Q: What is the history of the company and the fund?
Eric Brown founded Copeland Capital Management in 2005 with a separately managed large-cap dividend growth account strategy. The firm changed in 2009, when I joined along with other members of the investment team. We launched small- and mid-cap dividend growth strategies five to six years ago.
When we launched the mutual fund in December 2010, we saw the opportunity to bring the dividend growth philosophy—which had been largely only a large-cap phenomenon—across the market-cap spectrum. We now offer small-, mid- and large-cap exposure and both domestic and international dividend growth within the strategy.
The universe for this strategy includes all companies that have raised dividends for at least five years and have a market capitalization over $250 million. We also apply some liquidity restraints so that small-cap is not a big portion. We are the only managers doing small- and mid-cap dividend growth.
The firm has grown over the past five years from $100 million in assets under management to $2.2 billion today. In the domestic strategy, the fund has grown to about $600 million in assets. We launched an international version of this strategy at the end of 2012 and that has grown to about $40 million in assets.
Q: How do you define your investment philosophy?
First and foremost, we believe in dividend growth investing. We believe that companies that consistently raise their dividends year after year will outperform the market with less risk than the market.
If we provide alpha and a great adjusted return, and do it by owning only dividend growth companies, we think that is a way to differentiate ourselves and offer a solution for investors.
We have found when you look at the return patterns of companies with different policies around dividends, the dividend growth bucket is, by far, the most attractive from a risk/reward perspective.
The market and non-dividend payers have much higher volatility and lower returns over time. Even flat dividend payers – those that pay dividends but do not raise them – tend to be higher-yield companies that act more like bonds. They have more interest rate risk, and have more risk than dividend growers because they have a great risk of their dividends.
Companies that do cut their dividends tend to be the most volatile with the worst returns.
Q: What is your investment strategy and research process?
We receive information about the dividend growth universe from Ned Davis Research. Their research shows that no matter where you go in the market cap or region in the world, you find that companies with consistent dividend growth outperform with less risk.
It is not just in periods of market volatility when they tend to have their greatest outperformance, either. Over better decades, like the 1980s and the 1990s, dividend growers did well and even outperformed the market.
These companies share many of the same characteristics of dividend-paying stocks in general. But because they grow dividends – rather than just having high and non-growing dividends – they capture more upside and more market participation.
They also provide downside risk protection, which is very important as a strategy.
Q: How do you look for opportunities?
We look for the best dividend growth stocks on a daily basis. We know that if the market and the economy are rough our goal is to own companies that will raise their dividends regardless of the macro economic environment. Our focus is on the fundamentals of each and every company and their prospects for dividend growth going forward.
We prefer cash dividends. This is something that proves a company is effectively generating cash. When a dividend grows every year it shows a company is successfully growing its cash flow over time, which ultimately drives the stock price over time. What is more, when a company raises its dividend, it raises the bar for management performance.
The number of names meeting our five-year dividend growth criteria expanded during the economic upturn. During the 2009 crisis it was below 400 companies, but now the universe of dividend growers includes about 650 names.
We start to pick through those names using a commonsense ranking model. Being a fundamental investing firm, we use a quantitative model to easily identify companies in the dividend growth universe with a higher ability to raise dividends, versus those at risk of a dividend cut.
The model ranks stocks by sector and we use factors such as payout ratios. If we think of the earnings of a company relative to its dividend, or the free cash flow of a company relative to its dividend being paid, we can see how when that cushion between them shrinks, a company is less likely to be able to grow the dividend, and more likely to cut it.
We also look at other quality metrics such as return on investment, which we think evidences competitive management of a business model. Historic and recent growth rates of sales, cash flows, and dividends are among the other metrics that we follow on a regular basis.
From this ranking system, we pick names at the top for our detailed fundamental analysis and inclusion within the fund.
So, to find opportunities, step one is the universe of the five-year dividend growers. Step two is our ranking system, which identifies names with the healthiest dividends. Step three is the fundamental process where we look at identifying both the industry that the company is competing in, the competitive advantages that may or may not have lead to strong cash flow, and dividend growth historically.
Finally, we analyze how the management team is allocating capital. We require them to return cash to shareholders in the form of a dividend. We also examine how they invest in the business for future growth. It is important for us to see an opportunity in the industry and the business and how much run rate of growth may be available to them.
Our team follows the fundamentals of industries and stocks so we can ask whether there is anything we should be aware of that puts the dividend at risk on a forward-looking basis beyond what our model is telling us. For example, if oil prices have fallen, a company’s dividend might be at risk and it is not in the numbers yet.
Q: How do you decide which sectors to invest in?
We had a period in 2012 and 2013 when we were fully invested in all sectors of the market, but today we are substantially more defensive. We are 25% cash and are only invested in three sectors of the market. They are the consumer staples, consumer discretionary, and healthcare sectors. That is because for this month, the sector-signaling system put us in a defense position.
Our strategy has a sector overlay and a sector signaling system that will tell us when price and volatility of price are suggestive of future price declines. The overlay is not macro economically driven; it is technically driven. The sector signaling process drives our exposure to equities versus cash. Typically, we are 100% invested in equities, but when we have fewer than four sectors in which to invest, we will raise cash.
The sector signal is based on a price trend. It is technical in nature but it also incorporates the volatility of the price. We utilize the price action of each of the sector ETFs in the market. We look at how that sector’s price and volatility are acting. When you have a price decline and jump in volatility a sector is more likely to go negative.
We do not fundamentally sit back and try to make calls on the market as a team. Fundamentally we do not try to make bets on where the Fed might go, or interest rates, or where the GDP might be trending. We let price trends determine what those sector signals tell us.
Q: Can you provide examples of dividend companies identified by your research?
Our goal is to marry to companies that can raise their dividends consistently, and at rates well above the marketplace and index rate over time, which ultimately drives the stock price higher over time.
A good example is Steris Corp, a healthcare company that makes disinfection equipment sold to hospitals and to companies in the R&D process for creating new medical devices and need an intense process to make sure everything is sterilized.
It is one of the few domestic providers of disinfection equipment and has a great market position. We found Steris Corp from our ranking model first and foremost, where it was scoring very well. As a healthcare analyst I did more fundamental research to ensure there were no problems with the dividend. It has a more modest dividend yield of 1.5%; we’re not afraid of companies like that.
Steris Corp has been growing at a double-digit pace for at least nine years now. Disinfection and sterilization remains very important to hospitals, and is not typically cut back on, even in tough times.
Steris Corp recently made an acquisition overseas that has some controversy. The FTC initially tried to block it but just recently the company won a court case on appeal. We expect that deal to close. It is with a United Kingdom-based peer called Synergy Healthcare. When the deal closes Steris Corp will probably convert into a foreign-based company, which will have some tax benefits.
Overall this will benefit cash flow and the dividend and its ability to raise the dividend. We see this company having a long track record going ahead of double-digit earnings and dividend growth, aided by the expansion of that industry and the need for making sure that hospitals and medical devices are properly sterilized.
Another example is Bank Of The Ozarks Inc, a small- to mid-cap financial industry stock. It has had 18 years of dividend growth at a rate of over 20% per year, and that has correlated with the price appreciation it has had over that time period.
Although it is a relatively small bank based in Arkansas, Bank Of The Ozarks has expanded into other states by executing an effective acquisition strategy. Its yield is a little over 1%, and it pays out about a third of earnings as a dividend. The company is also reinvesting substantially in the business.
The bank has recently grown its loans at a very healthy clip. It was able to acquire some banks beaten down during the financial crisis, and as the economy improved, acquired other companies too. Bank Of The Ozarks has a core fundamental ability to properly evaluate targets and loan books, and bring its acquisition team in to figure out what price to pay in order to make a deal synergistic and accretive to dividends.
Additionally, their management has a very effective organic growth approach to branch openings. Coupled with recent acquisitions, this has lead to a nice run rate of growth over the past 20 years.
Q: Would you describe your portfolio construction process and your buy-and-sell discipline?
We tend to assign equal weightings to names on the way in, with a typical position of 2.5% to 3%. We let stocks fluctuate based on their price action and trim our winners. The number of sectors we have, and the number of names per sector, will influence our position.
Our sell discipline is organized around limits. We have as much discipline on the sell side as on the buy side. As a result, any company in our ranking system that shows a risk of a dividend cut will be sold. Our sector signaling system will tell us if a sector as a whole, such as energy, is negative and we will sell all names in that sector and bring it down to zero.
Any company that does not raise its dividend is sold, no questions asked.
We typically own between 45 and 55 names. There are approximately five to eight names in sectors with a positive signal. Since we are 25% weighted in the positive sectors today, we have 10 names per sector. Those are all approximately 2.5% position sizes.
Due to the tactical nature of our approach, it is extremely difficult to put a benchmark to the strategy. The most appropriate benchmark would be the Russell 3000 Index or the S&P 500 Index. At times the index is not relevant: when we get defensive, just like in today’s market when we start to raise cash and only own a few sectors, we no longer have the mentality of trying to participate with the market and have equity exposure. We are more defensive in trying to protect capital and we try to provide investors with a less volatile experience.
Q: How do you define and manage risk?
Our core definition of risk is capital loss. The goals of the fund are capital appreciation, dividend income, and income growth.
We evaluate ourselves in terms of standard deviation and beta, as well as our volatility over time. Our beta is 0.65, while our downside capture has been running at 72%. Those metrics are very important to us and our shareholders.
Our risk management tool is the combination of ownership of the superior risk/reward class of stocks together with the sector-signal overlay, which can both lead us to preserve capital and reduce exposure to the market.
