An Interview With Thomas J. Huber, T. Rowe Price Dividend Growth Fund
by Maria Crawford Scott
Dividends may be down, but theyre not completely out. And the certainty of a dividend payment is becoming increasingly attractive to investors who have been seeing too much red in their stock returns over the past few years. Several mutual funds focus on dividend-paying companies. One such fund with a particularly good track record is the T. Rowe Price Dividend Growth Fund. It has ranked among the top 25% of large-cap funds for the last year and last three years (through March 31, 2002), and it has done so at a risk level that is below its category average.
In mid June, portfolio manager Thomas J. Huber discussed the management of the fund with Maria Crawford Scott.
What is the investment objective and philosophy of the fund?
The overall objective is to provide shareholders with an investment product that provides a competitive return at a lower risk.
We start by focusing on companies that pay dividends—specifically, those that grow their dividends over time.
And then we want to buy them at what we consider reasonable prices.
Weve found that a screen for dividend growth tends to lead you to some very good companies, and it can also keep you out of trouble. If you think about it, if a company is growing its dividends over time, its growing its cash flow and its growing its earnings. Those kinds of companies tend to be in durable businesses.
Were also looking to provide shareholders with an above-market yield. But I would distinguish it from an equity-income type product that is much more pure yield-focused. We focus on dividends and growth.
What we like to find is a stock that is growing its top-line growth close to double digits, 9% to 11%, and leveraging that into earnings growth of 12% to 14%. These typically are companies that have good balance sheets, theyre not highly leveraged, and they throw off a lot of cash flow—above and beyond what they need to reinvest in the business. Theres money left over to pay dividends, theres money left over to buy back stock, and theres money left over to make it a strategic acquisition if management sees an opportunity. Theyre not companies that are coming to the market for capital on a regular basis—theyre self-funding, established businesses.
The problem with buying back stock is that most times companies dont buy it well. In addition, a dividend is more of a certainty than a stock buyback. Stock buybacks are really at the discretion of management—theyll do it if they feel like it and if they dont have anything else to do with the money. With a dividend, theres an implicit promise—its a big deal if they cut it. And I think that imposes a discipline on companies that a share repurchase doesnt—and its a good discipline.
Yes. Once we find dividend growers, we look at valuations—we look at price-earnings multiples and price-to-sales multiples, and compare those to where the company has traded historically.
It can be. A high yield can be a signal that theres value there, but it can also be a signal that theres trouble—if the stock price has gone down a lot, the yield goes up. Were looking for a competitive yield on the portfolio overall. On a stock-by-stock basis, I can buy a company that maybe is yielding less than 1%, less than the market, and I can make up for it by buying a REIT [real estate investment trust], which yields 6% or 7%, so that the overall, blended yield is attractive.
So, getting back to your question, youve got to be a little bit careful looking for high yield on an individual stock basis—it can be a sign of fundamental problems.
The fund has some mid caps as well as large caps—I own companies as small as $1 billion in capitalization, up to GE. The investment-weighted median is probably about $35 billion right now.
But its not necessarily the size of the company thats the driver. We really look at things on a stock-by-stock basis. Im looking for a unique company, one with a record of dividend growth, so Ive got to be more open across the capitalization range to have a healthy universe to choose from. And there are a lot of nice dividend growers in the mid-cap space.
One that I own a fair bit of, thats done very well, is Family Dollar Stores, with about a $6 billion market capitalization. Its got a very long track record of growing its dividend every year, over 20 years. It has a nice niche in the retail market, selling low ticket items, and its a business where the return on invested capital is very high. The company throws off a lot of cash flow—its completely self-funding. And theyre in an area of retail that I think is attractive right now, which is offering value to the consumer—thats something that they do, and they do it well.
There are certain sectors where our strategy tends to direct us, and we have to be cognizant of that. Its okay to have greater than market exposure to a particular area if its for the right reasons, but doing that just because that sector pays dividends is probably not the right reason—you want to make sure that theres an investment case.
Healthcare and pharmaceuticals, financials, energy—these are all areas where there are fertile fields of dividend growth. But we were actually underweighted in pharmaceuticals relative to the S&P 500 until two months ago because of investment concerns. There were significant patent expirations for a number of these companies, and for the industry in general there was a lack of new products—visible, big, blockbuster sort of products—to offset those patent expirations. In addition, the FDA has become a little more strict in terms of what it would approve and what it would not approve. So, there were all those issues on top of a political environment that isnt all that favorable now. That being said, I think we are starting to see some good opportunities in the sector right now—particularly when you compare it to other consumer non-durables.
We do diversify broadly across industries. We monitor our weightings on a daily basis, so we really understand where our relative bets are being made.
Enron was paying dividends, but we did not own it. We have our fair share of mistakes, but this is one we did not own. We just didnt understand it. We had one of our analysts take a hard look at it, and several of the portfolio managers here actually met with management. But it was just very difficult to understand how they were earning money—it was not a simple business. For awhile, we really felt like dopes, frankly, as the stock shot up. But I think its a good lesson—when you dont understand something, when it seems very complicated, when it seems almost too good to be true, the old saying is that it probably is.
I think its one time where our focus on the fundamentals really paid off. We werent attracted to the company because of the numbers that they were delivering on paper. When we tried to understand how they were delivering those numbers, we could never really figure it out. So we just moved on.
Thats the beauty of market liquidity—you can always invest in something else.
There are some good technology businesses—for instance, some of the semiconductors—that pay dividends. Companies like Intel pay a small dividend, but they grow it. Linear Technology, which happens to be one we own, pays and grows a dividend. Texas Instruments pays a dividend, although they dont grow it.
Technology is the one area where I do potentially have to sacrifice the stock-by-stock dividend. If it ever got to the point where we felt as though technology was a very, very attractive opportunity, wed probably be willing to buy a few of them that dont pay dividends.
Yes. Weve got a bit of an overweighted bet in the financials because of our outlook, which is for a recovery. I tend to focus on high-quality companies with nicely diversified businesses. For instance, I own a lot of Citigroup—it is actually the biggest position in the fund. I like the diversity of the company. It grew earnings 5% in 2001 when everybody else in the brokerage business was down significantly. Thats simply because theyre global and they do a lot in the consumer area, they do a lot in the brokerage area, they sell insurance—theyve got a lot of different engines moving, and when one of them is not hitting full stride, the others are making up the difference. It is also trading right now at a very attractive valuation, so I own a lot of it.
I dont. I have favored REITs over utilities over the past number of years when I have been looking for higher-yielding stocks. I favor REITs both for the above-average growth prospects, but also because utilities have been going through this period when so much money was being invested into infrastructure. In fact, an awful lot of capital was coming into that segment of the market, and whenever you see that, I tend to be a little bit wary because ultimately things implode. Ive seen it before in telecommunications and technology.
Also, there has been deregulation of the utilities industry, and the managements running these companies have been used to operating in an environment of high regulation. When you unharness that, it can be a little scary until everything settles down.
Weve kept a close eye on the fundamentals of the REIT industry and the real estate industry, and focused our holdings where we thought the supply and demand was in balance, where we felt we could get 5% to 8% growth in cash flow and in addition collect a 6% to 8% yield—which is a reasonable total return, especially in this environment. Right now, close to 5% of the fund is in REITs.
The biggest holding is Vodafone, and it has not been a rewarding investment—to me thats a nice way to say it—yet. We were looking for more exposure to wireless and I was looking to do that with a leader in the industry and, of course, with a company that had a track record of growing its dividend. Vodafone, which weve owned now for some time, screened well. Now, I think it will turn into a fine investment. But heres an example of where buying when things are down can also get you into trouble, simply because it can always get worse. What makes me feel relatively comfortable about Vodafone is that they have a very strong balance sheet, they generate a lot of cash flow, and they generate free cash flow. That compares favorably to other telecom companies that have a lot of balance sheet risk. And Im still a believer that wireless will continue to take share from wireline. And Vodafone is really the only global player. In my opinion, if youre looking for exposure in that area, its a less risky way.
Turnover is relatively low—its about 35% for the portfolio. And our strategy keeps it low, because were looking for good companies that we can own; were not looking for a lot of different trading opportunities.
However, well sell a company if theres some break in the fundamentals thats more than transitory or more than what I would consider to be noise. If theres a real change in industry structure that we think could disrupt the business for more than a year, we would probably move on.
We also have a valuation bias, so if a stock gets to the point where its done very well, and it looks expensive on most measures of valuation, we will probably trim back the stock—although we may not eliminate it. Youve got to be conscious of your weightings: If an area in which youve invested has done quite well, all of the sudden youve got a block of your portfolio that is too large and the relative upside just doesnt look that attractive compared to other industries or companies.
Its an odd time right now, with all the economic statistics that suggest the economy is improving. I would say its safe to say that things have finally bottomed. But the markets not going to do well until you can make a case that the profit stream is about to improve. It feels like were close, in my opinion.
Despite the markets behavior the past couple of weeks, three weeks, I feel pretty good about where things are. I think valuations are to a point where I feel reasonably optimistic about the second half of the year. I look through my portfolio and Im pretty happy with what I own. Part of what investors have to do is to remember that the long-term rate of return of the market is 8%, not 25%. And 8% should look pretty attractive to most people right now, particularly given where money market rates are.
And a market that returns to its long-term average can help those of us who focus on dividend-paying stocks. When the market was compounding at 20% a year, a 2% dividend didnt mean anything. But if were back to 5% to 8%, that 2% can be meaningful.
And perhaps it will also cause managements to take another look at dividends as a way of giving back capital to their shareholders. Im pretty optimistic that weve seen the worst of what I would call the dividend deficit, because I think people recognize that returns and growth are a little bit harder to come by right now. It just makes sense to return capital to shareholders.