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401(k) Fund Spotlight: Loomis Sayles Small Cap Value

Summary LSSCX is really a small cap “core” or “blend” fund. LSSCX has consistently beaten the Russell 2000 Index by at least 2% over all relevant, historical periods. With almost 1/3 of the fund in financials and little exposure to utilities, consumer staples, and REITs, the fund is well positioned for a rising rate environment. Introduction I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article, it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. Loomis Sayles Small Cap Value Fund The Loomis Sayles Small Cap Value Fund has the following share classes: If the fund is an option in your 401(k), it will likely come in the form of the I (institutional) or R (retail) shares. These two share classes are also much older and hold most of the overall fund’s assets. The expense ratio for the I shares is 1.04% and for the R shares it is 1.29%. For the purposes of this article, I will assume the I shares are being discussed and name the fund by its ticker – LSSCX . The fund is closed to new investors. Most readers, if they have access to the fund, will have it only through their 401(k). LSSCX is best classified as a small capitalization (“cap”) core (or blend) fund. Small cap companies are loosely defined as having a market capitalization of less than $2 billion. The “core” or “blend” description means that the fund owns stocks described both as growth and value. Performance Evaluation Loomis Sayles is a mutual fund outfit best known for its prowess in the bond market and their flagship Bond Fund, the Loomis Sayles Bond Fund (MUTF: LSBDX ). The immediate question for us is, “Can they pick stocks?” and “Can they pick small cap stocks?” I’ll let the numbers do the talking. The following table compares the performance of LSSCX to its benchmark index, the Russell 2000: as of Sept 30, 2015 1 Year Return 3 Year Return 5 Year Return 10 Year Return Loomis Sayles Small Cap Value – Inst 1.2% 11.7% 12.3% 7.6% Russell 2000 Index -1.6% 9.2% 10.2% 5.4% Excess Return 2.8% 2.5% 2.1% 2.2% The fund has beaten the index by at least 2% over the last 1, 3, 5, and 10-year periods (as of September 30, 2015). This is a consistent record of excess returns which clearly makes the fund a better option than owning the index. The following table compares the performance of LSSCX to its peers, as represented by the Lipper Small Cap Core Index. This data was taken from Barrons . as of Oct 31, 2015 1 Year Return 3 Year Return 5 Year Return 10 Year Return Loomis Sayles Small Cap Value – Inst .7% 14.3% 13% 8.6% Lipper Small Cap Core Peer Index .7% 13.4% 11.7% 7.5% Excess Return 0% .9% 1.3% 1.1% Over the last year, the fund is even with its broader peer group, but has out performed the average over the last 3, 5, and 10-year periods (as of October 31, 2015). Over the last 5-year period the fund finished in the 22nd percentile of its peer group and over the last 10-year period it finished in the 15th percentile. This means that it outperformed 85% of all other small cap core oriented funds over the last 10 years. From a performance standpoint, LSSCX can best be described as a superior option to the index and an above average option when compared to its peers. Additional Performance Considerations It is important to realize that LSSCX is not going to give you any sort of exceptional performance (e.g., 5%+) over its Russell 2000 index benchmark over a longer period of time. This is because the fund typically holds 150 to 180 different stocks (152 right now), with no one stock comprising more than 1.5% of the fund. The fund is just too overly diversified to vastly outperform the index. That being said, I view the consistent 2% excess returns as very good. Loomis Sayles “rigorous fundamental, bottom-up analysis” (as they describe it) adds value and makes the fund a better option than an index fund. It would be interesting to see Loomis Sayles launch a more concentrated small cap fund that owns what they think are their very best ideas. I am thinking of the Invesco Select Companies Fund (MUTF: ATIAX ), which I recently wrote about, which invests in the managers best 25 small cap ideas. Well Positioned for Rising Rates Here is how LSSCX’s assets were distributed across sectors, as of September 30, 2015: Financials – 31.5% Industrials – 18.4% Consumer Discretionary – 18.3% Information Technology – 14.8% Healthcare – 4.2% Consumer Staples – 3.5% Materials – 2.9% Utilities – 2.6% Energy – 2.3% Telecom – 0% Almost one third of the fund is invested in the financial sector. In fact, the fund’s 2 largest holdings are Signature Bank (NASDAQ: SBNY ) and Cathay General Bancorp (NASDAQ: CATY ). These small banks would benefit from a rising rate environment as their net interest margin expands. By this I mean they could continue to pay depositors 0% to .25% while at the same time increasing their rates on auto loans, mortgages, and commercial loans, netting more profit. The fund has little exposure to utilities and consumer staples stocks that could suffer as their high dividends become less appealing in an environment of higher bond yields. Furthermore, digging through the holdings I can see that the fund also has minimal exposure to real estate investment trusts (“REITs”), which could also suffer for the same reason. I am not expecting substantially higher rates for several more years, but wanted to point this out for some investors who may have a more immediate concern. Rising rates in the U.S. would also imply a strengthening U.S. economy which would benefit U.S. small cap stocks. Valuation If LSSCX has a weakness in the current environment it is the low dividend yield, which currently only runs about .6%. However, the fund is attractive from a valuation standpoint. As of September 30, 2015, it had a forward price to earnings multiple (“P/E”) of 15.96. This is slightly below the index and gives credence to the fund’s “value” slant. (It does call itself small Cap Value, even though it is really a small cap core or blend fund.) I have no problem sacrificing dividend yield for lower valuations. Strategic Positioning I have really warmed to U.S. small cap stocks over the last few months in the 401(k) plans I manage for clients. It seems little noticed, but valuations have come down substantially to the point that they are now broadly inline with U.S. large cap stocks. Furthermore, the 2-year chart of the Russell 2000 Index looks compelling: ^RUT data by YCharts The index put in a higher low in 2015 than it did in 2014 and appears ready to break out to new highs. Am I predicting this? No. I am just considering a scenario where the U.S. dollar continues to rise, putting pressure on the earnings of U.S. multinationals but buoying the attractiveness of U.S. small cap companies with little international exposure. In such a scenario, I could see the S&P 500 index treading water while the Russell 2000 index logs some high, single-digit gains. Conclusion The Loomis Sayles Small Cap Value Fund is a good option in the current global macroeconomic environment. 401(k) investors may want to consider giving it the nod, or at least a higher weighting, over comparable small cap fund options and especially over small cap index funds. Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to Americans within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser.

Westar Energy: A Progressive Utility With A 3.5% Yield

Summary Westar Energy harnesses wind in Kansas for cheap power. Westar Energy retiring three old coal and gas plants. Westar implemented a $78 million rate increase in October. Westar Energy (NYSE: WR ) is a progressive utility company that is aggressively moving to clean power. Westar Energy plans to nearly double its clean power while reducing fossil fuel energy by 7%. In my previous article about Westar Energy, I told investors to buy this stock around $37 per share as the company adds cheap wind power while reducing coal. Kansas has some of the strongest winds in the country. Westar is prepared for tougher environmental regulations from the Clean Power Plan. The Clean Power Plan establishes state-by-state targets for carbon emissions reductions, and it offers a flexible framework under which states may meet those targets. The final version of the rule would reduce national electricity sector emissions by an estimated 32% below 2005 levels by 2030. Westar Energy has sufficient capacity right now to meet demand. But on a conference call with investors, Mark Ruelle, president and chief executive officer, said the investment in wind is primarily because it’s so inexpensive with the tax credits. The move also is a bit of a hedge on what form the Clean Power Plan takes in Kansas. Ruelle said wind energy is a bargain right now. (click to enlarge) Ruelle said Westar Energy has sent out requests for proposals to add another 500 megawatts of power. Right now 9% of Westar’s generation is from renewable resources, but that number will grow to 17% of generation in 2016. Nearly all of this energy will be from wind. Westar Energy’s energy generation mix includes 700 megawatts from wind energy, with commitments to add another 600 megawatts under development for a total of 1,300 megawatts. In addition, Westar is now considering adding another 500 megawatts on top of the 1,300. “We’re continuing to evaluate, but right now it looks like it makes more sense for our customers if we own all of our sizable portion of the incremental renewables,” Ruelle said. “Today our renewables portfolio is heavily imbalanced for PPA (Purchase Power Agreement) vs. ownership and if we don’t re-balance it a bit that might set us and our customers up for problems down the road when the PPAs expire, plus customer economics favor ownership,” Ruelle said. Westar Energy recently announced plans to close three small units at Lawrence, Tecumseh and Hutchinson by the end of the year. These are the first major unit that Westar has closed in the past few decades. The Lawrence and Tecumseh units burn coal, and the Hutchinson one uses natural gas. “It’s been good for our customers to hold on to these small old units as long as we reasonably could, but for a number of reasons, now is the right time to let them go,” Ruelle said. “They have lasted decades longer than anyone ever imagined, some of them are older than me, but given the clean power plan, their age, size and our need to manage expenses, it just doesn’t make sense to pour more money into them. They reflect two small 50s and early 60s vintage COLI units and a 60s vintage gas steamer. Together they are just 350 megawatts and less than 1% of plant investment.” Third quarter Westar Energy’s third quarter was sluggish. Cool-to-mild temperatures in August hurt demand for electricity. Westar Energy posted 3Q15 earnings of $138.2 million or $0.97 per share, compared with $146.9 million or $1.13 per share in 3Q14. Earnings for the nine-month period ended Sept. 30, 2015, were $253.4 million or $1.84 per share, compared with $270.3 million or $2.08 per share for the same period in 2014. The company has narrowed its 2015 earnings guidance range to $2.18-$2.25 per share from $2.18-$2.33. The company issued preliminary 2016 earnings guidance of $2.38-$2.53 per share. The company has strong financial strength. The company’s debt is investment grade. Total long-term debt was $2.941 billion at the end of 3Q15, compared to $3.224 billion at the end of 2014. The stock trades around 18.8 times earnings, which is a slight premium to its peers. Westar will see earnings improve in the fourth quarter and in 2016 due to implementation of a $78 million rate increase, approved by the Kansas Corporation Commission. Risks Utilities are sensitive to interest rates. When the Federal Reserve begins raising interest rates, these stocks are likely to take a hit. Utilities had a nice run up in 2014, but haven’t performed well in 2015. The Utilities Select Sector SPDR Fund (NYSEARCA: XLU ) is down -9.47% YTD. Westar stock has held up fairly well in 2015, down only -1.14% YTD. Ruelle said one large chemical producer had reduced consumption of electricity due in part to the low prices for oil. I believe we are near a bottom in oil but the price recovery will be slow and arduous. Weather is always a factor with utilities. Westar benefits from extremely hot temperatures in the summer and really cold temperatures in the winter. 2015 was mild to moderate most of the year in Kansas. Conclusion If Westar falls into the high $30s again, investors may want to consider buying the stock. Westar is a well-run utility with strong financials and steady income. The stock offers a yield of 3.5% with potential for modest appreciation. I bought WR at $37.03 on Aug. 27, 2015. The stock recently traded at $41.32 per share, a gain of 11.58% plus the gain from the $0.36 dividend for a total gain of 12.55%. I’m holding o nto the stock. Long-term investors will get the dividend and likely modest appreciation with a 12-month target price of $44.

Oxford Lane Capital And Eagle Point Keep Churning Out The Cash, While High Yield Market Jitters Drag Down NAVs

Summary As high yield bond and corporate loan markets continue to be hammered by nervous investors, funds like OXLC and ECC have seen their NAVs drop even more. This is a natural result of their leverage, but essentially is irrelevant to their ability to generate cash flow and make their dividend payments. These are tough vehicles for some retail investors to understand and appreciate, but offer impressive income potential to those willing to make the effort. As the proverbial blood continues to run in the streets of the high yield bond and leveraged loan markets (because of a range of fears related to the Fed increasing rates, the world economy slump, etc.) the non-investment grade companies that comprise those markets continue to go about their business, making their interest and principal payments. This translates into strong cash flows and high distributions for Oxford Lane Capital Corporation (NASDAQ: OXLC ) and Eagle Point Credit (NYSE: ECC ), the two closed end funds that specialize in buying collateralized loan obligations (“CLO’s”). CLO’s are leveraged, special purpose vehicles that function like “virtual banks,” buying and holding senior, secured floating-rate loans to non-investment grade companies. (This is the same cohort of companies that issues high-yield bonds. But whereas high-yield bonds are unsecured and typically recover only 20-30% in the event of the issuer’s default, senior secured loans have historically recovered 70-80% in the event of default, so the overall credit loss on a portfolio of loans over time is less than half the credit loss on a portfolio of high yield bonds.) Both ECC and OXLC put out quarterly reports yesterday and followed up with investor conference calls this morning. In both cases the messages were similar, that the market for the assets they hold – CLOs and the loans held by CLOs – are way down, the cash flows from those assets continue strong, and the reinvestment opportunities for CLOs in the loan market are very attractive. But the strong income prospects this represents (OXLC yields over 22% and ECC over 14%) are not enough to offset the fears of many closed end fund investors, who remain fixated on the net asset values (NAVs) of both funds. These have dropped in recent months to reflect the depressed markets for their underlying assets. Here is why the NAV of a CLO fund would drop as the market for its underlying assets drops. Suppose the equity in a typical CLO is leveraged 10 times. If the market for the loans held by that CLO drops by 1%, then the mark-to-market or “paper loss” to the equity of the CLO will be 10 times 1%, or 10%. This means that investors should not be surprised to see NAVs of ECC or OXLC fall at about ten times the rate as the drop in market prices in the loan market. None of the drop however, has any relation to the ability of the portfolio to generate the cash needed to pay distributions. Investors who can understand that and be comfortable with it can appreciate the opportunity these funds represent for income investors. But be prepared for a potentially volatile ride in terms of market value, although many of us who have owned the funds for awhile may feel – given the current entry point versus where we got in – that today’s new investors will have a smoother ride than we did.