in money management. We started off with about $4 million of seed capital as far as investing in our large-cap growth and large-cap value strategies, which has now grown to approximately $6.1 billion in assets.

TWST: Who is your typical client?

Mr. Cain: It really runs the gamut. We manage money for clients in a broad spectrum of areas, spanning now from the institutional down to the individual. The bulk of our assets are institutional clients, but then we have intermediaries via subadvisory opportunities with different mutual funds that allow us to serve high net worth individuals as well as individual clients. We also manage money for foundations, endowments, Taft-Hartley, so in the institutional world we really offer the whole spectrum.

TWST: Would you give us an overview of the different products or strategies that you offer? And is there one in particular you would like to focus on today?

Mr. Cain: We run several in the large-cap universe, offering domestic-side large-cap growth and large-cap value and large-cap core, but then we also have a large-cap international strategy. And with the combination of the core domestic and international, we also offer a global strategy. We’ve also moved down the market capitalization curve to have a midcap growth and midcap value strategy as well. But the focus, I believe, for today is large-cap value.

TWST: How would you describe your overall investment philosophy or strategy?

Mr. Cain: In our investment presentation we have a quote that we use that comes out of the Bible, the Book of Ecclesiastes 3:1, that reads, “to every thing there is a season, and a time to every purpose under the heaven.” For us it really helps to crystallize in our minds that stocks exist in one of three phases, either being overvalued, undervalued or fairly valued.

Our charge, our focus, is to really focus on those securities that are undervalued, and we emphasize what we call value-creating opportunities. A lot of people hear that, and they kind of collapse all three words together, like a certain event or a certain thing that happens. But for us, when we think about it, each one of those words is instructive of what we do. From a value standpoint, we’re looking for securities that have a minimum of 30% or more upside according to our own unique way of calculating upside.

The next aspect, from a creating standpoint, is we’re looking for ongoing concerns. We don’t tend to focus on turnaround situations. We’re not focused on breaking up conglomerates and things of that nature. It’s really more so a matter of a company that’s functioning, and functioning well right now. It doesn’t have to be the good-to-great company, just solid companies: that’s what we’re interested in.

And then finally, from an opportunity standpoint, there is a certain exactness that investors or market observers seem to want in a market that typically never actually exists. It’s kind of like a dog chasing its tail: it never catches it. From our standpoint, the opportunity is to make sure that at the sector level and at the individual-stock level we have solid companies at attractive valuations, expecting over time for the market to recognize what we see, but not knowing exactly when that time is going to be. We tell our clients that there are three things we cannot do. We can’t predict the timing, the duration or the magnitude of outperformance. All we can try to do is position ourselves to achieve it.

TWST: Where would you say you are finding the best opportunities today? Are there particular industries or sectors that you are currently overweight or find most promising?

Mr. Cain: Absolutely. The areas where we are right now finding the most overweight opportunities within our portfolio happen to be within the energy sector. That’s most pronounced. We’re also seeing it in the consumer staples sector, as well as in materials and technology, as well as, to a certain degree, consumer discretion. So fairly broad areas but very distinct and unique, except for, I would say, the technology, the energy and the materials, which tend to have a more cyclical slant to them.

TWST: What sectors are you underweight right now?

Mr. Cain: The areas where we have the biggest underweights tend to be in the financials, utilities, telecom, as well as health care. One of the things that I think is a resounding theme among at least three of the four areas is the more defensive orientation of the health care, the utilities and the telecom. We actually have a 0% weight in utilities and telecom, and a pretty hefty underweight in health care now. And that was a function of what transpired over the risk-on, risk-off environment, where these sectors had been embraced going back to the third quarter of last year and moving forward to the second quarter of this year. The utilities and telecom didn’t perform that well in the first quarter, but they were stellar standout performers in the second quarter.

We have little issue with the companies from a fundamental standpoint, but we do believe that when you purchase safety, there is a price at which you can go so far that perhaps the safety you are purchasing is now becoming dangerous. We think that where the valuations are for some of these securities has gone beyond what we think a reasonable buyer should be paying for these particular companies. The same situation exists with financials, the largest sector within the Russell 1000 Value sector.

We don’t have issue with financial companies, per se, but we do have issues with the price you have to pay via the stocks to access them. Clearly they have done a great deal, a yeoman’s job, of being able to repair their balance sheets, get themselves into much more sound fundamental situations. But we think that the market is expecting them, by the prices they are paying, to return to levels of productivity that they haven’t seen since pre-2008. When we look at that operating environment, as we know now looking back at history with hindsight, that was a period of great returns and great margins, but also more reckless lending and business practices. I don’t think that they are going to be allowed to return to those same areas which will earn them the same margins and returns that, in my opinion, might justify some of the prices that investors are currently paying.

TWST: What are some of your top holdings or top investment ideas right now? Please tell us a little bit about what you like about them.

Mr. Cain: One thing that I must say is that when you look at our top holdings in the portfolio, for some investors that would correlate to their favorite holdings, but we don’t have any core holdings in the portfolio, and we try to steer away from having a lot of biases and subjectivity toward certain companies. Clearly for any investor to make an investment and the investment is working, they have an affinity for it. They want more of it. But in terms of making that something you would call a “favorite,” we shy away from that. Instead, our focus is on the total portfolio, and we are expecting that every company has an opportunity to outperform, it just may not be timely right now.

Of some of the more timely names which have worked their way into being some of our larger holdings, I will look at the top three, each coming from a different sector. Federated Investors (FII) is one of the larger publicly traded asset managers, and they have an overhang because they are one of the largest managers of money market fund assets right now. Clearly that part of the investment management industry has come under a great deal of pressure, and the bulk of their assets are in that area. Clearly, with interest rates being so low, it’s hard to make a lot of money there. You’re seeing some of the weaker or marginal players starting to sell off their funds and assets. Federated is a buyer of that, so in a business where margins are very thin — it’s almost negative; it’s next to nothing — they are building upon the scale that they already have such that when the interest rate environment does turn — and these things tend to run in cycles — they are going to be very well positioned and, we think, continue to garner share and generate solid returns on that asset class. What also is being neglected is that they are a diversified money manager. They also offer longer duration fixed income funds, as well as offering equity funds on a domestic as well as an international front. That doesn’t get talked about a great deal. This is still an extremely profitable company run by a family, the Donahue family, that tends to have an eye toward maximizing their returns as well as that of their coinvestors. So although the company has rebounded somewhat this year, we still think there is a good deal more upside to be generated there. 

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The next company is TJX Companies (TJX), the purveyor of T. J.Maxx, which has benefited from the trade-down effect of the middle-income and even upper-income consumer who wants to buy branded goods but wants to pay a discounted price for doing so. This company as well as another portfolio holding, Ross Stores (ROST), has done extremely well. They don’t get lumped so much in the same category as the dollar stores, because they typically are selling goods at higher price points, but what they are is an alternative to mall-based retailers that are selling goods at closer to full price that may be of similar brands. They have benefited from the economic environment that we have been going through, and the amount of loyalty, even as the economy is gradually starting to do better, has not dissipated. The same-store sales have continued to meet and beat investor expectations. So we think that there is still a great deal more upside here. The good thing about them geographically is they have not maxed out their potential — no pun intended on that. They have a platform that’s growing nationally, but they still have more growth opportunities. They have exposure to the Canadian market with their platform, and they also recently expanded to the U.K. The discounted branded retail platform is something that we are not sure if it’s going to be worldwide, but it’s something that clearly has a great deal more legs to it. 

And then the next one to mention would be Altria (MO). As the market has had issue from time to time with what’s taken place over in Europe, some of the consumer staples companies, which this company comes from as far as the sector representation, have done fairly well. And despite the issues regarding legislation, and even though there are well-documented, well-known and well-advertised ill health effects of the products that Altria makes, the company is still making a tremendous amount of money, paying a very healthy dividend and the stock price has responded.

One of the things to really like about a lot of the consumer staples companies is that their typical cash outlays to continue to manufacture their products is not that significant. A lot of the spending that they typically are doing is defending the brand. From a commodity standpoint, yes, the cost input levels do fluctuate with commodity prices, but those are pretty well managed. What they are really fighting for, in many cases, is additional market share. Some of the legislation that has taken place regarding marketing has allowed some of the major players to really form more so-entrenched positions, because the competitors can’t necessarily out-market if they don’t have the dollars. And then, two, they are not going to be allowed to continue to do that to the same degree from a legislative standpoint. So they have a pretty formidable market share in terms of the proverbial moat around the business. The challenge that they do have, unlike their international counterpart Philip Morris International (PM), which is also one of our top 10 holdings, is they are locked into the domestic market. So from a capacity standpoint, they are maxing that out, and clearly it’s been shown that the number of smokers is gradually declining. But they have actually been able to continue to get price increases to go through, and they stick because people still have a demand for the product.

TWST: What prompts a decision to exit a holding for you? Is there a recent example that you would offer to illustrate?

Mr. Cain: Normally there is going to be one of four reasons why we are exiting a security. The first is that we just need to have less exposure to a sector. Because we are not using ETFs or anything of that nature to where it would be more of just an overriding sector decision, when we make a sector move it has to be individual stocks. So whether we actually like a stock or not, if we are selling down a sector, we have to do it with individual securities.

The most well-known part of selling down is when everything works, good things happen, and you are taking profits on the investment.

The other situation that exists is where things may not be going so great with a company, there is an erosion of fundamentals and things deteriorate such that a company is no longer, as we call it, a value-creating opportunity, or we think that the future may portend it will not be. That’s another reason where we will work with our analysts to come to a conclusion about exiting that position.

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The most recent move that we made for choosing to sell out of one portfolio holding was on the basis of valuation, and that was Annaly Capital Management (NLY), and we made that decision on a basis of it being within the price target range that we had established. In spite of it having a very attractive dividend yield, we invest on the basis of capital appreciation, and by that measure the company no longer really fit what we were looking for from an upside perspective.

TWST: How much turnover does the portfolio typically have?

Mr. Cain: Since inception, it’s been about 66%. We have to put that in context, though, because our approach to our turnover has been somewhat relative to the volatility in the market. Prior to the big volatility move we experienced during and after 2008, our turnover in the strategy was below 50%. Since that time, when volatility picked up, what we have seen is that the time frame for the creation as well as the realization of value-creating opportunities kind of collapsed and diminished. Now, so far this year we have seen the turnover in the portfolio starting to come down, so perhaps we are moving into a period where the turnover will start going back to a lower level than what we have experienced since the 2008 through 2011 time period.

TWST: What is your outlook for the market for the remainder of this year and going into 2013?

Mr. Cain: That part is always tough. I have heard some investors say that the one projection you can count on is that it will fluctuate. I look at it from the standpoint of, if I had a dollar of capital to allocate, what would I do with it? And in the allocation of that dollar of capital, I want to put it into the context of, when will I need that money? If I need a dollar tomorrow, I wouldn’t invest it at all. If I need a dollar next year, I would probably put it in a duration-type asset where that will make sense, so possibly a money market. Three, five years and further out, I start thinking you could possibly look at some of the more volatile, or higher-deviation, assets. Simplistically, for what’s available to most investors, you might think about stocks, bonds and cash. We know that there has been a proliferation of access points for different vehicles, but for the average investor and what they can legitimately get their heads wrapped around, if we think about stocks, bonds and cash, I think that equity assets are pretty attractively valued.

We have not seen inflation pick up aggressively, primarily because growth has not picked up aggressively domestically. You have some spurts in certain commodities that may drive pricing pressures here and there, but collectively across the board, you are not seeing a pickup. We know that if there is one thing that is persistent across any market, it is change. And so while we have been a beneficiary of lower inflation and lower interest rates as the Fed has been very accommodative, we can expect that that is not always going to last. One of the best ways to combat inflation in terms of the easily accessible asset classes I mentioned is either going extremely short duration — such as cash or money markets, to where the interest rate increase has minimal impact on your capital — or going out to things that have the ability to reprice their goods and services more aggressively, which is equities, as companies have an ability to raise prices. With bonds they typically don’t have that ability; inflation goes up and bond prices go down and yields tend to go up. 

I think that equity assets are pretty attractively priced here, but we have some headwinds. We have the presidential election, and you’re going to have some people on one side try to paint our incumbent President as antibusiness and the challenger, Mitt Romney, as being probusiness. I don’t know that either one is going to have a chance to impact the outcome that much, but sentiment gets driven off sound bites. The situation in Europe, every time we think we’ve made a step or two forward, it seems like we are taking a step back. A lot of progress has been made there, but I think there is clearly going to be some flash point issues that will still likely come up to shake investors’ confidence. You look at the countries that have been providing the level of acceleration for growth from an economic standpoint, and that’s been more so the emerging markets. China has phenomenal growth, which any major developed country in the world would love to trade places with them on, but if they disappoint by a 10th of a quarter of a percent, the world gets nervous about what happens to the acceleration of global GDP growth. These are all issues where there is uncertainty, and the uncertainty, in my opinion, is what has pushed equity prices down to attractive levels. Once you get resolution on some of these issues of uncertainty, I think you will start to see the market rise.

TWST: Do you have any final thoughts you’d like to wrap up with?

Mr. Cain: One of the things that we are able to do at Herndon with the value strategy is to, in our opinion, do the right thing for clients’ capital, which isn’t always the easiest thing. The decisions that sometimes make you stay up at night are the things that we may struggle with, but that may be where the opportunity happens to lie. We invest with our convictions, and we try to do it not with reckless abandon, but trying to manage our fears to make sure that we execute our process appropriately. Our process frequently will find us in a contrarian position, not because we choose to be contrary, but because the contrarian neck of the woods may be where the next opportunity happens to lie. We have the courage to stand behind our convictions to pursue those, and historically that’s worked out very well, to our clients’ benefit.

TWST: Thank you. (MN)