By Philip van Doorn, MarketWatch
(This is the fifth in a series about dividend stocks in today’s low interest-rate environment based on interviews with professional investors. Links to the previous other articles are below.)
Why does a fund that has underperformed its benchmark for the past five, 10 and 15 years have $20.4 billion in it? The answer is that investors with long memories are still willing to pay professionals not only to screen stocks for quality but to gain further insight through access to management.
This may be especially important with systemic risks from the trade conflict with China and Brexit as the U.K. tries to leave the European Union, along with signs of a slowing U.S. economy.
The Franklin Rising Dividends Fund /zigman2/quotes/208345193/realtime FRDPX +0.42% seeks to achieve capital growth by investing at least 80% in companies that consistently raise their dividends. It makes no difference how high a stock’s current yield is.
The fund has blown away its benchmark — the S&P 500 index /zigman2/quotes/210599714/realtime SPX +0.24% —over a 20-year horizon, largely because of strong outperformance in the wake of the dot-com bubble and following the Great Recession. But it has struggled more recently, as a handful of technology stocks — which don’t meet its investing criteria — have led the market.
“Companies that have demonstrated sustained dividend growth tend to hold up well in challenging markets,” Nicholas Getaz, a manager of the fund said during an interview. He has co-managed the fund since 2014. Donald Taylor has been the lead manager since 1996. The other co-manager is Matt Quinlan.
‘Resilience’ and Microsoft
“We use very careful analysis of the resilience of any position,” Getaz said. He named Microsoft /zigman2/quotes/207732364/composite MSFT +0.64% , the fund’s largest holding, as an example of a company with the advantages he and his colleagues are looking for, including “a leading market position, products that are industry norms and standards, innovative growth drivers and a business model that increases resilience.”
He was referring to the distribution model for Microsoft Office 365. Users pay annual subscriptions and get continual updates and cloud storage services. This brings in more revenue than the old model, when a user might wait many years before upgrading to a newer version and paying again.
Microsoft’s sales for its fiscal 2019 ended June 30 were up 12% from the previous year, while operating income was up 20%. The company’s earnings show very strong numbers for various office and cloud services segments.
Microsoft is paying a quarterly dividend of 46 cents on its common shares, which makes for a yield of only 1.33%, based on the closing price of $137.86 on Aug. 30. Then again, the company increased its dividend by four cents, or 9.5%, in September 2018. With such strong numbers, it is reasonable to expect the company to increase the dividend again by a significant amount later this month.
Looking back, Microsoft has increased its dividend by amounts ranging from 7.7% to 25% each year over the past nine years. During 2009, the company left the dividend unchanged, which wasn’t surprising considering how long the postcrisis recovery took and how many companies were forced to cut their payouts.
Microsoft provides an excellent example of improving yield-to-cost. If you purchased shares of Microsoft at the close on Aug. 29, 2014 and decided not to reinvest your dividends (to keep our math simple), you would have paid $45.43 a share. The quarterly dividend at that time was 28 cents a share, for a dividend yield of 2.47%. Fast-forward five years and the current dividend yield on the shares is only 1.33%. But based on your original price of $45.43 and the current quarterly payout of 46 cents, the yield-to-cost for your shares is 4.05%. That’s not bad, especially when you keep in mind that the share price has more than tripled.
Of course not every company that steadily increases its dividend will triple its share price in five years, as Microsoft has.
Getaz said he, the other fund managers and their analysts follow “a debate-driven consensus-oriented process,” to narrow down investment candidates after an initial screen that includes:
• Dividend increases during at least eight of the past 10 years, with no cuts.
• A payout ratio below 65% of earnings.
If a company stops meeting that criteria, “we won’t add” to positions, Getaz said. But the fnd managers might not sell should they believe the condition is temporary or if it would otherwise be an inopportune moment to sell.
Following the screens, Getaz and his colleagues focus on analyzing business models to “be reasonably sure” that the next 10 years will be successful, after looking back 10 years during the initial screening process.
Getaz emphasized the access Franklin Templeton has to corporate management teams as a crucial component of the team’s management strategy. It’s obvious that corporate executives cannot tell Getaz anything that wouldn’t be disclosed publicly. However, the meetings can shed light on a company’ strengths and weaknesses, he said.
“One of the advantages with meeting with management is taking a sampling, over the long term, of how they answer the same question,” he said.
Franklin Templeton Investments
“I call us ‘culture investors’ to some extent,” Getaz said. After starting with senior executives, he tries to talk to divisional leaders as well, to “produce a mosaic.”
A company with a strong culture from the top down can “often find a way to prosper through difficult environments” because it can continue to innovate and make operational improvements, he added.