Pur­su­ing Current and Ris­ing Div­i­dend In­come for Your Clients’ Long-Term Re­tire­ment Needs

Man­ager Q&A: Fed­er­ated Strate­gic Value Div­i­dend U.S. Eq­uity

Investment Executive - - COMMENT & INSIGHT -

10/7/2017

“Man­ager Q&A’s” delve into in­vest­ment ap­proaches used by Fed­er­ated In­vestors strate­gists. This in­stall­ment fea­tures Senior Port­fo­lio Man­ager Daniel Peris.

As a re­minder, our in­come-first ap­proach is driven by a core be­lief that we in­vest as own­ers of com­pa­nies, not traders of stocks. As own­ers, we take the long view, seek­ing high-qual­ity com­pa­nies that make a prac­tice of shar­ing the prof­its with the com­pany own­ers, re­gard­less of mar­ket con­di­tions. Com­pa­nies in our rel­a­tively con­cen­trated port­fo­lio tend to be non-cycli­cal and well es­tab­lished, with sub­stan­tially higher div­i­dend yields than the broader mar­ket and a his­tory of pay­ing above-mar­ket div­i­dends and reg­u­larly in­creas­ing them.

The Strate­gic Value Div­i­dend propo­si­tion for clients is to in­vest as a busi­nessper­son, for busi­ness-like cash re­turns. But we do so through the stock mar­ket and can be mea­sured in stock-mar­ket terms. For those clients whose pri­mary in­ter­est is the stock mar­ket, the port­fo­lio’s to­tal re­turn (div­i­dend plus share price move­ment) has been roughly sim­i­lar to that of the broader mar­ket’s (mostly share price move­ment) but with a much lower stan­dard de­vi­a­tion or mea­sure of volatil­ity. In short, we seek to of­fer a high and ris­ing in­come stream from high-qual­ity busi­ness assets for those who want the cash. For clients who don’t need the in­come im­me­di­ately, we seek to of­fer the mar­ket’s over­all re­turn but with fewer ups and downs.

Q: How can the strat­egy help in­vestors reach their re­tire­ment sav­ings goals?

One of high­lights of the fund is its abil­ity to of­fer a unique bal­ance of risk and re­ward. The fund’s con­sis­tent strat­egy of long view in­vest­ments al­lows it to per­form well, even when rates rise.

While our port­fo­lio has no busi­ness sen­si­tiv­ity to near-term in­ter­est rates, the stock mar­ket his­tor­i­cally bids down so-called “bond-prox­ies” in a ris­ing-rate en­vi­ron­ment. While we are far from a bond proxy—we have ris­ing coupons and our in­come streams are well above those of govern­ment bonds—we have seen pe­ri­odic down­ward move­ments in share prices since cen­tral banks, in­clud­ing the Bank of Canada, have been eas­ing off the gas with no fun­da­men­tal change in the in­come stream we have gen­er­ated.

But over time, our strat­egy has held true and both div­i­dend and stock mar­ket per­for­mance have been con­sis­tent, de­liv­er­ing value to long-term share­hold­ers. The re­al­ity is that, given our longer-term ap­proach, a rise in rates and de­cline in prices among some port­fo­lio con­stituents can be ben­e­fi­cial. It helps to lift our port­fo­lio’s gross yield, which po­ten­tially means a higher rate of re­turn go­ing for­ward as new money pays less for the same in­come stream than it would when prices are higher. For those rein­vest­ing their div­i­dends, it also means this in­come stream is get­ting rein­vested at po­ten­tially more at­trac­tive prices.

Longer term, our strat­egy speaks for it­self. No mat­ter the level of in­ter­est rates or the out­come of a po­lit­i­cal elec­tion, the com­pa­nies that we choose for our port­fo­lio will con­tinue to sell their soft drinks, di­a­pers, wire­less ser­vices, pre­scrip­tions, food, etc. And they will likely con­tinue to share with com­pany own­ers a big part of the prof­its from those trans­ac­tions.

Q: With U.S. in­dexes at all-time highs, do val­u­a­tions in­flu­ence your team’s ap­proach?

For us, P/E was a use­ful proxy for ac­tual dis­trib­uted prof­its a half cen­tury ago. Now P/E is a kabuki show, part of the Wall Street The­atre. Which E? For­ward, back­ward, nor­mal­ized, GAAP, with­out all the bad stuff taken out, ab­so­lute or in com­par­i­son with com­pa­nies that are not our op­por­tu­nity set. That is, if Google had a P/E of 2, it wouldn’t mat­ter, be­cause it doesn’t pay a div­i­dend. The P/E that mat­ters to us is the re­la­tion­ship of the price to the E that is ac­tu­ally paid to com­pany own­ers, the div­i­dend. And as we know, the true re­turn of value to a share­holder is the div­i­dend check.

Q: What do you con­sider to be the three main virtues of div­i­dend-pay­ing com­pa­nies?

They tend to be solid and well es­tab­lished. The stock prices of such com­pa­nies typ­i­cally have been less vo­latile than those of non-div­i­dend-pay­ing com­pa­nies, a char­ac­ter­is­tic re­flected in our fund’s com­par­a­tively low beta rel­a­tive to the mar­ket. And div­i­dend-pay­ing com­pa­nies his­tor­i­cally have paid a size­able por­tion of their re­turns in cash, which in ad­di­tion to pro­vid­ing in­come can help cush­ion a port­fo­lio’s down­side.

Q: How does your ap­proach dif­fer from that of an ETF or other pas­sive strat­egy ?

Again, our fo­cus is on stocks that have a his­tory of gen­er­at­ing and grow­ing in­come and shar­ing that in­come with its own­ers. We home in on com­pa­nies that meet that cri­te­ria to de­velop a high-con­vic­tion, con­cen­trated port­fo­lio. We are not traders or bench­mark-cen­tric. Our port­fo­lio turnover is rel­a­tively min­i­mal.

Pas­sive div­i­dend strate­gies, on the other hand, seek to repli­cate a spe­cific part of the mar­ket as mea­sured by a bench­mark. When the mar­ket changes, their bench­mark com­po­nent weight­ings change, too, creat­ing the po­ten­tial for sig­nif­i­cant dis­rup­tion and port­fo­lio turnover. This can cre­ate wide, costly swings in port­fo­lio hold­ings with the po­ten­tial also to raise risk. Re­search shows that man­agers with high-con­vic­tion port­fo­lios and high ac­tive share (which is a mea­sure of how much a port­fo­lio’s com­po­nents vary from a bench­mark) have a bet­ter chance of out­per­form­ing their in­dex (and un­der­per­form­ing, too). The dif­fer­ences be­tween high ac­tive share man­agers and clos­est in­dex­ers can be dra­matic. In land­mark re­search, former Yale School of Man­age­ment col­leagues Antti Pe­ta­jisto and Mar­tijn Cre­mers stud­ied 1,124 funds over two decades and found ac­tively man­aged stock port­fo­lios with the high­est ac­tive share lev­els out­per­formed their bench­marks by an av­er­age of 126 ba­sis points after fees from 1990 through 2009. The out­per­for­mance widened to 261 ba­sis points be­fore fees and ex­penses.

Q: What is your team’s strat­egy in re­gard to hedg­ing cur­rency?

Frankly, we don’t do it. There are a lot of rea­sons. Many global com­pa­nies in our port­fo­lio al­ready hedge cur­rency risk, multi­na­tional com­pa­nies have ex­po­sure across bor­ders, mak­ing cur­rency hedg­ing murky, etc. But per­haps fore­most, we have found that over time, cur­rency fluc­tu­a­tions have had a ba­si­cally neu­tral im­pact on per­for­mance over long mea­sure­ment pe­ri­ods con­sis­tent with our long-term in­vest­ment hori­zon. Sure, cur­rency fluc­tu­a­tions can im­pact per­for­mance; it might be head­wind at one pe­riod, and a tail­wind in an­other. As far as Canada is con­cerned, the re­cent dol­lar weak­ness rel­a­tive to the loonie has the U.S. on sale.

What is the out­look and po­si­tion­ing for the strat­egy over the next 6 to 12 months?

While it would ap­pear rates are more likely to rise than fall, it doesn’t re­ally fun­da­men­tally change what we do—build a port­fo­lio of 25 to 45 stocks based on their div­i­dend yield, div­i­dend growth his­tory and po­ten­tial, and their fi­nan­cial con­di­tion. In­ter­est rates change; the stock mar­ket changes. Our ap­proach has not. We will con­tinue to fol­low the cash, as we al­ways have.

Thanks, Daniel.

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