Q: How would you describe your investment philosophy? What are the core beliefs behind your money management?
A: Our strategy is based on the belief that dividends are a key part of the return of an equity portfolio as they represent almost two-thirds of the total return. Capital gains are also important, but they represent only one part of the gain. We focus on stocks that are able to pay high and sustainable dividend yields with the goal to create a quality-biased product that is very different from the product of a value strategy. The most important characteristic of dividends versus earnings is that the trend of dividends is much more stable over time. Thatís why a strategy based on dividends results in lower absolute risk and much lower volatility compared to the rest of the market.
Q: Why do you believe that a dividendbased strategy is better than a strategy based on earnings?
A: There are several reasons for which we like dividends. The first one is that paying dividends on a regular basis implies a sound balance sheet and enough resources to ensure the payments. Also, a change in the dividend strategy provides important signals about the prospects of the company. A cap on dividends is usually a strong negative signal about the prospects of a company. On the other hand, an increase of the dividends means that the company is profitable and its prospects are good. If the management is not sure that it will be able to show stable growth, it would prefer to maintain the dividend to avoid strong increases followed by strong decreases. Thatís why the dividend trend over time is much more stable.
Overall, a stable dividend is a good indicator of the long-term health of a company. I believe that is a key message that enables our quality bias in terms of equity and leverage. Thatís how we differ from other value strategies. But in our selection process, the focus on dividend yield is only one of the criteria. The sustainability of the dividend is another important aspect because we know that if a company cannot grow its business and earnings, it will not be able to maintain that dividend. We consider high payout stocks only if they are backed by sound fundamentals and a sound business.
So the goal is to build a product that outperforms the market with lower risk. We are benchmark aware and we aim to beat the MSCI World Index on a three to five year basis, so we have a long-term strategy. Because we focus on high-dividend stocks, the average dividend yield of our product is higher than that of the market but the goal is not to maximize the yield of the portfolio at any price.
Q: How do you translate that philosophy into an investment strategy and process?
A: Our process is a combination of quantitative screening and qualitative assessment made by the portfolio manager on the output of that screening. We have a proprietary global database which includes more than 50,000 shares and thatís our starting point.
The first step of the process is screening, which aims to provide focus on the investable universe. We want to avoid the noise of the forecasters, so the screening is based only on historical data. We screen stocks on dividend yields and look for a minimum of 3% yield over the last 12 months. In terms of market capitalization, we maintain a threshold of $1 billion to avoid the micro-cap area for liquidity reasons. Then we look at the stability of the dividends in the past and the companies should be able to show positive dividend growth over the last few years. It doesnít mean that we look for the highest historical dividend growth. Rather, we look for stability over a five-year period because this is a sign of quality. In terms of geography, we are a global fund and we can invest in any market, including the emerging markets.
By putting the constraints on dividend yield, market cap, and historic dividend growth, we end up with a list about 400 names. That output is the basis for the second step of our process, or the pure fundamental analysis. In that step we focus on prospective data and the sustainability of the dividend going forward. We want to make sure that the names in the portfolio are able to grow the dividends in the future, so we review the companies to select only the names with strong fundamentals. For each specific name, we have to believe that thereís room for growth.
We have support from our research team, so the portfolio manager can rely on the valuation work of a team of about 30 sectors specialists. We regularly discuss the valuations and why they like or donít like the stock. We also meet on a regular basis with the managements of the companies that we own. The qualitative assessment is made by the portfolio manager, who takes into account all sources of information and the valuations of the analysts. The manager has to decide if to include the name in the portfolio or not. All the names that we put in the portfolio are high conviction names, or names that we want to invest in for the long run.
Q: Would you explain the qualitative assessment part in more detail?
A: I believe that the qualitative assessment is the only way to make sure that the stocks are able to grow the dividend moving forward. We look at and beyond the quality of the balance sheet. If a company has too high leverage, the debt payments may create problems for the dividend payments. The European telecom names, for example, were not able to pay their dividends in 2001 and 2002, because their debt payments were too high.
Also, if a company is not able to grow its earnings, it might be forced to cap or reduce its dividend. We examine the prospective earnings and we use the discounted free cash flow model. Iím not much interested in consensus data because it is not very accurate, but consensus estimates provide an insight to the market expectations. Overall, we focus not on the stocks with the highest earnings growth expectations, but on the stocks where there is good visibility on the future earnings and cash flow to bring quality to the product. The valuation is another key aspect of our stock selection process.
Q: What portfolio construction rules do you follow?
A: We have about 100 names in our portfolio and we are fully invested. Being benchmark aware means that we use the MSCI World Index for performance measurement purposes, but we donít build our products based on the weight of a stock in any index. The stocks in our portfolio are equally weighted at about 1%, which means that the portfolio significantly deviates from our benchmark.
The equal-weight approach is a key element of our strategy as we donít believe in penalizing a stock just because its market cap is lower. Every quarter we review the portfolio and meet our analysts to make changes in the names we own. Also, every quarter we rebalance the portfolio to the average weight. Of course, during the quarter we do better in some names and that leads to different weights, but we systematically rebalance the portfolio back to this average weight of 1% by trimming down the outperformers and buying back the underperformers that we want to keep. That approach allows is to systematically profit from the winners and to invest in the names that with unrealized growth potential.
Q: What would trigger a sell decision?
A: We have a very strict sell discipline. If the dividend yield of a stock drops below the three percent threshold, we would sell that name. For example, if a name that we bought at 4% dividend yield has been pushed down because of share price increases, our rule forces us to systematically take our profits and find better opportunities in the market. I believe that one of the most difficult tasks of an equity portfolio manager is to get rid of a specific name and to avoid falling in love with a company. With our approach, we may take profits a bit too early in certain cases, but we ensure that we take profits systematically.
Q: How is your portfolio distributed across geographies and sectors?