Q: Would you give us an overview of the fund?
During the 2008 credit crisis – an environment rife with dividend cuts within the financial sector – the Nuveen Santa Barbara Dividend Growth Fund avoided dividend reductions. The strategy, which began as a separate account in 2004 and was launched as a mutual fund on March 28, 2006, credits this achievement to a singular focus: it seeks high-quality companies with the fundamentals to sustain and grow its dividend over time.
Today, the fund and the separate account retain the same holdings and share a philosophy, approach, and process. Our firm, Santa Barbara Asset Management, is the fund’s subadvisor and manages about $10.4 billion in assets and the mutual fund has approximately $3 billion in assets (as of 6/30/17).
The hallmark of our approach is dividend growth investing with a fundamental focus. We look at companies with a market cap of $3 billion or more, and within that large investable universe, seek an aggregate portfolio with a higher dividend growth rate, lower beta, and yield equal to or greater than the S&P 500 Index.
At Santa Barbara, we believe the pursuit of high-quality dividend growers should not be constrained by rules-based investing – considering often overlooked dividend payers such as recent dividend initiators and companies with a yield below the comparable market or sector. Among our holdings, several have provided strong dividend growth, but have a yield below the S&P 500’s current ~2% yield, like UnitedHealth Group Inc. Others are higher-yielders with slower than market dividend growth, like AT&T Inc. Investments in these, and everything in between, result in a portfolio with a broad range of dividend growth and yield.
Many dividend funds that solely focus on yield tend to be expensive on a forward price-to-earnings basis – especially if they have higher concentration in sectors such as consumer staples and utilities. Our portfolio is currently cheaper than the market. Our fund’s dividend growth strategy tends to do well in periods of market volatility, as well as during periods of rising rates and when credit spreads tighten. Therefore we believe it can be a core equity holding in an investor’s overall portfolio.
Q: What core beliefs drive your investment philosophy?
Our philosophy is that a company with the ability to sustain and grow its dividend is a reflection of a well-run business. We believe stocks with strong end markets, favorable trends, attributes, and financial strength are simply much better places to invest than anywhere else.
We constantly evaluate the portfolio holdings to ensure we understand whether the trends affecting each company will weaken or strengthen them on a fundamental basis. We believe research and stock selection are paramount – identifying well-run businesses, and owning those that deliver strong performance on a risk-adjusted basis.
Q: What is your investment process?
The security selection process is based on bottom-up fundamental analysis, evaluating companies based on their balance sheet strength, earnings growth, return on equity, quality of management and their commitment to returning cash to shareholders. We also examine a company’s current and historical margins not just on an absolute basis, but relative to its industry or sector, as not all industries within the same sector share the same characteristics. Our fundamental research is geared to identify those companies that appear positioned to grow their dividends over time.
This brings the investment universe down to approximately 250 companies. We then review a company’s presentation materials and what the Street is saying about it. We attend conferences, talk with management, and visit companies to determine their different margin and return profiles, their position in the industry, and whether an industry is conducive to dividend investing. Looking at independent, third-party metrics, as well as government and industry statistics, also contributes greatly to our understanding of the company.
We go beyond the quantitative and financial measures that traditionally define quality: assessing management’s approach to returning capital to shareholders. We refer to historical transcripts to track whether they have delivered on their promises.
At this point, attractive stocks are assigned a ranking by our analysts and added to their watch list. Because our analysts have specific sector focuses, they have great familiarity with the competitive landscape within their industries, and can quickly determine whether a company is worth the attention.
Next, based on valuation or a new catalyst, the analyst compares the attractiveness of candidates, and ultimately recommends the one with the best potential at the time.
Q: Can you illustrate your process with a few examples?
A few years ago, while looking in the materials sector for something less cyclical than the overall sector, we came across Packaging Corp of America. The box manufacturer had consolidated quite a bit over the years and was becoming more stable.
The company had better margins than its competitors, an attractive yield, solid prospects, and a low payout ratio. Additionally, we observed that pricing power, as measured by the cost per ton of containerboard, was trending up.
We believe Packaging Corp was the best operator in an industry with a favorable consolidating trend, and therefore we saw the company as a positive opportunity and purchased it in 2013. It exemplifies how being sector and industry specific can be beneficial – it would be difficult for a generalist to find an esoteric industry trend like this.
Another example is Cisco Systems, Inc., which we recently purchased. The large-cap networking products manufacturer is more of an enterprise-type business. It makes a lot of money on its hardware, has exceptionally high free cash flow yield, and uses those proceeds to slowly invest in emerging areas of technology.
Last year, Cisco made many acquisitions in security software. As important area of the tech space, security companies tend to have high multiples with significant investor value. Cisco used its scale to get into the security software business and then synergize it with its hardware sales.
In tech investing, the sustainability of revenue is critical, and Cisco’s recurring revenue was increasing. Over time, we felt the company would be able to build a sustainable advantage by selling its hardware and software to enterprise customers, as well as in growth of mobile data traffic.
For us, Cisco is a high-yielding stock with a low payout ratio and plenty of room to continue to grow its dividend.
Q: How do you construct your portfolio?
Because there are only 40 names in the portfolio, risk management and allocation of risk are critical to portfolio construction. A fund with so few names, by definition, will exclude specific industries – with some industries having zero representation. Those industries we do allocate to are ones we view as positive, which will be additive to the strategy, and will help keep the risk profile inline (a portfolio beta less than the market). The fund tends to have low turnover and holds companies for an average of 3–5 years.
The average individual position weight is 1–3% at cost, with a maximum weight of 5%. All sectors are represented, with industry exposure limited to 25% of the portfolio. As of 6/30/17, the fund is overweight in insurance and underweight in consumer finance.
Our preference is to own the best name in many different sectors. For example, we believe in IT hardware and software, we currently believe the best opportunities are in Apple Inc. and Microsoft Corporation. We used to own QUALCOMM, Inc., but sold it when we noticed weakening trends – several years ago, its customers were unhappy with royalty payments, and a backlash against the company had begun. Qualcomm still continues to have royalty issues and faces major challenges in the mobile space.
In telecom we own AT&T, which we believe has a better growth profile and prospects than its top competitor, Verizon Communications Inc.
AT&T’s excess free cash flow enables the company to fund its next leg of growth. Acquisitions such as DirecTV have helped reaccelerate growth despite having little leverage. The DirecTV acquisition also awakened investors to AT&T’s potential to combine telecom and mobile with subscription television.
AT&T did face many technical challenges when it transitioned from 2G to 3G. The next iterations, going from 3G to 4G, or 4G to 5G, may bring new challenges and the company must continue to deliver the network and services its customers expect. We are closely monitoring company management to see whether they are making the right decisions.
Q: Why does the portfolio only invest in 40 companies?
Our belief has always been that a high-conviction portfolio is more conducive to fundamental investing. Also, active share is important to us and we believe it’s more manageable and credible with fewer names.
The portfolio has historically ranged between 30 and 40 names. Although 40 stocks allows for an opportunity to make huge home-run bets, we limit the position weight to 5% of the portfolio. In addition, when a company is in the crosshairs of a negative trend, we replace it or allocate the proceeds of its sale to existing holdings with higher conviction.
Q: Do you have any price targets?
We are constantly reviewing the Fund’s holdings and setting a price target based on the latest available data. A company’s latest earnings report or a recent acquisition are catalysts for us to review the price target and perhaps raise or lower it.
However, the dividend is paramount to what drives our sell decisions. We seek to own companies with above-average market dividend growth, and we are always looking for evidence that a company might be unable to continue to raise its dividend.
We try to identify dividend cuts early. One thing to point out is that if a company cuts its dividend it does not immediately trigger a sell. The analyst will re-review the company and assess whether or not they believe the company could be a dividend grower sometime soon. If a drastic event happens to the company and takes management by surprise, often we will hold the stock until it recovers and exit the position later.
Finally, we will sell if a stock has fundamental deterioration. Because our analysts focus on specific industries, they know which companies are gaining market share and which are pricing irrationally. These are important indicators regarding the health of both a company and its industry.
Q: What does risk mean to you? How do you monitor and control risk?
The primary risk is loss of capital. Our philosophy of buying dividend-growth stocks provides a natural buffer to capital loss; having an income stream from a company that’s historically committed to paying a dividend helps mitigate risk. In addition, dividend growth companies have historically had lower standard deviation, a measure of risk, than non-dividend paying companies – an indication that our investable universe has a lower risk profile.
The companies we hold are established companies within their respective industries and tend to historically perform better during market downturns. They have high market share, defendable margins, and defensible business models.
