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?

DAVIDSON: Typically, there is always something out of favor. The one opportunity we recently saw was in integrated oil companies, especially in the second quarter. BP p.l.c. ADS (BP) fell apart, yet we felt its long-term outlook was favorable, and its dividend yield was attractive.

S&P: What’s the fund’s weighting of convertible securities?

DAVIDSON: About 20%. Convertible securities provide participation in the underlying equity, assuming it goes up, and they help smooth out the ride.

S&P: Do you consider any top-down macro-economic criteria?

DAVIDSON: We don’t pay attention to where a company is in its profit cycle. We are more interested in companies with below-average profits for transitory reasons. For example, we’re avoiding Toys R Us (TOY) because of its weak position relative to Wal-Mart Stores (WMT), not because of overall demand due to the economic cycle.

S&P: What are the fund’s largest sector weightings?

DAVIDSON: At the end of May, financials were 15.2% of the fund, energy, 11.3%, consumer non-cyclicals, 10.7%, industrials, 9.6%, and utilities, 8.7%. Financials are our biggest underweighting relative to the S&P 500. It Financials are a cyclical area like technology, and are now over loved and over owned. Earlier this year, we had an overweighting in asset managers, but we’ve since pared back our holdings, including T.Rowe Price Group (TROW).

S&P: Why has the fund somewhat trailed its mid-cap value peers so far this year?

DAVIDSON: It’s not unusual for us to have below-average returns in market rallies. We tend to do well in periods of broad market underperformance.

S&P: Despite recent softness, why has the fund’s long-term performance been strong?

DAVIDSON: Quality contrarian investing wins out over time. We’ve gained by being against the conventional wisdom most of the time.

S&P: What are the fund’s largest holdings?

DAVIDSON: As of the end of May, they were BP, Kimberly-Clark (KMB), Ameren Corp. convertible preferred, Union Pacific convertible preferred (no longer a top-five holding), SBC Communications (SBC), and Emerson Electric (EMR).

S&P: What’s your outlook for value investing?

DAVIDSON: I think performance goes in cycles, and the last three years were very good ones. There has been a collapse in valuation spreads, so more modest relative performance is likely.