Phillip Davidson of American Century Equity Income

Dividends + Convertibles = Smooth Ride

Quick Take: Steering American Century’s “most conservative equity offering,” co-manager Phillip Davidson favors dividend-paying stocks, convertible securities, and quality companies temporarily under water for American Century Equity Income/Inv (TWEIX). Markets may rise and fall, but Davidson feels “quality contrarian investing wins out over time.”

While Davidson expects the recent dividend tax cut to help curb excess capital spending in many industries, he predicts there will always be some market segments under pressure, which can lead to opportunities. The manager has recently been focusing on integrated oil companies, which “fell apart.” The promising companies he picked up in that industry include BP p.l.c. ADS (BP).

The fund’s recent returns have been subdued, but the contrarian approach tends to work better in down markets. This year through July 22, the fund was up 9.6%, while the S&P MidCap 400/BARRA Value index rose 13.3%. Long-term returns show the fund generally offers a smooth ride with less volatility. For the five-year period through last month, the fund rose an average annualized 8.5%, versus a gain of 4.7% its mid-cap value peers.

The Full Interview:

S&P: What is your basic investment philosophy?

DAVIDSON: The fund is American Century’s most conservative equity offering. It’s a value-oriented portfolio emphasizing relative yield through dividend-paying stocks. We believe higher income reduces volatility.

To enhance the risk reward, we also hold convertible securities. We use convertible bonds and convertible preferred, depending on which is available, since companies don’t typically offer both.

S&P: What do you look for in a company?

DAVIDSON: We look for quality companies with good returns on capital and sustainable franchises that are out of favor for reasons that are transitory. We look for them to be the first or second leaders in their industry. The best players usually offer the best returns.

In addition, we are also patient and willing to wait for the right opportunities. Valuations are also an important consideration.

S&P: The fund is classified as a mid-cap value fund by Standard & Poor’s. Is that truly your focus?

DAVIDSON: The fund is an all-cap offering. About 50% is in mid- and small-cap securities, and about 50% is in large-caps. We’ve shifted a little more toward large-cap stocks because of opportunities for better yield. Many industries have consolidated, leaving a void in mid-cap stocks.

S&P: What impact do you expect as a result of the recent dividend tax cut?

DAVIDSON: Corporate America will focus on avoiding excess capital spending and destructive acquisitions. The companies that will most likely offer dividends will be those with the strongest financial positions. The biggest long-term change will be a greater return of capital to investors.

S&P: Has this year’s rally led to fewer attractive opportunities?