Low bond yields have sent investors piling into higher yielding sectors like utilities, stretching the valuations of many high-dividend-paying stocks. How should dividend-oriented investors navigate this environment of lofty valuations and low yields? Alan Berro, Principal Investment Officer of Washington Mutual Investors Fund℠, gives his perspective on addressing this conundrum. In this Q&A, he discusses:
- The importance of investing in companies that can grow their dividends over time
- Dividend opportunities outside the traditionally higher yielding sectors, such as information technology
- Equity strategies focusing on income and downside protection as a core to an asset allocation program
Seeking Yield in a Challenging Environment
How is Washington Mutual Investors Fund — a dividend-oriented fund — navigating this environment of ultra-low bond yields? How do you think about it?
If you look at the traditional dividend-paying groups such as consumer staples and utilities, their absolute valuations appear quite high on a historical basis. But if you are getting a 4% yield on a plain-vanilla electric utility, that’s significantly higher than the 10-year U.S. Treasury. That’s a tradeoff some investors are making, and I am not sure if that tradeoff will end well.
Sustainable income is a really important part of our focus as a growth-and-income fund. However, the traditional areas of the market that would provide income have become less attractive, and I worry that those stocks would be more vulnerable in a rising-rate environment. There are not that many high-quality companies that yield over 3%, and we are being cautious about stretching for yield.
The portfolio is still invested in the higher yielding sectors?
Correct. Although valuations are a consideration, there are some structural advantages right now in the telecommunications industry. For example, AT&T and Verizon, the two major players with the strongest networks, have evolved from traditional phone companies to more diversified businesses. These are the two dominant cell phone providers and they have learned to play nice with each other, so to speak. They have benefited from the fact that consumers have less of an incentive to switch cell phone providers nowadays, as the cost advantages are no longer as great. AT&T has been around for a long time. The company may not grow much, but it has been a reliable source of dividends.
A History of Lower Downside Capture and Volatility
As of September 30, 2016. Based on Class F-2 shares.
Source: Morningstar. Downside capture versus Standard & Poor’s Composite Index. Downside capture reflects the annualized product of fund versus index returns for all months in which the index had a negative return. A downside capture greater than 100% means that a fund fell by more than the market index did. A downside capture less than 100% means the fund fell less than the market index. Annualized standard deviation (based on monthly returns) is a common measure of absolute volatility that shows by how much returns varied from the average. A lower number signifies lower volatility. Please see americanfunds.com for more information.
Look for Dividends in Nontraditional Places
Given the high valuations of the traditional dividend-paying sectors, where are you finding yield opportunities?
We are seeking to identify companies with a slightly lower yield, but better dividend growth. We would rather invest in a company with a yield slightly above 2%, but with the potential to grow its dividend 15% to 20% a year. In some cases, valuations for those companies aren’t cheap either, but we think that they are more justifiable because we expect them to grow faster than an electric utility or telecommunications firm.
A good example of a company we believe is well-positioned for dividend growth is Home Depot. The company is well-managed and has benefited from a decent recovery in housing, along with its strength in catering to construction professionals. Another example is global security and aerospace firm Lockheed Martin. We believe the company is cash-generative and shareholder-friendly, and is well-positioned to benefit from a potential upturn in defense budgets.
We also have sought out more of those types of companies recently in the information technology sector. Certain technology companies have become more mature and intelligent about their capital allocation. Previously, these tech companies often had good cash flow, but they always perceived themselves as growth companies that did not want to pay a dividend for fear of being viewed as ex-growth.
Can you give us an example of such a tech company?
Microsoft is one. It has paid out and grown its dividend steadily in recent years. Moreover, Microsoft has become a substantially better managed company. It is focusing on its core business, including the Windows operating system and Office suite, which are very cash-generative. It is also having some success in its cloud computing business.
Favorable Rankings Against Peers Morningstar Category Return Rankings for Washington Mutual Investors Fund
As of September 30, 2016.
Source: Morningstar. Based on Class F-2 shares. The fund category shown is U.S. Open-End Large Value. Rankings are based on the fund’s average annual total returns within the applicable Morningstar category. The Morningstar rankings do not reflect the effects of sales charges, account fees or taxes. Past results are not predictive of results in future periods. When applicable, investment results reflect fee waivers and/or expense reimbursements, without which results would have been lower.
A Focus on Quality, Blue-Chip Companies
Why does the fund have such a strong focus on high-quality large-capitalization stocks?
Because high-quality large-cap stocks have historically shown greater resilience in down markets. Also, deriving a sizable portion of returns from income dampens volatility, as we all know.
How should investors think about the role of Washington Mutual Investors Fund in a portfolio?
We view the fund as a core holding in the large-cap space that, through its investment in high-quality large-cap stocks, aims to protect on the downside while participating in a large part of the upside. The fund’s characteristics can vary depending on valuations, market opportunities, longer term industry trends and the interest rate environment while keeping a focus on its long-term income objective.
What valuation or financial metrics do you use to evaluate whether a company is high quality?
Dividend-paying companies must have fully earned their dividends in at least four of the last five years — meaning that their earnings per share exceeded the dividend per share. In addition, the companies must have paid a dividend in at least eight of the past 10 years. This is the most important criteria for dividend-paying companies.
What is the rationale for requiring companies to fully earn their dividend?
The original philosophy is that companies that don’t earn their dividend are either having to borrow to pay it or do something unnatural to get there, and that could end badly for investors.
How has the eligible list affected investment outcomes for the fund?
The fund’s eligible list and yield focus are two reasons why its results have been less volatile than the S&P 500 index and many other value funds. In all large U.S. equity market declines, the fund has usually gone down by less than the market. The fund has sometimes lagged in bull markets because of its more conservative nature, but it usually picks up ground in a down market.
I think Washington Mutual has endured the test of time. It’s not a fancy formula. We basically seek to buy quality companies that aren’t very high risk. We buy blue-chip stocks that almost everyone has heard of. We think the fund is a good fit for investors who want a fairly smooth ride and who want to participate as much as they can on the upside while getting income along the way, and hopefully not participating as much on the downside. It is a no-frills, conservative fund.
What do you think about value investing and Washington Mutual? Is it a traditional value fund?
There is a lot of overlap between what is viewed as traditional value-style investing and a yield-focused fund like Washington Mutual. So there are long periods when this fund will fit neatly in the broadly defined value space.
That said, I think we have to be cautious about relying excessively on the metrics used to identify traditional value stocks. When a company’s earnings go down, its P/E ratio can go up, resulting in the company being taken out of the value bucket and reclassified as growth. We don’t think the metrics associated with value investing necessarily always provide the best lens for evaluating investment opportunities.