The Dividend Difference

By Natasha Gural, Editor-in-Chief

The Dividend Difference: Peter Vanderlee, managing director and portfolio manager at Legg Mason's ClearBridge Advisors is “cooking up a different meal” with the Equity Income Builder Fund.

By Natasha Gural, Editor-in-Chief

As Asian banks feasted on the remains of Lehman Brothers, Goldman SachsandMorgan Stanley converted into bank holding companies to cling to life and Putnam Investments shuttered a $12.3 billion money-market fund to spare investors from larger losses, September 2008 seemed anything but a good time to introduce a new equity fund. Against all odds, Legg Mason Partners Equity Income Builder Fund, launched that miserable month, has nearly tripled from the $10 million in seed capital provided by global asset management giant to $25 million.

Peter Vanderlee, managing director and portfolio manager at ClearBridge Advisors, the largest equity affiliate of Legg Mason, was sure of one thing when he started his newest fund along with co-portfolio manager Harry "Hersh" Cohen, managing director and chief investment officer: “Leverage didn't really sit well with me for this program.”

“Leverage amplifies your bet, but it's not a skill. The insight when I go long is a skill, but adding leverage doesn't amplify that skill, it amplifies that bet if it's a good one,” Vanderlee tells Markets Media in a recent interview at his New York office.

The equity-focused fund can invest in a broad range of income-producing securities, including common and preferred stocks and convertibles.

“This fund's asset level is rising even in this challenging market environment. It's doing so with little to no push and we haven't launched a targeted sales campaign yet. It's all or mostly word of mouth and the word is slowly spreading,” Vanderlee says. “The markets are down approximately 30 percent since our launch. It's a big test. A live program tested in real life. We're well over 2,000 basis points over the benchmark as of the end of April.”

In the fourth quarter of 2008, according to Lipper, it was the top performing fund in the U.S. in its category. “We've consistently outperformed the benchmark since our launch,” Vanderlee says.

Vanderlee, who has been working withCohen for a decade, makes it all sounds so simple in a subtle Dutch accent. “My approach to managing money is to not get killed,” he quips.

“I have a quality bias. I like companies with strong balance sheets that are generating strong cash flow, have competitive advantages that are sustained, and are often industry leaders, oftentimes an innovator, a lot of blue-chip names,” says Vanderlee.

The Dividend Edge

“There is such a thing as getting in at (the) right stock price. That's where a lot of analysis comes in. That's where we pick up a lot of entities on the cheap. I spend a lot of time on the dividend program. There are a number of funds and SMAs I co-manage with a dividend theme. Why is the dividend so important? It's certainly topical. I certainly look at the current yield based on the price of a stock. I look at management's, or more importantly, the board of directors' track record in maintaining or increasing dividends. Some companies we own have paid uninterrupted dividends for over a century, others have increased dividends for over 30 or 40 years in a row,” says Vanderlee.

He adds: “We look at a lot of other measures, such as how aggressive is this company in managing costs and what is the free cashflow profile of this company. Ultimately, dividends are paid in cash out of free cashflow so we analyze the free cashflow payout ratio in addition to the earnings payout ratio of the dividend? As you can see, this dividend component alone requires a lot of analysis and a lot of digging.”

As boundaries blur, and key players across all sectors battle within asset classes, the marketplace shifts constantly, making stock picking a growing challenge as even the old blue chip can no longer be regarded as a gold standard.

“The reason dividends are so important is that there is a real shift which is going to occur right now in terms of the investment landscape,” Vanderlee says.

Stock Selection

The Legg Mason Partners Equity Income Builder Fund's top stock holdings include: J&J, Proctor & Gamble, Kimberly Clark, Heinz, BP, United Technologies, 3M, ADP, Kraft, Travelers.

“That's a flavor of what I am talking about,” says Vanderlee. “We also own a few high quality utilities. It's as though I'm running a $20 billion portfolio, with high quality, household names in many cases. With such a bias to quality, the portfolio is well positioned from a tactical standpoint when cash returns to the equity markets.”

“Kraft is a good stock because the valuation is attractive and the company owns many valuable consumer brands; I believe people will continue to eat cheese even in a recession and, in my view, the market is overly pessimistic on Kraft's prospects. It has a 4.6 percent dividend yield based on the current stock price of $25,” he says.

Besides other household names like AT&T, the fund invests in Annaly Capital Management, which invests in U.S. residential mortgage-backed securities issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Like a bank, Annaly seeks “to earn positive net interest income from the difference between the yield on our securities and the cost to finance them,” according to the firm's Web site.

“We know this company very well. Essentially they buy government paper, MBS. Spreads that they earn on that business are very attractive,” says Vanderlee. “There is no credit risk, and the stock's dividend is in the double digits, and it paid a 14 percent dividend yield in 2008.”

Vanderlee makes it clear that Annaly is different from a real estate investment trust which sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. Mortgage REITs loan money for mortgages to owners of real estate, or purchase existing mortgages or mortgage-backed securities. Their revenues come mostly from the interest that they earn on the mortgage loans.

“We don't have any real estate REITS,” he says. “We were not comfortable with real estate REITS. Annaly is a mortgage investor,” he says. “Many REITS have cut their dividend or are paying it in stock. (Annaly) really is like a bond fund manager, but the corporate structure is more like a REIT.”

The fund also invests in American depositary receipts (ADRs) and has some foreign exposure.

“They tend to be liquid like BP,” says Vanderlee. “We have some other foreign stocks like Total, and they all tend to be liquid stocks, large cap household names. We don't take on overly concentrated bets. You have to spread out your bets in order to diversify and reduce portfolio risk. You want to stay clear of those companies that have weak balance sheets or are about to go on shaky ground. We also are not taking any large sector bets.”

Diversification is key, as the fund's largest position as of May was under 4 percent.

“There is very low turnover in our portfolio because these companies are so carefully scrutinized,” says Vanderlee. “We really want to think about long-term ownership. I want to be in it as a long-term holder. Ideally I never sell a stock.”

Vexing Volatility

“Our portfolios tend to exhibit lower volatility. You kind of sleep better at night when your portfolio is less volatile. On top of that we aim for long-term capital appreciation as we are mostly investing in common stocks,” says Vanderlee.

All equities markets posted losses in the first-quarter of 2009, according to Mercer's Defined Contribution Universe Summary. The quarterly report analyzes returns of various funds so institutional investors can evaluate their mutual fund managers' performance against other funds and asset class benchmarks. The S&P 500lost 11 percent during the quarter. The fixed income asset class was flat for the quarter, with the Barclays Capital Aggregate Bond Index gaining 0.1 percent. Money market instruments had a zero return, as measured by the three-month T-bill rate. The balanced asset class, using a benchmark of 60 percent S&P 500/40 percent Barclays Capital Aggregate Bond Indices, tumbled 6.5 percent. International equity markets, as measured by the MSCI EAFE Index, sank 13.9 percent during the first quarter.

The international equity asset class underperformed U.S. equities for the quarter by 290 basis points, Mercer said. Global equities lost 11.9 percent for the quarter and outperformed international equities by 200 basis points.

Over a 10-year time frame, the S&P 500 shed 3 percent, while the Russell 2000 Index jumped 1.9 percent. International equity markets dipped 0.8 percent over a 10-year time frame, outperforming their U.S. counterparts. Over a 10-year period, the fixed income asset class produced a return of 5.7 percent, trumping U.S. equity returns based on the S&P 500 Index.

“When we analyzed the equity income space, we did see some attractive yields, but what else we found was very sobering,” says Vanderlee. “A number of programs had very serious flaws. Quite a few equity income programs are using leverage which amplifies your bet but is not a skill. The insight when you go long is a skill but adding leverage doesn't amplify that skill, it amplifies that bet if it's a good one.”

He adds: “A lot of these programs engage in income mechanisms, some use dividend capture strategieswhich entails purchasing a stock prior to it going to ex-dividend. There is essentially a shift from principal into income. In my view, that didn't add any value as your total return is neutral.”

“What we want is a straightforward equity program,” he says.

Vanderlee said other flaws in equity income programs include a concentration risk that was significant; over-concentration in financials, utilities or telecom.

“We wanted to stay diversified and also believed that balance sheets of many financials were not strong enough,” he said. “The return on some of these programs over the last six months is heartbreaking.”

Convertible and Preferred

Vanderlee says the Legg Mason Partners Equity Income Builder Fund is unique because it can include convertible securities and preferred stocks.

“The convertible securities space and the preferred space both got killed. I like the preferred and the convertible space, which allows me to consider an extensive set of opportunities,” he says. “It's a bummer for our equity income program when a stock doesn't pay a dividend. However, going up the capital structure, and looking at convertible or preferred securities we can sometimes find substitutes and we certainly would look at that. The added advantage is that using some select convertible or preferred securities tends to boost the overall yield of the portfolio, because these securities can pay attractive yields, sometimes in the double-digits. This also allows me to be more broadly diversified on the stock side of the portfolio.”

Vanderlee notes that the technology sector tends to have no or low dividends.

“However, some of the technology companies have convertible securities that do have a high current yield that I can use in the portfolio, even adding a little flavor to the portfolio by having a more diversified asset mix. So it makes sense to look for opportunities in securities that are higher in a company's capital structure,” he says. “The added benefit is that the dividends of these securities are also less prone to dividend cuts. In fact, some convertible securities are akin to bonds in terms of their seniority in the capital structure, which provides for significant more dividend protection than the common shares.”

He adds: “Our approach to equity income is to add a little more protection from an income perspective instead of attempting to boost yield by using leverage, which is risky, or using gimmicks like dividend capture techniques.”

No Boon for Boomers

Individual and institutional investors alike are hit hard. Baby boomers ages 45-54 have lost 45 percent of their median net worth, leaving them with just $80,000 in net worth, including home equity, according to a report released in February by Washington- based think tank the Center for Economic and Policy Research. Those between 55 and 64 have lost 38 percent of their net worth, leaving them with $140,000, but have few working years left to make up the losses, the report says. According to the latest U.S. Census Bureau, there were 78.2 millionbaby boomers, as of July 1, 2005, and that number was projected to grow by 60 each day in 2006.

“That's a lot of people when you think about their predicament and how to sustain their lifestyle. A fair amount will find a sober new reality. 401(K)s, IRAs, Social Security, pensions, are all under pressure,” says Vanderlee.

“For many baby boomers, their nest egg is not sufficiently robust to sustain their current lifestyle. What we are trying to do is recreate their paychecks by providing an attractive income stream that supplements their savings,” he says. “I think there is a real need for an investment style that is conservative, quality-based and offers an attractive income stream. This cohort also needs inflation protection in retirement, which we attempt to provide.”

The fund is open to both institutional and retail investors, a growing trend in a dynamic marketplace where major managers can no longer limit their targets.

“Inflation protection is built in by companies' abilities to raise dividends. We believe that this is important to investors, especially those that are in or nearing retirement,” says Vanderlee.

Ownership Edge

“You need long-term capital appreciation,” Vanderlee says. “I certainly hope we're going to get it. Stocks that I own are good value, but that's not to say I'm a value investor. I'm an owner of stocks, not a renter of stocks. I want to own a franchise and know it's a company that is doing the right things for investors so that in three to five years you'll do well in this portfolio. One of our goals is to provide investors with upside to their principal, particularly in a market that goes up. This upside is in addition to the attractive income stream the portfolio generates.”

Hedge funds and others who were highly leveraged had to dump assets into illiquid and distressed markets. Under the “great deleveraging” companies are culling capital from secondary equity to rebalance their capital structures.

“There was a lot of cash raised in 2008 and a huge amount of deleveraging took place. A lot of this cash is still sitting on the sidelines. At some point in time, some of that cash will return to the equities market, which would be a positive for the equity market,” says Vanderlee.

Last year, “investor risk tolerance wasn't in sync with the actual risk taken in their portfolios. In response to this mismatch, many investors deleveraged and raised cash so they could sleep better,” he says. “This aversion to risk is human behavior. If and when the market normalizes, many of these investors will go back into the market and embrace the more risky equity environment once more. However, they may very well favor a less risky equity approach than before which would favor the equity income investing style we have adopted.”

Push for Pensions

Pension plans' assets plunged 26 percent last year, primarily because of investment losses, according to study by human resources consulting firm Watson Wyatt. The 100 largest corporate pension plans in the U.S. were underfunded by $217 billion at the end of 2008, holding just 79 percent of the assets needed to cover estimated long-term liabilities, the study said. That's a staggering loss compared with an $86 billion surplus, or 109 percent of estimated liabilities, at the end of 2007.

Pension funds are still sitting on the sidelines, but the sentiment is changing as the markets recover and Vanderlee and other fund managers predict renewed interest.

“Some pension funds have been more strict about track records. The Equity Income Builder program is new but we have been involved in equity income investing for a long time.Our Dividend Strategy Fund, which I co-manage with Scott Glasser and Peter Hable, has a four-star rating from Morningstar for the three-year period and three stars overall,” he says.

Ricardo Duran, a spokesman for CalSTRS, the nation's second-largestpublic pension fund, says: “We don't talk about future moves. I haven't heard about equity income builder funds as part of our portfolio.”

Vanderlee encourages investors to look at ClearBridge's track record with other funds, including the $4 billion Appreciation fund he works on with Cohen and Glasser.

“Hersh and I are chefs. We're just cooking up a different meal here in Equity Income Builder,” he says. “These chefs have been on other programs for decades.”

“I'm very encouraged,” says Vanderlee. “We've grown our assets 150 percent since our launch. I don't expect it to become a $10 billion fund overnight. I think the potential is huge, but I don't want to quote a number. I just want to do the right thing. I want to make sure people know what we are doing. I feel you can never be too educated. The assets will come. I'm a patient investor. If they recognize what we are doing they won't panic in a down market. I'm not providing such a bumpy ride which helps investors to stay the course in a challenging market environment. I have to stay patient with flows and asset levels.”

Work-Life Balance

“I love this business. It's like drinking water from a fire hydrant. You have flexibility to learn about new companies. Things change. It's like a slow drip, but the change is fundamental. I love doing this. It's analytical,” says Vanderlee. “It's like 24-7. It never leaves us so if you don't like it, you're not going to succeed. I am skeptical, curious, cynical. Those are healthy attributes when you look at things like companies projections.”

At work, Vanderlee relies on the resources of a diversified global asset management firm with proprietary research across asset classes.

“All of ClearBridge is very well integrated. I sit right alongside other portfolio managers and our research analysts,” he says. “It's a very free flowing dialogue, and we also have a formal process to introduce ideas. It's facilitates doing a deep dive into a topic when you have analysts available.”

Vanderlee also co-manages the Legg Mason Partners Dividend Strategy Fund and the Legg Mason Partners Equity Income Builder Fund. He also co-manages the ClearBridge Appreciation, Dividend Strategy and Equity Income Builder SMAs. He serves as the chairman of the ClearBridge Proxy Voting Committee. Prior to ClearBridge, Vanderlee worked in the financial services and information technology group of Booz & Co. and the information technology division of Citigroup.

When he's not cooking up a stock stew with Cohen, Vanderlee spends time with his two daughters, ages 8 and 10, with his wife Lesley. “They like to play sports, tennis or just bicycling, read books, movies, traveling,” he says.

Vanderlee, who is fluent in English, Dutch, French and German met his wife in Paris. Her late father worked for Desmond Tutu.

“I literally married the priest's daughter,” Vanderlee quips.

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Posted on June 29, 2009