Q: What is the background of the company and the fund?
The Boston Company Asset Management, an active equity boutique where I started right out of college 23 years ago, was founded back in 1970. Since that time, we have been delivering investment capabilities to the institutional community, as well as to retail investors through sub-advised mutual funds.
Today, we are an independently operated equity investment boutique, anchored by BNY Mellon, a global investments company with $1.7 trillion in assets under management (as of 12/31/14). Our Large Cap Value team is committed to a disciplined investment philosophy of buying stocks with attractive valuations, improving momentum and strong fundamentals.
In 2005, I assumed responsibility for our U.S. dividend-oriented products, and in 2007, I started managing the BNY Mellon Income Stock Fund. In 2011, we enhanced our investment process to emphasize higher-dividend-yielding stocks along with dividend growth stocks. We now have an objective to generate dividend income that is 150% of the S&P 500 Index.
This strategy generates an attractive yield, but importantly, we believe our dividends will grow over time. We believe our strategy is attractive to investors seeking income because our yield is not only competitive against the broad equity market, but also against bonds. One of the key differences relative to bonds is that our income stream should grow over time, so this would be particularly attractive if the economy experiences inflation in the future. Currently, assets under management in this fund, using this strategy, are about $1.1 billion.
Q: What is your investment philosophy?
Our High Dividend Income strategy focuses on identifying stocks that offer compelling dividend growth, solid fundamentals and attractive valuations by employing a forward-looking, bottom-up investment process. Our conservative investment approach endeavors to balance dividend growth and yield while ensuring a valuation-sensitive stock-selection discipline.
We believe that dividend-paying stocks outperform the broad market over time. Higher-yielding stocks tend to be more defensive in nature and outperform when the market or economy is weak. The addition of companies that can increase their dividends to a portfolio of higher-yielding stocks may help us to generate robust relative returns in periods when businesses are performing well because of a strong economy or when inflation rises. We believe this combination allows us to perform well through an entire market cycle.
We seek to do better than the index and other passive investments in dividend stocks by using our intensive, value-driven, fundamental stock-selection process. We are not deep value managers, but we always focus on valuations in our stocks, as we believe buying value stocks leads to overall success in the market. However, we want to avoid not just the value trap, but also what we call the dividend trap: We want to avoid companies that cut their dividends by investing in companies with a catalyst that promises to inflect momentum. We also look for companies with strong balance sheets and free cash flow. Many managers in the equity income space only focus on high-quality companies, irrespective of valuation. We have found that this type of investing can lead to long stretches of underperformance because during certain market environments, quality can become overvalued.
One area where we are finding our ideal combination of attractive values, improving momentum and compelling, growing dividends, is in the Financials sector. While a lot of equity income funds are underweight Financials because their dividends were cut in 2008, we’ve chosen to look to the future and not the past. We see a lot of what we believe are high-quality Financials whose balance sheets are the best they’ve been in the past 20 years.
They have a strong ability and willingness to increase dividends over time. Yet, these are investments that you would miss if you limited your focus to only companies that have increased dividends consistently over the last 10 or 20 years.
We do not believe a huge opportunity exists in the highest-dividend-yielding stocks at the moment because of extended valuations, but we appreciate the fact that some investors seek high dividend income. We seek to deliver high dividend income through a portfolio approach, where we have stocks that boast high yields alongside other stocks with good dividend growth prospects.
Q: How would you define your investment strategy and process?
We are forward-looking and use a bottom-up fundamental investment process.
We seek to exploit anomalies and inflections at both the stock and sector levels. It’s not just individual companies that can be under- or overvalued. This can also occur at the sector or factor level, and we pursue these opportunities as they change over time. For example, if high-quality stocks are expensive, we focus our research on more cyclically biased sectors and stocks. We believe this focus on where the value and momentum is most attractive at any point in time provides us with compelling results.
We use both quantitative and qualitative screens to identify a manageable number of names for our fundamental working list. We consistently source ideas through our quantitative process, looking for those companies that feature value characteristics, plus the momentum and fundamentals we seek. More importantly, we also source ideas in a fundamental way, by meeting with company management teams. The fundamental process is more nuanced, as we look to uncover alpha opportunities not yet reflected in quantitative data. We get ideas in many ways, often from our large research staff, including our dedicated Large Cap Value team.
Fortunately for us, our firm invests significantly in our investment research resources. We have a Global Research team who helps us do intensive, fundamental analysis. And we simplify the process. Essentially, our domestic analysts have two primary customers: the growth team and us. This enhances their effectiveness in working with our team, as we can have an important influence on their work flow.
At the end of the day, what we want to see are companies with catalysts for business improvement, ones that generate high and consistent free cash flow and have a lot of room to pay and grow their dividend over time. We talk to a lot to company managements to discover for ourselves their willingness to increase their dividends.
Once the research is completed, it gets presented to the portfolio manager. I’m the portfolio manager for the U.S. dividend-oriented portfolios. Therefore, I have full accountability and control over what stocks go in and out of the BNY Mellon Income Stock Fund.
Q: What is your research process and how do you look for opportunities?
I can explain our approach by using the media sector as an example. I have analyzed media stocks for over a decade, as has our global research analyst who covers the media industry. Back in 2010 we uncovered, through our quantitative screening, some interesting stock ideas in the media space. Earnings estimates were going up, fundamentals were strong, and yet the stocks were attractively valued.
The reason they were attractively valued was because investors were worried about changing media-consumption patterns, a shift to digital advertising and a pickup in advertising share by Internet companies. This gave us an opportunity to do some good fundamental work.
It is rare, from a quantitative perspective, to get good valuation, good estimate momentum and dividend growth at the same time. However, in 2010, we were seeing that in the media sector.
This analyst and I arranged to meet with a number of different media-related companies, and our resulting assessment was that the market was overly skeptical about their fundamentals. The reasons people were selling the stocks were legitimate, but their fears were not about to be realized immediately. It was going to take a lot of time for the big secular worries to come to fruition.
Thus, after talking to numerous management teams, we chose to overweight the portfolio in the media sector with those stocks that had the characteristics we look for: good valuations, improving business momentum and dividend growth. We were especially encouraged by the good capital-allocation decisions that managements were making with the focus on growing their dividends and share buybacks versus using their cash on expensive acquisitions.
Q: How do you go about constructing your portfolio?
We build the portfolio one stock at a time and view the benchmark as a bogey for the yield we want to achieve. We look for a portfolio dividend yield that is 150% above the S&P 500 yield. We ensure good diversification, maintaining about 50 names in the portfolio. That’s small enough to provide high active share, yet large enough to prevent any one underperforming stock from becoming an issue.
Our portfolio is well diversified across industries. We examine every sector, as we can usually find one or two names in each that we are comfortable owning. For example, we do not like the Utilities sector overall, but we don’t overlook it.
Once the portfolio is built, we review all the factors with our quantitative team, and we focus on the type of risk present, both intended and unintended.
The goal is to build a balanced portfolio that gives our clients high dividend income. We are willing to overweight the dividend yield factor because that is what our clients look for and what we believe helps us outperform over time.
When we analyze stocks, the recommendation that is presented to the portfolio manager includes both upside and downside targets. Each individual stock has a risk/reward ratio. We look for stocks that give us better risk/reward than the overall portfolio.
The ideal sell situation is when what was an attractive valuation becomes less so. That means our investment case has played out, the stock has hit its target price, and we sell the stock and move on.
In other instances, we sell if our initial assessment that a catalyst is or will be present turns out to be mistaken. If the catalyst for improving business momentum does not pan out and there is no prospect of it panning out in the future—we simply sell the stock and move on.
And finally, if we believe that the free cash flow has been impacted sufficiently to negatively affect the dividend, whether imminently or over the next two or three years, we will likely sell the stock.
Q: How do you define and manage risk?
We manage risk both at the stock and portfolio level. At the stock level, we have an upside and downside target price on each stock to help us understand our margin of safety. At the portfolio level, we examine both the intended and unintended risks present in the portfolio, such as interest-rate sensitivity, oil-price sensitivity, China economic growth sensitivity, to name just a few. We meet each week to discuss the factors that could potentially affect the portfolio.
We construct the portfolio to maintain positions we believe have limited downside, good intrinsic values, and real positive upsides, and we look at valuation, balance sheet, and cash flow sustainability on a stock-by-stock basis. We make sure we have a well-diversified portfolio. We are presently overweight Financials because of where we see value in the marketplace.
In the current environment, we believe higher rates could be a risk to equity income and fixed-income portfolios. Our dividend-oriented portfolios have delivered solid results in a rising rate environment. One example of this was back in 2013, where [then-Federal Reserve Chairman Ben] Bernanke started the “taper tantrum” with the 10-year Treasury around 1.63% in May 2013 and lasted until the end of 2013 at a 3.03% rate.
The S&P 500 was up 17% in this environment, which demonstrates that the market can still rise as rates move higher. Conversely, Utilities and other sectors that we consider to be bond proxies declined, as companies that look and act like bonds weakened during this higher-interest-rate period. While many of our peers that own a significant share of bond proxies underperformed the overall market as a result of higher interest rates, we performed well.
To summarize, we believe that high dividends, dividend growth, and value work. These portfolios offer the advantage of a competitive yield relative to bond alternatives, with the protection of equities if yields or inflation rise.
