Dividends: Why quality and risk management matter

Transcription

1 NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE Dividends: Why quality and risk management matter A conversation with lead portfolio manager Clare Hart In an environment of increasingly volatile markets and persistently low interest rates, where can investors find the potential for upside participation, downside mitigation and a reliable income stream? This is a question on the minds of many investors, especially those anticipating extended retirement years. In a recent interview, Clare Hart, portfolio manager of the JPMorgan Equity Income Fund, explained why she believes a fund like the one she and her team manage offers a solution well worth considering. However, Hart is quick to point out that this is not just an interim waiting for rates to rise strategy. The fund invests in high-quality, dividend-paying companies to pursue total return, income and a smoother ride in uncertain times. Here is what Clare had to say. Q Why invest in dividend-paying stocks? A While one obvious part of the answer is income, especially with 10-year Treasury yields in the 1% to 2% range, the real answer is that dividends have, on average, accounted for more than 40% of the total returns from the market over a long time horizon. In some years, dividends have accounted for an even larger share of returns. RISKS ASSOCIATED WITH INVESTING IN THE FUND. The price of equity securities may rise or fall because of changes in the broad market or changes in a company s financial condition, sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or industries selected for the fund s portfolio or the securities market as a whole, such as changes in economic or political conditions. Equity securities are subject to stock market risk, meaning that stock prices in general (or in particular, the prices of the types of securities in which a fund invests) may decline over short or extended periods of time. When the value of a fund s securities goes down, an investment in a fund decreases in value. The fund may invest in derivatives, which may be riskier than other types of investments because they may be more sensitive to changes in economic or market conditions than other types of investments and could result in losses that significantly exceed the fund s original investment. Many derivatives create leverage thereby causing the fund to be more volatile than it would be if it had not used derivatives. The manager seeks to achieve the stated objectives. There is no guarantee the objectives will be met. There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.

2 DIVIDENDS HAVE BEEN AN IMPORTANT COMPONENT OF TOTAL RETURN OVER TIME S&P 500 total return, dividends vs. capital appreciation, average annualized returns [%] Capital appreciation Dividends s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 2010s Source: Standard & Poor s, Ibbotson, J.P. Morgan Asset Management. Data are as of Total return assumes the reinvestment of income. Chart is shown for illustration and discussion purposes only. Past performance does not guarantee future results. Q Many investors think of these dividend payers as stodgy, uninteresting companies. Is this an accurate view? A No. I would attribute that view to our memories of the 80s and 90s when capital appreciation dwarfed dividends. The fact is, over roughly the last 40 years, dividend-paying stocks within the S&P 500 have outperformed non-dividend-paying stocks and by a significant margin. I believe this is because companies that can commit to a recurring dividend payment in cash are inherently healthier companies. RETURNS FOR S&P 500 DIVIDEND-PAYING STOCKS HAVE SIGNIFICANTLY EXCEEDED THOSE OF NON-DIVIDEND-PAYING STOCKS Equal-weighted geometric average of total returns, [%] Source: Ned Davis Research, Inc. Returns based on monthly equalweighted geometric average of total returns of S&P 500 component stocks, with components reconstituted monthly Chart is shown for illustration and discussion purposes only. Dividend growers and initiators Dividend payers with no change in dividend Dividend cutters or eliminators Non-dividendpaying stocks Past performance does not guarantee future results. 2 DIVIDENDS: WHY QUALITY AND RISK MANAGEMENT MATTER

3 Q How do you think about investing? A Broadly speaking, we are looking for quality, valuation and an income component. The first thing we think about is quality. We target companies with durable franchises, consistent patterns of earnings, high return on invested capital, conservative financials and strong management teams. Valuation is also critical to our entry and exit points but I m not just looking for cheap stocks. When we talk about buying quality companies, it doesn t surprise me that quality companies are not always the cheapest in the market. From my perspective, if you don t nail the quality part, then who knows if you re going to get that dividend or not. You could be destroying capital as you go. Finally, the dividend yield is important because the fund has an income component. While we look for companies that pay a minimum 2% yield, looking for the highest yield is not our goal. The highest yield is often high for a reason the market, for example, may not believe it is going to get paid. Alternatively, the company may have nothing else to do with its money so it pays it all out in dividends, leaving nothing for capital appreciation. Q What do you look for in the companies you invest in? A We want to invest in companies with durable franchises, strong balance sheets, and good cash flow generation with solid management teams that are effective capital allocators the same characteristics that can help identify stocks with the consistent performance most investors want. All of these factors together should support a healthy dividend at a low payout ratio the proportion of earnings paid in dividends to shareholders. Q Why is a low payout ratio important? A A low payout ratio generally means that these well-managed companies can reward investors with a dividend today while leaving capital available to grow shareholder value and enhance the dividend for tomorrow. The best performing stocks over the past 20 years have been those with above average yields and below average payouts. Q How do you identify companies that meet your investment criteria? A Ours is a bottom-up, fundamental research approach, supported by a team of more than 25 sector-specialized analysts. We spend a lot of time going through the numbers and meeting with management teams to find the companies that exhibit the characteristics we seek. J.P. MORGAN ASSET MANAGEMENT 3

4 DIVIDENDS ARE IMPORTANT, BUT SO IS THE ABILITY TO PAY THE DIVIDEND QUALITY MATTERS* Equal-weighted total return from % High dividend yield, Low payout ratio Low dividend yield, Low payout ratio 350% No dividend High dividend yield, High payout ratio 300% S&P 500 Low dividend yield, High payout ratio 250% 200% 150% 100% 50% Source: Credit Suisse Quantitative Equity Research. The graph shown is for illustration and discussion purposes only. There is no guarantee that companies that can issue dividends will declare, continue to pay or increase dividends. * U.S. equities returned 6% on average since However, without dividends the annual gain drops to 1.7%; Treasury bonds returned 2.1% during the same period. According to inflation-adjusted data compiled by the London Business School and Credit Suisse Group AG. Past performance does not guarantee future results. 0% Q Can you provide an example of the type of stock that makes it through your rigorous research and due diligence? A Sure. Hershey s is a great example and not necessarily the first stock that comes to mind as an innovative investment idea. It has dominant market share (compared to other packaged food companies) and strong pricing power, which has allowed it to dampen the impact of higher commodity prices. What s more, demand for its products (primarily chocolate and related confections) is relatively steady across economic cycles. And, management has exhibited a clear bias toward dividend growth as a top capital allocation priority. Q How do you know when to sell an investment? A While we have a low turnover strategy, our sell discipline is essentially the opposite of our buy discipline. The number one reason to reduce or eliminate a position is when the stock becomes overvalued by the market. I m not doing anyone any favors if I say that I found a great company but the stock does nothing over time. You have to be careful about how much you pay for stocks and how the market values them. We will also sell positions when there are changes to company management, their capital allocation decisions or the competitive landscape. We re constantly reevaluating positions because companies are living, breathing things. Our job is not to retrofit our thesis. If we need to take our lumps, we take our lumps and move on. Finally, we may sell a stock if we find a better idea. 4 DIVIDENDS: WHY QUALITY AND RISK MANAGEMENT MATTER

5 Q Where do you see the most promising market opportunities today? A We have been adding money to the technology sector, as we are finding more companies in that space that meet our investment criteria than ever before. There is clearly a growing dividend culture among technology companies, many of which have historically resisted adopting dividend programs for fear that their investor base would flee the stock. However, given the record amounts of cash on their balance sheets and, in many cases, a more stable earnings pattern, they are in a better position to both support a dividend and grow their businesses than ever before. Q Not only have you consistently beaten the Russell 1000 in terms of returns, you have done so with lower average volatility than the market. How have you been able to accomplish this? A That s correct. Since I became co-portfolio manager in January 2005, the fund has outperformed the Russell 1000 Value index by an average of more than 2% per year on an annualized basis, making it a top quartile performer with bottom quartile volatility.* There are a number of components of our risk management approach behind those results. While we are benchmark agnostic, that certainly doesn t mean we take huge bets. In fact, a high degree of diversification across sectors and holdings is a hallmark of our strategy. In addition, we tend to avoid extremely cyclical stocks and stocks with a high sensitivity to commodity prices. Q What are the other ways in which you seek to manage risk? A There are lots of ways to think about risks in the market. One of the risks as a value manager is that you can have a stock that goes to zero. My job is to avoid the value traps those stocks that look cheap but continue to get cheaper. We also manage risks by identifying effective management teams. If I m investing in a dividend-paying stock with a 30% payout ratio, I m leaving the company 70 cents on the dollar. How is the management team going to make more money with the money I leave behind? That s what will drive the capital appreciation. If the management team is not good at what they do, they re not effective. Finally, we also manage the portfolio to be broadly diversified overall and within sectors and subsectors. Even when you have done as much due diligence as you possibly can across sectors, bad things can happen to good companies. *For Select shares over the period through vs. Morningstar large value category. See performance information on page 7. Morningstar overall rating 5 stars; 1,063 funds. Three-year rating 5 stars; 1,063 funds. Five-year rating 5 stars; 938 funds. Ten-year rating 5 stars; 587 funds. J.P. MORGAN ASSET MANAGEMENT 5

6 Q How has your background shaped your investment approach? A After studying political science at the University of Chicago, I got a master s degree in accounting and earned my CPA while working as an auditor at Arthur Andersen. My background taught me that balance sheets always matter in good times or bad. That is why today we care about things like free cash flow and debt levels. Q Are there some market environments that are more/less challenging for equity income strategies? A A sharp rally in poor quality companies can be a challenging environment. We navigate this by looking where others are not investing essentially by going in the other direction to see what great companies may be attractive as people sell them to chase a theme elsewhere in the market. 6 DIVIDENDS: WHY QUALITY AND RISK MANAGEMENT MATTER

7 4 JPMorgan Equity Income Fund Invests in high-quality, dividend-paying companies and aims to deliver higher returns than the stock market with lower risk GROWTH OF $10,000 AND CUMULATIVE RETURNS OVER A FIVE-YEAR MARKET CYCLE [SELECT SHARES] $14,000 $12,000 $10,000 $8,000 JPMorgan Equity Income Fund: $11,393 5-year cumulative return: 13.93% Russell 1000 Value Index: $9,557 5-year cumulative return: -4.43% $6,000 $4, A $10,000 investment in JPMorgan Equity Income Fund [Select shares] at NAV, with dividends and capital gains reinvested, would have grown to $11,393 from through The chart is plotted daily. There is no direct correlation between a hypothetical investment and the anticipated performance of the fund. For illustrative purposes only. Past performance does not guarantee future results. Overview Morningstar rating HHHHH Portfolio managers, industry experience Clare Hart, 20 years Jonathan Simon, 32 years Tickers A SHARES OIEIX C SHARES OINCX SELECT SHARES HLIEX For Select shares as of Morningstar overall rating 5 stars, Class S; Large Value Category; 1,063 funds. Threeyear rating 5 stars; 1,063 funds. Five-year rating 5 stars; 938 funds. Ten-year rating 5 stars; 587 funds. Ratings reflect riskadjusted performance. All data as of The performance quoted is past performance and is not a guarantee of future results. Mutual funds are subject to certain market risks. Investment returns and principal value of an investment will fluctuate so that an investor s shares, when redeemed, may be worth more or less than original cost. Current performance may be higher or lower than the performance data shown. For performance current to the most recent month-end, please call Fund highlights Seeks total returns from monthly dividend income and long-term capital growth Leverages a dedicated team of 29 career research analysts to identify high-quality companies paying above-average dividends May be well suited for more conservative equity investors Performance at NAV [%] TOTAL RETURNS AVERAGE ANNUAL TOTAL RETURNS SELECT SHARES AS OF Latest qtr. YTD 1 yr 3 yrs 5 yrs 10 yrs JPMorgan Equity Income Fund Russell 1000 Value Index Lipper Equity Income Funds Index Annual operating expenses [%] Fee waivers Expense cap Total annual and/or expense expiration date Expense cap operating expenses* reimbursements* Net expenses* % 0.84% 0.04% 0.80% *The Investment Advisor, Administrator and Distributor (the Service Providers ) have contractually agreed to waive fees and/or reimburse expenses to the extent that Total Annual Operating Expenses (excluding Acquired Fund Fees and Expenses, dividend expenses relating to short sales, interest, taxes and extraordinary expenses and expenses related to the Board of Trustees deferred compensation plan) exceed the expense cap of the average daily net assets through the expense cap expiration date. This contract continues through that date, at which time the Service Providers will determine whether or not to renew or revise it. J.P. MORGAN ASSET MANAGEMENT 7

8 NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE Contact JPMorgan Distribution Services, Inc. at for a fund prospectus. You can also visit us at Investors should carefully consider the investment objectives and risk as well as charges and expenses of the mutual fund before investing. The prospectus contains this and other information about the mutual fund. Read the prospectus carefully before investing. 2012, Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its providers; (2) may not be copied or distributed; (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damage or losses arising from any use of this information. Past performance is not a guarantee of future results. For each fund with a three-year history, Morningstar calculates a Morningstar Rating metric each month by subtracting the return on a 90-day U.S. Treasury Bill from the fund s load-adjusted return for the same period, and then adjusting this excess return for risk. The top 10% of funds in each broad asset class receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. The Overall Morningstar Rating for a fund is derived from a weighted average of the performance figures associated with its three-, five- and ten-year (if applicable) Morningstar Rating metrics. Past performance is no guarantee of future results. Different share classes may have different ratings. The performance of the Lipper Equity Income Funds Index includes expenses associated with mutual funds, such as investment management fees. These expenses are not identical to the expenses charged by the fund. The Russell 1000 Value Index is an unmanaged index which measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The performance of the index does not reflect the deduction of expenses associated with a mutual fund, such as investment management fees. By contrast, the performance of the fund reflects the deduction of mutual fund expenses, including sales charges if applicable. Investors cannot invest directly in an index. The S&P 500 Index is an unmanaged index generally representative of the performance of large companies in the U.S. stock market. The performance of the index does not reflect the deduction of expenses associated with a mutual fund, such as management fees. By contrast, the performance of the Fund reflects the deduction of the mutual fund expenses, including sales charges if applicable. An individual cannot invest directly in an index. Securities highlighted have been selected based on their significance and are shown for illustrative purposes only. They are not recommendations. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Depending on a fund s share class, there are different purchase minimums required to establish an account and to add to an account. The purchase minimum for Select Class shares is $1,000,000. The fund prospectus states the applicable purchase minimums for each of the fund s other share classes. Total return assumes reinvestment of dividends and capital gains distributions and reflects the deduction of any sales charges, where applicable. Performance may reflect the waiver of a portion of the funds advisory or administrative fees for certain periods since the inception dates. If fees had not been waived, performance would have been less favorable. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. There can be no assurance that the professionals currently employed by J.P. Morgan Asset Management will continue to be employed by J.P. Morgan Asset Management or that the past performance or success of any such professional serves as an indicator of such professional s future performance or success. J.P. Morgan Funds are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates of JPMorgan Chase & Co. receive fees for providing various services to the funds. JPMorgan Distribution Services, Inc. is a member of FINRA/SIPC. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc. JPMorgan Chase & Co., November 2012 QA-EI-HART