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Finding Sustainable and Superior Dividend Yielders
Manning & Napier Disciplined Value Series Fund
Interview with: Christopher Petrosino

Author: Ticker Magazine
Last Update: Jun 06, 10:27 AM EDT
Valuations matter because they drive returns in the long term, according to Christopher Petrosino, portfolio manager of the Manning & Napier Disciplined Value Series Fund. With a systematic approach, the fund invests in companies with above-average dividend yield that are sustainable, with attractive free cash flow yield and low estimated risk of financial distress. These characteristics not only drive performance, but also mitigate downside risks.


ďThe governing philosophy is that valuations matter and drive returns in the long term. Our focus is on buying stable businesses at attractive prices. We also believe that a systematic approach is crucial for overcoming the potential biases of the manager.Ē
Q: What is the genesis of the fund? Could you give us some background information?

A: The strategy behind the fund dates back to early 2003. At that time it was really a research project, which aimed to develop a definition of value that was consistent with how we tended to value companies across our portfolios. The firmís investment portfolios, including mutual funds and separate accounts, are exclusively bottom-up stock selection processes, where our analysts focus on the underlying earnings power of the businesses.

We wanted to get a proxy for our valuation approach and looked at the existing value indexes. At the time, S&P/Barra was one option, where value was just low price-to-book and growth was high price-to-book. Russell Investmentsí definition was a bit broader, but would still define a company as value in part if it wasnít a growth company. So, we found shortcomings in these definitions relative to the way our analysts viewed the world. Then we started to search for alternative approaches by reviewing academic and industry research and by doing our own research as well.

We realized that we should be looking at free cash flow yield. In our valuation models, we focus on discounted cash flow. Over time we found that free cash flow yield might not be the best valuation metric over a particular stretch of time, but over the decades it was fairly consistent.

At the same time, there were tax cuts that lowered the income tax rate for individuals on high dividend income. We began to see demand from our high net worth investors for a portfolio that could benefit from the change in the tax law. As a firm, we didnít have an equity income strategy at that point.

When things progressed, we combined in a systematic way free cash flow yield with a competitive and above-average dividend yield. As we started to take the research in that direction, we saw a portfolio that tended to provide stable businesses at attractive valuations over time. The combination of committing to a dividend policy and generating attractive levels of free cash flow resulted in competitive performance over market cycles, particularly in down markets, when the strategy showed a tendency to experience less drawdown than the broader market.

That is the genesis of the portfolio. We had some clients, early adopters, who were interested in our research, so we started our first separately managed accounts with this strategy in late 2003. The fund came into existence in late 2008. Since then we have been able to introduce variants of the strategy such as developed non-US.

Q: How do you define your investment philosophy?

A: The governing philosophy is that valuations matter and drive returns in the long term. Our focus is on buying stable businesses at attractive prices. We also believe that a systematic approach is crucial for overcoming the potential biases of the manager. For example, we have owned companies like computer disk drive makers, which may not be the businesses with strongest returns in the modern technology world, but turned out to be a great investment. Overall, we focus on identifying companies that over time have proven to be effective at generating return, while also providing downside risk management.

Q: What is your investment process?

A: We have a systematic process. It is a screening or filtering process, where we look for companies that meet our investment criteria. We donít build alpha models attempting to forecast the excess return at the individual company level and we donít assign ranks or scores based on individual criteria. Instead, we set up hurdles that make good investment sense and we look for companies that satisfy all those hurdles.

Our investment process is built around four key inputs. The first one is free cash flow yield. We want companies that trade at attractive free cash flow yield. For us ďattractiveĒ means a higher free cash flow yield than what we would earn owning investment grade corporate debt. So, we look at a BBB corporate bond index and make sure that the companies we own have free cash flow yield in excess of that bond yield. As an equity investor, if we canít earn yield that is at least on par with what we would earn from interest, we canít define that company as value.

Dividends are another key input, because they are valuable from a total return perspective. Generally, companies donít adopt a dividend policy lightly, because they have to be able to maintain or grow that policy across a variety of economic conditions.

For us, dividends offer two important components. First, we want to own companies that offer a competitive dividend yield. We donít necessarily look for the highest 10% of dividend yields in the market, but for companies with dividend yield above the one of the broader market. Second, we want the dividend to be not only attractive, but also to be sustainable. So, we look at dividends relative to the free cash flow of the company. We make sure that the ratio is reasonable and the company can sustain that dividend. We prefer to own companies with attractive yield and a dividend that is not necessarily the highest on the market, but is sustainable.

Finally, we focus on the financial health of the company. We add that additional filter to the universe to remove any companies that havenít been filtered through the other criteria. At the end, we build the portfolio from the companies at the intersection of these four investment criteria. It is a disciplined approach, where we let the data tell us if the financial health of the company is at risk.

Q: Do you incorporate macroeconomic views in your sector or security selection?

A: No, but it is interesting how the sector allocation in the portfolio has evolved over time. Before the inception of the fund, in the period to 2004 to 2006, there was little technology in the portfolio. Companies were still evolving from their business models of the late 1990s and there were no real dividend policies, except for the most established businesses and the industrial technology companies.

However, we had tremendous exposure to the energy sector. This exposure was not the result of our macro view, but was the outcome of the screening process for companies trading at attractive free cash flow yields and offering competitive dividend yields and sustainable dividends.

More recently, we have seen an increasing share of technology companies in the portfolio as they moved towards more recurring business models. For many companies now business is about licensing their intellectual property or about a service agreement. These businesses have evolved, free cash flow has gone up, and dividend policies have been implemented.

We build the portfolio stock by stock, based on our criteria. That approach directly contributes to our sector exposures and has played a positive role for the portfolio performance over time.

Q: Could you give us an example that illustrates your research process?

A: I consider our research process to be the development and the refinement of the systematic criteria that we apply. Our work is to review and refine the inputs that we view as key aspects of our research. Itís a deliberately lengthy review, in which we contemplate modifications to the criteria, because we make sure that we remain faithful to the philosophy of disciplined focus on valuation, based on the underlying earnings power.

For example, a few years ago we added parameters to explicitly assess the companies in the banking industry for potential inclusion in the portfolio. One of the challenges for banks has always been the measures for judging the financial health. Just looking at the financial statements wouldnít tell us everything that we need to know about a bank and the risk it may or may not have.

It was an ongoing quest to develop an analog of the four factors that would make sense for the banks and that would fit in with our philosophy. For more than a year we examined the underlying earnings power of banks. One of the problems with banks is the provisions for loans. Late into a credit cycle, banks ramp up provisions to account for loans they have made previously and that maybe at risk of becoming non-performing. Similarly, early in the cycle, if the loans at risk were not charged off, the provisions would go back into earnings. That dynamics overstates the earnings power. So we began to look at earnings on a pre-provision basis to get an idea of the normalized earnings power.

In terms of financial health, we came up with two factors that were effective over time. The first one was evaluating loans/deposits ratio to screen for banks that were able to organically fund their loan book. Second, we looked at non-performing assets/total assets with the idea to remove the banks with higher risk loan portfolios.

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