Q: What is the history of the company and the fund?
I have managed the fund since its inception in July 1990, maintaining a consistent investment strategy over these 25 years.
We are a true equity income fund. All the investments are quality stocks, or occasionally equity equivalents, and we do not use any derivatives, options, or futures.
In the past we have used some convertibles, but never a high percentage of the portfolio and we do not have any convertibles today. We also stay substantially fully invested all the time and we have never gone into cash as a defensive measure.
Q: What motivated your focus on dividends?
We have had a dividend focus from the beginning. The idea was not to provide high yield but rather to use dividends as an analytical way to get into companies and analyze quality and management’s commitment to shareholders.
Generally, we look for companies with long dividend-paying history and a track record of increasing dividends over time. In addition, we determine whether they are providing for their other capital needs, such as expansion, research and development, occasional strategic acquisitions, share repurchase, additions to working capital, and all the other appropriate uses for cash. If a company can do all that while also regularly paying a dividend with a rising rate over time, it is probably quite a good company.
By starting with the dividend record, before working back to the rest of the company and its characteristics, we can get into growth through the back door. In summary, we want to find companies with the longer-term characteristics and appreciation potential that we seek for our stock portfolio.
Q: What kind of companies typically pay dividends?
Because we focus on dividend-paying companies, we tend to stay with more mature and established names, in other words with more established lines of business. Such companies tend to be more resilient on the downside of the market. As a result, over the past 25 years we have had very good performance in many of the down markets. At the same time we may not keep up with growth spurts in the market when people are focused on high-flying companies in technology or biotech, for example.
We have done well over a longer period of time with lower than average risk because of our very conservative approach to balance sheets. We are simply not looking for the highest-yield stocks. We want to be sure that companies paying dividends not only cover them out of well-balanced financial strategies and programs but they also have good coverage for their dividends and are not borrowing to pay them.
If a company can keep paying dividends over a longer period, this tells you a lot about its management. Caring about shareholders is one of the characteristics we always like to see.
Even though we look at each company individually, we still want to stay diversified. Not only do we have a lot of different companies but we also invest in companies in many different sectors and industries. In this way we can benefit from higher-yielding sectors of the market such as utilities in addition to technology, healthcare, industrials or materials through our broad range of companies in the portfolio. We do our best to protect shareholders from losses in any individual name or industry.
Q: Where do you start in your investment process?
We start with a steady focus on the universe of dividend-paying companies. At this stage we exclude non-dividend payers—even very high-quality, non-dividend paying companies like Berkshire Hathaway Inc. and Alphabet Inc., the parent of Google. Although one might think we miss those opportunities, by focusing exclusively on dividend-paying companies we stand a better chance than average of getting both higher-quality and resilient companies.
Since we need to conform to third-party fund classification, we consider the market cap and the valuation characteristics of companies. We make every effort to stay on the value side of things with an emphasis on larger-cap companies.
We also have the flexibility to buy smaller- and mid-cap companies in many different sectors as long as they have the same financial characteristics and dividend-paying records. In fact, our portfolio tends to be more diversified by market cap than the average large-cap value fund.
Then, we look for companies that have increased their dividends over time. We generally avoid any that have cut their dividend, or where we think the dividend is at risk. This second level of screening requires some financial analysis and balance sheet evaluation, looking to see whether the dividend is covered, and whether all other capital requirements of the business can be met. We want to be sure the dividend is secure and that the payments can be sustained over time.
Q: How do you drill down further?
Now that our universe of names has narrowed after the second level of screening, we search within it for those with a germ of growth and prospects of development. We look for an edge— companies that can provide leadership in their industry over time, expand their businesses, or explore new markets and services. Does a company’s business dynamic suggest earnings will grow? That is where we actually see the prospect of higher dividend payments over time.
We have a cosmopolitan approach and our screen is broader than the U.S. markets. As we confine ourselves to developed markets and established, high-quality companies, we do invest anywhere from 10% to 15% of the portfolio in European and occasionally Asian stocks.
Next we may consider the diversification of the portfolio. We do not stick to the Russell 1000 Value Index weights or the S&P 500 Index weights. At the same time, we do not want our results from one quarter to the next to be so different than the market’s that they will not make sense to shareholders. Today we are more diversified than ever because a broader range of companies has been paying dividends over the past few years.
Q: What other factors do you take into consideration to balance portfolio risks?
When we are looking at maybe five or six different companies that might be of interest, we consider diversification, the overall structure of the portfolio, and the balancing of risks that would come into play. In our new purchasing we want to emphasize companies that would probably balance other risks in the portfolio, or provide our shareholders with new opportunities.
We look at liquidity because we want to be able to buy and sell with ease. As part of this, we keep an eye on trading because we do not want to get involved in companies where we might be able to buy but never sell. That might restrict us from buying certain stocks or buying larger amounts of them. Although we have a number of relatively illiquid stocks in the portfolio, they are generally smaller positions.
After going through this screening and narrowing process, we can typically come up with 200 or so names that could conceivably be attractive for the portfolio. A good number of those are generally in the portfolio already. We regularly screen the universe to see if there are new names, or names that had previously failed to meet our criteria but have improved or come into our buying range. After all, as value-oriented investors, we keep looking for stocks that are out of favor and selling at a good price.
Q: What types of stocks are in the portfolio?
We have had a number of companies in the portfolio for more than a few years. Generally, we have 100 names in the fund, plus or minus.
One of the longer-term portfolio holdings is The Valspar Corp., which is a paint and coatings company. Another name is Cedar Fair, L.P., which operates amusements parks. Its flagship park is Cedar Point in Sandusky, Ohio. Becton Dickinson & Co, a medical supply company providing disposal syringes, IV equipment or diagnostic kits for diabetics would be another example.
There is a socially responsible tilt to the portfolio too. We have had a policy since the fund’s inception of not buying tobacco, liquor, or gambling names. Apart from this, we have no restrictions.
Historically, we have had a lot of holdings in the consumer staples area, such as food companies. We have occasionally invested in soft drink companies too, including Dr Pepper Snapple Group Inc and The Coca-Cola Co.
Additionally, we have had success in the packaged food area, in part because of M&A activity. Berkshire Hathaway Inc. has bought two of our companies, H.J. Heinz Company and Kraft Foods. Hershey Co has been another success story in the food industry.
With our value approach emphasizing out-of-favor companies, we probably have a higher incidence of M&A in the portfolio than you would see in a pure growth fund buying market-leading stocks that everyone is quite familiar with.
We typically have a lower-than-average weight in financials. This has usually served us well, particularly during the subprime meltdown of 2007–2009. Because we insist on sustainability of dividends and quality of earnings, in the mid-2000s it struck us that banks, and other financial institutions, were really stretching the rules a bit and making money that may not be for the long term.
We have a 20% investment in financials, but we are underweight relative to the Russell 1000 Value Index, which has about 30%. We have mostly paid attention to regional banks and some of the investment management services companies. Within that category, a company like Northern Trust Corporation, or U.S. Bancorp, would be typical of the kind of investment we make.
Chubb Corp has been another major position in the fund for a long time. We were very patient and saw the quality of the company’s business and management, as well as the strength of its finances. Getting through the subprime meltdown without any government assistance, Chubb Corp stayed profitable the whole time and emerged from that turmoil in even better condition relative to its competitors. ACE Limited, a Bermuda-based company, is currently acquiring Chubb Corp, which we are still holding on to.
Q: What is your portfolio construction process?
We will generally not buy a position in an amount greater than 1% to 2% of the assets of the fund. With regard to weights in the portfolio, if stocks do well and appreciate over time, we will occasionally have names that get up to 3% or 4%. We would feel uncomfortable with the amount of individual company risk if we were to hold a higher position.
We let companies grow and develop. We aim to keep the top 10 positions about 30% of the fund maximum, although this level will be typically lower, around 20% to 25%.
At a sector level, we do not have any particular limitations in terms of weighting. We refer to the Russell 1000 Value Index weightings but do not have any firm requirement to be within a certain percentage. As a general rule, we overweight utilities and underweight financials. We also overweight consumer staples, where we have had a preference for food, some soft drink companies, and some household product companies from time to time. We have found a lot of good, steady dividend payers there.
Q: What kinds of risk do you identify and how do you manage them?
First of all, we pay attention to absolute risk, not just relative risk at underperforming the market. We take into account the chances of preserving the value of our investment in a particular stock by estimating the chances of a company’s staying in business even during a period of stress in the business cycle.
We like companies that have been through at least two or three complete business cycles as publicly traded companies; companies that have been in the same business or set of businesses during that period. This enables us to have a usable, historical record on the basis of which we can make an estimation of how the company might fare in some coming period of difficulty.
In an absolute sense, the best way to mitigate risk is to invest in companies with strong balance sheets. We want to identify companies with the kinds of businesses that will continue to support strong balance sheets over time. Personally, I prefer companies that have a little more cash than they need and a little bit less debt than they might be able to service. Overall, these are the metrics that create financial flexibility.
Companies of this kind can take advantage of business downturns, by adding market share, adding capacity, making acquisitions and so forth. More leveraged companies may not have that luxury.
We also look at corporate governance, trying to understand if management is concerned about shareholders. We look at salary arrangements, the make-up of the board of directors, and compensation. As soon as we see a different agenda at a particular company, we consider this an element of risk.
Additionally, we analyze the competitive framework to see if new companies coming along fast have services and products that might compete more successfully with those of our holding in the fund. We probe into the condition of a company’s customers to ensure they are in good financial shape to continue to buy goods and services. We also ensure the supplies needed by a company are secure.
In this way we do a full 360-degree analysis of a company to identify risks in its ecosystem, as well as within the company itself.
Relative risk entails some comparison of the prospects for a company and the industry in which it operates versus the potential for other industries and companies in the market. We are committed to making relative judgments and aiming to get an above average total return for our shareholders over a longer period of time.
