Discipline, Dividends, Diversification

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.