Q: What is the history of the fund?
We launched the Dividend Income Fund at the end of March 2012, and the strategy has not changed since the initial paper portfolio, except the name—we changed the original “Capital Income” to “Dividend Income.” to better position the fund in the marketplace in October 2014.
In total, the team has over $3.5 billion in assets under management which includes the dividend income fund ($30 million), large cap value fund ($1.5 billion), and the large value and focused value strategies
Q: What makes your approach to dividend-oriented investing unique?
We do not buy high dividend yield stocks just for the sake of high dividend yield. Instead, we consider the trade-off between capital appreciation and dividend yield, and our use of options to generate additional income sets us apart. We also leverage our fixed income research effort through modest exposure to credit.
We employ the same process that we have used on the Loomis Sayles Value Fund for many years, but we include a dividend overlay for any of the stocks being considered for the dividend income portfolio.
First, we identify stocks that are unloved, marked by low sentiment, and trading at a discount to intrinsic value. Then we look for ones that feature a significant dividend yield.
These companies can often be thought of as “unintentional high yielders,” whereby a business has been thrown out by the market for a transitory reason and the stock goes from theoretically having a 2% or 3% yield to something much higher. There is a nice dividend yield, with the added opportunity for capital appreciation based on improving fundamentals off of a low base.
Q: How would you define your investment philosophy?
Everything for us starts with price. We think the price one pays for a security is the key determinant of excess returns. Great businesses do not necessarily make great stocks when they’re expensive. With this in mind, w look to buy stocks that are trading at a discount to intrinsic value, primarily in situations where they have suffered a transitory negative catalyst, perhaps a bad quarter, a delayed product cycle, a management change, or some kind of questionable M&A.
In more rare cases, the market simply offers us a chance to buy a good business at a discount to its intrinsic value. We seek to exploit these situations.
We look for low expectations and low sentiment for any stock in dividend income, similar to what we would look for in large cap value. Whenever we buy names in large cap value, we target a reward to risk ratio of roughly 2 to 1. That does not necessarily hold true for dividend income, however, because we put a yield overlay on any stock we buy.
Dividends are important for two primary reasons. The first is that over a long period of time dividends are responsible for roughly 40% of the total return of the S&P 500. Secondly, companies that have reasonably high dividends, and a history of growing them, put a constraint on themselves to operate within that parameter, and in doing so communicate a level of confidence to investors with regard to the sustainability of cash generation
An even higher ratio of reward-to-risk, say, of 3 to 1, might make us willing to accept a lower yield than is reflected in the overall portfolio. Conversely, we might find a stock that does not have our preferred 2-to-1 reward-to-risk ratio but its excessive yield offsets that and makes it attractive to the portfolio.
We loosen some of the constraints on reward vs. risk in dividend income depending on what the yield is on the individual security.
We are primarily discounted cash flow (DCF) investors. It is intuitive that a business today is worth the sum of its future of its cash generation. But we also triangulate other valuation methods—metrics such as free cash flow yield, price-to-earnings, and various other valuation metrics.
Q: What is your investment strategy and process?
Our team consists of seven people, us—the two managers—and five product analysts; who spend 100% of their time dedicated to research for the value suite of products. All seven of us have specific sector coverage across our investable universe.
Most of our ideas initially come to us through a proprietary screen. There are a number of variables we take into consideration and they all align with our investment philosophy.
Our screens consist of many components that score our universe based on valuation, sentiment, business model durability and quality. Additionally, there is an LBO factor that attempts to isolate situations where profitability is well below historical averages and balance sheet capacity is healthy.
When we feel something is worth an initial pass, we spend a few days establishing a broad investment thesis: amassing background, thinking about valuation and potential price targets, and identifying issues that need to be reconciled before progressing into the heavier due diligence period.
Once a two- or three-day initial assessment is done, the two managers green-light the new idea and we start a full fundamental research project on it, building models and different scenarios. This length of this process can vary, because, like navigating a ship, we do not simply want to set sail only to find three weeks later that we’re off course. We want the ability to make midcourse corrections. Other issues might arise and steer us to take our research in a different direction, or there are other things to explore that we did not initially anticipate.
We take the time needed, to dive deeply into the business, the industry, the management team; all the while building a financial statement and generating forecasts and projections.
The discounted cash flow primarily guides our scenario analysis. We usually have three or four potential outcomes in each case. What we are looking for is a healthy reward to risk ratio. This ratio is predicated on our base case (most probable outcome) to downside case (a reasonable, pessimistic outcome). Sometimes our conclusions are positive; at other times we might decide something is not analyzable.
If the downside is not quantifiable, we may terminate the project and move on to something else. This is because we consider risk in security-specific terms, so we spend a lot of time trying to understand the downside during the research process. That helps guide our position size as we go forward and our decisions after the initial purchase is made.
Given our iterative research process, each stock is scrutinized exhaustively, so, if it the name is finally formally pitched to the entire team, the success rate is often high.
Q: Would you give an example that illustrates your research process and how you look for opportunities?
We recently sold Federated Investors, which we bought back in April 2012, right after the initial launch of the fund. Federated runs many money market funds and there was considerable fear over what the new rules might be following the financial crisis; with concerns ranging from the need to have capital held against money market funds, or the implementation of a gating factor, where an investor cannot withdraw their money immediately.
We gauged what their equity and fixed-income businesses were worth and attempted to handicap some type of recapture rate. After all, if money market funds shut down, the money has to go someplace.
If there was a money market reform, we asked ourselves what the possible upside and downside scenarios would be, and what Federated would be worth as a result. What would happen if they had to raise $300 million in capital in order to hold that? What if, instead, it went to Federated’s fixed income products? Those have higher fees. There were only maybe two Buy recommendations from analysts and easily more than a dozen Hold or Sell recommendations.
When we bought the stock, the yield was over 4%. Over time, the rhetoric on money market funds declined. It has not been resolved but the fear has subsided. A month ago, there was a 3% yield, which is not unattractive, but the thesis for any upside was really predicated on rising interest rates.
The one thing we did like about Federated was that if it stayed in our portfolio, it would help manage the risk of rising rates to the other stocks in our portfolio. We are an equity income fund and so we generally own higher-yielding stocks, which do not typically perform as well when interest rates rise.
Based on our matrix of risk/reward versus yield, the primary reason to continue to hold Federated was rising interest rates as a risk mitigator. Therefore, we chose to sell the stock as sentiment had dissipated.
Q: Could you use another example?
Another example is Harley-Davidson, Inc. It came through our screen as it has been particularly weak year to date; largely on fears over Asian competition—the weak Japanese yen has provided competitors such as Kawasaki Motors Corp. and Honda Motor Company, Ltd., extra money to invest in price. This has happened once or twice before, and pricing aggression generally abated after a reasonably short period of time.
The stock was down 20% to 25% when we bought it and the stock was cheap by almost every conceivable measure. In our opinion, it is a solid business, a strong brand, with market share over 50% in the 600cc engine size bike range. They had a new chief executive, a fiercely loyal customer, and it is a solid industry that is growing globally. Aside from currency fluctuations, it’s generally rational on price.
Our issue was that the dividend yield was not particularly high, around 2.4%, below our average. Our target at the portfolio level is 1.5 times the yield of the S&P 500, our benchmark, which at the moment is about 3.3%, and we are higher than that. But there were mitigating factors to justify making such an exception.
As mentioned earlier, we look to balance capital appreciation and dividend yield, In this case, the risk/reward ratio was attractive; there was very little downside as we were buying the stock, maybe 5% to 10%, and the upside had multiples higher than that. So, even though the stock would be a detriment to our yield, the value it would add on the capital appreciation side would overwhelm the lower yield.
Harley-Davidson also has a finance company, Harley-Davidson Financial Services, but on an operating company basis the balance sheet was pristine. There were hints that they were going to increase their return of capital to shareholders. While the yield was 2.4%, there was a chance of the yield going up by utilizing the balance sheet.
They elected to utilize the balance sheet, but chose to repurchase shares instead, but we did not lose out. While not in our yield favor, it boosted capital appreciation.
We do not just look at current dividends. We consider the possibility of these dividends going up through a leveraging of the balance sheet or increased capital returns, or the healthy earnings growth.
As value managers, we believe everything has a price. Quality is not the overriding factor. This belief helps us to stick with businesses in tough times, but as value managers, we look for low expectations and low sentiment.
We stop short of buying businesses where the intrinsic value is declining. While we do have exposure to energy names, where yields are high, such as Chevron and Royal Dutch, many are macro-oriented, and it’s harder to nail down their intrinsic value. That overwhelms whatever security-specific work we do.
One example of businesses we do not want to own is telecom companies that are wire-line only, as well as those that are clearly losing units and have no pricing power. Some are admittedly cheap, but they don’t fit our process: there is no real competitive advantage and the secular headwinds are substantial enough to keep us away, despite any healthy dividend yield.
Because we are discounted cash flow focused, we are not just looking at the low price-to-earnings ratio or low enterprise value. We are more concerned with what the terminal value is—what will you get in 10 or 12 years?
Q: What is your portfolio construction process?
We are almost exclusively bottom-up stock pickers. Right now, we have exposure in every major sector of the S&P 500, our benchmark.
Our decisions to buy and sell are guided by the scenario analyses we do up front. Names that hit our targets force conversations with the analysts on whether something has changed and new targets are warranted. Oftentimes, when we sell stocks, it is simply because they have reached their fair value.
We run a matrix on risk/reward vs. yield. Every stock we put into the portfolio should be additive to the portfolio overall—we want it to contribute to the portfolio’s overall yield and/or we want it to contribute to the capital appreciation capture. Therefore, there is room for 2%-yield stocks with a 3-to-1 reward/risk ratio as well as those with 5% yield and a 1-to-1 reward/risk ratio.
When a stock is no longer additive, such as if it has an above average yield but the risk/reward is not good enough anymore, it becomes a topic for discussion.
A stock with a low yield may get booted earlier than a high-yielding stock, even though the risk/reward is good.
Since we see our risk as security-specific, the risk/reward vs. yield matrix helps determine when a stock is a source of funds, when we should be writing call options against it, or when we should be adding to it.
As far as concentration is concerned, we typically run the portfolio with 45 to 65 stocks. We currently have 50, and the largest weight we ever have is 5%. At the moment, it is a little over 3%. We look to be diversified but we really do not have sector bounds as far as what we’re allowed to do. Naturally, we gravitate toward sectors with higher yields. We are underweight technology, but given our yield mantra in this product, it’s a risk that is acceptable to us.
Q: How do you define and manage risk?
Again, we define risk as security-specific, beyond what we anticipate.
Going back to Harley-Davidson, if we think that the downside chase is, say, $47 and the stock drops to $40 but it is related to the U.S. GDP grinding to a halt, we accept that. But if it is security-specific, for example, if pricing issues from Asian competitors do not abate as we anticipated they would, or if we missed something in the new product line, that is our definition of risk.
Before we buy, we create a thesis, examining what could go wrong, and we establish a downside then. Our risk lies in whether something happens that we did not consider when establishing our downside level. Our risk lies in something going wrong that we failed to budget for.
To make buying stocks at a discount to intrinsic work, you have to believe that market price and intrinsic value are going to be correlated over the long run. You have to believe that, for a variety of reasons in the near term, market prices dislocate from intrinsic value. To exploit these dislocations, we run a disciplined investment process that’s well defined. We take the emotion out of it as best we can.
In our effort to establish a good reward/risk ratio, we consider the consensus, the sentiment, out there and what arguments oppose that. Investors tend to short-term oriented. Some have to make numbers on a monthly or quarterly basis, so we use not only sentiment, but also the time horizon factor in our favor.
We are both patient and willing to be early if we believe in a stock’s long-term prospects. We want stocks whose intrinsic value is growing at a faster pace than the consensus in order to capture two elements of reward: a reversion to mean and the growth in intrinsic value as we wait for that to happen.
