As a young naval officer on the U.S.S. Essex, Jim Cullen learned that in a fogged-in harbor, a skilled navigator could pilot the 27,000-ton aircraft carrier into port with just one navigational “fix,” such as a lighthouse. Having a second fix dramatically increased the chance of success, and with three fixes, “the captain could bring the ship into port with his eyes shut,” says Cullen, the founder and chief executive officer of Schafer Cullen Capital Management in New York.
Today, Cullen still relies on three fixes to chart his course, but now it’s through the choppy waters of the U.S. equity markets. He, along with Jennifer Chang, an executive director at Schafer Cullen, manages three value equity strategies that seek consistently strong risk-adjusted returns by targeting stocks that share three characteristics:
- Low price-to-earnings ratios
- An absolute dividend yield of at least 3% with strong dividend growth potential
- “Out-of-favor” status that positions them to surprise to the upside
If asset growth is any indication, the three-fix formula has been as effective at attracting investors to the firm’s equity strategies as it is at guiding an aircraft carrier to its berth. Schafer Cullen’s assets under management have climbed from $150 million when the firm was founded in 1983 to about $18 billion today — largely on the appeal of the firm’s strategies to investors seeking long-term upside potential with downside protection.
“Our investors are institutional and high-net-worth individuals who value capital preservation, so they want solid risk-adjusted returns but also some protection during down markets,” Cullen says.
Managing the ups and downs
The cornerstone of the firm’s investment process is price/earnings (P/E) discipline. The managers aim to avoid overpaying for stocks by focusing on companies with P/E ratios in the bottom 20% of the market. Targeting unloved stocks with low multiples can mean sizeable returns if strong earnings growth, industry consolidation or other catalysts cause the stock price to pop.
“We look for attractively valued stocks that ideally will be rerated by the market and provide downside protection in a sell-off,” Chang says. “We’re playing offense and defense.”
The inexpensive holdings favored by Cullen and Chang help contain price volatility during turbulent markets because they have less room to fall during market downturns than pricey growth stocks. The floor under low P/E stocks is reinforced if they offer a healthy dividend, which is why Cullen and Chang target companies with at least a 3% dividend yield and — just as important — strong potential to hike their dividend in the future.
“A healthy dividend may offer investors a safety net because investors' desire for income can help support the stock price even if the company’s earnings drop,” says Cullen, who notes that over the past 70 years, dividends on the S&P 500 have risen during every recessionary period save for the one that followed the 2008 financial crisis.
To fully realize the promise of dividend payers, Cullen and Chang seek out companies they believe are well positioned to increase their dividend no matter the macroeconomic or market environments. For the two fund managers, dividend growth is a proxy for quality because companies with high debt levels and unreliable earnings typically cannot maintain, let alone increase, their dividends. This emphasis on dividend growth helps them sidestep “value traps,” stocks that deserve their low prices because of inept management, lackluster products or pressures from foreign competitors, for example.
Getting the story straight
As central as metrics like P/E ratios and dividend yields are to the fund’s investment process, they are by no means the only drivers of the managers’ stock selection. Cullen, Chang and their team of 15 research analysts conduct extensive analysis to find cheap stocks they believe will deliver significant earnings and dividend growth and, by extension, multiple expansion. The key to identifying those underperformers is to isolate the catalysts that could surprise the market, turning an out-of-favor stock into a Wall Street darling.
“There needs to be a story that gets us excited about the company’s prospects and changes the sentiment on the stock,” Chang explains. “We really dig into businesses to spot opportunities for upside."
Today Cullen and Chang are targeting companies that are positioned to drive earnings growth by spinning off underperforming or non-core businesses. Years ago they focused on businesses they believed would benefit from rising wages in the emerging markets. Sometimes a company makes it into their portfolios because they see something in it that the market missed. A case in point: an undervalued food company largely shunned by Wall Street.
“‘Food stocks are boring.’ ‘It’s a low-margin industry.’ ‘Management is unimaginative,’” says Cullen, describing the Wall Street consensus on the portfolio holding. “What they missed was that this company was growing faster than other food stocks because of phenomenal sales growth in emerging markets.”
Profiting from patience
Cullen and Chang have been adept at spying underappreciated stocks with strong upside potential, but this ability only partly explains their past success. Just as important, they say, is giving those stocks time to justify their confidence in them.
“We have a three- to five-year time horizon because that gives a company time to bounce back from an earnings setback or some other issue that’s dragged down its stock price,” Chang says.
When asked to name the most important factor behind the firm's success, Cullen does not hesitate. “Discipline,” he says. “It's sticking to our investment process and keeping our holdings long enough for them to bear fruit.”
Two of Schafer Cullen Capital Management’s equity strategies are on the U.S. Trust platform. To learn more about the strategies, including their suitability for your portfolio, contact your U.S. Trust advisor.
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Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.
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OTHER IMPORTANT INFORMATION
Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.
Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.
International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments.
Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.