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Textron going regional with equity allocation

The head of investments for Textron Inc.'s roughly $7 billion defined benefit plan says his team is moving to disaggregate a portion of its international equity allocations in favor of concentrated regional mandates.

Charles Van Vleet, Textron's chief investment officer and assistant treasurer, in a recent interview said that Providence, R.I.-based Textron has identified managers with competitive strengths in Japan, the U.K. and Europe, and will allocate roughly $150 million to them, in proportion to those regions' relative weights in the MSCI Europe, Australasia and Far East index.

He declined to name the selected managers, but said the strategies will be concentrated, high active-share offerings.

That disaggregated portion will amount to roughly 2% of Textron's portfolio. As of Sept. 30, 2017, Textron reported 13.7% of its portfolio, or just less than $1 billion, benchmarked against the MSCI EAFE index.

Mr. Van Vleet said with stock markets globally boasting correlations of roughly 90%, he's comfortable making those regional allocation calls for a portion of Textron's international equity allocation, as opposed to leaving it to the discretion of an active EAFE manager to favor the regions offering the best value.

The move will add incremental risk to the portfolio, he acknowledged. Even if it pays off in additional alpha, Textron won't disaggregate more of its EAFE allocations, he said, explaining, "I have to size my allocations" appropriately.

Other recent moves by Textron's team have been more defensive in nature, positioning the DB portfolio to bolster its resilience as the post-crisis rally grows ever longer in the tooth.

For example, over the past 18 months, Textron has shifted roughly 5% of its portfolio from large-cap U.S. equities to single-B rated credits, to get exposure that's less dependent on investors betting the bull run by financial markets is going to last forever, he said.

Textron, an aerospace and defense company, expects domestic corporate earnings to remain strong for the current quarter with top line revenue growth up 8% on year and net profit growth of 20% but "that only translates into better stock prices if forward earnings multiples stay the same or go higher," he said.

Over the past nine months, multiples have drifted lower to about 15 times earnings from 16 times, against a backdrop of U.S. Federal Reserve Bank tightening and concerns about the cycle coming to an end, shaving 4% off equity holders' returns, Mr. Van Vleet said.

At this late stage of the cycle, "it's all about where you want to be in the capital structure," he said. Do you "attach to the earnings" of a company by owning its equity, going up the capital structure to hold its debt, or owning the real estate the company makes use of and being its landlord, he said.

At a moment when investors are wondering about the business cycle's staying power and other threats, such as growing trade tensions, holding a company's debt can make more sense, he said. Investors in a company's equity can sell it down even as earnings give that company more than enough wherewithal to cover its debt payments.

"We expect to remain in modest multiple contraction," with a drop to 14 times earnings trimming another 4% off returns, which has left Textron favoring exposure to single-B credit through collateralized loan obligations, business development companies and other vehicles, he said.

Year-to-date, that decision to shed large-cap U.S. equities and favor leveraged loans and single-B mezzanine paper has been "working great," Mr. Van Vleet said.

He noted that a decade ago a number of corporate defined benefit plans were structuring their bond portfolios with the idea of facilitating in-kind transfers of pension risk to big insurance companies. But more and more corporate plans are now are finding it more efficient to use 30-year Treasury strips, futures or swaps, he said.

That allows them to get the bond exposure they need with roughly a third of the cash, freeing up the remaining two-thirds for investment in instruments such as short-duration high yield or convertibles — leaving them with market exposure of between 120% and 150%, he said.

Textron has market exposure of around 120%, said Mr. Van Vleet, adding roughly 25% of U.S. corporate DB plans may be structuring their portfolios similarly at present.

That remains an efficient way to structure a portfolio as long as stocks and bonds are negatively correlated, as they have been for almost the past three decades, he said.

If they become positively correlated, however, as they did during the oil crisis of the 1970s and early 1980s, then stock and bond prices could drop at the same time, dealing a body blow to portfolios, he said.

He conceded that a trade war is one shock that could push both down at the same time. "It worries me," he said.