Perspectives on 20 Years of Income Investing

Jeffrey D. Lent is a Partner at Torray Investment Partners and the Portfolio Manager for the Torray Equity Income strategy. He is also Co-Portfolio Manager of the Torray Fund (TORYX) and the firm’s concentrated growth strategies. Mr. Lent began his investment career in 1987 with Kemper Mutual Funds in Chicago. Prior to joining Torray in 2010, he was an Analyst and Portfolio Manager with Resolute Capital Management, and a Vice President with Tucker Anthony Inc. where he formed the Corporate Services Group. Mr. Lent received a B.S. from the University of New Hampshire in 1987.

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TWST: Let’s start with an introduction to Torray. Tell our readers a bit about the firm’s history and its business today.

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Mr. Lent: It’s somewhat convoluted, but it’s quite a special outcome. Torray the firm was started in the 1970s by Bob Torray. A traditional value investor shop, it started the Torray Fund, which in its heyday, in the mid-to-late 1990s, had about $3 billion of assets. So, quite a success story from a mid-Atlantic value shop; that was not heard of in those days, and he made quite a name for himself.

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We remain an independent boutique, with eight active partners, that specializes in concentrated equity investing.

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My involvement began at a company called Resolute Capital Management back in 1999. That was a growth shop. My Director of Research now, James Bailey, and I were with Resolute back in the early days; we were employees three and four at that company.

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Fast forward 10 years, and Torray, seeking to bolster their research and investment lineup and also branch out from their value roots, was looking to acquire a growth shop. Torray bought Resolute in 2010, and that’s how we got our current investment team and process that we have honed since that 2010 merger putting those two teams together.

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It’s quite interesting, because the Equity Income portfolio, which I’ve managed since 2005, does lie in the middle of the growth and value DNA of the company. When we come across investments that aren’t quite growthy enough for the growth portfolio, or they’re too expensive for value, but they pay a robust and growing dividend, I’m interested for the Equity Income portfolio.

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So, it’s a unique position for me to be in between those two investment teams, those two mindsets. It really is an income product, an income portfolio, but produced from a growth mindset or screening process that we’ve run for years at Resolute. It’s worked very well, and we think it can continue. The Equity Income strategy turns 20 years old in April of this year.

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TWST: Let’s delve into that strategy more. What would you note in terms of the investment thesis and investment philosophy behind the Equity Income strategy?

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Mr. Lent: It is, as I said, fed by the process and people of the Torray-Resolute combination, and that process begins with a series of quantitative screens using our proprietary risk-adjusted growth model. We run regression analysis on revenue, cash flow, earnings per share, and we look for businesses that can produce stable but robust fundamental outcomes.

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We get pushed away from hyper growth, things that can be all over the board with their fundamentals. We tend to gravitate towards later-growth-stage companies, not IPOs and things that are still cutting their teeth or proving themselves.

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So, Equity Income participates on the cutting room floor, because things that are not quite growthy enough, or a little bit older company that’s still in a growth phase but is now paying dividends, might not be attractive to the growth process — they fall to Equity Income. Then I will do further analysis on our expectations of their dividend payout and their yield growing.

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We’re looking for recurring, non-cyclical revenue. I think everyone says that, but we solve for the recurring by running that regression analysis on the revenues, earnings and cash flows, to find companies that are producing positively sloped but consistent outcomes. When a company’s data plots are all over the place, we question the quality of the business model.

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I don’t want to say we’re dogmatic, but we’re very much guided by that process, and that’s very key to understanding our firm and our three different products, which all have a track record of outperforming when markets get dicey, as the time period we’re in now. That’s when we really shine, and you really see the value of our process and insistence on these robust but steady fundamental outcomes.

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Sticking to that process — and I think you see it across the portfolios — that’s really our differentiating factor.

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TWST: The recurring and non-cyclical revenue, do you find that comes from certain types of companies or sectors more often than not?

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Mr. Lent: It can go in phases. We find them across the spectrum. I think your question is very on point, because it does favor, in this day and age, technology and software. But we do have investments in financials and industrials and health care, so we are able to find that same demographic of fundamentals in different businesses.

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I do think it changes depending on where the yield curve is, where interest rates are, where we are in economic cycles; those groups can populate differently. I think all companies, all industries, go through phases of growth, not necessarily that they are a growth company and forever a growth company.

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One is a non-traditional piece of paper, it’s a preferred, and it is not owned for any of the things that I just described — steady, robust, recurring, non-cyclical revenue — it is owned simply as an incredible hedge against the likely largest risk of an equity income or a fixed income stream, which is higher interest rates.

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The company is Sallie Mae, and they issued probably 25, 26 years ago now a preferred stock (NASDAQ:SLMBP). I own it for its terms. I don’t own it for the business, I don’t own it for the name, I’m not trying to have a credit quality upgrade to get paid. This piece of paper is priced at three months SOFR, plus 170 basis points. That’s the coupon, and your coupon will clearly rise as three-month interest rates rise.

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It trades at a discount, it’s $75 on $100 par, so you’re getting it at $0.75 on the dollar. And that math, that SOFR plus 170 basis points right now at a $75 price, is getting you a 9% or 10% yield. In this world, with all of the concerns that we have right now, straight up higher interest rates based on inflation are probably the biggest threat to future income streams.

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“I understand diversification, but we rely on proprietary correlation analysis to help make sure that we’re not introducing more of the same risks when thinking about an investment action. We find diversification at the sector and industry levels too simple of a concept for our risk management demands that we place on ourselves.”

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We do identify and try to participate in that phase when a company — whether it’s a product release, a new technology, a merger — different things can cause companies to start to produce a more robust and/or stable set of outcomes.

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TWST: How do you balance that with seeking a certain level of diversification?

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Mr. Lent: I understand diversification, but we rely on proprietary correlation analysis to help make sure that we’re not introducing more of the same risks when thinking about an investment action. We find diversification at the sector and industry levels too simple of a concept for our risk management demands that we place on ourselves.

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For instance, you could own a railroad, a bank and an insurance company, or a railroad, a bank and a health care company, and think you’re diversified. But if your largest revenue sources are all based in China, for example, and you have a large China exposure, you’re not as diversified as you think you are.

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So, we run different factor tests, whether it’s the 10-year Treasury yield or currency movement, etc., to see how different factors affect the portfolio and the investments in them. We rely more heavily on correlation and not owning all of the same attributes of risk, as opposed to trying to be diversified by name or sector.

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TWST: Could you tell us about a few investment ideas from the strategy? They could be top holdings or new or recently expanded positions, your choice, but tell us about how and why they fit the criteria you’re looking for.

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Mr. Lent: I struggled with this as I thought about preparing for the interview. Newest, oldest, largest, smallest, best, worst? I selected two that I think are differentiating.

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I’ve owned that paper for a long time. It has never really produced the capital appreciation I would have expected, but the coupon has gone straight up the last three years, since 2022. We all had that miserable year of 2022 when the Fed was raising interest rates every meeting. So, its coupon went from $1.84 at the end of 2021 to $6.40 in March of 2023. It was the perfect hedge in the biggest threat dynamic that I can think of for the portfolio.

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1-Year Daily Chart of Sallie Mae preferred

I own that simply as an anchor to windward. If higher interest rates are going to threaten the economy and cash flows, I want to own this paper for that time period and for that possible downside outcome. So, I’ve owned it for a long time.

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I do somewhat ignore the credit rating, but I feel very comforted because the common is doing well, the company is buying back stock and raising their dividends, so I feel somewhat insulated being in the preferred. But I own it simply for those straight math terms that are on the paper; that’s the reason we have this in this portfolio.

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TWST: That is definitely an interesting example and not one I was expecting.

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Mr. Lent: The next one is also quite different, but this one is a straight common stock, so this does reflect all of the fundamental attributes that I explained.

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This one is Royalty Pharma (NASDAQ:RPRX), and it’s very much like a private equity company. They make investments in future pharmaceutical royalty streams, so they will partner with biotech and pharmaceutical companies on a certain product or molecule and invest in the probability of a positive outcome from the development of that drug, and then they will participate in the future royalties that it produces.

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The founder has a background in investment banking. His team has the biomedical research backgrounds. What we need them to do is pick the right molecule, pick the right drug program, and then price it correctly.

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“That’s another attribute that’s quite prevalent in the Equity Income portfolio — buybacks. I like businesses and management teams that are understanding of and capable of paying the owners of the business, paying the shareholders either by retiring shares or paying and raising their dividend.”

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Innovation and R&D are expensive and very risky. Different stakeholders — academics, foundations, biotech and pharmaceutical companies — approach RPRX looking for capital in exchange for royalties on either existing or future products. Stakeholders prefer to partner with RPRX because it is non-dilutive and does not leverage their balance sheet. RPRX evaluates and selects deals based on their due diligence.

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1-Year Daily Chart of Royalty Pharma

So, there are two things that Royalty has to get right: Pick the right molecule, and pay the right price for that future royalty stream. The CEO has a long, very successful track record of doing just that, paying the right price. He was an investment banker at Lazard, and so he gets the future cash flow discounting pricing correct, and his team guides him to the different drug development opportunities.

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The real unspoken attraction here is, these guys get to legally use non-public information, inside information, and as shareholders of RPRX we get to benefit from that — because behind the protection of an NDA, they get to go in with their drug company partner and look at all of the data that isn’t publicly available to public pharma or biotech investors. So, they get to see all of that while they make their offer of Royalty capital.

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They can’t then go buy the stock or do anything like that. There’s nothing nefarious going on. But they get to see a lot of things that a public investor in that same company doesn’t get to see as they make their capital commitment, and that’s really unique, very private equity like, but with the overlay of a very specific biotech specialty.

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Private equity has high returns, number one. Biotech has high returns, number two. But with the added knowledge and experience and capability of pricing these things, they have a very high success rate. It’s a $15 billion-ish market cap company, and there are less than 100 people working there, so it’s a highly lever- able business model.

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They don’t use leverage, that’s not my point, but it’s highly scalable. They can do this over and over and over again, as long as they have capital, and they have a very good track record of doing this.

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And the dividend is growing at a very nice clip right now. It’s just under 3%, but they’ve raised it several times, and they’re buying back stock. That’s another attribute that’s quite prevalent in the Equity Income portfolio — buybacks. I like businesses and management teams that are understanding of and capable of paying the owners of the business, paying the shareholders either by retiring shares or paying and raising their dividend. I like that mindset.

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TWST: How important is the growth of dividends to your stock selection overall?

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Mr. Lent: Absolutely, extremely important. Otherwise, I could own all utilities or something like that. It is an income product, it is an income portfolio, but better said, it is a future income portfolio.

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I’m not a big proponent of bonds and “fixed” income, per se. I do think, as an investor, you have to have a dynamic, growing cash flow. We all know about inflation. We all know about unforeseen life expenditures. I do think as an investor you need to have a rising income stream, a rising dividend flow.

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So, that’s very important to the portfolio — that the business be capable of raising dividends in the future, have a history of doing so, but also have a business that indicates a high probability that that will continue into the future.

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It’s not all high yield, like SLMBP is 10% right now, and we own a couple of other names that I use to bring the yield up. Then I have names like Royalty, or Broadcom (NASDAQ:AVGO) is also a portfolio holding, that are growing their dividend mid-double- digits every year.

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It’s very important for me, and the ultimate public investor in this portfolio, that those income streams are rising. Right now, the current yield is right around 4% on the portfolio, and a double-digit dividend growth rate across the portfolio. So, it’s capable of keeping up with our lives. That’s the real mantra of the portfolio.

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TWST: What might prompt trimming or exiting a position? Are there any recent examples that you could use to illustrate?

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Mr. Lent: In an ideal world, it would be simply trimming strength to maybe augment income — if something goes straight up, to trim into strength to buy a higher-yield holding in the portfolio. That is typically where I find most of my turnover and activity: a straight up move in a stock, and that gets sold because I can buy a similar business or a set of business demographics at a better yield. So, sometimes a straight up move will cause it to come out of an income portfolio like this.

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Sometimes it’s a changed thesis. I did just sell UPS (NYSE:UPS). It wasn’t in the portfolio very long, but the feeling is, in this changing political and global trade environment we’re finding ourselves in, with the risks of slowdown or changing freight routes, it just seemed not as attractive as it did two years ago. So, we stepped aside.

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I don’t typically react to short-term things, but this feels more than short term, it feels widespread and global. We’re sort of the center of the storm right now, but I do think there’s a lot of freight and supply chain rethinking going on, whether it’s North America or other. So based on some new economic and political inputs, we did sell that position.

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TWST: Broadly speaking, how do income-oriented equity strategies tend to perform in different economic and investment market cycles or environments? And how have you positioned your Equity Income portfolio for 2025, at least as it’s been shaping up so far?

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Mr. Lent: As I tried to say, it lies south of growth. When we’re in an everything rallies growth mode, as we’ve been the last 10 years or so with somewhat suppressed interest rates, it’s been very lucrative to be a growth investor the last several years. So, it’s going to trail in those go-go momentum growth environments, but it’s going to exceed typical value, and it’s going to exceed bond returns.

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I view it, and I have always viewed this for my ultimate public customers, as a 60/40 portfolio without any bonds in it. By that I mean, I have a mental benchmark of 10% return. I think an equity investor should expect something in the zip code of 10% returns. And if I can get 40% of the way there on straight cash — the 4% dividend — if I can get 40% of what I’m chasing in cash and 60% from market appreciation, with downside protection, I’m doing my job for my investors.

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Our downside protection on this portfolio is evident. It was evident in the Financial Crisis. It was evident in 2022. It has faced a couple of different drawdown reasons. The Financial Crisis was one thing, and interest rates were actually going down. And then in 2022, inflation and interest rates were going up. Both times, market indexes had very large drawdowns, and the Equity Income portfolio did its job. It protected the downside.

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It trails in a straight up market, but it outperforms in a straight down market, and over the long term, those numbers come out quite favorably. By not losing money in the down markets, you’re OK to not make quite as much in the up markets.

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And then, how is it positioned for 2025? Again, I want that 4 points of cash. I’m looking at the 10-year, right now it’s 4.30%. I think that’s a good thing as a citizen and as an investor. I think the suppressed interest rates that we had for 10, 12, 15 years was a false prophet, a false indicator for investors, and there’s a lot of froth and we might have to pay a price at the index level for some of the great equity returns we’ve had in the last several years or a decade.

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But with the 10-year now back at mid-4s, I think that’s indicative of a healthy, growing economy. With a mid-2% or 3% GDP, you would expect your 10-year capital to cost something in that 4% range. So, to me this is a very normal yield curve, a normal cost of capital. I view that as a positive, especially for the types of companies that we own, because we’re not overexposed to levered companies.

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We own a couple of real estate investment trusts, American Tower Corp. (NYSE:AMT) and Prologis Inc. (NYSE:PLD), that are by their nature levered. But we don’t own levered balance sheets, companies who have found a way to surf this low-interest rate environment for the last 10 years and build their business doing that. Our balance sheets are very light on leverage, very high-quality balance sheets.

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So, I think that as the cost of capital starts to become friction for other companies, our companies will have an even greater benefit on the go-forward, and that’s what we’re positioned for in 2025.

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TWST: Do you want to wrap up with any final thoughts?

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Mr. Lent: What we’re trying to do here is extend the holding period, to buy things that can be held for longer periods of time. The longer you can hold an investment, the more you can benefit from compounded returns, and compounding happens at the end, right? You don’t know that your returns have compounded until you sit down and say, wow, I have a very small amount of capital in this and it’s worth quite a bit now.

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That’s really what I’m looking for in this portfolio. That’s what we’re looking for on the growth side, long holding periods and, as I said, steady, robust fundamental returns.

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But in the Equity Income portfolio it can be even more powerful, because if you can wait out a growing dividend for a 10, 12, 15-year holding period, you’d be amazed at the cash flow that you can receive from that company. As opposed to having bought a bond in that company 10 or 12 years ago; your bond comes due, you get your money back and you got your 3%.

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In a rising dividend environment, you put your money in, you get your compounding yield growth over that 15-year period, and you still have your capital invested. So, it’s quite rewarding if you can find the right investments and the right businesses to make those commitments.

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TWST: Thank you. (MN)

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JEFFREY D. LENT

Portfolio Manager & Partner Torray Investment Partners

(855) 753-8174

www.torray.com

Email: info@torray.com

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Torray Investment Partners, LLC (Torray) accepts no liability whatsoever, whether direct or indirect, that may arise from the use of information in this material. Torray can in no way be held responsible for any decision or investment made based on information contained in this material. Accordingly, this material is for distribution solely in permitted jurisdictions and to persons who may receive it without breaching applicable legal or regulatory requirements. The information in this document is deemed accurate as of 03.31.2025, is provided for informational purposes only, and is not to be relied upon as advice or interpreted as a recommendation. Torray may change the data, opinions, and estimates without notice. This document neither constitutes an offer to buy nor a solicitation to sell a product and shall not be considered an unlawful solicitation or investment advice. Past performance is not indicative of future results.

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Sallie Mae preferred (NASDAQ: SLMBP) and Royalty Pharma (NASDAQ: RPRX) represented 4.9% and 5.4% of the Torray Equity Income strategy’s assets as of 03.31.2025, respectively. The value of portfolio securities selected by the investment team may rise or fall in response to company, market, economic, political, regulatory or other news at times greater than the market.

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Torray Investment Partners LLC. is an investment adviser registered under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. For additional information about Torray Investment Partners LLC, including fees and services, please contact us or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

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To learn more contact:

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Director of Business Development

bleibrand@torray.com | 301.979.9302