Felix Choo, a 40-year-old financial analyst, is focused on long-run returns without a lot of volatility – so he prefers moderate risks and a balanced portfolio. Yet, he has earned respectable returns of 7.6 per cent annually over the past 10 years. Let’s take a look at Mr. Choo’s portfolio, particularly its position in convertible bonds (or debentures).
What does your portfolio look like?
For equities, I tend to favour dividend payers with a track record of being able to grow the dividend. At this point in the cycle, I’m emphasizing large-cap, higher quality stocks to help keep a lid on volatility. My fixed income is currently biased toward shorter durations and higher quality issues. A substantial portion is in convertible bonds.
You are especially interested in convertible bonds and blog about them at The Canadian Convertible Debentures Project (convertibledebentures.blogspot.com). What’s to like?
A convertible bond can be converted into a prespecified number of the common stock of the issuing company. This is attractive because an investor has the opportunity to participate in share price increases, yet enjoy the downside protection afforded by bond interest and principal payments.
What have the returns been like on your convertible bond holdings?
Over the long-term, the returns have been just over 8 per cent per year. My current holdings have struggled in this interest rate environment, but I’m comfortable holding them to maturity to get my principal back with interest, should no opportunities for capital gains materialize.
How do you decide which convertible bonds to buy?
Convertible bond issuers in Canada tend to be small and mid-sized companies so can be higher credit risks. That means it’s important to check balance sheets and business prospects.
I also look for undervalued situations. The market is relatively small and not very liquid, which means there aren’t many institutional investors scouring the listings. This leaves more scope for smaller investors to spot opportunities and outperform the market.
How do you value convertible bonds?
From one perspective, convertible bonds are corporate bonds with embedded call options on the issuer’s stock. Corporate bond valuation looks at things like government bond yields and credit spreads. Option valuation considers factors such as the variance in the price of the underlying stock, conversion ratios and the maturity of the option.
I have developed a quantitative model based on such factors and run the specifics of a convertible through it to impute a fair-value price. Then I compare this estimate with the market price and rank the securities on the basis of valuation in a spreadsheet [available on his blog].
Can you tell us about your convertible holdings?
Tricon Capital Group Inc. is one of the largest owners of single family rental homes in United States. I like its positioning to grow earnings long term. And given my bearish view on the Canadian dollar, I like that its convertible bond is denominated in U.S. dollars.
American Hotel Income Properties REIT is also denominated in U.S. dollars and I believe its assets are undervalued by the market. I have confidence in the CEO, who was the principal behind Canadian Hotel Income Properties REIT until it was acquired at a hefty premium in 2007.
Diversified Royalty Corp. receives royalties from trademarks like Mr. Lube, Air Miles and Sutton Royalty – all well-regarded brand names. The company’s payout ratio slightly exceeds 100 per cent, so management needs to boost cash flow by dipping into their cash hoard to close additional royalty deals. These deals could be catalysts for price gains and dividend increases.
DHX Media Ltd. is a children’s programming company that has taken a beating during the past year, making its convertible bond speculative in nature. But the company has strong assets including the Peanuts, Strawberry Shortcake and Teletubbies franchises. It is also refocused on supplying children’s programming to digital streaming platforms such as Netflix, Amazon and Hulu.
Osisko Gold Royalties Ltd. collects royalties from world-class gold mining assets and as such, doesn’t have exposure to the risks of mine operations. Given the geopolitical madness in the world today, it provides optionality on any future price spikes in gold.
What advice would you give to other investors?
Diversification is so important. It is the best way to reduce volatility in a portfolio of risky assets. Also, the market has a habit of reverting to the mean, so it is useful to have a temperament of not getting too high when things are good and not getting too low when things are bad. I know it may sound like a cliché, but investing really is a marathon, not a sprint.
The above interview has been edited and condensed.
Special to The Globe and Mail