Q: Can you give a brief history of the fund?
Founded in 1988, the fund first focused on dividend-yield investing. The primary concept was to buy companies with a high divided yield; when the yield declined because the stock price had risen, we sold it and bought something else with a high dividend yield.
I became fund manager in 2005. Then, in 2007, the strategy changed to what it is today. Presently, it focuses more on the yield of the portfolio and building a fund with high-quality, dividend-paying stocks. Our goal is to pay out a distribution at net asset value (NAV) at or above our benchmark, the S&P 500 Index, while providing a good level of income to our shareholders.
The fund’s assets under management at the end of August were about $1.96 billion. We also manage another insurance product with a similar approach with assets of about $275 million.
Q: What core beliefs guide your investment philosophy?
Our overarching belief is that companies that pay dividends, particularly blue-chip companies, provide better-than-market returns over the long term. We believe this happens because companies that return money to shareholders in the form of dividends are more focused on earning a good return and have tighter capital discipline.
To our way of thinking, companies that historically pay dividends are better capital allocators. Such businesses are less likely to make a misguided or inappropriate acquisition that could destroy shareholder value rather than create it. They also make wise decisions with company cash in various capital projects other than acquisitions.
Another characteristic we want to see in a company, in addition to better-than-average returns on capital, is better margins. Most companies in the fund have a sustainable competitive advantage over their peers and have strong competitive advantages in the markets they compete.
Q: Do you require a company to have a rising dividend or minimum dividend growth?
No, we don’t have strict criteria governing these. At the security level, we do not even have a specific yield requirement. But as I mentioned before, our goal is to distribute at NAV, so that after expenses we offer a level of yield greater than the overall market on a portfolio level.
We like companies that are raising dividends because that is certainly a sign of increasing cash flow. We also think strong payout ratios are attractive—but only when they’re reasonable enough to allow companies to reinvest as needed to continue growth.
Q: What is your investment strategy?
After we screen for dividend-paying stocks, we use a fairly complex and sophisticated security selection process driven mostly by bottom-up fundamental research.
Our research team primarily includes equity analysts, and to a lesser extent we work with the analysts at our fixed-income group. Each analyst covers one or more industries; they have expert understanding of the competitive dynamics of the industries and the relative strengths and weaknesses of companies within them. They are critical in our security selection.
The analysts use financial models to value a company in the future based on earnings and cash flow. Then, after applying a discounted cash-flow model, they formulate a current value of the company’s stock.
Typically they consider different scenarios—like a bear case, a base case, and a bull case—and come up with stock valuations for each, weighing up the different outcomes to set a blended price target. They assign ratings, basically a more sophisticated version of “buy, hold, or sell.” The analysts tell us what they like within their industry and essentially recommend what securities we should be holding.
As portfolio managers, we work with the analysts to understand the strengths and weaknesses of a company. It is important to understand where risks lie, what drives a company’s performance, and what outside influences it may be susceptible to—like economic or commodity cycles, or perhaps events with geographic exposure.
Then we evaluate each individual company to see how it would fit in the portfolio. What would it add in terms of our expected return and risk? What would it take away? Using this input and overlaying a certain yield distribution, we build a diversified portfolio that meets our income goals at the dividend level, follows our philosophy, and gives good risk-adjusted returns.
Q: Would you illustrate your research process with some examples?
One of our top holdings is Microsoft Corporation, the software developer. The company has had a good history of increasing its dividend for the last decade or so and has very strong cash flow. Its brand and market position give it a very strong competitive advantage. We became very excited by Microsoft’s move to Office 365, which took the Microsoft Office franchise to a cloud-based subscription model available online.
Also, on the enterprise level, the company competes with Amazon.com Inc.’s hosted web-services business. Microsoft is one of the top players in that industry; this scale brings a great economic advantage and makes it difficult for others to compete.
Something we like about the evolution of moving products into the cloud is that companies are able to capture a greater piece of the technology value chain. Not only are they paid for their software but they no longer have to provide a lot of hardware or technical support. That is all handled by the Software as a Service (SaaS) provider. Companies pass some of those savings along to customers, but they also capture some in the form of profits.
These factors encouraged us to buy Microsoft quite a while ago, and as I said, it is one of our top positions. At present, it has a 3% yield.
Another holding is L Brands Inc, the fashion retailer that includes Victoria’s Secret and Bath & Body Works. Again, its brands and store experience give it a competitive advantage and it is seeing a lot of growth overseas and online. The company has had strong cash flow and has been disciplined about returning cash to shareholders.
In addition to growing the dividend in the last 10 years, over the last five years the company has also paid out a significant amount of cash in the form of special dividends. The company has been a great source of yield and a strong performer for the fund.
Q: How do you construct your portfolio?
We own only our best ideas and own them in a size that matters—enough to have an impact on the fund if they perform well. If we have less than full conviction in a company, we won’t own it at all.
Other factors we consider when building the portfolio include drivers that may affect companies but remain outside their control: exposure to commodity prices or emerging markets or government actions or regulations or movements in the economic cycle.
The portfolio is diversified to control risk with a target of about 2%–3% as a full position. At the end of August, we held 59 positions in the strategy, with 2.6% in the top holding and 2.15% in the tenth holding. On the sector level our largest position at that time was about 16.5% in industrials.
Q: How did you select the fund’s benchmark?
Originally, the fund’s primary benchmark was the Russell 1000 Value Index, with the S&P 500 Index serving as a secondary benchmark. When the fund’s strategy changed in 2007, it was no longer a typical value strategy to the extent that value involves an analysis of price-to-book when searching for undervalued stocks.
So we went away from the value benchmark and selected the S&P 500 Index as our current benchmark. Since we seek to compete with the overall equity market, we feel it is the best representation of that.
Q: What is your definition of risk? How do you measure and manage risk?
It is part of our business to take risk. However, we want to make sure we get paid to do so in the form of our expected return on the investment. A lower return may be more attractive than a higher one if a lot of different outcomes and risk are involved.
Risk management starts with our analysts and their “feet on the street” understanding of companies and industries. By examining every piece of data they can get and talking to primary sources like company suppliers and customers, they know what is going on, the trends and drivers, and how they will likely play out. It is this kind of day-to-day monitoring that gives us the best risk management tools.
From a traditional risk management point of view, a dedicated team within Franklin Templeton provides us with detailed and quantitative analysis. Their primary concerns are volatility and diversification, and they report on which holdings represent the greatest risk to the portfolio. We use that information to make sure the likely return from riskier names is good enough to compensate us for that risk.
At the portfolio level, we mitigate risk by keeping position sizes below 3% and look at sector weightings relative to the benchmark. Lastly, the interplay between different companies in a sector—even if they may be in different industries—shows us what the macro drivers are. We take that into consideration when managing the portfolio.
