An Interview With Brian Rogers, Portfolio Manager, T. Rowe Price Equity Income F
by Maria Crawford Scott
What is the investment objective of the fund?
The objective is to provide the investor with a reasonable but relatively less volatile means of investing in equities. Dividend yield [dividends per share divided by share price] is a characteristic that can both enhance return and also protect stock investors if market environments are difficult. My experience is that many investors are not as risk-oriented as they think they are, and therefore a conservative, yield-oriented stock investment makes sense for many of these individuals.
Yes, for two reasons. First, having dividend income is an important part of our strategy—hence the name of the fund.
Second, it is one of the ways we use to gauge relative value. When we do screening work looking for relative value opportunities, one of the most important things we look at is how a companys dividend yield has varied over time relative to the market—basically, we are trying to identify companies whose dividend yield is higher than it normally is, relative to the market. That often corresponds to a company that hasnt performed particularly well and may be relatively inexpensive.
We also use other measures to gauge relative value. For instance, we look for companies whose price-earnings ratios are lower today than they might normally be, and we look at how a companys revenue stream, its price-to-sales ratio, varies over time.
Not really. In our basic screening, we will include companies with yields slightly less than the market if their relative yield is very high for some reason. Often there is a good relationship between a company with a high relative yield and a pattern of recent underperformance. Thats the type of combination we like to see. Our holdings tend to be solid, large-cap [market capitalization—number of shares outstanding times share price] companies that go through these bouts of being out-of-favor and then being back in favor.
Its all over the lot. We dont have a strict formula that leads us to say we wont buy a stock if it yields less than 1.0%. Right now we have 119 holdings in the portfolio, and probably three or four of them do not pay a dividend. We have a couple of companies that started dividends this year in response to the tax law change. Microsoft is one of those, and an even newer investment for us is Viacom. Those would be at the lower yield level of the portfolio. When you get into the oil stocks, the financials, the utilities, and the telephone companies—which have been a huge disappointment—those get us up into the 5% and 6% range. The average right now, as of the end of the third quarter, is about 2.7%, and the S&P yield is about 1.7%.
Yes. With 119 stocks, we are well-diversified and have exposure in all sectors.
What we try to do with respect to the value-oriented S&P sectors—financials, utilities, energy, telecom, some of the cyclicals—is to be not less than half-weight and no more than double the weight of the S&P 500. Thats a simple risk-control measure so we dont get either too negative or too euphoric at the wrong time.
The long-lived charter of the fund is that it is a relatively conservative portfolio thats not going to take huge bets. That, from a risk-control standpoint, describes how we look at sector weightings.
For instance, in terms of the utility sector, right now we have 4½%, versus 3% for the S&P. In the telecom sector—basically the old regional Bells—were 6% versus 3½%. We have little overweightings, but not large overweightings.
One thing to keep in mind is that utilities are great from a current yield standpoint, but not necessarily from a growth or valuation standpoint. We have a fairly recent investment in Johnson & Johnson, which is one of maybe six remaining AAA-rated companies, it yields a little bit shy of 2%, it sells at around 17 times next years earnings, it has a great dividend history, and we think it can grow at about 10%, which of course also translates into dividend growth. The issue for us becomes: Which is the better relative value, Johnson & Johnson, or a plain old-fashioned utility selling at 12 times earnings with a 4½% yield that can only grow at 5%? Thats where the relative valuation work we do comes in, because it helps us compare those two situations. If the utility is cheaper relative-valuation-wise, well buy it, but if Johnson & Johnson is cheaper, which was the case this year, well go with that. We want to have the flexibility to be able to move into those kinds of situations, even though we might be giving up 200 basis points in terms of current yield. We think the total return combination is a better proposition.
We also tend to shy away from the highest-yielding sectors, just from a dividend protection standpoint. We prefer the second-highest yielding decile companies. One of the ways we have gotten into trouble in the past was when we were willing to bet that a very high-yielding dividend was a safe dividend. Often the market will know more than we do about any given companys dividend situation, and the highest-yielding stock in an industry may not necessarily represent the safest investment in that area. We try not to stretch for yield to too great an extent if we think theres a chance it could be cut.
Well, now that you mention it—we made two investments this fall. One was in Marsh & McLellan, which is the parent of Putnam—Putnam represents probably a quarter or so of their income, so Marsh Mac is much more than Putnam. But implicit in that investment is a bet that the company will be able to straighten itself out.
We also just made a much smaller investment in Janus. If Janus doesnt work as a turnaround, I think there are companies that will try to buy Janus, and we may make a little bit of money that way.
Basically, yes. For instance, a company whose relative price-earnings ratio has risen sharply, whose relative dividend yield has declined sharply, or whose relative price-to-sales relationship has risen sharply would be a candidate to sell. For instance, we recently sold investments we had in some of the consumer products companies—like Clorox—that did very well in the bear market, because their price-earnings ratios had gone up and their yields had dropped as the stocks appreciated.
Yes, and you have to be careful because then you can get into an overreaching for yield situation. One of the ways we try to control that is to watch for dramatic balance sheet deterioration—forget earnings, forget dividends, forget what a company is saying about its business in a given quarter, and try to watch out for steady debt-to-total-capitalization deterioration.
To me, this has been one of the great examples of how, when you think you know something is going to play out—it doesnt!
In terms of its intellectual underpinnings, it makes immense sense to take down the marginal rate on dividend income. I think that is great.
But the big conundrum for investors is that the last investments you would want to own this year were high-yield stocks. What happened was that everybody got very excited about the legislation when it was proposed in January—there was more buzz about this than anything I can remember. Once the act passed, there was enough market excitement to cause a real rally in all the stocks that had performed so disappointingly over the last couple years—the small tech, the dot-coms, things like that. And the high-dividend-yielding stock was left in the dust.
That was a real surprise, because people—including me—thought that as soon as the act passed, everyone would go out and buy the high-yield stocks.
Of course, high-yielding stocks may have been due for a pause because in the depth of the bear market, yield was a great source of protection. But my new theory is that there is so much money sitting in money market funds, earning only 70 to 80 basis points and taxed as income at a maximum 35% rate, that when people actually start to do their taxes for the 2003 year, theyre going to start playing around with the numbers. Theyll look back and see a year in which the S&P was up around 20% with a 1.7% yield and dividend income taxed at a maximum of 15%. And you will then see a massive shift of liquidity in 2004 out of the aggressive stock market sectors into more stable, higher-quality, dividend-paying companies.
I dont think that, when all is said and done, well change what we are doing. Weve had to make some mental adjustments. For instance, when we do our screening work, a company that all of a sudden starts paying a dividend looks as though its relative yield is incredibly high in a historical context, obviously because they didnt have one before. But that doesnt necessarily mean the stock is cheap all of a sudden.
It is very similar to the situation several years ago when we began to mentally factor in stock buybacks as a return of cash to shareholders. Our screening work didnt pick that up naturally—we had to override our valuation screens for stock buybacks.
Tweaking is always necessary, both intellectually and in terms of actual systems. But the new tax law wont materially change what were all about.
The tax law change certainly has led a number of prominent companies to alter their view of dividends in terms of being willing to pay out more—the big Citigroup increase to me was a pretty representative move.
And some firms are paying dividends for the first time. Just by way of anecdote, the head of Viacom, who comes down here usually once or twice a year, sat in our office in the spring and said, If the tax bill is signed into law, we will begin to pay a dividend. Before, they had always said that they would return capital to shareholders through buyback activity and not a dividend. So the tax taw changed, and the next thing you know they declared an initial dividend.
No, we actually bought after that. When they made their declaration, I thought the stock was too expensive—it was probably in the very high 40s. We bought it recently at about $39.
One of the beauties of having done this for a reasonable amount of time—which can also be a negative—is that you are less susceptible to being whipped around by extremes in markets or psychology. The negative is that you are entrenched and stubborn—thats something one has to watch out for.
But Ive lived through a handful of what Ill call these megacycles going back and forth between growth and value. The late 1990s pro-growth environment, from maybe 1996 into early 2000, was a very extreme period. Obviously, I felt like quitting every day. But deep down I figured, this too shall pass.
That was followed by a pretty severe market in 2000 through 2002, and then value had this huge catch-up move. We entered this year in no-mans land in terms of style preferences.
When the market is moving away from you, you try to focus on the micro-elements of your investment analysis. When markets are going with you, you try not to get too carried away.
Well, that of course really gets into the world of guessing, but nonetheless we are pretty positive. Youve got a low inflation backdrop. Youve got investors with tons of money in low-yielding money market funds. And you have companies building cash up, with good balance sheets and better earnings performance.
I think the recovery will continue to be moderate, and in that environment, some of the better-quality companies should do well. So, all in all, I think 2004 will be a good year.