Finding Sustainable and Superior Dividend Yielders
Manning & Napier Disciplined Value Series Fund
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
We tested these criteria historically to see how the portfolio would have changed if we have been applying them from the beginning. We also made sure that they had the general performance characteristics of companies with a tendency to outperform in difficult markets. The other important goal was to avoid a static allocation to the banking sector, because that would not be consistent with our approach of letting the investment process gravitate towards the areas of the market that meet our criteria.
Q: Does your process have any bias built into it?
The bias of the approach is that we want companies that meet our definition of value. Thatís an effective way to sort through a large investment universe and to identify the companies that are consistent with our strategy. On different fundamental metrics, the composition of the portfolio has a tilt towards higher quality and more defensive attributes, which is a logical outcome of the attractive free cash flow and the sustainable dividend policy that we seek.
Overall, the portfolio is the result of a filtering process that weeds out a lot of the universe. My team shares the companies that we identify with a large number of bottom-up stock analysts, who are able to take that information as another input to their process. So, there is also an ancillary idea generation benefit to the process for us as a firm.
Q: What is your portfolio construction process?
When we apply our investment parameters, we reduce the universe down to about 75 to 100 companies that meet our criteria. We have a market-cap based approach to portfolio construction in assigning weights to the companies that meet our investment criteria. We impose limits of 4% on the position sizes at the time of the portfolio formation. Additionally, we limit our exposure at the industry group level to 25%. The other important element is applying the financial health test to make sure that we reduce the probability of distress at the company level.
Over time, itís been a reasonably diversified portfolio. We believe that the flexibility to move towards the market areas that present the most attractive opportunities is an important feature. We are able to own significantly less in areas with higher risk, for example. We internalize some of those concepts in a systematic way as part of the process.
We evaluate the portfolio on an ongoing basis. We look at the portfolioís exposure to a number of various factors such as ROA, P/E and interest rate sensitivity to identify anything that may be at odds with our investment process.
Q: What are the key elements of your sell discipline?
If a company fails to meet one of our multiple investment criteria, we would sell it. A unique element of our process is that we build the portfolios on an annual basis. We utilize factors that tend to be sustainable and keep their efficacy over time. If we were utilizing momentum factors, we would be more active in refreshing the portfolio.
In our research, we have actually evaluated the outcome of constituting the portfolio on a quarterly or semi-annual basis and weíve found that we donít need to reconstitute the portfolio more frequently. Our five-year average turnover has been only 33%, which is reasonable. A turnover of 70%, 80%, or 90% would indicate an opportunity to reconstitute the portfolio sooner or investment trends that are shifting quicker than our framework. But that hasnít been the case and we stick to the annual process, which has served us and our investors well over time.
Q: How do you define and manage risk?
Since financial markets certainly go through cycles, it is part of our objective to manage the risk of capital impairment. Therefore, we want to own companies with low likelihood for significant or permanent impairment. The security selection process itself helps to manage this risk, because we invest in companies with sustainable dividends, low estimated risk of financial distress, positive free cash flow and an attractive free cash flow yield. These features help to manage the risk of permanent loss of capital.
We utilize traditional risk models as useful tools for evaluating the portfolio and identifying potential risk exposures. Our focus is the research process as the juncture of interacting with the portfolio. If we start to see risks that are contrary to our expectations, we would have an in-depth discussion. If something has fundamentally changed in the market, we would revisit our process for an alternative expression of these factors. Again, we donít expect that to happen.
The portfolio is built upon research that goes back decades and has been reasonably consistent over time. We donít expect it to change dramatically, but we have diagnostic tools in place to monitor for this risk.
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