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New Opportunities in Total Return
10/01/2012 10:00 am EST
A decade ago, the markets began to change...more and more growth-focused companies started kicking off dividends, and now total return investors are reaping the fruit of that transition, says Dan Genter of RNC Genter Capital Management.
Gregg Early: I am here today with CEO and CIO of RNC Genter Capital Management and manager of RNC Genter Dividend Income Fund (GDIIX), Dan Genter. Dan, I was wondering, because your fund's goal is long-term capital appreciation with dividends included, where you are looking for good candidates for your fund?
Dan Genter: I think the interesting thing about the marketplace right now is our job has really become easier.
What’s been happening, especially in the last five years, is there not only are more dividend payers out there—402 companies of the S&P 500 pay dividends—but in every single sector except for financials, not only are more companies paying dividends but the dividend level is higher. In most cases, the dividend levels are up 30% to 40% than where they were five years ago.
We really look for all domestically listed stocks, so everything that’s on the New York, American, Nasdaq. And then we also look at ADRs that are listed here, which is about 500 international companies.
So when you look at the entire universe, it’s literally about 3,500 different issues that we screen for, and that’s really the key. When you look at our process it’s really threefold:
- No. 1, there’s an initial screen.
- No. 2, there is a very extensive fundamental analysis after that screen.
- No. 3, there’s a portfolio management process which is really designed to help control risk in the portfolio
But the first part of that screen is running that universe through. We’re looking for a minimum dividend yield of 2.5%. We’re looking for very consistent dividend payments. Basically, unless there’s some type of extraordinary circumstance, no cuts in dividends in the last five years.
We’re looking for a minimum market capitalization of $2 billion. The company has to have an investment-grade debt rating on its underlying debt and all the dividends that are being paid or qualified dividends.
So that’s a lot of criteria that literally takes that 3,500-security universe down to about 250 that really become the stocks that we know meet all the dividend criteria, and then we go from there. Because job one, it is a high-income strategy. I mean, the income there is not just something that’s ancillary. We’re trying to provide a very high income.
The target for the portfolio is to be double S&P, and so that’s why we start with the dividend screen...because we don’t really care what your story is. If you’re not paying a dividend, or you’re paying a low dividend, it’s not going to be right for our portfolio, so we start with those dividend screens that I mentioned.
We make sure that it’s going to be compatible to us from a cash flow standpoint, and then the second step for us is where we’re somewhat unusual, because the next step for us is that we’re really looking at the company’s balance sheet versus the income statement and looking at the company as though we’re reviewing it to buy the bonds of the company and not the stock.
This is a critical element. If you’re going to be a good high-dividend manager, it is very important that you think like a bond manager—and you need to think like a bond manager first, because if that dividend is as important to you as it should be, then it should be as important to you as the coupon payment on a bond. And if you’re looking at it that way—and you should because it’s probably going to be on average over 40% of your return—you better be paying attention to it.
You need to look at it as though you’re a bondholder and know and not forget that you are subordinate to those bondholders, so if they run into a cash crunch they are going to cut that dividend or eliminate that dividend far before they’re going to miss a coupon payment.
So you want to go through everything, all the screens you would on a balance sheet, and basically walk away with a feeling that you have earnings and free cash flow coverage to debt service ratios of all the senior debt that’s in front of you, and you would not only buy the bond, but you feel very comfortable from buying that stock in the sanctity of the dividend.
Then the third element is, once you have satisfied yourself from a balance sheet standpoint and a fixed-income standpoint, and satisfied yourself from a dividend exclusively standpoint...then basically, you strip those away and say, “Would I buy this stock if it had no dividend."
You’re specifically looking at the stock. You’re running it through all the same valuations and coefficients that you would as primarily a value investor to say, “Yes, it’s a good company.” But the stock has to have fair value, and you really need to be where you can put all three of those pieces together to get a buy signal.|pagebreak|
Gregg Early: Well, that’s a nice rigorous process, and especially with people these days being so hungry for dividends, but not really understanding that they'd better make sure that they’re sustainable as well as looking at a company.
I have some friends that are bond traders, and every time they look at stocks, their question is, “Would we lend this company money?”
Dan Genter: Right.
Gregg Early: That’s the way they look at it.
Dan Genter: Yeah. Would you lend the company money, and is this someplace you’d like your kid to work?
Gregg Early: Right.
Dan Genter: And that it’s going to be around. You know we feel that that is just absolutely critical as you look at these situations. Total return is a double-barrel strategy. I mean, you’re looking for that income. That income is key.
As I mentioned, in the long term, the income is over 40%. If you look at S&P averages since the 1930s, it’s 42% of total return. But you’ve got another 58% or 60% that you need to get in appreciation. And what the statistics show is that the highest dividend-yielding, pure highest percentage dividend-yielding stocks, do not do the best in total return.
That's the second quintile when you look at just yield. The second quintile are the ones that have the best total return. So it’s showing that in many cases, just having your nose to the ground and trying to sniff out very high dividends alone doesn't work.
In many cases, that high dividend is tied to possibly a distress situation, or where the dividend percentage is very high because the share prices have come down, or there’s a very high payout ratio that’s not sustainable, and so someone can’t take a position. I’m not just going to screen and pick the highest yielders, because history really demonstrates that those are not the best performers. You really need to look at both sides of it.
Gregg Early: Yeah, absolutely,and I can see even from your holdings...I mean, the top five that I see are AT&T (T), Total (TOT), Merck (MRK), Johnson & Johnson (JNJ), Intel (INTC). It’s a diversified bunch, but they’re all rock solid, and there’s a growth story as well as a stable dividend story there as well.
Dan Genter: Right, and I mentioned earlier, the nice thing about having more names out there now is that you now can get a lot more. Not only can you find more names individually that you like, you can find more names in more diversified sectors than you used to be able to previously. Technology, for example, had almost nothing ten or 15 years ago.
Gregg Early: Right.
Dan Genter: So, now not only do you have more names in sectors that give you more growth, but as a portfolio manager controlling risk, you now can get much better diversification in different economic sectors versus a strategy that historically tended to be very sector-concentrated in utilities and energy and industrials.
So I think that’s very, very key to this strategy. I mean, not only are there more names—more names in more sectors that provide more growth—but you can get a lot more diversification in these different sectors, not only for representation for total return, and it also reduces your risk.
I mean you’re not in a position where you’re handcuffed to one or two sectors, where you might get caught in sector rotation. Now you can diversify the risk, and you can also manage the sector diversification and roll from one to the other. That is something that was very difficult to do 15 years ago.
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