Dividends: Why quality and risk management matter

For Professional Clients only
Dividends: Why quality and risk management matter
A conversation with JPM US Equity Income Fund lead portfolio manager Clare Hart
In an environment of increasingly volatile markets and persistently
low interest rates, where can investors find the potential for upside
participation, downside mitigation and a reliable income stream?
This is a question on the minds of many investors, especially those
anticipating extended retirement years.
Clare Hart,
Portfolio Manager
In a recent interview, Clare Hart, portfolio manager of the JPM US Equity Income Fund, explained
why she believes a fund like the one she and her team manage offers a solution well worth
considering. However, Hart is quick to point out that this is not just an interim “waiting for rates
to rise” strategy. The fund invests in high-quality, dividend-paying companies to pursue total
return, income and a smoother ride in uncertain times.
Q
Why invest in dividend-paying stocks?
A While one obvious part of the answer is “income,” especially with 10-year Treasury
yields in the 1% to 2% range, the real answer is that dividends have, on average,
accounted for more than 40% of the total returns from the US market over a long time
horizon. In some years, dividends have accounted for an even larger share of returns.
DIVIDENDS HAVE BEEN AN IMPORTANT COMPONENT OF TOTAL RETURN OVER TIME
S&P 500 total return, dividends vs. capital appreciation, average annualised returns [%]
Capital appreciation
Dividends
13.6
13.9
3.0
4.7
5.4
6.0
5.1
12.6
4.4
1.6
3.3
4.2
4.4
1960s
1970s
1980s
15.3
6.2
2.5
1.8
-2.7
2.1
1990s
2000s
2010s
-5.3
1926–
1929
1930s
1940s
1950s
Source: Standard & Poor’s, Ibbotson, J.P. Morgan Asset Management. Data are as of 12.31.2011.
Total return assumes the reinvestment of income. Chart is shown for illustration and discussion purposes only.
Past performance is no guarantee of future results.
5.5
4.1
1926–
2011
Q
any investors think of these dividend payers as stodgy, uninteresting companies.
M
Is this an accurate view?
A No. I would attribute that view to our memories of the 80s and 90s when capital
appreciation dwarfed dividends. The fact is, over roughly the last 40 years, dividendpaying stocks within the S&P 500 have outperformed non-dividend-paying stocks —
and by a significant margin.
I believe this is because companies that can commit to a recurring dividend payment
in cash are inherently healthier companies.
RETURNS FOR S&P 500 DIVIDEND-PAYING STOCKS HAVE SIGNIFICANTLY EXCEEDED
THOSE OF NON-DIVIDEND-PAYING STOCKS
Equal-weighted geometric average of total returns, 1972 – 2011 [%]
9.4
7.0
Source: Ned Davis Research, Inc.
Returns based on monthly
equalweighted geometric
average of total returns of
1.4
S&P 500 component stocks,
with components reconstituted
monthly.
-0.9
Chart is shown for illustration and
discussion purposes only.
Dividend growers Dividend payers Dividend cutters
Non-dividend-
and initiators
with no change
or eliminators
paying stocks
Past performance is no
in dividend
guarantee of future results.
Q
How do you think about investing?
A
Broadly speaking, we are looking for quality, valuation and an income component.
The first thing we think about is quality. We target companies with durable franchises,
consistent patterns of earnings, high return on invested capital, conservative financials
and strong management teams. Valuation is also critical to our entry and exit
points — but I’m not just looking for cheap stocks. When we talk about buying quality
companies, it doesn’t surprise me that quality companies are not always the cheapest
in the market. From my perspective, if you don’t nail the quality part, then who knows
if you’re going to get that dividend or not. You could be destroying capital as you go.
Finally, the dividend yield is important because the fund has an income component.
While we look for companies that pay a minimum 2% yield, looking for the highest
yield is not our goal. The highest yield is often high for a reason — the market, for
example, may not believe it is going to get paid. Alternatively, the company may have
nothing else to do with its money — so it pays it all out in dividends, leaving nothing for
capital appreciation.
2 | DIVIDENDS: WHY QUALITY AND RISK MANAGEMENT MATTER
Q
What do you look for in the companies you invest in?
A We want to invest in companies with durable franchises, strong balance sheets,
Q
Why is a low payout ratio important?
A A low payout ratio generally means that these well-managed companies can reward
and good cash flow generation with solid managements that are effective capital
allocators — the same characteristics that can help identify stocks with the
consistent performance most investors want. All of these factors together should
support a healthy dividend at a low payout ratio — the proportion of earnings paid
in dividends to shareholders.
investors with a dividend today while leaving capital available to grow shareholder
value and enhance the dividend for tomorrow. The best performing stocks over the
past 20 years have been those with above average yields and below average payouts.
DIVIDENDS ARE IMPORTANT, BUT SO IS THE ABILITY TO PAY THE DIVIDEND …
QUALITY MATTERS*
Equal-weighted total return from 1990 – June 2012
Source: Credit Suisse Quantitative
High dividend yield, Low payout ratio
400%
Equity Research. The graph shown
Low dividend yield, Low payout ratio
is for illustration and discussion
350%
No dividend
purposes only. There is no
High dividend yield, High payout ratio
guarantee that companies that
300%
S&P 500
can issue dividends will declare,
Low dividend yield, High payout ratio
continue to pay or increase
250%
dividends.
200%
* U.S. equities returned 6% on
average since 1991. However,
150%
without dividends the annual gain
drops to 1.7%; Treasury bonds
100%
returned 2.1% during the same
period. According to inflation50%
adjusted data compiled by the
London Business School and Credit
0%
Suisse Group AG.
-50%
‘90
‘92
‘94
‘96
‘98
‘00
‘02
‘04
‘06
‘08
‘10
‘12
ast performance is no guarantee
P
of future results.
Q
How do you identify companies that meet your investment criteria?
A Ours is a bottom-up, fundamental research approach, supported by a team of
more than 25 sector-specialised analysts. We spend a lot of time going through the
numbers and meeting with management teams to find the companies that exhibit
the characteristics we seek.
J.P. MORGAN ASSET MANAGEMENT | 3
Q
an you provide an example of the type of stock that makes it through your rigorous
C
research and due diligence?
A Sure. Hershey’s is a great example — and not necessarily the first stock that comes
to mind as an innovative investment idea. It has dominant market share (compared
to other packaged food companies) and strong pricing power, which has allowed
it to dampen the impact of higher commodity prices. What’s more, demand for its
products (primarily chocolate and related confections) is relatively steady across
economic cycles. And, management has exhibited a clear bias toward dividend
growth as a top capital allocation priority.
Q
How do you know when to sell an investment?
A While we have a low turnover strategy, our sell discipline is essentially the opposite
of our buy discipline. The number one reason to reduce or eliminate a position is
when the stock becomes overvalued by the market. I’m not doing anyone any favors
if I say that I found a great company but the stock does nothing over time. You
have to be careful about how much you pay for stocks and how the market values
them. We will also sell positions when there are changes to company management,
their capital allocation decisions or the competitive landscape. We’re constantly
reevaluating positions because companies are living, breathing things. Our job is not
to retrofit our thesis. If we need to take our lumps, we take our lumps and move on.
Finally, we may sell a stock if we find a better idea.
Q
ith current market weakness, more companies are meeting your 2% or better
W
dividend yield criteria. Has this made a difference in the companies likely to appear
in the fund?
A It has, but while a 2% yield is a hurdle for companies in our portfolio, it in no way
assures them a place. There are a handful (not a whole host) of companies that we
have viewed as strong contenders for inclusion, but that only now meet our 2%
criteria or look attractively valued at this point in the market.
Q
Where do you see the most promising market opportunities today?
A
e have been adding money to the technology sector, as we are finding more
W
companies in that space that meet our investment criteria than ever before.
There is clearly a growing “dividend culture” among technology companies, many
of which have historically resisted adopting dividend programs for fear that their
investor base would flee the stock. However, given the record amounts of cash
on their balance sheets and, in many cases, a more stable earnings pattern, they
are in a better position to both support a dividend and grow their businesses
than ever before.
4 | DIVIDENDS: WHY QUALITY AND RISK MANAGEMENT MATTER
Q
ot only have you consistently beaten the S&P 500 in terms of returns, you have
N
done so with lower average volatility than the market. How have you been able to
accomplish this?
A That’s correct. We launched our Equity Income Strategy nearly ten years ago in
November 2002. Since inception, our strategy has generated over 200 bps of alpha
on an annualized basis, with a lower standard deviation than the market.
There are a number of components of our risk management approach behind those
results. While we are benchmark agnostic, that doesn’t mean we take huge bets. In
fact, a high degree of diversification across sectors and holdings is a hallmark of our
strategy. In addition, we tend to avoid extremely cyclical stocks and stocks with a
high sensitivity to commodity prices.
Q
What are the other ways in which you seek to manage risk?
A There are lots of ways to think about risks in the market. One of the risks as a
manager is that you can have a stock that goes to zero. My job is to avoid the “value
traps” — those stocks that look cheap but continue to get cheaper. We also manage
risks by identifying effective management teams. If I’m investing in a dividendpaying stock with a 30% payout ratio, I’m leaving the company 70 cents on the
dollar. How is the management team going to make more money with the money
I leave behind? That’s what will drive the capital appreciation. If the management
team is not good at what they do, they’re not effective. Finally, we also manage the
portfolio to be broadly diversified overall and within sectors and subsectors. Even
when you have done as much due diligence as you possibly can across sectors, bad
things can happen to good companies.
Q
How has your background shaped your investment approach?
A After studying political science at the University of Chicago, I got a master’s degree
in accounting and earned my CPA while working as an auditor. My background
taught me that balance sheets always matter in good times or bad. That is why today
we care about things like free cash flow and debt levels.
J.P. MORGAN ASSET MANAGEMENT | 5
Q
And what role, if any, do derivatives play in your strategy?
A None. We don’t use derivatives because we want the capital appreciation that
comes with owning equities. Our approach is straightforward — we own dividend
paying stocks, so there is no guesswork around embedded risk in the portfolio
from derivatives, synthetic instruments, etc.
Q
What about the role of non-US stocks?
A None. Ours is a US equities strategy. However, the companies we do invest
in may sell goods and services overseas, which can boost growth potential.
And while we draw mostly on the research expertise we have in the US, the
walls between countries and across continents have come down in the global
economy. It is therefore a real advantage to be able to tap into our global
research platform and have people on the ground watching for trends in Asia,
Europe and the rest of the world that can influence the sectors and companies
we cover.
Q
re there some market environments that are more/less challenging for equity
A
income strategies?
A A sharp rally in poor quality companies can be a challenging environment. In
such a market environment we tend to look for attractively valued, high quality
companies in areas where other investors may be selling out to chase a theme
elsewhere in the market.
Summary
In summary, Clare believes that to be a successful US equity income manager requires:
A proven investment philosophy which focuses on attractively valued companies that are
in good financial standing, have consistent patterns of earnings, and healthy dividend
yields with low payout ratios.
A consistent investment process that employs a bottom-up stock selection process that
uncovers companies with proven management teams and strong brands that offer longterm stability.
A focus on high-quality companies with attractive dividend yields, which may provide
relative stability in a slower/uncertain growth environment. Because high yielding stocks
have a lower beta, the fund may be expected to have lower volatility than the broader
market over time.
6 | DIVIDENDS: WHY QUALITY AND RISK MANAGEMENT MATTER
JPM US Equity Income Fund
The JPM US Equity Income Fund focuses on high quality stocks that are
attractively valued and have sustainable dividend yields, providing an ideal
way to share in the future returns from the US stock market.
Greater opportunities for equity income investors outside the UK
Gain exposure to attractive income yields from corporate America
Share in the long-term returns from the US stock market
Benefit from the insights of our dedicated 28-strong US equity research team
Best fund in the IMA North America sector for 2011*
*Ranked 1 out of 97 funds in the IMA North America sector as at 31 Dec 2011. Source: Citywire Money.
Investment Objective:
To provide a portfolio designed to achieve income by investing primarily in US
equities in any economic sector whilst participating in long term capital growth.
Key risks:
The value of your investment may fall as well as rise and you may get back less
than you originally invested.
The value of equity and equity-linked securities may fluctuate in response to the
performance of individual companies and general market conditions.
As the portfolio of the Fund is primarily focused on generating income, it may bear
little resemblance to the composition of its benchmark.
The single market in which the Fund primarily invests, in this case the US, may be
subject to particular political and economic risks and, as a result, the Fund may be
more volatile than more broadly diversified funds.
For investors in Share Classes which are not hedged to Sterling, movements in
currency exchange rates can adversely affect the return of your investment.
This Fund charges the annual fee of the Authorised Corporate Director (ACD)
against capital, which will increase the amount of income available for distribution
to Shareholders, but may constrain capital growth. It may also have tax
implications for certain investors.
J.P. MORGAN ASSET MANAGEMENT | 7
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