An Interview With Thomas J. Huber, T. Rowe Price Dividend Growth Fund

    by Maria Crawford Scott

    T. Rowe Price Dividend Growth Fund (PRDGX)

    CATEGORY: Large-Cap Stock

    PERFORMANCE (as of 3/31/02):

      Fund Category
    1 Year 5.6 -0.8
    3 Years 2.8 -1.4
    5 Years 9.0 9.3

    RISK: Below Average

    TOTAL ASSETS: (as of 6/15/02) $650 Million

    CONTACT: T. Rowe Price Funds 800/638-5660

    Dividends may be down, but they’re 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.

      We’ve 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, it’s growing its cash flow and it’s growing its earnings. Those kinds of companies tend to be in durable businesses.

      We’re 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 kind of yields and growth rates are you looking for?
      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, they’re not highly leveraged, and they throw off a lot of cash flow—above and beyond what they need to reinvest in the business. There’s money left over to pay dividends, there’s money left over to buy back stock, and there’s money left over to make it a strategic acquisition if management sees an opportunity. They’re not companies that are coming to the market for capital on a regular basis—they’re self-funding, established businesses.
    What about companies that use their cash to buy back stock?
      The problem with buying back stock is that most times companies don’t 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—they’ll do it if they feel like it and if they don’t have anything else to do with the money. With a dividend, there’s an implicit promise—it’s a big deal if they cut it. And I think that imposes a discipline on companies that a share repurchase doesn’t—and it’s a good discipline.
    You said you’re also concerned with buying at a reasonable price.
      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.
    What about dividend yield—is that a good valuation measure?
      It can be. A high yield can be a signal that there’s value there, but it can also be a signal that there’s trouble—if the stock price has gone down a lot, the yield goes up. We’re 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, you’ve got to be a little bit careful looking for high yield on an individual stock basis—it can be a sign of fundamental problems.

    Do most of the companies you own have large market capitalizations [share price times number of shares outstanding]?
      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 it’s not necessarily the size of the company that’s the driver. We really look at things on a stock-by-stock basis. I’m looking for a unique company, one with a record of dividend growth, so I’ve 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, that’s done very well, is Family Dollar Stores, with about a $6 billion market capitalization. It’s 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 it’s a business where the return on invested capital is very high. The company throws off a lot of cash flow—it’s completely self-funding. And they’re in an area of retail that I think is attractive right now, which is offering value to the consumer—that’s something that they do, and they do it well.

    Doesn’t your strategy tend to cause you to overweight certain industries and underweight others?
      There are certain sectors where our strategy tends to direct us, and we have to be cognizant of that. It’s okay to have greater than market exposure to a particular area if it’s 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 there’s 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 isn’t 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.

    You mentioned energy companies as being a source of dividend growers. Was Enron on your radar screen? Was it paying dividends?
      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 didn’t 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 it’s a good lesson—when you don’t 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 it’s one time where our focus on the fundamentals really paid off. We weren’t 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.

      That’s the beauty of market liquidity—you can always invest in something else.

    What about the technology area? Are you able to find enough dividend growers to get technology into the portfolio?
      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 don’t 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, we’d probably be willing to buy a few of them that don’t pay dividends.

    Right now you are overweighted in financials.
      Yes. We’ve 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. That’s simply because they’re global and they do a lot in the consumer area, they do a lot in the brokerage area, they sell insurance—they’ve 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.
    What about utilities? You don’t seem to have too much there.
      I don’t. 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. I’ve 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.

      We’ve 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.

    What about foreign holdings? You’ve got almost 7% in foreign stocks. What does that consist of?
      The biggest holding is Vodafone, and it has not been a rewarding investment—to me that’s 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 we’ve owned now for some time, screened well. Now, I think it will turn into a fine investment. But here’s 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 I’m still a believer that wireless will continue to take share from wireline. And Vodafone is really the only global player. In my opinion, if you’re looking for exposure in that area, it’s a less risky way.
    What would prompt you to sell a stock?
      Turnover is relatively low—it’s about 35% for the portfolio. And our strategy keeps it low, because we’re looking for good companies that we can own; we’re not looking for a lot of different trading opportunities.

      However, we’ll sell a company if there’s some break in the fundamentals that’s more than transitory or more than what I would consider to be ‘noise.’ If there’s 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 it’s 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. You’ve got to be conscious of your weightings: If an area in which you’ve invested has done quite well, all of the sudden you’ve got a block of your portfolio that is too large and the relative upside just doesn’t look that attractive compared to other industries or companies.

    What’s your overall outlook for the market?
      It’s an odd time right now, with all the economic statistics that suggest the economy is improving. I would say it’s safe to say that things have finally bottomed. But the market’s not going to do well until you can make a case that the profit stream is about to improve. It feels like we’re close, in my opinion.

      Despite the market’s 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 I’m 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 didn’t mean anything. But if we’re 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. I’m pretty optimistic that we’ve 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.

→ Maria Crawford Scott