Higher Dividends Rooted in Consistent Earnings

Fidelity Equity Dividend Income Fund

US > >

Oct 30, 2015
  • 52 Week HL
    11 - $7.55
  • Net Assets
    $34.02 M
  • Expense Ratio
  • Inception Date
    Feb 03, 2014

Q: What is the history of the fund?

The fund was started in 1990 and I took it over in November 2011. I am the seventh portfolio manager of the fund. We currently have about $5 billion in assets.

It is a classic equity fund, consisting of pure equity—no fixed income. In our search, we look for low beta and attractive valuation. We try to play solidly down the middle, to hit doubles and triples instead of targeting singles and home runs. 

Current dividend income is just as important as the potential for dividend growth, both of which allow us to achieve a higher yield, lower beta, and generally a lower-risk profile vs. our peers and our benchmark. 

Q: What is your investment philosophy?

Our fund fits within the large-cap value style box. That is where we find the most attractive valuations and the most attractive yields.

The objective is to deliver yield in excess of the equity market. We try to be 50 to 100 basis points higher than our benchmark, the Russell 3000 Value Index. The benchmark yield is about 2.6%, while ours is about 3.3%, and we try to be 100 basis points higher than the S&P 500 index.

We prefer the stocks of dividend payers where the underlying business model of the company has relatively low volatility. Low volatility in the fund is important to us because that is a key aspect of what our shareholders want. Our beta is roughly 0.9. The low beta is less an explicit target and more a result from the kind of stocks we own, which is a conscious part of our strategy.

Q: Why is a dividend-focused approach important to you?

Our research indicates that funds where dividends grow generally outperform higher-yielding funds featuring dividends that do not grow. We want to invest in companies where the cash dividend grows.

In addition, we want the dividend to be supported by a sustainable payout ratio, generally between about 20% and 70% of the cash flow. We like low payout ratios because it is another lever to increase the dividend, giving a company the room to grow dividends by increasing the payout ratio. And a low payout ratio bolsters the security of the current dividend because it hedges the current dividend against any short-term business downturn.

Dividends are a significant part of stock market returns, yet they have been overlooked for a long time. Since the 1930s, dividends have been responsible for about 40% of stock market return. More recently, it has been about 20% to 30%.

Our investment process offers two durable, enduring advantages in this space. First, we have a lot of in-house analytical horsepower which helps in the “science part” of equity income investing, forecasting cash flows and doing deep investment research.

Second, we have frequent interactions with management teams who find us to be a credible source of insight on capital allocation and dividend policy. Management teams respect us and seek our advice on how to manage their cash flow.

Q: What is your investment strategy and process?

Cash flow is important to us. We need to be sure that the cash flow for the coming two or three years is sufficient to do more than cover the dividend plus any other necessities. It is critical that we understand what is happening with the capital of a business, how much reinvestment is required, what the return on that is, what the payback is. 

Our theoretical investible universe is the entire list of stocks trading on financial markets. While we do have about 11% to 12% international, this is at its heart a U.S. dividend oriented fund. We look for stocks that have a higher-than-average yield with a market cap greater than $1 billion.

Our investment process starts by running quantitative screens to determine which stocks boast above average dividends and free cash flow yield and discard those with unfavorable payout ratios. 

Then, as a second step, we run a valuation analysis because, fundamentally, we are value investors. We avoid high-yielding stocks with deteriorating fundamentals in favor of stocks with the best prospects for not only the current dividend but also earnings and cash flow growth.

After that, we look at the balance sheet and perform a credit oriented analysis. The dividend is naturally the most subordinated use of cash a company has, so it’s important to understand what the balance sheet looks like and what off-balance-sheet obligations look like in order to gauge how sustainable the dividend is. 

Once we do all that, we typically end up with about 100 to 150 possible stocks. As of today we have about 115 holdings in the portfolio. We end up with materially higher dividend yields than the equity market, and typically a lower valuation. 

Of the 11% or so international stocks we own, some of them are companies that have secured a tax domicile outside the U.S. in order to avoid U.S. tax liability. The rest are large multinational companies, with similar revenue profiles, that compete globally with U.S. companies. 

For example, the customer mix of a U.S. drug company does not materially differ to that of European drug companies. The international company may simply possess more attractive valuation and fundamentals. This allows us to feel comfortable about buying the best name in the group without worrying about where the company is domiciled.

Our maximum absolute sector weight is about 2500 basis points. We typically take active sector weights in the plus or minus 500 basis points range. We do not make outsized sector calls, but we do have the flexibility to go where we think dividend stocks are most attractive. Part of risk mitigation is avoiding problems, and one of those problems is over-enthusiasm. 

Q: What is your research process and how do you look for opportunities?

Investment ideas come from a variety of sources, primarily other Fidelity portfolio managers and the research department. Often, it starts when analysts ask my opinion on a name and we start talking. 

Our fundamental analysis is supported by two quantitative analysts, who do many forms of risk analysis and screening for ideas, but we do not make buy decisions based on the results of quantitative screening—it’s merely a starting point. We take the screens and the ranking of the stocks and discuss them with the fundamental analysts.

Our analyst’s build models, which can be upward of 10 or 15 pages, serve to determine where revenues come from, what drives the story, and what the end markets are. Then we examine the balance sheets and sometimes also consult with our fixed income colleagues.

We want a portfolio that, in aggregate, yields 70 to 100 basis points above the index. We like low volatility of revenue and we like stable businesses, but we have to balance that against the fact that we need the businesses to grow their dividends. It is a matter of optimization.

The fund owns some energy companies and as the current price of oil is low, we need to determine whether an oil company can pay its dividend. The risk premium one demands for valuation from an energy stock is going to differ significantly from that of a consumer staple stock.

Individual holding size depends on our level of conviction because in the end we are price takers. In this universe, you cannot make things happen—you can only locate the best opportunities available.

We do everything on forward estimates. When you are dealing with the future, you are dealing with the unknown and so it pays to be conservative. The forward-looking earnings estimates underpin everything we do.

With value investing, invariably you have to be cognizant of the value trap. We avoid value traps by understanding the cash flow and where it derives from. To do that, one has to understand the end markets. 

Q: What is your portfolio construction process?

Let me first state that the portfolio is not a list of anyone’s favorite stocks. It is a group of stocks assembled in such a way as to derive a desired risk-adjusted performance. A portfolio manager might love Google (Alphabet Inc.) and Facebook Inc., but if that comprises the bulk of their portfolio, they need to understand the risk they’re taking and have shareholders who are willing to accept that level of risk and volatility.

Our shareholders are not willing to assume that level of risk and volatility, and so I have a portfolio that is designed and constructed to yield low beta, low volatility, and high dividend yield. We do that by putting together individual names, developing conviction and weighting names, to get the desired blend.

We work hard to understand the inherent risks in the portfolio. One could, for example, build a portfolio by buying energy companies, financials that lend to energy companies, energy equipment services companies and industrials, and utility companies that are dependent on energy prices. Even though it might appear to contain sector and name diversification, the one overriding risk theme is energy. This is precisely what we try to avoid—unintended risk.

We want to fully understand where the risk is coming from. We do not only understand things in terms of fundamental characteristics; we also want to understand things in terms of market characteristics.

Factors to look at are momentum, volatility, size, financial leverage, value, growth, international risk, country risk, and currency risk. We look at all kinds of industry and style factors and try to understand what drives the portfolio. We want intended risk, not unintended risk, and try to minimize style factors and let stock selection be the primary driver of returns.

We have roughly a two-year holding period. Although we may hold for longer, we do not have a specific time horizon in mind. As we stated earlier, we are valuation focused and let value guide us. I screen what I own constantly. The holding period falls out from the fundamentals and the valuation.

Our sell discipline activates when a security reaches our valuation target or when some aspect of our initial investment thesis changes negatively. We optimize what provides the best risk return profile at any given point in time, both in the portfolio and by adding and subtracting stocks to and from the portfolio.

We do not design the portfolio to have a certain turnover or target, as turnover is by no means free. Instead, our construction is a function of the opportunities available in the marketplace on a risk/reward basis. Relative to our peer set, our turnover average is about 50%, which we feel is reasonable in normal market environments.

Q: How do you define and manage risk?

Risk to me means one thing: are we giving the clients the product that we sold them? We offer them a product that we represent as having low volatility—low beta—high returns, a solid dividend yield, and a yield that grows and, at minimum, beats inflation. We take stock-based risk, not a lot of market-based risk—intended risk, not unintended risk. 

Our investment thinking focuses a lot on risk. During our monthly risk meeting, where the other members of the investment department dissect the fund, we look for any weaknesses in the portfolio. In addition we have a monthly risk review with management. We have a quarterly report to a broader group inside the company, which focuses on portfolio positioning, outlook, and risk.

Intended risk, to me, means taking active positions based on research. 

Risk lies in concentrating too much on any one thing, whether unknowingly or deliberately, such as having that broad, heavy reliance on energy I mentioned. That is not a risk I want to take. 

We want a portfolio that is truly diversified, one that has sufficient disparate factors driving the fundamentals so that it is not overly dependent on any particular element. Stock picking is what drives this fund. We do not bet on interest rates, which we cannot predict in the short term, or oil prices, which are hard to understand, or a host of other factors on which people trade.

Many studies have shown that the highest performance comes from non-correlated risk taking, from avoiding auto-correlated risk. That is what we try to do.

Annual Return

FEQTX 3.2 11.1 -2.4 17.3 -9.3 14.1 15.9 -2.6 11.6 29.1

in percentage

More Information

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The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.

The history of the fund actually starts before it was established. The team came together at the end of 2003. Using the same strategy we employ today, we primarily managed institutional international and global equity portfolios.