Q: How is NFJ Group affiliated with PIMCO? A: We started out in 1989. Because we did that, we have certain privileges, as far as autonomy goes, than other firms that were bought a little bit later. We have complete control over who we hire and what we buy or sell in our portfolio. Q: Moving onto the fund's philosophy, you combine value with dividend paying stocks. How is it these days for this particular area of the market? A: Since we do buy out-of-favor stocks, we should be getting a chuckle on anything we buy if we're doing our jobs right as contrarians. Being independent, and not having that political pressure from the top as to why we bought that name is really key to making our style work. That's saved us during the bubble period in 1998, 1999 and early 2000. If we had changed our style to the prevailing knowledge at the time that we were in a new economy and a new era, we certainly wouldn't have the returns that we've posted to date. Q: You also work with a team of two other managers. A: We are a real team of six around here. We don't have any stars. We certainly don't want to give the impression that any of us is more important than the other. We do run it from a strict process and strict discipline. The way we pick stocks is whoever has the idea, becomes the champion of that name, does the research and then walks up and down the hallway and defends that name. Q: In your overall strategy, you prefer to search out for low PE stocks. That also entails a bottom up approach. Can you elaborate? A: We are an absolute value shop. Where we shake out as far as sector weighting is a fallout from our process. We are bottom up. We are firm believers that if you stick to a process of buying low price-to-earnings, price-to-book and price-to-cash flow stocks and then require a dividend, the higher the better, over time you're going to beat the market. Q: Such a strategy can't be measured by the short-term results. A: Obviously we underperformed in the first quarter. And that's going to happen. If the first quarter was a situation where your stocks paid a dividend and no one had any interest. Since all our stocks pay dividends, obviously we would under perform. Low PE is an absolute necessity for inclusion of a stock in this portfolio. And we're also looking for a very good yield as well. Q: This is a fund specific issue. The A share class was initiated in the third quarter of 2001. From what I can tell from the chart, shareholders that invested at that time are not only ahead in terms of NAV, they're also ahead of the S&P 500 benchmark. A: Usually we're held to the Russell 1000 Value Index. We've beaten it, and by a wide margin. We literally bet this firmly that value would come back in early 2000. It got pretty depressing around here when everybody knew that dividends didn't matter, low PE was antiquated and was no longer an issue in stock selection. The returns you see there are an indication of what we were buying back in 1998 and 1999. I think the fund had a PE of under nine for the entire portfolio and the yield actually hit about 5%. We kept the product pure and we knew if it did come back, and we were confident it would, that it would be looking good going forward. Q: The turnover ratio is very low. Anybody who buys for a dividend has a long-term horizon. They wouldn't matter to a trader. A: A great fall out of this is it's become a tax-efficient portfolio. Since the turnover is low, I think most of the sells will be long-term capital gains. The fact that the dividend yield is so high, with the tax break, it really makes it that much more attractive. We're looking at a 4.7% dividend yield in the portfolio and a PE of about 10.5. Q: That PE is roughly one-half that of the S&P 500's trailing 12-month multiple. A: Right. Buying low PE consistently will beat those high PE names. It's always been that way. It's been very, very consistent. Q: With a current composite yield of 4.7%, how does it relate to what George Bush signed as the Jobs and Growth Tax Relief Reconciliation Act of 2003 that we understand as the dividend tax relief bill? A: It all depends on their marginal tax rate on their ordinary income. Then you compare that to the 15% tax on the income, probably 10% for the average investor. If you are up to the 35% marginal tax bracket, it actually becomes more attractive. And that's great for us. When people think of dividends, it’s funny in the consultant community, a lot of times when people ask for dividends, NFJ comes to mind. Q: How did the alliance with PIMCO actually start? A: We're called NFJ because of Chris Najork, Ben Fisher and John Johnson. These three guys ran the trust department at Republic Bank in Dallas. After all the Texas banks failed, Hugh McColl with NCNB bought Republic. They tried to work a deal with Hugh to manage the trust assets and Hugh would have nothing to do with it. Fortunately at that time they had some fantastic returns as well. PIMCO was looking to augment Bill Gross with some equity managers. These guys became the value managers for PIMCO back in 1989. Q: One thing about the tax savings for mutual fund shareholders is the ‘bang for the buck,’ but also an incentive to reinvest dividends to achieve the benefits of compounding. A: That is an absolute requirement if you are going to be a dividend receiver and a dividend lover. You can't spend those dividends on movie tickets. You've got to reinvest them back into the stock market. That's the main reason that dividends account for about 40% of your total return since the 1920s. You can compound a cash dividend. You can't compound market appreciation. You let that eighth wonder of the world work for you in this case. That is why dividends are so important for total return. Q: What about stock buybacks? A: People ask me if stock buybacks are the same as dividends and they're not. In a stock buyback situation, there are three things to look at: First, if you look at how many stock buybacks are actually completed, you'll learn that about half of them are not. Second, it's not you valuing whether the stock is cheap; it's the company management. They are definitely not a dispassionate source of neutral information as far as stock values go. They tend to buy on emotion, which we do not. Third, when they have stock buybacks, you're likely to see those shares reissued as options at below market prices. I think there is a tendency to become deluded, as a shareholder, when they announce stock buybacks. Q: A lot of noise made about the buybacks by these companies but very little is said about the re-issuance. A: I tell you, if you would look at some of the prices that some of these companies buy their own shares back at, it's pretty embarrassing. They tend not to be very good valuators of their own shares. I say, ""Give me the cash."" If I think you're undervalued, well, I'll be the first to buy more shares. Otherwise, I'll go somewhere else. It transfers power from the company management to the actual stockholder. That's why it's such a benefit to the shareholder to get that dividend. Q: You're the long-term expert that has studied dividend-paying companies. Do you have a preferred list that you maintain? A: What we do on the Equity Income Fund is we take the thousand largest names. We eliminate those names that we would never buy, obviously those that don't pay a dividend, and those that have a price-to-earnings multiple above the average of the S&P 500. At that point, we utilize some timing models such as price momentum – we don't want to buy that falling knife. We will use price momentum to let us know when a stock has reached a base where that knife has stopped falling. Also, we use earnings revisions. If analysts are just starting to cut earnings, they tend to herd just like individual investors do. When they start cutting, they tend to do it in slices. If they start cutting, you can expect three or four to be coming down the pipe. So, these models keep us from buying these stocks too early, which is the worst thing a value manager can do. At that point, we probably have about 300 to 500 names that we can build a portfolio. Right now we have 43 names in the portfolio. It's easy to get investable names in our process. Q: The typical range of a portfolio seems to be between 40 and 60 names. A: I think that gives you enough leeway to where you can have some capacity to sell the product, but it also allows you to show and make an alpha. If you have 300 names, you end up turning into a closet indexer and you're just tracking the index and anybody can do that. To create alpha like we have, you have to take risks; you have to move away from the pack and you have to have a limited number of names. Q: When it comes to dividend payers, there are more details to consider, of course, when it comes to buying and selling what the team argues over. A: That is important. We do about 85% of our own research in-house. We will look at Wall Street research facts and figures. We don't care about their opinions. Everybody realizes now about how distorted their opinions are. We've been utilizing that fact since we formed the firm. In buying these names, our job is eventually to be able to sell these names to a growth manager. If I had to find another value manager to sell my stock to, then that is the greater fool theory coming into play. You're not really going to make good returns that way. The good thing that NFJ has done is they've added a second layer of which I'm one. Cliff Hooper and I both started out as credit loan analysts at the large banks here in Dallas, so we saw a lot of industries. But we also know our way through cash flows statements, income statements and balance sheets, and loan covenants in financing. I'm also a CPA. That really helps out, too. Finding those names that aren't going to blow up in a year is key. Since our turnover is slow, that company has to have the financial wherewithal to get its act together. We can't have it be one foot in the grave and then buy it and hope for the best. That’s not what we do. We're looking for quality names that will turn around eventually. We get the question, what's the catalyst going to be on that name? Q: That is a frequent question asked of value fund managers. A: What's funny is if you write down what the value manager says is going to be the catalyst, I will bet you more times than not, it is going to be something completely different. That is what you have to realize in this business. Our forecasting ability as humans is severely limited. This is a fluid environment we're in. I can tell what I think the catalyst is gong to be, but my experience more times than not has been completely different. The lesson here is if you buy names right and cheap, then good things will happen to you. If you are counting on one thing to happen like a growth manager might do, that is a recipe for disaster. Our process gives you a cushion. It's more of a relaxed investing atmosphere. Q: You sleep better at night is the expression. A: That's right. The process here is very methodical. What we buy, we hold and just wait for those good things to happen. I might mention we also run a small-cap product that in 1999 had nearly 20% of its names taken out by other companies. That really helps augment your returns in down times. Q: Do you have your own equity in the firm? A: We all invest through our company 401k options. We have the option to invest NFJ Equity Income and the Small Cap Value Fund.