Q: What is the background of the fund?
Our fund was launched in 1996, and I became the lead manager in 2001. The fund has always been in the Lipper equity income category. Wellington Management Company has been subadvisor to the fund as part of a long-standing relationship with Hartford.
As the name Dividend and Growth suggests, our goal is to outperform the category with less risk. We are less deep-value investors in style and a little more core in focus, and our fund yield is slightly lower than average compared to our peers.
Q: How would you define your investment philosophy? What makes you different from your peers?
Our investment philosophy is based on three key aspects. First is a focus on above-average-yielding stocks, companies that are number one or number two in their business, with good balance sheets. These are companies that tend to hold up very well in a recession. Also, because of their focus on dividends, they are less likely to make the dilutive acquisitions that companies without the dividend commitment often make.
The principal idea is to manage risk within that portion of the fund through a combination of good cash flow and attractive dividends. These companies are not necessarily in growth markets, but they are well positioned within slow-growing markets.
Our second area of focus on reducing risk is supply and demand. We focus on supply and demand over 10- or 20-year periods so that we can clearly see how trends develop. We buy industries or sectors at a time when capital spending has been low for a long time, and we are dramatically underweight in areas where capital spending is quite high. We do not fall in love with the fact that earnings might be good right now, when the reality is that there is just too much capacity entering the business.
For example, back in 2002, when oil bottomed at around $20 a barrel, most people thought oil might go to the high $20s. Our thinking was different, though. We had people traveling to China, and we also were meeting with individual companies who were laying out a bullish case for the demand for oil.
When supply is not growing but demand is, it takes a long time for companies to ramp up production. So we made energy a very big bet in our portfolio. We thought oil could go to $70—and in the end, we still weren’t high enough. It ended up going well over $100 a barrel, which led to our good performance from 2003 to 2006.
Another example of how the focus on supply and demand helped us reduce risk came in 2007 and 2008. Even though financials was the highest-yielding sector—and we do like yield—we were underweight versus the S&P 500 index, because the housing cycle was so abnormal, and most financial companies ultimately depend on housing-related securities to make money.
The third and final portion of our philosophy to protect us on the downside has to do with buying what we call “broken growth” companies at a market multiple or less. The idea is that we are not willing to pay up for growth, but we are willing to own growth, so we might invest in a technology company or pharmaceutical company. In a recession these companies typically have good balance sheets; and in a growth-oriented market, they allow us to keep up to a degree. Therefore, we get both price-to-earnings expansion and earnings growth, and that’s a good combination.
Those three key tenets of our investment philosophy are each quite different, but they are all tied together by the idea of protecting investors on the downside.
Q: How do you go about finding opportunities?
We start with bottom-up research. We meet with company management and work with our own industry analysts at Wellington to identify the companies that are doing a particularly good job, and the ones that might be more vulnerable.
For example, we own Ford Motor Company rather than General Motors Company, because we think Ford has better technology in its product line. It also has the opportunity to expand into places like China, where General Motors has probably peaked in China and its total sales are likely to decrease.
In the banking area we think that larger bank companies, like Wells Fargo & Company or JPMorgan Chase & Co., have the best position in terms of customer satisfaction and number of ATMs, so those are our biggest positions. Again, this is a specifically bottom-up approach.
As far as supply and demand, we closely monitor capital spending. I get updates twice a year for all the different sectors and industries as I monitor what is going on. We also get a sense of that from talking to companies, but we want to understand it on a broad basis as well. If we see an area where capital spending has been low for a while and capacity is being shut down, we see an opportunity. And we start to time when to get into it.
We also consider what is going on outside the United States. For example, China is spending a fortune on building its infrastructure, which probably will create overcapacity in some manufacturing areas.
Lastly, to identify “broken growth” companies, we analyze the companies that are temporarily out of favor. We try to analyze if it is because they missed a product cycle, or if they have some interesting new product that we’ve uncovered from our research that will take a couple of years to come out. The idea is to identify these companies when they’re trading without high expectations.
Q: What are the assets under management in the fund and the strategy?
The mutual fund has $7.2 billion as of September 28, 2015, and we manage an additional $3 billion for a variable annuity product.
Q: What is your research process? Can you share some real-world examples?
I have been a mutual fund manager since 1985, so I have studied a lot of companies over the years. When I analyze a company for purchase, 90% of the time I already know it well. We are looking for new products, or changes in management focus, competitive environment, or supply and demand. We update all those things in real time to form an opinion on the company.
The other 10% are companies that perhaps were growth stocks that I never could own. For example, we bought Medtronic plc some years ago. I had never owned the company because it had always had a high price-to-earnings and a low yield, and it just would not fit with what I was trying to do. However, it went through a couple of years of underperformance, it put in a dividend, and suddenly it was a stock that fit our process for the first time.
My colleagues went to Medtronic headquarters in Minnesota and spent the day there, taking extensive notes and sharing them with me. It took a couple of years before the stock actually went up, but it has been a good performer since then.
Equifax Inc. is another example. The company’s management came through our offices and we really liked their growth potential. The stock was out of favor following the market decline in ’08-09, so we got a chance to buy it at an unusually low price.
Q: How do you build and harvest industry expertise, especially as it relates to disruptive new technologies?
Wellington has 56 global industry analysts, as well as team analysts, both on my team and on other teams, who are encouraged to share. We have a lot of horse power to throw at the analysis of an industry. To make an intelligent decision about a stock, one has to understand both the broad industry and the context of something potentially disruptive coming in.
In addition to that, we are always on the lookout for new technologies. Personally, I am focused on the idea of being made obsolete by some internet development. Fortunately for our share owners, I am not in vacuum. Along with the full-time internet analysts here at Wellington, all our other fund managers have a growth-oriented approach, and they are obsessed with new disruptive technologies. Even though I might not own some of these companies, I get full access to all the information on a regular basis.
Going to see a company and having management tell you a good story is not enough to understand whether it is going to be a good stock in the long run. Companies are often the last to know that they are vulnerable to some new technology.
Right now we are doing a lot of work on wind and solar to see how much of an impact they could have on the energy market and the electric/utility market. They could end up substituting for coal, and for gasoline if people start using electric cars.
Generally speaking, we try to be leaders in predicting what will happen next.
Q: What is your portfolio construction process? What role does diversification play in your thinking?
Although I make the final decisions and no one can outvote me, I am a very collaborative person and trust my people. If they make a good case to me, more often than not I will follow their recommendation, even though there are times when I push back. I may have seen this situation before and I may not trust the company, or I may see some of these disruptive risks coming out that the rest of the team may not have identified.
Our focus on supply and demand leads us to significant overweights or underweights in a particular industry or sector. If we see supply and demand in our favor, we are not afraid to get significantly overweight in that industry; if we see a bubble emerging, we are not afraid to get significantly underweight. Still, most industries do not have a massive shortage coming or bubble bursting. As a result, it is a matter of looking at valuation and trying to find companies that fit relative to one another and relative to what we do.
Generally, I would not want to have a large overweighting in an industry that I am neutral on. If I am neutral on something, and if I do not have any better ideas, I’ll probably be close to neutral relative to the S&P 500 Index. If I am not neutral, I’ll go underweight or overweight.
While the portfolios I have managed over the past 15 years at Wellington have had, from time to time, very big divergences from the benchmark, that is less true over the past several years. When the market crashed, it mashed valuations closer together, and it was not as obvious where you needed to be relative to the benchmark.
Interestingly, over the past few years the best areas have been non-yielding companies that have fairly high Pes, and it has been harder for us to offset that because we are not focused as much on zero-yielding companies. Yet, we have kept up pretty well. Although we are a little behind, we are very well positioned for a correction as we do not have some of the very expensive stocks that have gone up so much.
Q: Which index do you use as a benchmark? Do you have limitations at the sector level?
We use the S&P 500 Index as our benchmark. The mutual fund rules state that we cannot have more than 5% in one stock, and our informal rule for sector weightings is that we like to be within plus or minus 5% to 10% of the benchmark.
Our supply and demand process is designed to help us avoid areas that are bubbles. In 2000 our divergence was greater than 10%, simply because it was such a ridiculous time. If you remember, the market, excluding Internet stocks, was trading at 14 times earnings, and the Internet companies were trading at between 50 and 100 times earnings. The S&P rating in technology reached as high as 32%, and we were under 10%. However, there is no reason to be more than 10% today.
Q: How do you define and control risk?
I define risk differently from most people. Since we don’t know the future, most people calculate beta looking backward. They think that buying low-beta stocks means there is no way you can beat the market. But beta and standard error are backward-looking measures; they do not capture what may happen in the future.
We manage risk in terms of valuation, balance sheet, competitive position, and supply and demand.
As I described in the supply-and-demand scenario, an industry that has been out of favor for a long time and where people are losing interest, where capital spending is exiting the business, is going to look like dead money to any kind of a quant investor. However, that is actually a pretty safe place to be because areas like these can provide good total return. In fact, it is the areas that are very high beta, that have been outperforming the market for a long time, that are risky. They are up a lot, and what goes up fast can go down even faster.
As part of our risk control, we also focus on above-average dividend yields. In a flattened-down market, that dividend can be a big part of total return that you won’t get from a zero-yielding company. And the competitive position of a company is also important. Even if a company is cheap and has a low PE, if it is not competitive, it might not ever get better.
Finally, there is also balance sheet risk. A lot of value investors get into trouble by buying a stock which has been out of favor for a while and whose price is down, and then unexpectedly there is a recession. If you do not have a good balance sheet, you can easily get devastated in a recession because people are not sure you will survive. We certainly don’t like to play that game.
Q: How has your experience in the market served as an advantage?
When the financial services world started to suffer severely in 2007, I knew it was a very big deal because I had lived through the ’89-90 period. We got significantly underweight in financial services even though it was the highest yielding part of the market because I did learnt from past experiences.
After a boom in the early ’80s, technology stocks fell sharply in ’86-’87, and a lot of them went to single digits. When technology goes south, there’s really nothing there. Technology companies have to constantly innovate and come up with something new every two or three years or else they will be obsolete. I have seen a lot of technology companies come and go over the years.
That experience really does allow me to do reality checks that someone with less experience would have trouble imagining.
