An Interview With Theodore T. Southworth, Northern Income Equity Fund

    by Maria Crawford Scott


    CATEGORY: Convertible Bond

    PERFORMANCE* (as of 3/31/03):

      Fund Category
    1 Year -7.7 -7.6
    3 Years -3.0 -6.1
    5 Years 1.7 2.5

    RISK: Below Average

    TOTAL ASSETS: (as of 3/31/03) $235 million

    CONTACT: Northern Funds 800/595-9111

    Mutual funds offer a particularly attractive approach to investing in areas of the market in which it is difficult for individuals to enter on their own. And one area of the market that is particularly difficult for do-it-yourselfers is the convertible market.

    Convertibles, which encompass both convertible bonds and convertible preferred stock, are securities that a holder may exchange for common stock in the issuing company. The convertible also pays interest or dividends. When the price of the underlying common stock rises, the convertible price also rises and its yield drops; when the underlying common stock price falls, the convertible falls also, but the yield rises. The appeal is an income-producing equity, with a floor provided by the yield.

    There are a limited number of low-load mutual funds that focus on the convertible market. One that has been a consistently good performer over the long-term is the Northern Income Equity Fund; it has a Value Line ranking of 1 (among the best 10%), and a four-star Morningstar rating. Currently, the fund has $235 million in total assets.

    In early May, portfolio manager Theodore T. Southworth discussed the management of the fund with Maria Crawford Scott.

    Can you give a basic description of the fund?

      The fund’s primary objective is current income, with capital gain a secondary consideration. But obviously total return is important.

      My goal in running the fund is to provide an equity-like return, but with a higher component of current income. This fund historically started out as a fairly straightforward income fund. Before I became manager in late 1995, there was a decision to concentrate on convertibles. I was given the opportunity to reexamine that decision, but I decided it looked like a pretty good way to go.

    Perhaps you could give a brief description of convertibles.
      There are nowadays a very wide range of structures. But the original idea, either as a convertible preferred stock or as a convertible bond, was that you have this security that basically has two halves. One half is a fixed-income instrument with a stated maturity, a stated periodic cash flow for the life until maturity. The other half is the alternative—you could convert or exchange the holding into a set number of shares of a particular common stock. And it was up to the owner as to which of those paths was taken.

      Convertibles have become a lot more complex and there are a lot of variations, but that is the basic idea behind the original, standard convertible structure.

      With a basic convertible, you have an asymmetric return profile. That simply means that if you compare the return on a convertible if the underlying stock goes up 25% over a one-year period, to the return on the convertible if the stock goes down 25%, what you find is that the convertible historically returns something on the order of 70% of the underlying stock on the upside, while exposing you to only around 50% of the negative return on the downside. In other words, you have a better chance with the convertible than with a straightforward common stock, because if you are right about the stock, although you didn’t get 100% of the return of the common stock, you still get more than you would be exposed to if you were wrong and the stock went down. That’s the asymmetric return profile.

    Your fund’s name is “income equity.” Is it actually an “equity” fund or an “income” fund?
      My goal is to provide an equity-like return. The fund has equity in its name, which means that 80% of the holdings have to be equity related. As a matter of fact, according to the SEC, I can have any amount of convertibles, from 0% to 100%, because that’s not part of the fund’s name. It’s simply that we have chosen to use convertibles as a preferred asset class.
    How do you classify convertible bonds, though, in an asset allocation sense—as an equity or as a bond?
      It’s a good question. The problem is that it really depends on which convertible you’re talking about. Let me go back one step and explain some terminology. When you’re calculating the intrinsic or theoretical value of a convertible, there are two things that you look at. One is the so-called ‘investment value’—the value of the security as if it were a pure, straight, fixed-income instrument. The other thing you look at is the underlying value of the stock if you were to convert your holding in today’s market.

      Typically, the convertible will be selling at some premium over investment value. But if the underlying stock has dropped in value since the time the convertible was issued, the premium over the fixed-income value will be much lower—in this case, it’s trading really more like a fixed-income instrument. That’s called a “busted” convertible, and there’s no hard and fast rule as to what premium over the conversion value you have to be at before it becomes busted.

    So in other words, sometimes it’s trading like a stock and sometimes, when its “busted,” it’s trading like a bond?
      Exactly. The interesting thing is that, with a standard structure—let’s say a 4% coupon at a 30% premium over conversion—what happens is that as the stock moves up, the premium over conversion goes down. So the bond, or the preferred, tends to become more sensitive to the price of the common stock as the common rises. The inverse is also true—it tends to become less sensitive to the price of the common as the common falls, because the fixed-income part of the security becomes a floor or a support for the value.
    In general, then, when the overall market is going up, the convertible fund provides more stock-like returns, and during bear markets it tends to be more fixed-income-like?
      Essentially what the convertible asset class does is it dampens the extremes. It doesn’t go up as much as the stock market in a really strong up move, but it doesn’t go down as much when the market goes down—and due to its asymmetric return profile its downside is less as a percentage of the market’s move than its upside percentage move.
    And that seems to be reflected in the fund’s returns.
      Yes. And, incidentally, one of the two periods where we underperformed was very much a junk market (1999). Most of the new issues and convertibles had to do with telecomm and technology, and were mostly companies that had no history of earnings and were rated either below investment grade or non-rated. At that time we had a limit on what we could own below investment grade, and that meant we were shut out of using the bulk of those new issues. I finally got that changed, but not until about mid-2000. Now, that’s not to say that we necessarily would have participated fully in that because I’m not sure I would have had the chutzpah to buy all that junk.

      In the last six months or so, the reason we’ve underperformed is because we haven’t taken enough credit risk. The convertibles that seem to have had the strongest performance recently have done so not so much because of any move in the common stock, but rather because of the very extreme narrowing of these credit spreads, just like the junk market. In fact, that’s what the convertible market has been—an annex to the junk bond market. A lot of our buying lately has come from crossover funds—junk bond funds that are buying both straight bonds and the convertibles of the same issuers.

    In terms of your own investment approach, how do you decide which convertibles to buy?
      Ideally, we want three things. The first thing is that we want an attractive underlying common stock. Secondly, we want to have a convertible that is reasonably priced and provides a better current yield than the common. And third, we want to find one that has a particularly attractive asymmetric return profile—my ideal is to have a three-to-two ratio, upside to downside. In other words, if the calculations showed that with a 25% upmove in the stock you’d get 75% of the upside, then I want to have exposure to no more than 50% of the downside.

      It used to be that convertibles with attractive upsides-to-downsides were quite common, but now unfortunately, for the last couple of years, we’ve had an influx of hedge funds that are looking at the convertible market in a very different way, and they have distorted valuations. And the influx of money to junk bond funds, which have crossed over into the convertible market, has also made the market much more expensive.

    One of the things you are looking for is an attractive underlying common stock. On what basis are you valuing a stock?
      We don’t define ourselves as acquiring specifically growth or specifically value stocks. We’re looking for a common stock that we think is worth more than the market is charging for it right now. Simply put, when I look at the fundamentals, do they make sense, and do they support the valuation of the stock? I also look at the technicals—is the behavior of the stock’s price congruent with what I’m hearing on the fundamentals and seeing from the earnings progression? If one of those two is out of sync, particularly if the technicals are negative, I’m probably going to stay away from it.
    Then, is your opinion of the value of the underlying common stock a critical element in the decision to buy?
      Yes. Of course, some convertibles you may be buying because they’re busted and you’re really buying it for the fixed-income value. In that case, you don’t much care about the common stock because you’re probably not expecting much of a return from any movement. In that case, you’re paying more attention to the question ‘Am I going to get paid in full and on time?’ But barring that, yes, the primary driver for a purchase is really your opinion of the underlying common.
    How do you decide if the convertible is reasonably priced?
      It’s based on past market history and current model calculations, the two “judgment” inputs of which are the credit spread and the volatility factor.
    What would prompt you to sell a convertible?
      There are basically three reasons to sell, and they’re pretty straightforward. The first is when the size of the position gets to be too big for the fund. Very few of my actual positions are exactly 2%, but that’s the standard; if one gets up to the 3% range, then I’ve got to be really sure that I want to keep it. Or if it goes much above that I’d probably start trimming it almost automatically. So that’s rule number one. That’s really the most pleasant.

      Also, if the convertible got to be overpriced relative to the common, we’d think about trimming. We probably wouldn’t sell outright unless it was the underlying stock that we thought was out of line with our valuation.

      Reason number two is if something is not working out the way you thought—the stock is declining, the company’s earnings are not meeting the targets that you set if it was based on the earnings, or the market’s just not valuing it the way you thought it would even though the earnings and other things are unfolding as you thought. And I am a technician too. I do pay attention to the technical report. Any of those things can convince me that I’ve made a mistake and it’s time to step back.

      The third reason is if I’m fully invested but have found something that is more attractive.

    Does investing in the convertible market skew you toward any particular industry?
      The only thing it skews you toward is whatever is available in the convertible market.

      The convertible market, at least for the last several years, has tended to be a place for less than the highest-grade companies to raise capital pretty cheaply compared to their alternatives. In come cases, like in 1999, these types of companies were all considered to be growth companies. Of course, they didn’t turn out that way, but that’s what everybody thought at the time. More recently, some of the issuers have tended to be companies who are having to refinance existing debt because it’s coming due, or because they can cut their cost of capital, or both. In some cases, it’s companies that don’t have too many alternatives.

      Unfortunately, this is one of the things that I’m a little concerned about—a lot of the money that’s coming into the convertible market might not be as discriminating as it used to be on that score.

    What index do you compare the fund to, and how does the fund compare to it in terms of diversification?
      Our official bogie is the Merrill Lynch Domestic All Inclusive Convertible Index. It has about 500 issues and $220 billion or so in market cap.

      I do examine the economic sector breakdown of the fund, but typically, the fund’s economic sector breakdown is what I would call a dependent variable. In other words, I’m looking for individual issues and that’s how I construct my portfolio, not on the basis of what sector I want to be in. Of course, we try not to get too far out of line without at least being aware of it and double-checking that we want to be there.

      However, one of the things about convertibles is that you can be overweight a sector but, depending on the holding, you still might be more or less exposed to the movement of the stocks. If I were to heavily overweight a particular sector but I had all busted convertibles, that’s really not the same exposure as if, say, I was index-weighted but very exposed to the common stock. There are a lot of different ways that you can measure and analyze it—there’s an additional step whenever you’re analyzing convertibles over what you’re used to with stocks.

    Is the fund always fully invested, and is it always invested in convertibles?
      The fund’s cash position typically does not go above 10%. We’re starting to think more about buying straight equities. We’re relatively low in equities now, about 6%, but we’ve been much higher in the past—as high as 40%.
    At what point would you switch to a greater percentage of equities?
      When I can’t find enough attractive convertibles and when equities start looking better.
→ Maria Crawford Scott