Why Talaria is holding 20% cash (and still able to generate healthy income)

As a value investor, Chad Padowitz of Talaria Asset Management is sticking to his knitting. And while others may rejoice as the US bourse enters a new bull market, Padowitz warns that “economic conditions will drive down earnings and share prices” from here. 

“We expect the lagged impact of tight economic conditions (mainly on the monetary side) and tightening credit standards to have a lagged impact on the economy," he argued. 

"We don't think that impact has been fully felt yet and will reveal itself over the next one to two years. As a result of that, we don't think the earnings estimates and expectations are conservative enough." 

And while the 20% cash holding in the Talaria Global Equity Fund is not a call on the market (Talaria uses a bottom-up research process), Padowitz readily admits that the high cash level “is also a function of what’s happening in the economy and how stocks are priced." 

While that is a sobering assessment of conditions, it is not fatal to Talaria’s process. On the contrary, Talaria typically benefits from a more volatile environment, like the one seen currently, and has a powerful approach to generating income that does not rely purely on dividends.

As part of Livewire’s Income Series, I explore that approach with Padowitz, as well as which metrics he values highly in his bottom-up process.

Padowitz also explains how volatility can be beneficial, the current state of the portfolio, and a couple of opportunities the Talaria team is pursuing.

What are you looking for?

As noted above, Padowitz doesn’t believe that earnings estimates and expectations are conservative enough and is therefore taking a cautious approach. This translates into exposure to “a lot less economically sensitive companies." 

More specifically, the Talaria team is looking for “companies that are less susceptible to the dynamics of interest rates, inflation, and a weakening economic environment." 

While the Talaria process involves looking at a company’s fundamentals within the context of its operating environment, Padowitz broadly nominates companies that have lower earnings variability, and higher return on equity (ROE) as those that are gravitating towards the top of his opportunity set.

In regard to balance sheets, Padowitz likes companies with healthy cash positions and less short-term debt that needs to be refinanced.

All that said, Padowitz is keen to point out that it’s a combination of normalised earnings AND valuation that drive investment decisions.

The Goldilocks zone

Padowitz argues the current market conditions are conducive to the Talaria process. But rather than simply talking his own book, he adds that low volatility conditions like those seen pre-COVID were not ideal, nor were the max volatility days of the pandemic.

“Prior to COVID, for about two or three years when interest rates were very low, there was no volatility, and the VIX was sub-10, we never thought it was an overly attractive time be in the equity markets or selling insurance on shares," he said. 

"Equally, if you fast-forward to peak COVID concerns, when VIX went up to 40, 50, while you do get paid a lot, there is a lot of uncertainty and risk... And those tend to be unsustainable levels as well." 

Rather than those extremes, Padowitz says a VIX in the 15-25 range “tends to be an environment that we think is very conducive to getting paid for taking the risk that we're prepared to take, as well as a more normalised equity market environment." 

The VIX is currently around 15 and has traded in a range of 13-26 over the past six months.

The Talaria Process

As Padowitz describes it, the Talaria process is “different but proven." It involves selling put options to enter stock positions, which generates a premium for the potential buyer, regardless of whether the stock is ultimately bought or not.

There are, however, some key rules that are always adhered to.

While Talaria uses options to facilitate its strategy, it is not a derivatives trader.

“We only sell options as the last step of a process to get the share we want to get. 80 to 90% of the investment team's time is spent conducting bottom-up fundamental assessments. Only once we've come to a bottom-up view do we look at implementing," Padowitz explained. 

The second rule is that every option is 100% cash backed. There is no leverage whatsoever. 

"There's no scenario where you can have a margin call or where you won't have the money to pay for the share. And we are always happy to own that share. As I said, it's the last step of the process," he said. 

And the final rule is that there is no counterparty risk. 

"All the risks that people often associate with derivatives tend to have to do with one of those three things...we don't have that," Padowitz said. 

"There's no leverage. We own the underlying asset, we want to own the underlying asset, exchange traded and backed in the underlying currency." 

So, what do these three rules create for Talaria and for investors?

• A downside buffer to prevent first loss,
• More consistent income,
• Less portfolio volatility, and
• Diversifies the sources of return.

Ultimately, the process also means that investors have somewhere else to go for income, and don’t have to rely purely on dividends.

Interesting process... Does it work?

Since the Fund's inception 18 years ago, income generated has averaged approximately 7% per annum and, as Padowitz puts it “that consistency has shown that we're not reaching for anything. It's been a consistent process that delivers that outcome." 

Padowitz adds that in highly volatile environments like 2008, 2009 and 2020, option premium income was higher than average and in the 2017 to 2019 period it was lower, amid very low zero interest rate policy and a low volatility environment.

As for right now, he says, “It's now more in line with the averages. We're generating a very respectable amount of income without having to take any more risk than usual. If anything, we're taking less risk." 

Although there has been variation during extreme periods, Padowitz puts the consistency of income down to patience and discipline – the former being a product of the latter.

“We stick to our process. We don't style drift. One of the advantages of our process generating north of 7% a year from our income component, is that it allows a base of return, which in turn, allows us time to own the other companies," he said. 

Padowitz adds that the patience he speaks of is born out of the robust process he and his team employ. “Everything we do is the product of process. The manner in which we fundamentally assess shares and what we think the right price to pay is," he said. 

"There'll be periods in time where the market agrees and disagrees but we ultimately believe that if the fundamental analysis is correct and the valuation is attractive, you will get the rewards over time". 

Current portfolio and opportunities

While the MSCI global index contains approximately 70% US companies, Talaria’s portfolio weighting to the US is around 30%. Put simply, Padowitz explains that “being a bottom-up investor, we are not finding the valuation as attractive there." 

One geographic region Talaria has a higher weighting to is Japan. Padowitz cites "improving corporate governance and improving profitability” and, of course, “attractive valuations”. 

“Japanese companies have generally kept very conservative balance sheets, and they have quite a uniquely positive macro backdrop in that interest rates are still very low and you're starting to get inflation coming through," he said. 

As for the biggest sector exposures in the portfolio, Padowitz points to healthcare and global pharmaceuticals – which comprise 25% of the portfolio. It is also important to note that being a bottom-up investor, Padowitz is not influenced by the aging population argument that top-down investors focus on.

Padowitz likes companies like Johnson & Johnson (NYSE: JNJ), Roche (SW: ROG), Sanofi (EPA: SAN), and Novartis (NYSE: NVS), and while the thesis for each company is independent of any broad theme, they have some common characteristics.

“Their products and services are not overly sensitive to changes in GDP. They're not at the discretionary end of things. They have almost uniformly very good balance sheets. The pharmaceuticals that they manufacture don't have [patent] expiries until the end of the decade," Padowitz said. 

"You can quite reasonably and confidently map out their earnings trajectory. On those bases, they're trading very attractively." 

When pressed for a single name within the space that the Talaria team likes best, Padowitz highlights Sanofi - the French pharmaceutical company.

Padowitz explains that Sanofi has substantially no debt, no patent of any significance that expires until the end of the decade, and trades on a 9% free cash flow yield.

“You're getting a very high return and very low business risk," he said. 

Another company in focus for Talaria is Mitsubishi Electric (TYO: 6503). 

Many investors would know Mitsubishi for products such as air conditioners but Padowitz focuses on the factory automation division as a potential growth engine.

“That is a very good business and it's also one that will benefit over time from reindustrialization in certain developed economies as CapEx booms," he said. 

"They're benefiting from pricing power that's showing up across the board in Japan. Even though they remain the exporter as well." 

A little certainty can be empowering, especially in volatile times

For more than 17 years Talaria has been delivering a greater certainty of returns through its unique and alternative approach to global equity investing, with over 7% p.a. average income distribution for the last 10 years, low volatility and lower market risk.

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