Q:  Do you just look for yields or for rising yields? Is dividend growth critical?

A: The dividend growth story is not our strategy. Actually, Fifth Third Asset Management does have a dividend growth strategy, but that’s not the strategy of the large-cap value fund.

Q:  What are the key elements of your portfolio construction process?

A: We have between 40 and 60 stocks with no more than 5% in a single stock. We have a minimum sector weight of one-third of the sector weight of the Russell 1000 Value so that we’ll always be in each of the ten major economic sectors. We have a maximum sector weight, which is the lesser of two things: 1) three times the weight of the sector in Russell 1000 Value’; and 2) the Russell 1000 Value sector weight plus 10%. The second constraint keeps us from being 100% in financial stocks, which are currently in the mid 30’s as a percentage of the benchmark.

Q:  How do you decide on the size of the position or the sector weights?

A: It’s much more bottom-up than top-down. If we find a lot of attractive stocks in a particular sector, then we’ll have an overweight in the sector, and the more attractive the stock is, the bigger the weight will be.

We occasionally have some conviction about a top-down issue. For example, we may have a high degree of confidence that the economy is going to continue to expand and so we would emphasize cyclical sectors.

Q:  What kinds of risk do you perceive and how do you mitigate them?

A: Aside from the position limit of 5% in a single stock and the constraints on our sector bets, we also get a lot of statistical information about our portfolio relative to our benchmark, such as beta, tracking error and risk index exposures. We want to be different enough from our benchmark so that we’re not a quasi-index fund, but we don’t want to be so different that we’re not actually delivering the performance of large-cap value stocks. We don’t want to be drifting off into growth space or down into mid-cap space.

In each of our valuation approaches, we have a quantitative way of determining relative stock risk. We run a report that includes measures of financial strength, including interest coverage and balance sheet ratios, stability of earnings, volatility of the stock price, variability of earnings estimates, and liquidity. We rank all the stocks that we follow on that basis and then divide them into quintiles, with quintile one being highest quality and quintile five being lowest quality.

So, for example, with the PEGY ratio and implied growth rate analysis, we are comparing the results with the other stocks having the same risk quintile. That’s our way of risk adjusting and recognizing that for two stocks with the same projected growth rate and yield, the higher quality one deserves a higher PEGY ratio.

Q:  How do you see the challenges for the large-cap value manager in the current environment and for the next two or three years?

A: We’re seeing increasingly better values in larger-cap stocks and, recently, even in mega-cap stocks. I believe large cap value stocks will outperform smaller cap value stocks in the next several years.

In terms of whether value will do better than growth, value has outperformed growth for the last six calendar years and is ahead year-to-date. And over longer periods of time value has outperformed and I believe that will be the case over long time periods going forward. But value stocks are now fairly expensive relative to growth stocks in terms of P/E’s, price/book, etc. So near term, it’s likely that growth will be more competitive.