CEF Insights: Equity & Income in Focus: The SCD Approach

Transcript

CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association. Today we are joined by Peter Vanderlee, Portfolio Manager with ClearBridge Investments. ClearBridge is an affiliate of Franklin Templeton and sub-advisor for LMP Capital and Income Fund, symbol SCD. We're happy to have you with us today, Peter.

Peter Vanderlee:
Thanks for having me. It's a pleasure being here.

CEFA:
Peter, I mentioned the LMP Capital and Income Fund, an actively manage strategy that invests in a broad range of equity and income securities. Can you discuss the investment strategy and how the components of the portfolio complement each other?

Peter Vanderlee:
SCD's investment objective is to seek an attractive total return with an emphasis on income. SCD has a flexible design allowing it to invest in a wide range of securities with an emphasis on common stocks, MLPs, REITs, and convertible securities. These asset classes complement each other in that they exhibit low correlations to each other providing diversification benefits to SCD's investors.
In our investment process, we favor companies with strong balance sheets, which generates copious amounts of free cash flow, have a leadership position in the sector and have the ability to not only maintain a dividend, but also grow the dividend over time.

CEFA:
We mentioned that this strategy invests in a broad range of securities. How do you determine your asset class allocations and then make specific security selections as you build your portfolio?

Peter Vanderlee:
We essentially deploy three steps in our portfolio construction process. In the first step, we begin with a broad universe of around 1200 securities and assess the overall attractiveness of the various equity income asset classes such as common stocks, MLPs, REITs, and convertible securities on an absolute basis and relative to each other.
In the second step, we conduct an in-depth fundamental analysis to narrow down the universe of potential investments and examine various sectors and individual companies. In particular, we seek out companies with strong balance sheets, which generate lots of free cash flow, demonstrate sound business strategies, exhibit market leadership, have good management teams in place, and offer an attractive income stream in the form of current yield and the prospect for income growth over time. We then perform a rigorous valuation analysis using a variety of metrics such as free cash flow, yield, enterprise value to EBITDA ratio, price earnings ratio, price to book ratio, among others.
Now, in the third step, we construct the portfolio ensuring we are diversified across various asset classes and sectors and continually assess its risk profile. The risk assessment involves analyzing asset class exposure, sector exposure, and individual security exposure, and an example of continuous risk mitigation would be to cap individual position sizes at 5% at cost, which is what we typically adhere to.

CEFA:
What factors or events would lead you to significantly change your portfolio allocation?

Peter Vanderlee:
To significantly alter a portfolio allocation would imply a changed outlook on the opportunity of the various asset classes such as stocks, MLPs, and REITs. In addition, we do analyze the relative attractiveness of equity income securities versus fixed income securities to see if there are opportunities outside of equities we should consider. Now, I should mention that for a long time now, we have favored owning equities over fixed income securities.
We continually assess and examine the factors that either increase the risk to the growth trajectory of these asset classes or accentuate its growth potential. At times, we may tactically reduce or increase exposure to an area if there are short-term or cyclical factors at play that would warrant such a shift. However, our long-term view on the attractive opportunities in dividend-paying stocks, MLPs and REITs has been in place for a while now and remains intact.
Let me clarify this further. With respect to dividend-paying stocks, we continue to be constructive on owning the next generation of dividend aristocrats, those companies that have not yet reached 25 years of consecutive annual dividend increases but are well on their way and have at least 10 years of consecutive yearly increases. We have thoroughly researched and analyzed these emerging dividend aristocrats and have identified them in many sectors such as information technology, healthcare, industrials, real estate, financials and utilities. We believe this cohort is well positioned to show resiliency in the current market environment while offering the potential for dividend growth and capital appreciation over the long run.
Further, we believe that in the long-term midstream energy companies and energy MLPs continue to represent an attractive opportunity as the US continues to cement its status as an energy superpower and exhibits sustained hydrocarbon production increases, which can bode well for high quality energy MLPs as volumes to be processed are poised to increase over time.
Meanwhile, many of these MLPs offer a high and attractive current yield while retaining the potential for distribution growth over time. Also, many midstream companies have cleaned up their balance sheets with more conservative leverage ratios than in the past, which lowers their financial risk profile. Lastly, with relative weakness in the REIT sector over the past few years, largely a result of high interest rates, we see a number of opportunities there. In particular, we favor those REITs that show attractive growth potentials such as data center REITs and telecommunication REITs. These infrastructure REITs exhibit robust growth characteristics due to the build out of artificial intelligence and cloud computing ecosystems. We believe these next generation REITs are well positioned to capitalize on this large opportunity ahead.

CEFA:
How did the portfolio perform in the shifting markets we have experienced over the past several months?

Peter Vanderlee:
I'd say SCD's long-term track record speaks for itself. The portfolio has gone through many shifting market environments since I got involved some 16 years ago. It has successfully navigated the great financial crisis, a booming economy, a recession, a Trump administration, a Biden administration, another Trump administration, and the COVID pandemic in between. Its flexible design allows the portfolio to navigate different investment climates over time.
More recently, over the past several months, we have seen a number of additional risks emerge, such as risks associated with punitive tariffs, the potential for inflation to rise, the potential for growth to slow down, the status of the dollar as a reserve currency, growing angst over our fiscal deficit, as well as geopolitical risk factors. In our view, the resulting volatility we're witnessing is indicative of markets trying to reprice assets to account for these new risk factors, which has led to heightened volatility on a constant and even intraday basis. In our view, the situation sets up a good opportunity for the long-term investor. We believe this economic uncertainty is relatively short-term in nature and will get resolved within a reasonable timeframe and on rational terms with our trading partners. Therein lies the opportunity if one is willing to look out beyond the current environment characterized by heightened volatility.

CEFA:
Peter, the Federal Reserve has held rates steady. The rate of inflation has improved, although the policies of the new administration have introduced some volatility to investment markets. Where do you see the investment markets currently and what is your outlook for the rest of 2025?

Peter Vanderlee:
Market risks remain elevated as a result of more anemic economic activity due to still high interest rates, tight financial conditions, and heightened political uncertainty, particularly in the areas of tariffs, taxes, and fiscal spending priorities. The cloud of unpredictability and uncertainty surrounding these topics remains elevated. The US housing market remains weak in large part due to elevated mortgage rates and weakening economic fundamentals. Corporate earnings are solid but under pressure from a slow economy and high interest rates, which puts upward pressure on interest expense.
In the energy complex, we are closely monitoring OPEC's recent decisions to add incremental barrels of oil to the market, which has caused weakness in oil prices and increases risk in the broad energy complex. Now, we carefully weigh these short-term risks against longer term opportunities and can tactically adjust the portfolio positioning accordingly. We believe many of these risk factors will eventually get resolved with some likely settled in the short term paving the way for a steadier investment environment. As such, our outlook remains constructive for the long term and we continue to be comfortable owning high quality companies that exhibit leadership positions in their sectors, have sound balance sheets, generate strong free cash flow and offer attractive dividend yields and dividend growth potential.

CEFA:
What are the most significant risks you consider in the current environment?

Peter Vanderlee:
The most significant risk in my view is to exit the market, to get scared out of the market because of the incessant drumbeat of negative headlines and articles on stagflation, deficit, interest rate risk, political turmoil, and so forth. In the end, much of this will get resolved and this cloud of uncertainty will lift.
Over many years and decades, American companies have proven to be astute and adept at navigating different investment environments. Even in today's climate, many our portfolio companies continue to show revenue, earnings, free cash flow, and dividend growth. The trend, I believe, will continue even in today's environment. So, especially for those investors with a longer term view and time horizon, the most significant risk is that they exit the market to these short-term concerns and angst and will be missing out in the process on opportunities in the long run.

CEFA:
How is the SCD portfolio currently positioned?

Peter Vanderlee:
We own quite a few next generation dividend aristocrats where we see strong dividend growth compounding and income growth over time. This next generation of dividend leaders provides a compelling risk reward proposition in our view by offering a coveted investment trifecta of one, current income, two, income growth, and three, the potential for capital appreciation over time. In addition, risk profiles for these companies tend to be reduced due to the high quality nature of these franchises and their balance sheets. We expect the demand for these securities to be long-lasting and widespread from both institutional and retail investors.
On the retail side, for example, the US has roughly 70 million baby boomers who are either in retirement or entering into retirement. This cohort needs income to supplement the general lack of savings, income growth to stay ahead of inflation and capital preservation as risk appetite tends to be reduced in retirement. And that is precisely what these dividend stocks can provide.
We also own midstream energy companies, which are well positioned to pay attractive dividends while growing their cash flows as the US continues to increase hydrocarbon production. I'd emphasize that these midstream companies depend more on handling volume of crude oil, natural gas and liquids, and are less dependent on the price of the underlying commodity.
Take the liquefied natural gas opportunity, the LNG opportunity. We expect US LNG export capacity to nearly double by 2028 from the roughly 10 billion of cubic feet capacity today. That is tremendous growth translating into more volumes to be extracted, processed, and transported directly benefiting some of our energy midstream holdings.
We are also positioned to capitalize on the growth opportunity in artificial intelligence, cloud computing and a related data center build out. We expect capital expenditures to double over the next four years to facilitate the build out of AI capabilities. Areas where we have exposure to this growth opportunity include the hyper-scalers as well as some carefully selected companies in areas such as software, semiconductor, infrastructure REITs, midstream energy and utilities.
In our view, the portfolio is well positioned to capitalize on these trends, which we believe to be large and long-term in nature. Further, we like and own a few alternative asset managers. Quite a few of them have recently issued mandatory convertible securities, which offer a substantially higher income stream compared to their stocks, providing not only additional income, but also more downside protection. We like these alternative asset managers as many institutional investors like endowments and pension plans seek uncorrelated returns, which these companies can provide.
Further, they operate in a loosely regulated environment, unlike their large bank counterparties, providing a competitive and sustainable advantage. The growth we have witnessed has been substantial with assets under management for the alternatives growing from $6.6 trillion to $16.8 trillion in the past 10 years ending 2023. We particularly like the sector leaders and we expect the growth of assets under management for them to continue to increase for many years to come.

CEFA:
Where are you seeing the best opportunities to put new capital to work?

Peter Vanderlee:
While we recognize the current volatile investment landscape, we do see a number of attractive opportunities where we can put new capital to work. In my view, the best approach in the current environment is to focus on quality, income and income growth and mitigate risk by rigorously diversifying. As such, I believe it is wise to cast a wide net and pursue opportunities across asset classes and sectors. The areas I mentioned before in dividend paying stocks available in many different sectors, midstream energy companies, REITs, technology companies, especially those involved in the AI ecosystem are all areas where opportunities exist today and remain abundant. This diversified approach includes a value oriented investment style mixed in with plenty of growth. Its eclectic approach should provide some downside protection while retaining upside potential.

CEFA:
Peter, how do you see an allocation to a strategy focused on income oriented equities like SCD best positioned in an investor's diversified portfolio? And likewise for an investor that is more income oriented?

Peter Vanderlee:
Every investor is different, but in general, SCD offers an attractive income stream to investors while retaining the potential for income growth and capital appreciation. If you look at its history, that is exactly what it has provided. Its eclectic and diversified mix of investments can appeal to a broad set of investors, including income investors, value investors, total return investors and alternative asset investors. Market environments and opportunities shift over time, and we like the flexible approach we can take so its capitalizing on the best opportunities at hand, so we have to worry less about what is in and out of favor.

CEFA:
Peter, thank you so much for taking the time to join us today.

Peter Vanderlee:
Thanks for having me.

CEFA:
And we want to thank you for tuning into another CEF Insights podcast. For more educational content, please visit our website at www.CEFA.com.

Podcast recorded June 2025.

Disclosure
This material is not and is not intended as investment advice, an indication of trading intent or holdings or the prediction of investment performance. All fund-specific information is the latest publicly available information. All other information is current as of the date of this presentation. All opinions and forward-looking statements are subject to change at any time.
Franklin Templeton and ClearBridge Investments disclaim any responsibility to update such views and/or information. This information is deemed to be from reliable sources; however, Franklin Templeton and ClearBridge do not warrant its completeness or accuracy. This presentation is not intended to, and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any security, product, investment advice or service (nor shall any security, product, investment advice or service be offered or sold) in any jurisdiction in which Franklin Templeton and ClearBridge are not licensed to conduct business, and/or an offer, solicitation, purchase or a sale would be unavailable or unlawful.