3 Questions: Federated Strategic Value Dividend

11-15-2016

“3 Questions” delves into investment approaches used by Federated Investors strategists. This installment features Senior Portfolio Manager Daniel Peris.

Q: Can you explain the Federated Strategic Value Dividend Strategy? Our income-first approach is driven by a core belief that we invest as owners of companies, not traders of stocks. As owners, we take the long view, seeking high-quality companies that make a practice of sharing the profits with the company owners, regardless of market conditions. Companies in our relatively concentrated portfolio tend to be non-cyclical and well established, with substantially higher dividend yields than the broader market and a history of paying above-market dividends and regularly increasing them.

The reason for this approach is simple and embedded in chapter one of any book on business valuation: the measure of any successful commercial enterprise is the amount of cash it can distribute and the trajectory of that distributable cash stream. For publicly traded companies, that’s the dividend and the growth rate of the dividend.

The Strategic Value Dividend proposition for clients is to invest as a businessperson, for business-like cash returns. But we do go through the stock market and can be measured in stock-market terms. For those clients whose primary interest is the stock market, the portfolio’s total return (dividend plus share price movement) has been roughly similar to that of the broader market’s (mostly share price movement) but with a much lower standard deviation or measure of volatility. In short, we seek to offer a high and rising income stream from high-quality business assets for those who want the cash. For clients who don’t need the income immediately, we seek to offer the market’s overall return but with fewer ups and downs.

As for our portfolio construction, we rely on a strict bottom-up approach that allows us to tap into a wide variety of income streams from companies that operate here and abroad. Our team of analysts scrupulously evaluates each company based on its fundamental strength, dividend sustainability and dividend growth potential. Our choices are made substantially without regard to near-term or tactical stock market conditions.

Q: How is the strategy performing in the current rising-rate environment? While our portfolio has no business sensitivity to near-term interest rates, the stock market historically bids down so-called “bond-proxies” in a rising-rate environment. That has been the case since July, and even more so since the election in November. While we are far from a bond proxy—we have rising coupons and our income streams are well above those of government bonds—we have a seen an approximately 10% “correction” in share prices since the summer, with no fundamental change in the income stream we generate.

Part of this was to be expected. Given unprecedented monetary accommodation in the post-global financial crisis world, we’ve been living with unsustainably low interest rates that, if central banks continue to step off the gas, may be moving toward normal, pre-crisis levels. Rates are rising because we no longer are in crisis, not because of any signs of problematic inflation. In fact, rates fell to record lows in part out of fear of deflation; any move away from that is a positive development.

In addition, early risk-on moves in the stock market typically see shifts out of so-called defensive stocks (a moniker we don’t particularly think applies to our portfolio members) as hot money chases returns. So be it. We have been here before—the summers of 2015 and 2014, the fall of 2012, to name a few. Short-term periods in which price performance either leapt ahead or lagged. But over time, our strategy has held true and both dividend and stock market performance have been consistent, delivering value to long-term shareholders.

The reality is that, given our longer-term approach, the recent rise in rates and decline in prices among some of portfolio constituents is actually beneficial. This recent sell-off has lifted our portfolio’s gross yield. That potentially means a higher rate of return going forward—that is, new money would pay less for the same income stream than it did during the summer. For those reinvesting their dividends, it also means that this income stream is getting reinvested at potentially more attractive prices. Some traders may prefer to pay more for an income stream; as business investors, we are comfortable paying less for the same income stream.

While we are well aware many investors and financial advisers just look at share prices on any given day and not the cash generated by the underlying operating companies that they own, we do hope that they will understand our continued focus on the business ownership proposition and the long-term benefits, both cash and total return, that we strive to offer. Longer-term, our strategy speaks for itself. Remember, no matter the level of interest rates or the outcome of a political election, the companies that we choose for our portfolio will continue to sell their soft drinks, diapers, wireless services, prescriptions, food, etc. And they will continue to share with company owners a big part of the profits from those transactions, about three-quarters on average vs. a payout ratio of about one-third for all S&P 500 Index constituents.

Q: What is the outlook and positioning for the strategy over the next 3 to 6 months? The dividend outlook for the portfolio continues to improve. Interest rates have changed; the stock market has changed. Our companies have not changed. We will continue to follow the cash, as we always have.

Thanks, Daniel.