Mutual Fund Shines By 'Hedging' Its Bets

Wondering how to invest in a stock market that's stuck in a funk? James Abate, manager of $332.5 million Centre American Select Equity Fund (DHAMX), is outperforming. And even he is hedging his bets. In more ways than one.

First, although he runs a value-oriented mutual fund with heavy weightings in traditional value sectors of materials and energy, his portfolio also holds some megacap technology stocks that became the darlings of growth-style fund managers in recent years.

Abate expects those now-beaten-down tech stars — Apple, Google-parent Alphabet, Amazon.com and Microsoft — to rebound. So he's sticking with them.

Among other benefits, they provide his portfolio with diversification.

How To Invest: Fund Soars With These Stocks

The second way he's hedging his bets reflects the core of his longtime overall investment strategy. It's similar to the way many hedge funds are run, especially in three of its traits.

He pursues companies that reinvest back into their own business. Also, he's interested in companies whose current share price undervalues the firm's potential for capturing excess future returns.

And he wants companies that know how to wisely contract when growth slows. Right now, believe it or not, that applies to many of his energy and materials names.

"Companies like Exxon Mobil, Chevron and the majority of the energy and materials sectors are wisely contracting," Abate said. "Look at the asset replacement ratio (capital spending divided by depreciation) for XOM. It's not even spending to meet depreciation. That's a big difference from prior history when capital expenditure nearly always exceeded stock buybacks and dividends in terms of capital allocation. With oil prices elevated this translates into sales growth from rising prices. It will lead to operating leverage (asset efficiency) and margin expansion as a key driver of current and future stock price performance."

That's what it takes for those companies to know how to invest in their own businesses.

True to his value investor outlook, Abate looks for undervalued stocks. "Secular growth is obviously an area that is of great attraction for investors," he said. But his fund tends to do well when cyclical growth opportunities present better opportunities than secular growth stocks, he says. He's also been rewarded for recognizing when "the price to pay for secular growth is simply too rich," he added.

Supply Lags Demand

CF Industries is a cyclical stock that benefits from global demand for nitrogen fertilizer exceeding supply. "Global nitrogen supply will remain very challenged," Abate said. "So CF Industries will continue to benefit from nitrogen pricing. Even if volumes (of demand) stall out because of actions by the Federal Reserve or general economic stagnation, this company can pass along price increases without compromising its own margins."

CF Industries will be able to maintain its pricing power because "it will remain disciplined in terms of capital spending," Abate said.

To Abate, that discipline is a key to knowing how to invest.

EQT is another company that knows how to invest, Abate says.

Total return so far this year for the integrated oil and gas explorer, producer and distributor has been 83%, going into Tuesday.

"We added to EQT in the first quarter of this year," Abate said. "It said it would run unhedged for most of its production going forward."

Hedging involves selling future output at today's spot prices. It sacrifices potentially higher prices in the future for today's certainty. Companies do that to avoid the risk of prices slipping in the future.

Abate was glad to see EQT commit to a reduction in hedging because many E&P companies use hedging to take on debt. That's how they pay for debt to expand exploration.

"One of the things that we applaud with EQT is their significant reduction in debt outstanding," Abate said. "That gives EQT more operating leverage and more financial leverage."

Mining Company Knows How To Invest

Canadian mining company Teck Resources extracts coal, copper, zinc, molybdenum, gold and lead. Abate sees it as well positioned to capitalize on its investments in recent years.

How so? Because it knows how to invest in itself, Abate says. "It's one of the few companies that undertook capital spending, most notably in copper, in the past few years," Abate said. "They've expanded their copper production."

The most promising aspect of Teck's situation is that their investment phase is largely complete for now, Abate says. The should allow more revenue to flow to the bottom line. And that's at a time of rising commodity prices. "It's going to essentially allow its capital efficiency to basically increase at a higher rate than what we've seen in the past," Abate said. "So the free cash flow generation of the company is actually going to get exponentially better."

All of this has translated into smooth sailing for Centre American Select Equity Fund recently. The fund is up 6.34% this year going into Wednesday vs. a 12.02% decline by the S&P 500 and an 11.75% tumble by the fund's large-cap blend rivals tracked by Morningstar Direct.

Over the past three years, the fund's average annual return is 21.91% vs. 14.32% for the big-cap bogey and 12.60% for its peer group.

Follow Paul Katzeff on Twitter at @IBD_PKatzeff for tips about retirement planning and actively run portfolios that consistently outperform and rank among the best mutual funds.