An income fund built for tough times

This article was featured in Wealth Professional.

A great deal of ink is being spilled lately over inflation and interest rate hikes, and rightly so. These twin scourges on the economic landscape tend to accompany one another in economic cycles and wreak havoc on markets and businesses that are over leveraged or can’t absorb steep cost increases.

The Manulife Monthly High Income Fund, which celebrated its 25^th anniversary in 2022, is built to minimize the impacts of such economic headwinds, by focusing on corporate profitability and the holistic set of factors that propel “the best businesses in the world.”

You might, in fact, call it a fund built for tough times.

According to Prakash Chaudhari, Senior Portfolio Manager at Manulife Investment Management, acquiring businesses and diversifying the fund’s portfolio so that it can potentially withstand economic shocks is a core tenet of the fund dating back to its beginnings in 1997.

“The investment philosophy and process have been unchanged since inception over 25 years ago,” he says.

It's a bottom-up philosophy that favours building the fund one company at a time. Rather than focusing on themes, the commonality of these companies is that they maintain a “competitive advantage” in their industries. They meet an essential set of criteria including high and stable profitability, high returns on capital, a long runway for growth, and limited leverage. “If you look at the entire universe of companies, it's very rare to be able to have this competitive advantage,” says Chaudhari, a 22-year money management veteran who has navigated numerous market corrections.

“There are a number of features of a business that we look to understand deeply And through our experience and looking for these features and how they combine, we are able to identify those companies that have an enduring and lasting competitive strength that positions them to win versus their competitors.”

The fund, which returned 14.98% in 2021, sits in the global neutral balanced category and currently holds about 58% in equities and about 38% in bonds, with the remainder in cash. Chaudhari says the fixed income component compliments the equities and provides downside protection during periods of economic concern. “Typically, bonds perform especially well when equities struggle, which is wonderful, because then those bonds can appreciate in value and that capital can be used to take advantage of dislocations in the equity market,” he says.

With a portfolio that features companies such as Constellation Software, Microsoft, Costco, and BCE, it is this focus on competitive advantage that is vital to the fund’s ability to shrug off inflation.

To illustrate, Chaudhari points to the fund’s investments in several of North America’s largest waste management companies including Waste Management Inc. A common feature these businesses share is stable margins maintained through pricing power.

“The best companies have pricing power, meaning that when their costs go up, they're able to pass that along. And their customers accept that higher price. Because they want the quality service that they're getting,” Chaudhari says.

Historically, waste management companies have maintained highly stable earnings during inflationary times because they're able to contractually pass along cost increases and therefore protect margins.

“You can imagine, if you're the mayor of a municipality and you're in charge of sanitation collection, the last thing you want for your constituents is that waste isn't being collected, or it's not being done properly,” he says.

Chaudhari gives full credit to his team that has been together for many years and has really developed a knack for identifying companies that can withstand many market calamities. It’s predicated on an understanding of the features of a given industry, the competitive landscape of the industry, and the critical elements a company must have to be a leader within that industry.

Turning that skill with interest rate hikes, however, is much harder.

There is no way to completely avoid the negative impacts of interest rate hikes. Never has this been clearer than in the past year where increases to interest rates have been so dramatic that all asset classes have struggled. But, because the Manulife Monthly High Income Fund is also structured to avoid investing in firms that tend to use debt to finance either dividends or to simply stay afloat, the negative impacts have been considerably offset.

Additionally, the fund invests in companies that hold a lot of short-duration bonds on their balance sheet which, of course, tend to do well in a rising interest rate environment.

“We have offsets in the portfolio, so that we can benefit from rising interest rates. But we don't base our thesis on it, meaning that even if interest rates don't go up, the value that we see in the companies that we buy is high,” says Chaudhari. “What we do is we construct the portfolio so that in various economic scenarios, we have companies that have a tendency to benefit from those scenarios.”