Phil Davidson admits that most of the time, he likes to play it safe. The 53-year-old Davidson, who oversees value strategy investing at Kansas City, Mo.-based American Century, has been at the same company for 15 years and rarely misses work. He always bought used cars until last year, when he splurged on a new BMW. In his spare time, he enjoys a nice, relaxed game of golf or watching his son play baseball.
As an investor, he and a team of seven analysts gravitate to quality companies with solid balance sheets-a conservative and some might say boring strategy that in some years has produced yawn-inducing returns. American Century Equity Income, the $3 billion fund he has managed since 1994, missed out on the bounties of the dot-com boom in the late 1990s as Davidson and his team sidestepped expensive technology companies in favor of tamer fare. In 2006, the fund largely sat out the commodity boom because it was underweight in a roaring sector its managers deemed overpriced. In 2007, its returns trailed the S&P 500 Index by 3.7%.
Then there is the other side of boring: Davidson was able to even out the score in 2008, a time when investors quickly learned that, in the long run, losing less can mean making more. As the daunting year drew to a close, the fund had beaten the S&P 500 by more than 15 percentage points, even after a year-to-date loss of nearly 24% by mid-December. It was in the top 1% of its Morningstar large value peer group over the same period and also for the one-, three- and ten-year periods, and it was in the top 4% over a five-year period. On December 31, the fund narrowed its loss to 20.5% for the year while the S&P was down 34.06%.
While the American Century Equity Income fund's strong long-term numbers come largely from 2008 results, it is more than a one-year wonder, says Morningstar analyst Gregg Wolper in a recent report. "Even excluding this year's showing, it has been a fine performer overall since its 1994 inception, and lead manager Phil Davidson has been around from the start. It's certainly worth considering, as long as you don't expect it to consistently top the charts," Wolper notes.
The fund's strong showing against its peers last year was as much due to the stocks it didn't own as those that it did, says its manager. Even though it had nearly one-quarter of its assets in financial names, the fund's search for solid balance sheets helped it avoid the hardest-hit members of the group, including American International Group, Wachovia and mortgage lenders Fannie Mae and Freddie Mac. The fund also significantly underweighted metals and mining stocks because Davidson believed that earnings for the group were at peak levels and unsustainable. This strategy paid off when commodity prices fell later in the year.
Besides avoiding some of the year's biggest losers, the fund also owned several major health-care companies, such as Johnson & Johnson, that held up better than much of the entire market. The firm's individual stock choices also made their mark. In the third quarter, Rohm and Haas, a specialty chemical company, rose more than 50% on the news that it would be acquired at a substantial premium by Dow Chemical. Consumer staple holdings such as Campbell Soup and UST, the leading producer of smokeless tobacco products, also did relatively well.
Detractors from performance included financial services firm AllianceBernstein as well as Total S.A. and BP Plc., companies whose prices declined sharply near the end of the third quarter as energy prices fell.
Although convertible prices declined later in the year as hedge funds unwound positions, the fund's convertible bonds and preferred stock holdings still held up better than the underlying common stocks. Nearly 25% of fund assets were in convertible bonds and convertible preferred stock at the end of October, up from 15% at the beginning of the year, while the stock allocation decreased from 84% of assets at the beginning of the year to 72%. Davidson likes to own convertible bonds when the underlying stock is reasonably priced or undervalued, when the underlying credit is stable or improving and when the bond offers a higher yield than the common stock.
Seeking Sustainable Dividends
He admits his strategy can lag the broader market indices during times of strong economic growth. But as 2009 gets under way, few observers believe the stage is being set for a solid near-term recovery. Problems in the financial services industry-the epicenter of the economic fallout-will continue to mount as asset qualities deteriorate. Of the federal bailout, known as the Troubled Assets Relief Program, he says, "All TARP money did was stabilize the system, not improve it. Banks need to increase their loan loss provisions and that's going to have an impact on earnings. Cutting dividends and consolidating to rationalize excess capacity are the necessary remedy for an industry that has fallen victim to the credit bubble it created."
With a flat or weak economy as a backdrop, Davidson plans to continue his focus on well-capitalized companies with sustainable cash flows that have the ability to sustain dividends even in tough economic climates. After years of being ignored, dividends are coming back into fashion, he says. While they have historically represented about 40% of stock market total returns, they fell out of favor in the late 1990s, when the yield of the S&P 500 index fell to about 1% and companies preferred using cash flow for business growth.
But with stocks so battered, people are once again waking up to the importance of owning solid companies with sustainable dividends that can pump up total return, he says. The fund's recent portfolio yield has been 5% to 5.5% before expenses, and about a percentage point lower after expenses. At those levels, the fund's recent yields have been higher than Treasury securities and competitive with investment-grade bonds.