Q: What is the history and investment philosophy of the fund?
Although the Guinness Atkinson Dividend Builder Fund was launched on March 30, 2012, the fund’s co-manager Ian Mortimer and I have been working on the strategy for longer. After becoming interested in companies that generate high return on capital, we started developing the philosophy behind this fund in 2010.
It was our belief that companies that consistently generated returns on capital above their cost of capital would make true cash profits – and ultimately accumulate wealth so long as returns remained consistent and cash was reinvested.
To examine this idea more thoroughly, we looked at 25 years of history for approximately 16,000 companies and identified 500 or so that met our criteria of consistently high return on capital.
Drilling deeper into this universe revealed a number of interesting things about the companies. We found an extremely high level of persistency in those with a 10-year history of generating very high return on capital, meaning they were likely to continue to do so.
As a group, they were attractively diversified across defensive industries like consumer staples and health care, as well as in growth sectors like consumer discretionary and information technology. They were geographically diverse as well, with roughly half in the U.S., a third in Europe, and the rest in Asia and emerging markets.
Most interestingly, about 90% of these high-return-on-capital companies paid dividends, and many were growing the dividends consistently. Not all were necessarily high yields, but solid, and on average had a yield well above the benchmark.
So, having identified such a robust set of companies, we thought it was an attractive starting point from which we could build a concentrated portfolio of dividend growth companies. The strategy was originally offered in Europe as a UCITS funds, or a mutual fund based in the E.U. After seeing demand for the strategy in the U.S., this fund was launched in 2012.
Today, assets under management for both strategies exceed $450 million.
Q: Would you describe your investment process?
Our process starts by identifying companies that have generated a high return on capital each year for the past 10 years. It is a very difficult screen for companies to meet and excludes around 95% of companies globally. We then look for a strong balance sheet and a market cap of over a billion dollars and that comprises our investable universe of about 500 companies.
To narrow this list down to a portfolio of just 35 names, we apply a strict discipline that assesses value in a number of ways.
First, we search for companies trading at a discount relative to their own history; a company trading below its average price/earnings (P/E) or EV/EBITDA over the last 10 years would be attractive.
When we find a company that has been trading one standard deviation below its historic average multiple, it poses several interesting questions: Will its return on capital actually stop fading? Has the market perhaps overreacted to a negative narrative about the company, a story we can disagree with?
For example, in 2012, some defense companies were trading at one to two standard deviations below their historic averages due to concerns that the fiscal cliff in the U.S. could lead to large cuts to government spending. To us, though, the situation didn’t appear overly dramatic, so bought a couple of stocks and saw rapid re-ratings after that based solely on that multiple expansion.
The second way we look at value is versus peer groups. Because a company can appear expensive relative to its own history but cheap relative to its peers, we want to be sure not to exclude these opportunities.
Third, we use reverse discounted cash flow analysis to figure out the long-term growth rate baked into a company’s valuation.
In each of these crucial valuation steps, we are drilling into everything that may be a risk to a company, including fundamental factors like its balance sheet and credit metrics. We assess its return on capital to see whether it’s growing or fading, and what the main contributor to this evolution is.
Finally, we look at a company’s dividend. Having this as the last step is quite unique among dividend funds, which normally begin by screening for a specific level of yield and then determine whether a business is attractive.
Q: Do you invest in non-dividend-paying companies?
Our quality criteria are applied to every company around the world. The crucial point, though, is that while 90% of the companies that remain after this screen do pay a dividend, we think all of them have the ability to do so. Then it just comes down to the priorities of management and the board regarding how they want to spend cash.
If a company hasn’t yet paid a dividend, we won’t invest in it. However, if our conviction is strong that it will begin paying one in the near future, we might add it to our watch list so long as the company was otherwise attractive. So far, though, we haven’t run into this.
Q: Can you highlight your process with an example?
Northrop Grumman Corporation, an aerospace and defense technology company, comfortably met our criteria for high return on capital, which at the time was one standard deviation below the 10-year historic average.
We moved forward on Northrop with modeling and due diligence and looked back over 15 years of company financials to learn how the company had evolved and grown. Generally, we examine things like growth rates, margins, and the evolution of working capital to see how a company has spent its cash historically.
This analysis of capital spending is further broken down: does a company pay a dividend, buy back shares, make acquisitions, or repay debt? Has it been consistent or erratic? Has the company grown organically then suddenly started making big acquisitions? Also, we assess if projected free cash flow will be sufficient to cover any dividends.
After going through this entire analysis Northrop still appeared attractive, so we moved on to valuation. Compared to its peers, the company looked good and its traditional valuation metrics were compelling.
We then progressed to a more subjective analysis of the industry trends, U.S. defense spending, and the fiscal cliff – the word “cliff” is a decidedly emotive word for investors, but it signals opportunity to us. From what we could see, it seemed like defense spending would pick up after a small decline lasting two to three years.
Ultimately, Northrop met all our criteria and became a candidate to go into the fund. We acted swiftly on it because there was an opportunity to get in at a cheap valuation. Just 12 months later, we sold the company because we saw a rapid re-rating just in terms of that multiple expansion.
Q: Would you discuss another example in a different country or industry?
Novo Nordisk A/S, the Danish healthcare company, has quite a strong business and high return on capital. At the beginning of 2017, many healthcare and pharmaceutical companies had been de-rated as a debate about drug pricing in the U.S. had taken off around election time.
In looking at Novo’s valuation, we saw that 18 months earlier it had been trading on plus-two standard deviations relative to its history; by the time we bought it, it had gone to minus-two standard deviations – an extremely quick de-rating.
The company’s earnings expectations had been reduced, so we waited for that to turn around. For us, earnings momentum is a key consideration because of the risk of value traps. Although we’re less likely to face them because companies with high return on capital provide us with a bit of defense, it’s still possible for them to occasionally become value traps.
With Novo, our concern over drug pricing pressure was more of a concern if Hillary Clinton had won the election, but the unexpected outcome of the election provided us with our opportunity to invest.. Also, the company had net cash on its balance sheet which we liked. We ended up taking a slightly contrarian position going in and the purchase has done well for us so far.
Q: What is your portfolio construction process?
Portfolio construction is a balancing act of getting the best ideas in, controlling sector weights and risk, and hopefully creating additional performance.
To ensure only the best ideas are in portfolio, we limit the number of holdings. The fund has 35 names 95% of the time, with exceptions for the occasional stock split or if we urgently want out of a position. Holdings are kept fresh with our one-in, one-out policy; in order to buy something new, something must be sold.
As a starting point to find our best ideas, we run a screen on the Credit Suisse HOLT database of 20,000 companies worldwide and identify those which have generated a return on capital of more than 10% in each of the last 10 years.
Where a company is listed geographically isn’t a concern to us. What matters most is that we ensure the portfolio offers our investors an average return on capital that is substantially higher than the benchmark, but with a valuation that is equal to the benchmark or preferably cheaper.
To do this, we want the portfolio to have companies that are paying sustainable dividends. Although there’s no absolute level of yield that must be met, typically dividends are 10% to 20% higher than the benchmark.
The portfolio is constrained to a maximum of 30% in a single GICS sector and no more than 20% directly in emerging-market companies. All positions are equally weighted to just under 3%, in part to limit the fund’s stock-specific risk.
We create additional performance by rebalancing the fund. Rather than trying to second-guess the market, we think our time is better spent using its volatility to our advantage by rebalancing when companies are more in favor than out of favor.
Rebalancing isn’t done just for the sake of it; it doesn’t happen on a mechanical, regular basis, but generally occurs three or four times a year as needed. A position going up to 4% would flag us to consider rebalancing it down, and if one dropped to 2%, it would flag us to consider rebalancing it up. Should a position underperform, the act of rebalancing forces us to consider whether we want to continue to own this company, and if we can’t bring ourselves ot buy some more, then it’s probably time to sell it.
Finally, we want the portfolio to express a high active share; typically, ours falls between 90% and 95%.
Two analysts provide support with stock analysis and idea generation, and we’re all generalists. It’s the best approach for us, because to understand global context we need to look at every type of business. When viewing growth industries like IT, semiconductors, or hardware, having this perspective is particularly important as it allows us to see a company not only in the context of its peers but also of in that of other industries and sectors.
Decisions about what goes into or out of the fund are made jointly by me and the fund’s co-manager. It’s a relatively streamlined process – there are no big committees – but we have to reach a consensus and agree.
The fund’s benchmark is the MSCI World Index, although we tend to be agnostic when building the portfolio.
Q: How do you define and manage risk?
To us, risk is the potential for a permanent loss of capital. We don’t think of volatility as risk, but as market inefficiency that we approach by applying our value discipline.
Even though the fund isn’t managed to a benchmark, we recognize that our performance will still be measured against it. This means we keep an eye on the fund’s over- and underweights relative to the index and also think about them in the context of what’s happening in the world.
More broadly, risk management is built into our process. We know from our quantitative analysis that when things get particularly discouraging – whether from a recession, market dislocation, or some kind of external shock – the types of companies we invest in tend to outperform on a relative basis.
Actually, companies with consistently high returns on capital tend to be able to use difficult periods to their advantage. Their stronger balance sheets help them sail through and remain profitable through challenging cycles, and perhaps even fuel their growth by allowing them to buy businesses that are less well-capitalized.
