Q:  Could you explain your philosophy and why dividends are such an important element?

A: We believe that companies with sustainable cash flow and strong dividend growth outperform over long periods of time because they deliver superior returns with less volatility. The basis of our philosophy is to focus on dividend growth, not just on absolute yield, as there’s a distinct advantage in that approach.

For example, long-term studies by Ned Davis indicate that since 1972, dividend growers have generated average returns of about 10.6% annually, dividend paying companies have returned about 10.1% per year, while the companies that don’t pay dividends at all, have returned about 4.1% per year. So we try to identify companies with historic growth rates and future cash flows that make those growth rates sustainable, or at least better than the overall market.

We also believe that it’s very important to buy quality versus cheap valuation, while many of our peers focus on valuation first and then look for the gem that’s been discounted too heavily. We apply a bottom-up selection approach in that process.

Q:  What is your strategy for putting that philosophy into practice? How do you screen the universe and select the companies?

A: The strategy is to conduct research on each industry and to identify the most attractive companies based on a qualitative ranking. Our universe largely consists of the stocks in the Russell 1000 Value Index with market cap of more than $10 billion, or about 200 names. We rank the companies within their industries and identify the specific industry drivers and success factors. Then the analysts rank the companies on several measures, which typically include management, R&D, same-store sales, or some other industry-specific factors.

That ranking allows us to focus on the top names, all other things being equal. Then we look at historic and forward- looking dividend growth rates and apply a dividend discount model to get our valuation.

Q:  Where do you typically find such names? What are the characteristics that would make an industry attractive for your investing style?

A: That has changed over the years. Traditional value managers tend to invest in higher-yield, lower price/book, or lower P/E industries, and typically avoid areas like media or technology. With our approach, we find companies across the board and that’s another differentiating factor. That’s because we’re not chasing absolute yield, but we’re pursuing dividend growth.

We will look at technology companies, for example, if they’re raising dividends aggressively. Even if their absolute yield is low, they may be growing dividends because their cash flows allow them to. The companies raising their dividends usually have optimistic outlooks for their businesses. No company would raise its dividend if it expects rough seas ahead, so I believe that boosting the dividend is a vote of management confidence.

Q:  Many companies have been raising dividends recently, including Lehman Brothers and Nordstrom. Is your universe expanding?

A: Yes, we expect the S&P 500 companies this year to raise dividends about 12%, which is a significant increase. One of the reasons is that cash and marketable securities on the balance sheets at the end of 2005 were near all-time highs, according to Ned Davis Research. Cash and marketable securities was in excess of $2.3 trillion, which at the end of 2005 represented about 20% of the S&P 500 market capitalization.

So we look for companies with very high cash balances as they must do something with that cash or it would depress the return on equity. Managements are frequently compensated based on the ROE, so they need either to make an acquisition, buy back stock, repay debt, or boost the dividend. We feel that boosting the dividend is the most efficient use of cash and that’s our focus.

Q:  Why do you believe that boosting the dividend is the most efficient use of cash?

A: In a high interest rate environment, it makes sense to buy back debt, but that’s not the current situation. Most companies have refunded their debt at lower levels and don’t have high-coupon debt outstanding. Acquisitions don’t generate the synergies expected and claimed by management. In fact, most companies are not particularly good at making acquisitions, so these events can have a negative effect.

Repurchases are very popular with investors right now, but we see a number of problems. Most companies are repurchasing shares to offset the dilution from issuing options, and often end up issuing more than they buy back. So the argument that repurchases boost the EPS is not always valid. They may help maintain your EPS, but if you’re issuing more shares, you’re using a lot of cash just to tread water with your EPS.

In the end, management is weakening the balance sheet by burning off cash. It is buying back shares at relatively higher prices, because the market has done well in the past few years and most prices are up dramatically. So from our standpoint, it is not an efficient use of cash. And while a repurchase at times may boost earnings, that boost is artifi- cial as the business hasn’t grown organically or through an acquisition. It’s the same business with a weaker balance sheet; the repurchase just prevents the management’s shares from diluting.

Another reason some companies favor buybacks is that management’s options often don’t adjust for the dividend paid, so they become less valuable after the stock price trades ex-dividend. Managements would rather repurchase shares to neutralize that impact than pay a dividend that would lower the share price. So we try to find cases in which managements actually own shares, not option positions.

But we recognize that for most investors buybacks are portrayed as a positive thing, so we’re not going to stand against a favorable sentiment. We just don’t look for buybacks because we consider them, at best, neutral. Of course, in the case of a stock that’s hammered by the market for a short-term reason, there may be a real opportunity to buy back shares at a 20% discount. That’s an efficient use of cash, but an ongoing share repurchase program generally doesn’t make sense.

Q:  I understand the argument against acquisitions and buybacks, but paying dividends also doesn’t strengthen the balance sheet or the business. What’s the rationale there?