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Portfolio > Portfolio Construction

Discipline, Dividends, Diversification

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Not so long ago, investing in stocks that paid dividends was decidedly uninteresting. Investors clamored for companies in which smart CEOs plowed cash back into the company so that it would grow. Capital gains were what investors wanted; dividends were pass?(C) and highly taxed to boot. But when taxation on dividends fell to 15%, and the equity markets went through a period of adjustment in the early part of this century, dividend-paying stocks got more attractive.

If investors could realize good dividend yields as well as potential capital appreciation in high quality companies, would that be a popular strategy? It would seem so, if you look at the $2.45 billion Allianz NFJ Dividend Value Fund (PNEAX). The overall portfolio has about $17 billion in assets, including the fund, institutional accounts, and managed accounts. Dallas-based portfolio managers E. Clifton Hoover, Benno Fischer, and Chris Najork look for “those companies that are temporarily out of favor but which are fundamentally strong on a long-term basis,” says Fischer.

The fund gets five stars overall and in the one-, three-, and five-year periods from Standard & Poor’s, with a five-year annualized total return of 10.37%, versus 6.68% for the S&P 500 Value Index; and an annualized 17.52% return, versus 16.15% for the index for the three years ended June 30.

Cliff Hoover and Ben Fischer talked to Staff Editor Kate McBride in late June.

You’ve already closed the managed accounts to new investors. Is there a point at which you may close the fund?

Fischer: We have been wrestling with the contrast between our ability to perform above the market averages and the amount of money that we run, because we’re doing a good job for our clients and at some point you have to be careful about how much money you take. When you start out with $1 billion or $2 billion it’s a little bit easier to run the money than when you’re running $17 billion or $18 billion.

Hoover: I think a high end for this product would probably be in roughly the $20 billion range. In our view anything north of $25 [billion] is considered a very large portfolio–so it’s not going to be open forever.

If you look at our process, we’ve always selected from the top 800 stocks in the U.S., and today that’s about $3 billion and above market cap–it’s in the large-cap value slot, because we’ve been buying the Mercks (MRK), and Pfizers (PFE) of the world. We’re going to continue to slowly move up cap-stream; we bought Coca-Cola (KO) this year; we own Budweiser [Anheuser-Busch--BUD], Pfizer, Merck. The average [market-cap] is about $42 billion today, with a median of about $22 billion. Back in the ’90s this portfolio had a median of about $7 billion–we found more value in the mid-cap value space. Today we’re finding it more and more up in the large-cap value space.

Would you tell me more about your investment process?

Hoover: Sure. We’ve always been known as the 3-D investment firm, meaning discipline, dividends, and diversification. We take as much emotion out of the investment process as possible; try to be very methodical, very disciplined; we are process-driven here, all the alpha comes from our process. We have a team approach that works on the process, and we look at the process as being our engine–that’s what drives the alpha. We fish in that [low] P/E fishing pond with stocks that pay dividends. Every stock that we buy has to pay a dividend.

Half the weight of our selection factors in this portfolio is fundamentals: low P/E, low price-to-cash-flow–and the other half is actually dividends–which we think is very unique. Most value portfolios today have a dividend yield as kind of a byproduct, but this portfolio explicitly focuses on dividends, so half of the stock picks come from the yield side. Dividends are very important for a number of reasons: we know that about 50% of total return has come from dividends–over long periods of time–it’s that dividend compounding that’s so important. Domestically or internationally, it’s the same story: dividends are defensive, and our portfolios tend to hold up very well in tough markets. We like that margin of safety that a nice dividend yield gives you. We like dividend growth with our companies, and quite frankly, studies are now coming out showing that over the last 15 years, your higher payout ratio companies actually have higher ROEs. That might sound counter-intuitive because we all learned in business school the more earnings you retain, the more you can grow your earnings and your return on equity, but in reality, the studies are now showing it’s just the opposite.

Diversification is a unique area of our process; we’re not just buying all the low, six-, seven-P/E stocks. We like to buy value by industry. We categorize every company that we own into its respective industry, 53 industries in this dividend value portfolio, and then we compare within each industry. We don’t believe that you can compare a 14-P/E company in one industry with an eight-P/E company in another. [There are] completely different industry growth rates, capital reinvestment requirements, different leverage, and some companies are heavy R&D type companies.

We do all the fundamental research in-house. We look at Wall Street research, of course, we have access to all of it, but we really see that research as more of the consensus opinion. Invariably we’ll have a stock we like and they’ll have a hold or sell on it, and stocks we don’t like–you know, a high-P/E stock–they’ll have a buy or strong buy. We look at those guys as more the herd; they are important because they form that consensus view, and then we’re always going to be in the contrarian part of that consensus view. Coca-Cola is an example of a stock that Ben and I actually predicted, in 1998, when it was 50-times earnings, $87 a share, that we would own someday, but we had to sit on our hands for eight years. We picked it up about three months ago at about 16-times earnings, $42 a share, 3% dividend yield. It’s also a big dividend grower; it’s grown its dividend in double digits over the last five years, as well as buying back a lot of stock–so it’s a free-cash-flow machine.

We use several quantitative models that assist us more from a timing perspective. We use a price-momentum model that attempts to show us, from more of a technical perspective, if the stock looks cheap on fundamentals: Do you buy today or wait a month, or is there something really wrong with the company? Is it a value trap? Somebody always knows, right? So that’s picked up in those technicals, occasionally, and that would make us shy away from a stock we liked fundamentally. As a value manager we’re always looking at something that’s out of favor–there’s something wrong with it per se by the market–we have to make sure that we avoid those value traps, and that falling knife. We’re not a deep turnaround firm that likes to buy the falling knives; [if] we like the stocks, they’ll fall and then base for a while–create a bottom–before we’re really interested.

And these are quality companies at a very opportune price?

Fischer and Hoover (in stereo): Right!

Hoover: But each company has to go through a rough patch or they wouldn’t be cheap, right? We like that rough patch–we can’t tell you whether it’s going to be three weeks or three years before the market realizes that it’s had a too pessimistic view, but we’re long-term holders and we think that’s how you compound money over time.

Fischer: While the product that we’re talking about today is closer to being closed, we can apply the same principals to new, exciting areas. International value is a very unexploited area, which we think is perfect for our system. By managing information, and doing it on a global basis, we have an international value portfolio that’s essentially run off the same general disciplines, which has a 3.1% yield and a 9.7% forward PE, and it’s run the same way. We look at the cheapest stocks in industries that we define worldwide and what it gives us is diversification against a falling dollar, but it gives us the same relative equity values that we would get in our domestic products. What we like about it is we can apply the same knowledge-gathering foundation, and structure, and screening discipline, to that particular arena of investing, and I think it’s likely to outperform there just as our domestic stocks outperform here. [NJF International Value Fund] is really an exciting product from a timing point-of-view because we’ve just come through a little bit of a rain-delay, I think markets got a little skittish in May. Some of the emerging market returns were disappointing short-term, but longer-term we think it’s inevitable the dollar will decline, and you can pick up an awful lot of good value by being in international. That’s one that we don’t have any near-term constraints on in capacity, and we really would encourage people to look. What we try to do is be timely in our portfolios. We’re contrary [in] opinion [on] when you should be in particular styles. For example, in 2000, Cliff would go around to the various forums and try to convince them that our Small-Cap Value [portfolio] was the place that they should be investing, and of course, most people were enamored of high-tech, momentum-style, internet investing. The point is, a contrary approach would have led you into that small cap [portfolio] at less than 10 times earnings and a yield of 4%; five years later, it’s fairly mature. We can tell you that international is where small cap was five years ago; it’s somewhat new to people and they’re not used to the idea of the dollar being weak, but it’s really going to be a great product for the next five years. We try to make sure that what we are actively getting people to accumulate are timely products.

Fischer: One other aspect of this is we’re not arguing against other domestic equities, we’re arguing against the tendency for people to try to hide in long-term fixed income assets. I think that one of the big traps over the next 15 years is going to be rising secular interest rates; it won’t happen right away, but I think it’ll be the mirror image of the period from 1982 to 1999, where long-term, 10-year bonds were probably yielding 14+%.

Are you able to pass favorable dividend taxation along to shareholders?

Hoover: Dividends are taxed at 15%, except REITS, and we do have a 2% position in a REIT in the portfolio. The portfolio is 98% tax-efficient.

Can you talk about something that you liked that seemed to fit your profile but didn’t work out the way you wanted it to?

Fischer: Well, we did own GM (GM) for a while, and that’s the most recent memory that we’d like to eradicate. The idea was that we felt that the stock got so statistically cheap–had such a high yield–that they could rationalize their business, and for a while it worked pretty well.

Hoover: We originally bought that stock around 32.

Fischer: And it went up to 55 or so. But inevitably it fell because of the demands of the industry: the wages couldn’t be overcome, the unions demanded higher retirement and health care benefits than the industry was ultimately able to sustain. It really turned out, in our view, to be a less-well-managed company than we had originally envisioned. We were hoping the management would be able to renegotiate and rationalize its position within the industry. It’s been a pretty rocky road. We decided that when we saw that their earnings were deteriorating, we would have to stick to our discipline and reduce the holdings.

You have this discipline for buying. Do you have a discipline for selling?

Hoover: We have the portfolio online and we look at valuations every day. Our sell discipline is very important; we have to sell a stock before we buy one. We don’t like to own a stock that has a higher valuation than the market; today, say, it’s an 18 P/E or so. So it’s a kind of a governor on the portfolio. The second parameter, which is used quite frequently, would be the relative value. If a stock within a particular industry has appreciated to the point–it usually crosses the median P/E of that industry– where we think it’s approaching full value, then our goal is to recycle that money back into better value. Initially we’ll look back in that same industry, back in the low valuation quintile, we try to find something, [and] if we find something, fine. If we don’t, we’ll move to other industries. Our turnover is not that high, about 30% a year, but that’s the main sell-discipline parameter. It’s taking that low valuation stock that’s done very well and recycling it back into another low-valuation stock. Third [comes] if we have a takeout; typically we have one or two of those a year. If the market doesn’t care how cheap a stock is, eventually corporate America or corporate Europe will come in and buy our company–that’s kind of a forced sell, if you will. [We'll also sell] if we have a company that’s deteriorated from a fundamental perspective, like if it starts leveraging up too much.

We mentioned that we use price momentum on the buy side; we’ll also use it on the sell side. If you have a company in the portfolio, and it starts exhibiting very, very weak price momentum, we’ll sell a stock just on price momentum–it’s like, somebody knows something that you don’t know. The most recent example of that is Fannie Mae (FNM). We sold Fannie Mae at $66, $67 a share based on pure price momentum. The price momentum model was telling us, “There’s something wrong here, and you don’t see it yet.” All the other fundamental guys were saying, “Wait a minute, the stock’s getting cheaper.” That stock went to the low $40s. We do weed the garden occasionally, so our sell discipline is very important, we try to be as non-emotional as we can be, and it’s a very important part of our process.

What else do advisors need to know about the fund?

Hoover: We’re long-term, bottom-up stock pickers. In general, the value guys have had a great time these last five years. Today, value is not expensive [compared] to growth, and growth has closed the gap with value from a valuation perspective. So going forward, our view is this is going to be a great stock picker’s market; good value pickers are going to be able to make some money and some good growth stock pickers are going to be able to make some money–so it’s not going to be just value or just growth. It’s going to be a tough market in the U.S. We still think the S&P is going to be in that single-digit range– 4% to 5% annualized. We think the stock pickers are going to rise to the surface.

Staff Editor Kathleen M. McBride, a former stockbroker and bond trader, can be reached at [email protected].

For a complete transcript of the interview with Clifton Hoover and Ben Fischer, go to “Web Extras” at


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