Q: How has the fund evolved since inception?

A: The fund was established in 1996 because many of our investors were interested in a dividend investment philosophy. We started the fund to meet that need.

The strategy evolved over time to become more oriented towards dividend growth, because it provides a real benefit to shareholders. Breaking down the returns of dividend-paying companies, we observed that companies that grow their dividends have outperformed companies that have not grown their dividend over time.  And both of those groups perform better than the companies that reduce or eliminate the dividend.

Q: What core principles drive your investment philosophy?

A: We look for companies with good businesses, which means businesses with a durable competitive advantage. We like financially strong businesses that don’t have a lot of debt. We believe that a key element of a good business is the strong management team, which is innovative and responsive to customers and employees. We want these managers to be honest, ethical, and foster a high performing culture.

Growth is another key element of a good business. We need companies that can grow over time. Growth allows a company to invest more in their business such as research and development or hiring more sales people.  A really good business generates more cash than it needs which can then be paid out to shareholders as dividends or used to buy back stock, both of which add to investment return. 

We do a lot of valuation work and we aim to invest in companies trading below our estimate of their worth. We try to pay a discount to that price. This helps to control downside risk of the investment.

Finally, we manage the fund in a concentrated fashion. As of December 31, 2019, there are 32 names in the fund which has been a pretty typical number over the fund’s 23-year history. We spend a lot of time researching the companies and we want each of our investments to make a meaningful contribution to the performance. We are not afraid to have large position sizes in the portfolio.

Q: How does the fund differ from its peers?

A: Many of the funds using a dividend strategy are large-cap funds. Their investment universe is the S&P 500 Index and these funds may invest in 200 or 400 names. By definition, they essentially own the same names.

Our Dividend Focus Fund operates more in the mid-cap space, so our universe is significantly different. Mid-cap companies tend to grow faster than large-cap companies which provides more appreciation potential. Dividends for mid-cap companies also tend to grow faster than in the large-cap universe.

Q: Would you describe your investment process? Where do ideas come from and how do you evaluate their investment merits?

A: Our investment process starts with screens. First and foremost, we look for companies that pay a dividend. Second, we look for dividends that grow over time. We like to see companies with a long history and an approximate 10% compounded dividend growth rate over the last five years.

The next step is looking for companies with low levels of debt and high return on invested capital. We examine their reinvestment opportunities and how steady the business has been. We like to see growth in the top line, margins, and cash flow over time. The company should be generating enough cash to reinvest into the business. These financials allow the company to pay dividends and to grow them.

Another factor is the share count and whether it is going up or down. We like the combination of a growing dividend, share buybacks and a decreasing number of shares every year.

The screening process is the easy part. The difficult part is the qualitative evaluation. At this stage, we talk to the management, visit the company and participate in analyst meetings. The goal is to know the company well and to understand its key growth drivers. How does it keep the competition at bay? What percentage of the revenue is recurring? Will margins shrink or expand going forward?  Is the return on capital better than average and moving even higher?  Multiple factors go into this analysis to make sure that there is an enduring runway for growth.

Once we make an investment, we seek to visit the company each year for a face-to-face meeting with the management. We typically hold our investments for many years. There are companies that we’ve owned for over 15 years; we’ve owned a third of the portfolio for more than seven years. I believe this long-term investment horizon gives us an edge.

Q: Is screening the only method to generate ideas? How many new names do you include each year?

A: We do a lot of reading and we go to many conferences, so an idea can come to us many different ways. We read Wall Street research - various Wall Street firms publish a list of their best ideas. Sometimes other investors talk to us about investments that may fit our criteria. Overall, most of our idea generation comes from screening, but we always keep our ear to the ground.

In our mid-cap universe of companies from $2 to $40 billion market capitalization, there are more than 800 companies that pay dividends.  It is a large universe and we only own 31 names. In any given year we only need to invest in three to five new names, so the universe is large and gives a lot of opportunities.

Over time, we have seen companies that outperform our valuations and expectations. I call such companies “compounders.” They have a competitive advantage, a long runway for growth, reinvestment opportunities and high returns on capital. The compounded return on these names can be much higher than our internal estimates, so we like to hold them. We don’t necessarily trim a stock only because we think it might be a bit ahead of itself. When we look at the compounders, we actually want to own more shares over time, not fewer.

Q: How do you assign value to each company?

A: We primarily use discounted cash flow models. We also look at historic multiples, including P/E, EV/EBITDA and EV/Sales. We compare the value we reached from the discounted cash flow model to the historical multiples for those companies. That represents a reality check to see if a stock has ever traded at that valuation. It also shows some of the potential portfolio risks.

We like conservative managements and companies that run their business without a tremendous amount of debt. We may make an exception for a company funding an acquisition with debt if the management commits to paying down the debt quickly and returning to a lower level of debt.  We also make sure that we don’t invest in companies with a history of dividend cuts. Studying the past is important to make sure that what led to mistakes in the past are not repeated.

For example, there have been tremendous boom and bust cycles in energy historically. As a result, when investing in an energy company, we believe that the most important thing is to look at the balance sheet and to make sure the company isn’t overleveraged. We avoid overleveraged companies because nothing good happens to those companies when the cycle turns.

Q: Could you illustrate your research with an example of a long-term holding?

A: Ross Stores, the off-price retailer, is a top10 holding in the fund. We bought the stock in 2001 and we have owned it continuously since then. The company has more than 1,800 stores in 39 states and the management targets 3,000 stores in the U.S. It has a long runway for growth. Each year they add 90 to 100 stores, which tend to be in strip malls.

The advantage of Ross Stores is that it provides apparel at prices, which are 40% to 60% below department store prices. The stores offer a treasure hunt environment, where people don’t necessarily know what they are going to find when they go into the stores. As long as their customers find an item or two when they visit a store, Ross Stores remains top of mind and customers are likely to go back the next month. The treasure hunt experience and the frequent changes of the merchandise helps to combat e-commerce competition and to keep Amazon at bay. But we are always on the lookout for changes to that situation.

The company has delivered terrific results in contrast with mall-based apparel retailers, which have been disastrous over the last few years. Ross Stores continues to generate strong same-store sales. They not only increase the dividend each year, but also buy back shares religiously. The share count is down 28% in the last 10 years and 42% since we first bought the stock in 2001.

We trimmed the position in 2006 because we doubled our money and decided to put that capital into investments with lower valuations. Looking back, we never should have sold those shares of Ross Stores. The return since May 2001 has been 3,917 percent. That example illustrates that doing the homework upfront and then holding the shares can lead to great results.

If Ross Stores was only a 1% position in the portfolio, it would not contribute much to the performance. That’s why many of our top 10 positions have been larger, long-term holdings. They rise to the top over time because we try to not trim these names on valuation, unless they get obscenely expensive and present too much downside risk. Our strategy is to hold onto the winners. It took us several years to figure out that this is not a company that we should be trimming. We are not afraid to have large positions; currently our largest position is 7% of the fund.

Q: Why did you choose Ross Stores over TJ Maxx?

A: At the time of the initial investment in 2001, TJX was trading at 15 times earnings and Ross Stores was trading at 10 times earnings.  We thought that if Ross closed the multiple gap, we would do quite well. The company actually managed to increase same-store sales and add new stores and geographies. Ross Stores was able to grow faster than TJX, because they had fewer stores at the time. TJX also had an international operation that we weren’t comfortable with.

However, we keep a close eye on TJX to make sure that Ross is tracking with the industry and that the industry is healthy.

Q: What gives you the conviction to hold a company for a long time?

A: We meet with management every year, which is tremendously important when the markets are choppy and the stock is trading down. Our conviction is built up over time by owning the name, seeing the results, and knowing how the management will respond to the environment. That’s important for committing capital at the best times in the market cycle.

In the case of Ross Stores, it was important for us to understand that the vast majority of the people who walk into their stores buy something. Any retailer that can convert most of their traffic into paying customers will almost certainly be a huge success.

Q: Can you cite another example of a specific stock holding?

A: CDW is a reseller of PCs, laptops, servers and routers; basically any IT product that small or mid-sized businesses would need. We owned shares in the company for a few years before it was taken private in 2008 by private equity.  After it came out from the private equity, we bought the shares again. The company is slightly different now. In addition to the products it had before, it provides solutions for small and mid-sized businesses in the areas of security, mobile solutions, cloud computing, virtualization, collaboration and data center optimization. They’ve done a great job in helping customers who don’t have large IT departments.

CDW’s goal is to grow 200 to 300 basis points faster than the U.S. IT market.  Its market share is only 5%, so although it is a fairly large company that has grown over the number of years, it also has a long runway for growth. As the company gets larger, we believe they become more advantaged versus their primary competitor, which is the local value added reseller.

In each market there are local value-added resellers, who typically specialize in a single vendor solution. The industry requires them to be certified and licensed in a particular technology and it is expensive to maintain a certified workforce. CDW, on the other hand, is agnostic to the hardware used for the solution; its employees are licensed and certified in many different technologies. They are able to get vendors on the phone with customers to architect a particular solution, so CDW provides a better experience for the customer.

In comparison with distributors like Ingram or Tech Data, CDW has higher profitability because of the solution content and the added value they deliver to their customers. That’s why we believe that its competitive position is getting stronger and their growth will be enduring.

Another reason for the growth is the concentration on certain vertical markets, such as education, health care, and government. In fact, CDW provides the tablets that the census workers will be using.

On the financial front, the company grows the dividend as fast as the adjusted net income, while reducing the share count each year. When it came out from private equity, CDW had high-cost debt. It was paying 18% interest on a large portion of the debt, held by the private equity firm, but the management was committed to paying it down.  Once the debt decreased to a manageable level, they began to make acquisitions, which have been additive to the results over time.

Q: What is your portfolio construction process?

A: We construct the portfolio company by company. On the one hand, we let the compounders compound and they naturally become a larger percentage of the portfolio. On the other hand, the companies that don’t meet our expectations are moved out of the portfolio fairly quickly.

Our benchmark is the Russell Midcap Index. We don’t target a specific exposure to sectors or industries, but we pay attention to our exposure. We have guardrails around the sector exposure to make sure that no sector gets too large. The guardrails are two times the benchmark weighting for any sector. We like to have holdings in every sector, if possible. We don’t have anything in communications, because it consists mostly of large-cap companies, while the mid-cap companies aren’t very attractive in our opinion.

We typically keep our cash well below 10% and prefer to be below 5% of assets. At the end of the last quarter we were closer to the 10% mark because we thought there may be some attractive investment opportunities during earnings season.  Today the cash is much lower.

Q: How do you define and manage risk?

A: By investing in companies that pay dividends, the fund has generated better than average returns at below average risk, according to a third-party analyst. The second component to reducing risk in the portfolio is our aversion to high levels of debt. We don’t invest in companies with too much leverage, because during market corrections these companies typically do the worst.

We define risk as the permanent loss of capital, not as volatility. To us, volatility is opportunity, while risk can lead to permanent loss of capital. Risk is inherent to the investment process, but we believe our advantage is that we invest in higher-quality names, which tend to be less volatile. The dividend aspect certainly helps to control risk as it has historically provided stability during turbulent markets.

Our portfolio is concentrated in 31 names, but studies show that you can diversify away enough risk with only 20 names. We all use the Dow Jones Industrial Average as a proxy for the market, and it consists of only 30 names. In comparison with the S&P 500, the Dow Jones has done a little better over time. In down markets, the Dow has fallen less than the S&P 500.  That’s an easy way to illustrate that a 30-stock portfolio isn’t necessarily risky.