Q: Why and when did the fund originate?

We developed the Strategy in 2003, when interest rates were low and traditional investment income sources for investors were not particularly attractive. Most equity income funds at the time yielded significantly less than their benchmark. Those few funds with higher yields were often more sector-centered funds. 

We envisioned building a diversified equity fund where every stock in the portfolio featured yield. In contrast to fixed income, we could achieve growth in principal, and potentially mitigate the impact of inflation while maintaining an attractive income stream. 

Additionally, focusing on companies that not only pay handsome dividends but also grow those payments over time creates a growing income stream, which fixed income-type products also lack. Existing funds were primarily large-cap-focused, but we chose an all-cap approach because there is a large universe of small and mid-cap companies with attractive yields.

The Strategy was designed with a dual objective: total return and yield. We want to generate as high a yield as we can within the context of achieving a total-return objective. In addition, we want a risk profile that’s more attractive than the benchmark, which in our case is the Russell 3000 Value Index.

Q: What are the assets under management and how does this fund differ from its peers?

We sub-advise mutual funds in the U.S., the U.K, Europe, and Canada. As of September 2016, River Road’s total assets were $6.9 billion, and total assets in the Dividend All-Cap Value Strategies totaled about $5.3 billion. In this specific fund, assets are about $864 million.

What helps set us apart is our focus on value and the all cap nature—there aren’t many all cap equity income funds. 

Q: What core tenets guide your investment philosophy?

Our core philosophy is “Absolute Value®”, a value approach that is ideally situated between the more traditional deep-value and relative-value styles. It is designed to capture the more proven aspects of those styles while avoiding the common pitfalls, value traps, on the deep-value side and more momentum investing on the relative-value side.

We seek to generate attractive, sustainable, low-volatility returns over the long term while emphasizing and minimizing downside portfolio risk. We focus on excellent companies trading at attractive prices, not beaten-up companies.

We look for less efficient areas of the market. One advantage of all cap is that the smaller cap side tends to be less efficient and a bit more subject to market whims—it swings in and out of favor at times, creating interesting buy and sell opportunities.

Additionally, our sell discipline, coupled with diversifying across size, sector, and/or industry helps us to manage downside risk.

Q: Why focus on dividend-paying stocks?

Dividend-paying stocks can outperform non-dividend paying stocks, with less risk. Even with our small cap strategy, which doesn’t have an income mandate, we favor companies that pay dividends.

Also, a company’s earnings, balance sheet, and market share represent backward-looking information. But when a company raises its dividend, that is forward-looking information. It validates the financial information they provide and demonstrates how comfortable management and the board of directors are with the direction of the company and the health of the business.

Q: What is your research process?

Primarily, the portfolio management team generates investment ideas, identifying new opportunities and doing the preliminary work to see whether they merit additional analysis. 

One of the primary ways we identify new opportunities is via “Value Line,” a publication that provides a one-page summary of all the pertinent financials for companies across a large part of the investable U.S. universe. We review that universe week by week, over a 13-week period, four times a year.

We employ screens to look at ideas even more frequently, and maintain a watch list of ideas we’ve worked and owned in the past, ideas we like but need a better price or fundamental change before we pursue it. 

Once we identify a company worthy of further digging, we pass the name to the analyst, who stacks that company up against six critical investment criteria. 

This process is how we build conviction around a name, establish valuation, work through the model, and, when constructing the portfolio, the portfolio managers step in and size the position based upon three major factors: our conviction, the discount to assessed value, and the dividend yield.

Q: What are your six criteria?

This fund’s primary criterion is the high, growing dividend. The analyst assesses the free cash flow profile, and ensures the dividend policy makes sense.

The second criterion is financial strength. The analyst scrutinizes the balance sheet structure, not only the absolute level of debt but capital expenditure profiles and covenants they may have on term loans. The balance sheet must support the ability and willingness to grow their dividend, as significant balance sheet stress can lead to dividend cuts.

Third, we examine price to value. Since we are a value shop, we assess valuation around every position and look to buy at 90% of assessed value, or better, for an initial position.

The fourth consideration is to find companies with attractive business models—predictable, sustainable cash-flow streams that support the dividend stream. We analyze what enables them to sustain and grow cash flow over time, be it a moat, patents, or strong business position. 

Fifth, we want good stewards of capital atop organizations that manage their debt appropriately, buy in shares at reasonable prices, do sensible acquisitions and/or mergers, and divest assets when it makes sense, all while growing their dividend. In addition, we examine how much of the company’s stock management owns, because those who own company stock will want to grow the dividend.

Lastly, we look for undiscovered, underfollowed, and misunderstood companies. The analyst sets out to determine why the opportunity exists and looks for changes in that, over time. 

Once all that is done, the name passes back to the portfolio management team, which vets the idea with the analyst—an iterative process that involves a lot of back and forth. We contact management with any specific questions and dig further into the company.

Among the last steps is establishing our conviction. We use a numerical scale of 1 to 5 for each of our investment criterion and then those roll up into an overall conviction.

The idea is to ensure sizing of a position balances conviction, discount, and yield in a manner that supports the overall objectives of total return, yield, and lower risk profile.

Q: Can you provide an example that illustrates your research process?

Microsoft Corp. is our largest position. It currently holds the highest overall conviction position in the portfolio. 

A large part of Microsoft’s value lies in its under-appreciated Enterprise business. That under-appreciation is slowly changing as that business continues to do extremely well and grows rapidly on the cloud. 

We believed that change would drive value for Microsoft shareholders. Moreover, they’ve increased the dividend by more than seven times since it was first paid in 2003, and increased it another 16% in September 2015. Microsoft’s financial strength is solid. They have some debt, but that’s dwarfed by the cash balance. When we acquired it, it was trading at an attractive discount. 

We generally view valuation in terms of EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization) over the coming 12 to 18 months. In the case of Microsoft, we work through the revenue line and market cap gain to bring it down to what, to us, is a more appropriate EBITDA. We place an appropriate multiple on that to arrive at our assessed value.

When we look at the business model, we see the network effects around the Microsoft Office Suite as well as on the Enterprise business. They possess dominant market share, high switching costs among their three key product suites, Windows/Office, the Windows back office server database, and cloud businesses. Together, these represent a large part of the business and generate the high consistent returns necessary to support the dividend.

Insiders own a significant percentage of company shares, which might account for its strong dividend growth. We have also seen capital allocation change under its new leadership, which pleases us, as that allocation under prior leadership was a concern. 

Lastly, in our criterion of undiscovered, underfollowed, and misunderstood, it has done extremely well in recent years around cloud growth, and clearly some of the opportunity we saw is now more commonly understood.

Q: How do you construct the portfolio?

Our portfolios are built bottom-up in terms of company, industry and sector weightings, and that is a function of where we find value at any given point in time and our associated conviction level in those holdings.

We seek to accumulate individual opportunities that, together, meet our overall objectives, sizing based on the specific conviction, discount, and yield, letting the larger positioning aspects, like sector and market-cap weightings, sort themselves out. 

We have three main points to our sell discipline. When a stock hits 100% of assessed value, we have the analyst ensure it reflects our current information. At 110%, we typically begin to trim, but when it hits 120% of assessed value, we must be out. We would also exit the position if dividend support declines, or we see issues around our thesis playing out.

Lastly, we manage unrealized losses in the portfolio, beginning by not compounding them. Once we establish an initial target position for a company, if the price drops, we do not “average down” by buying more. 

When individual losses accumulate, we implement our portfolio stop-loss process, taking every position trading at a net unrealized loss, totaling those unrealized losses, and dividing that sum by the portfolio value to determine what percent of the portfolio it represents. When that number exceeds a certain threshold, it starts a triage process. The portfolio managers analyze that list of losers every week and meaningfully reduce at least one of them, until we move back below that threshold. 

Diversification is important to us. We want a properly diversified portfolio, not only by sector or size but to introduce different structures, such as real estate investment trusts and master limited partnerships that have substantially higher yields.

We hold between 60 and 80 positions in the portfolio in order to reduce stock-specific risk. No position ever exceeds 5%. We keep cash below 5% and we allow no more than 30% in any sector. Our limits are not relative to the benchmark—they are absolute limits. 

Having a portfolio of high-quality stocks that pay and grow their dividend over time makes for a good portfolio, but there are two potential concerns we are vigilant about: paying too much for them, and holding something too long, because it gets expensive or experiences problems and loses money. We trim things if they get expensive and/or if the fundamentals begin to erode.

Q: How do you define and manage risk?

Many active managers focus on benchmark risk, but, for us, risk is about losing money. We focus on the business risk of individual companies—the risks they face and whether they might fail to perform as expected—as opposed to how we perform relative to something else. If we minimize downside well, then we don’t have to outperform dramatically on the upside to do well over a complete market cycle.

Our sell and buy disciplines manage risk through appropriate sizing. We work hard to maintain a similar risk profile during both good and bad times, and have spent considerable time developing management guidelines to help manage risk consistently.