When he's managing the Merrill Lynch Equity Dividend Fund/A (MDDVX), Bob Shearer aims for dividend yields that are comparable to the S&P 500-stock index. Along with yield, he looks for stocks with traditional value characteristics, such as low valuation, disciplined management, and a solid balance sheet. Shearer overlays these bottom-up criteria with a top-down search for underperforming sectors.
Shearer has generated competitive returns with low volatility since he started running the fund in 2001. For the three years through last month, the portfolio was up 8.1%, on average, vs. a gain of 5.2% for its large-cap value peers. For the one-year period through Sept. 30, Equity Dividend climbed 20.6%, vs. a 16.5% rise for the peer group.
standard deviation, a measure of volatility, is 11.26, vs. 15.38 for its peers. Based on risk and return characteristics over the last three years, Standard & Poor's gives the fund its highest rank of 5 Stars.
This year, Equity Dividend has benefited from overweightings in materials and energy stocks, which have outperformed due to worldwide economic growth and higher commodities prices. Shearer believes investment gains in these areas are sustainable for at least the next 12 to 18 months.
Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Shearer about the fund's investing strategy and top holdings. Edited excerpts of their conversation follow:
Q: What are the fund's investment goals?
A: Our aim is to provide a dividend yield after taxes that equates to the dividend yield of the S&P 500. We look for stocks that are trading at a discount to their historic value and to their peer groups.
We look for some catalyst that will change the stock, such as management imposing greater financial discipline or getting out of a volatile decision. We screen for companies with strong balance sheets and avoid those with a debt-to-capitalization ratio above 50%.
Q: Has the federal government's dividend tax cut changed the universe of dividend-paying stocks?
A: Dividend rates have marginally moved up, and many companies have increased their dividends. We're starting to see a trend toward more companies paying dividends, although some of that has slowed down, partly due to the uncertainty of the presidential election. Dividend yields would probably be higher if there were less uncertainty about long-term tax policy.
Q: What major changes have you made in the fund in the past year?
A: The only major changes were last year, when we moved to a significant overweighting in materials and increased our energy weighting. We also boosted our market-cap size from small-cap stocks to large-cap stocks because of better relative value and continued dividend increases.
Q: Do you consider broad macroeconomic trends in selecting stocks?
A: We look top-down for industry groups that are depressed. With interest rates rising, we've looked over the last year at sectors with the best earnings momentum. We're overweight in energy and materials, as commodity prices have run up due to rising demand from China. BluesScope Steel (BLSFF) in Australia is a materials holding that's benefiting from rising Chinese demand.
Q: How long do you expect to focus on companies benefiting from rising commodity prices?
A: We think this is a sustainable play, at least for the next 12 to 18 months. Despite rising energy prices, world economies are growing.
Q: Do you avoid any sectors?
A: We have a big underweighting in financials because of rising interest rates. We're also underweight in consumer discretionary because the benefits of tax cuts and mortgage refinancing have probably come to an end. The consumer probably faces headwinds.
Q: What's the fund's foreign-equity exposure?
A: We're about 77.6% in the U.S., 6% in Australia, and 2% in France. Our foreign holdings usually are in energy and materials companies where the commodities are priced in U.S. dollars.
Q: What is the fund's cash position?
A: It has drifted up in recent months to about 8%. We actively manage the fund in downturns, so our cash position got as high as 15% in 2002. If we had high confidence, our cash stake would be under 5%.
Q: What's your view of current valuations in the market?
A: If earnings come through, the market looks fairly valued with some upside, although there are some headwinds from energy prices. We're starting to see some companies with difficulties due to energy prices, such as Wal-Mart Stores (WMT), as higher fuel costs have led to lower consumer spending.
Q: What's the fund's
A: It's around 30%. Our time horizon is about 18 months because a lot of companies, particularly in metals and mining, have multiyear time horizons
Q: Why has the fund outperformed its peers in the one- and three-year periods through last month?
A: We've always focused on companies that are financially strong, so we've suffered less in down markets. Our overweightings in natural gas, energy, and materials have helped our returns.
Q: What are the fund's largest holdings?
A: At the end of August, they included Exxon Mobil (XOM), General Electric (GE), Citigroup (C), BlueScope Steel, Procter & Gamble (PG), and St. Paul Travelers Cos. (STA). St. Paul Travelers seems likely to benefit from improved pricing in the property and casualty insurance market, which often happens after natural disasters.
Q: Would you describe a stock you recently purchased?
A: We've been buying ConocoPhillips (COP) over the past year, largely due to changing fundamentals in the refining business. That's now a tight market as economic growth in Asia has absorbed capacity.