By STEVE GARMHAUSEN
It’s not just about yield: Choosing a dividend fund involves assessing its return, as well as the manager’s unique strategy.
Over the past few years, dividend stocks have enjoyed an approval rating that would be the envy of any presidential candidate.
The elusive combination of income and safety these stocks augur has caused investors to pour money into dividend-stock mutual funds. Assets in equity-income funds have more than doubled since the end of 2008, from $99.6 billion to $222.8 billion through September of this year, according to Lipper. And fund companies are only too happy to feed that demand. In the past two years alone, asset managers have launched 48 — that’s an average of two new funds every month — equity-income mutual funds and exchange-traded funds.
Too much choice can make for a perplexing environment. So Barron’s enlisted the help of Lipper to narrow the starting universe of nearly 100 funds by screening out any that had less than $100 million in assets and lacked a three-year record. The result: a total of 53 names ranked by three-year returns that you’ll find on page 28. Then, because dividend investing isn’t as straightforward as it sounds, we took a closer look at the top 25.
Many of the most successful fund managers are employing approaches very different from their rivals’, especially as the flood of money has made good value — not to mention high yields — much harder to find. “Dividend investing is becoming a crowded space,” says Laton Spahr, co-manager of the Columbia Dividend Opportunity fund (ticker: INUTX). Just 24 of the 53 funds on our list have a dividend yield that exceeds 2.1%, which is what the S&P 500 provides. And just six of the funds have yields above 3%.
It’s not just about yield, however. Indeed, the highest-yielding stocks are often those of troubled companies that might not be able to sustain their payouts. The best fund managers have continued to find high-quality, high-yielding shares at good prices, often by veering off the beaten path. Foreign issues, temporarily troubled stocks, equities from outside the traditional dividend-paying sectors, and even mid-sized companies have provided a boost for many top equity-income funds.
Standout performer Federated Strategic Value Dividend (SVAAX), for instance, has 28.6% of its assets in European stocks. And Neuberger Berman Equity Income(NBHAX) has fueled its portfolio with mid-caps in recent years.
“We’ve seen such a migration into large-cap dividend stocks over the last eight months that we don’t think there’s as much potential there,” says Sandy Pomeroy, co-manager of the Neuberger fund. “There’s been more value in mid-caps since the beginning of 2010.”
There’s one thing that dividend-fund managers do seem to agree on: An increase in the tax on dividends won’t hurt the stocks. Pundits have speculated that if the 2001 tax cuts expire and dividend income is once again taxed at ordinary- income rates, investors would sour on the asset class. Others worry that corporations might cut or eliminate their payouts. But fund managers say there’s too little historical precedent to predict the impact of a big tax hike.
Plus, they point out that a tax increase might not matter. Institutions, which don’t get a tax break, own the largest portion of dividend-paying stocks. And a huge percentage of fund shareholders invest via tax-deferred accounts, such as IRAs and 401(k)s, which also wouldn’t be hurt by a tax boost. Besides, many argue, investors seeking safe income don’t have many alternatives. “I don’t see wholesale selling by grandma of the assets she’s held for the last 50 years because the tax rate went up,” cracks Daniel Peris, co-manager of Federated Strategic Value.
Barron’s spoke with four of the top managers on the list to hear how they’re navigating through the dividend landscape.
JPMorgan Equity Income
When it comes to picking stocks, quality trumps timing, says Clare Hart, the lead manager of JPMorgan Equity Income (OIEIX).
“With a quality company, a lot of times people will say, ‘That’s interesting, but I don’t know what the catalyst is — how are you going to make money on the stock?’ ” notes Hart. Her perspective: Just invest. With quality companies, it’s worth the wait for the earnings to come. And based on her fund’s performance, Hart seems to know what she’s talking about. Over the past three years, $2.7 billion-asset JPMorgan Equity Income has returned an annualized 15.61%. That’s tops among U.S.-registered, domestic equity-income funds, according to Lipper.
Hart initially invests in companies with at least a 2% dividend yield, though the fund’s yield has now dipped to 1.86%. She shuns the highest-yielding stocks because she wants to know that her portfolio companies are reinvesting enough to grow earnings and to sustain or increase dividends. “Instead of squeezing every last penny out of companies, we really try to think holistically,” she says.
These days, Hart sees opportunity in the consumer discretionary and financial sectors. They’re full of the sorts of companies that impatient investors overlook, she explains.
In the financial sector, Hart likes banking outfits, such as M&T Bank, (MTB), U.S. Bancorp (USB), and Cullen Frost Bankers (CFR). Those institutions are rooted in the mundane business of retail- and small-business lending. But right now, their bread-and-butter businesses look good alongside those of financial companies that have their fingers in riskier areas, Hart says. “These guys are not in business lines that might disappear,” she says.
Another company Hart likes is Dunkin’ Brands Group, (DNKN). Dunkin’ Donuts stores abound on the East Coast, which might make the company seem built out if you live in that region. But there’s plenty of room for Dunkin’ to grow, elsewhere in the U.S. and around the world, Hart says. And because the company uses a franchise model, that growth will come without requiring huge capital investments.
Investors have shied away from consumer-discretionary companies because of uncertainty about Americans’ willingness to spend. But fretting over whether a store is selling as much as it did last year is shortsighted, Hart insists. “If [sales] numbers are off short-term in this very difficult environment for consumers, we step back and ask, ‘Is this a brand people are going to want long-term?’ “
One distinguishing feature of JPMorgan Equity Income is its relatively low portfolio turnover rate, which ranges from 30% and 44% annually. The lack of sound and fury reflects Hart’s overall approach. “You’ve got to be patient in all environments, but especially in this one,” she observes. “You’ve got to give companies time to deliver.”
Vanguard Equity Income
There’s nothing flashy about $9.3 billion-asset Vanguard Equity Income (VEIPX) — except for its performance.
The fund’s annualized total returns for one year (14.7%), three years (15.3%), and 10 years (8.2%) are among the highest in the industry. Its yield is also among the best, at 2.74%.
Wellington Management’s W. Michael Reckmeyer III, who runs about two-thirds of the portfolio for Vanguard, says his approach is straightforward: “We focus on good companies under temporary problems.”
Reckmeyer and his team seek a “comfort level” by interviewing management in person. “Knowing things like how they allocate money and how they quantify risk gives us a better understanding of what’s actually behind the numbers,” Reckmeyer says. One of his main concerns is assessing a business’s ability to sustain and grow its dividend. Part of what allows a company to do so, Reckmeyer adds, is having a sustainable competitive advantage, or “moat.” Wide-moat companies within the portfolio include Intel (INTC),Exxon Mobil (XOM), and Home Depot (HD).
Reckmeyer avoids companies whose high yields might not be sustainable. “We think chasing stocks based on yield can create problems,” he explains. What’s more, many of the higher-yielding stocks in the market have become overvalued, he adds.
And he uses information from Wellington’s 51 global industry analysts and 35 fixed-income investors to help inform his decisions. “They are very relevant in stressful times because they can see signs of stress earlier,” he comments.
The remaining third of the fund is managed by Vanguard’s Quantitative Equity Group, where James Stetler and his team use computer models to pick stocks from the FTSE High Dividend Yield Index. Investments in that portion of the portfolio largely follow the sector and industry allocations of the benchmark.
Not only have investors in the 24-year-old fund gotten strong performance, they’ve gotten it for a bargain price: Vanguard Equity Income’s net expense ratio is a rock-bottom 0.31% — the lowest on our list.
Year-to-date, the fund’s performance has lagged behind its category’s by just a hair. Reckmeyer chalks this up in part to the fact that the fund has no exposure to hot but low-yielding stocks like Bank of America (BAC) and Citigroup (C). That’s no surprise, as the manager is known for his insistence on healthy dividends. “The yields are insufficient for me,” he says.
Columbia Dividend Opportunity
Eight years ago, Columbia Dividend Opportunity (INUTX) retooled its approach. Ever since, the fund has been on a tear.
Prior to 2004, Dividend Opportunity was essentially a utility fund. While utilities are traditionally a reliable source of dividend income, the single-sector focus left the fund at risk of falling behind, especially as dividend income was increasingly available from a wider variety of companies.
The fund is now far more versatile, says co-manager Laton Spahr. “Regardless of the market environment, we feel we can deliver a substantial part of your total return in income,” he says. And the numbers bear this out: The fund has a 12-month yield of 3.16%, and an annualized total return of 11.1% over one year and 14.3% over three years.
The $4.7 billion Dividend Opportunity attempts to earn 150% of the yield of the S&P 500 index after fees and expenses — and with its current yield of 3.16%, it’s reaching that goal. To accomplish this, Spahr and his colleagues typically funnel 20% to 25% of the fund’s assets into the highest-yielding dividend stocks in the market, those that typically pay twice the average of the S&P 500. That part of the market is riskier; companies there often lack the earnings to sustain their lofty payouts. The trick: finding companies with stable cash flow. The team has chosen so well that stocks in the highest-yielding category have accounted for about half of the fund’s return over the past eight years, according to Spahr.
Dividend Opportunity has the lion’s share of its assets in traditional dividend stocks, often with some pent-up pop. It also looks for stocks that other managers would typically shun. “We’re rooted in contrarian value investing,” Spahr says. Top-five holdingGeneral Electric (GE), for example, has spent the past few years trimming its noncore businesses in order to focus on energy infrastructure. “We look to identify unanticipated acceleration in returns on invested capital,” says Spahr. “GE is very much a [return-on-equity] acceleration story in our mind right now.”
A similar play is Royal Dutch Shell (RDS), the fund’s largest position. The huge energy outfit should start to reap the reward of heavy investment in its global natural-gas capabilities, says Spahr. One result, he predicts, will be accelerating dividend growth.
And Spahr likes that acceleration. As much as 10% of the fund’s assets are invested in “emerging-dividend” companies, those that are close to initiating a dividend or are poised to dramatically accelerate dividend growth. Such names are often found in the technology sector. One of the team’s current favorites: Cisco Systems (CSCO).
With stocks in traditional dividend sectors, such as utilities and consumer staples, getting pricey, Spahr expects to continue to shift to nontraditional groups, including technology and consumer-discretionary. The challenge for fund managers, the portfolio chief adds: “Finding that next wave of dividend growth.”
Federated Strategic Value
If Federated Strategic Value‘s (SVAAX) turnover seems exceptionally low — and it is, at just 17% — there’s a good reason for it, says co-manager Daniel Peris. “We view what we do as not so much investing in stocks, but investing in businesses,” he adds.
The long-term approach of Peris and his partner, Walter Bean, has paid off, as the $7 billion fund has returned an annualized 14% over three years. It currently has a 3.74% yield, the highest on our list.
At the core of management’s approach is a hunt for “positive net present value,” a way of analyzing a company’s cash inflows. This metric is usually employed by those buying businesses, but in the case of Federated Strategic Value, it’s a means of selecting solid companies with the ability to boost their dividends.
Peris has little patience with benchmarks, such as the S&P 500, which his fund has narrowly outpaced over three years, but trails over the past year. The fund’s team combs through the S&P and a roster of large foreign companies to find stable, mature, dividend payers. “Turns out, when you do that, the result looks nothing like any kind of benchmark,” observes Peris.
Strategic Value’s sector allocation is also out of step with many of its large-cap value rivals’. The fund is more heavily weighted toward the communications-services, consumer-defensive, health-care and utilities sectors than its peers, according to Morningstar.
Though nearly half of the fund’s assets are in the consumer-defensive and health-care areas, Peris says its holdings are adequately diversified. Part of the reason: 29.4% of them are in non-U.S. stocks. London-based AstraZeneca (AZN) is the top foreign holding, accounting for slightly more than 4% of Strategic Value’s assets. “We feel we meet any kind of diversification standard, given the types of companies we invest in and our geography,” the money manager says.
His main challenge is to maintain a stable of stocks with high and rising income streams. “We have a lot of clients who rely on us for income,” Peris says. “Making sure we can deliver that is our risk management.”
To do so, his team carefully monitors business developments at its portfolio companies to make sure that these corporations have the ability and inclination to pay dividends over the next three to five years.
Investors shopping for funds based on the past year’s performance will be tempted to pass up Strategic Value: It trailed its large-value peers by five percentage points over that span. But Peris says he isn’t concerned about the short term.
“They’re the hares,” he says of rival funds. “We enjoy being the tortoise.”