CONSUELO MACK: This week on WealthTrack. Following the income trail… the Franklin Income Fund has been paying monthly dividends for 65 years in a row. Where is current portfolio manager Ed Perks finding the best income streams now? Great Investor Ed Perks is next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. The search for investment income might be getting a little less frantic. Ever since 2008, when the Federal Reserve lowered short term interest rates to near zero and embarked upon its government bond buying binge to suppress longer term rates, investors have been scrambling. Yields on U.S. Treasuries and investment grade bonds, the traditional conservative choices for reliable interest payments plummeted and investors were forced to look elsewhere. They flocked to more risky areas- including common stocks where several times in the last year and a half dividend yields actually topped those of ten year treasuries and corporate bonds. That unusual trend appears to be over. In recent months bond yields have started to tick up, once again offering somewhat higher income than their stock equivalents. According to this week’s guest the pick-up in bond yields means more opportunities for investors seeking income. He is Ed Perks, director of portfolio management at the Franklin Equity Group and portfolio manager of the venerable Franklin Income Fund since 2002. The fund has paid a monthly dividend ever since its founding in 1948. The nearly 90 billion dollar fund, which can invest in stocks, bonds and other income producing investments is one of the top ranked funds in its Morningstar conservative allocation category for the last ten, five and three year periods. I began the interview by asking Perks why contrary to Wall Street beliefs, he sees the recent rise in bond yields as a positive for investors.
ED PERKS: I think it’s something that particularly on a year-over-year basis where we’re coming close to anniversary-ing that kind of low in long-term interest rates with the 10-year Treasury down as low as 1.6 percent, and really the challenge we had at that time was really across the board in fixed income asset classes, different sectors of the fixed income market. Yields were declining across the board.
CONSUELO MACK: So you couldn’t get good income.
ED PERKS: No, and more so actually a year ago at this time every sector in the S&P 500 had an average weighted dividend yield higher than the 10-year Treasury. That’s something that we’ve never been able to say before. So from our standpoint, Franklin Income Fund, I think a real hallmark of our strategy is the flexibility around different asset classes that we invest in. At the time, we were very focused on the opportunities in dividend-paying common stocks. Many of those common stocks actually had yields on their common stocks higher than the yield you could get by buying that same company’s long-term corporate debt.
CONSUELO MACK: Extremely unusual.
ED PERKS: It is.
CONSUELO MACK: Which is why so many bond investors or income-seeking investors such as yourself started going to common stocks for their dividends.
ED PERKS: Yeah, exactly, and that is really what we saw happening in Franklin Income’s portfolio and relative to, say, 2009 or ’10 where we were actually overweight fixed income relative to equity. We saw that flip-flop from 65 percent fixed income, 35 percent equity, just seeing that completely flip to 65 percent equity, 35 percent fixed income. Now we’re still pretty close to that, and when we look at 2013, if you look at investment grade corporate bonds or even in high-yield corporate bonds, the higher quality segment, so triple Bs, double Bs, even single Bs had a very difficult time dealing with the backup in long-term interest rates. Most of the return in the fixed income markets last year were more in speculative type credits, the triple C rated high-yield bonds and below, but that opportunity where those companies sold bonds very close to the lows, that long duration component with the backup in long-term interest rates moved many bonds well below par value. So that’s a different dynamic and a different offering to then look in the secondary market and see a bond trading now at 90 or 92 or 94 cents on the dollar. Obviously the yield’s more attractive but also now you’re buying at a discount and have that opportunity as well as having had some time go by so that maturity shortens up a little bit. So that’s been one of the kind of more interesting opportunities, and our view is, look, we have a very steep yield curve today.
CONSUELO MACK: Short-term interest rates are much lower than long-term interest rates.
ED PERKS: Exactly.
CONSUELO MACK: So there’s a big gap between the two.
ED PERKS: Exactly. The gap between the yield, say, on the two-year U.S. Treasury and the ten-year U.S. Treasury is pretty close to historic highs, and we also continue to think and certainly get guidance from the Federal Reserve which the new chair …
CONSUELO MACK: Janet Yellen.
ED PERKS: Yes, has continued to emphasize the Fed’s commitment to keeping short-term interest rates lower, the so-called zero interest rate policy, out to somewhere in the middle to latter part of even 2015. So because of that we think that the upper level or upper limits on long-term interest rates might remain somewhat subdued. So further significant moves in the long-term interest rates might be a bit further out in time, and it’s our view that a rise in long-term interest rates is not necessarily a bad thing when it’s happening because of normalization.
CONSUELO MACK: How significant has that been, the fact that the Fed has started to taper and is withdrawing its bond-buying purchasing program? So how … ?
ED PERKS: You know, that’s I think one of more interesting aspects of the increase in long-term interest rates that we’ve experienced, the vast majority of which happened prior to any tapering.
CONSUELO MACK: Because of expectations in the market instead of the actual …
ED PERKS: Exactly, and that’s the market discounting what it’s anticipating happening going forward. Now I think the offset to that is look at the progress we’ve made in the economy, the progress we’ve made with the federal budget deficit. We don’t have the same kind of deficit levels and don’t need that same kind of financing, if you will, from the Fed’s purchasing of long-term Treasuries, so the needs are a little bit lower, and that’s why I think as we’ve actually seen the taper, the bond-buying program start to decline, we’ve actually seen stabilization and even a slight decline in long-term interest rates having reached about 3% in the latter part of 2013 on the 10-year. So we actually think we might be in a period of relative stability in long-term interest rates. Now certainly it’s going to be dependent on the economy and how that progresses going forward, but there we fall back to, okay, if you were investing in dividend-paying common stocks, if you’re investing in corporate bonds, long-term interest rates moving higher from here will likely be dependent upon favorable overall economic conditions, favorable corporate fundamentals, and that’s a nice offset to the impact that rising rates is going to have.
CONSUELO MACK: Your outlook then for rising rates, again, this big scare that Wall Street has said rates are going to rise, and that’s terrible for bond prices and it’s terrible they’re also saying for equity investors in many respects. What is your view at Franklin?
ED PERKS: Ultimately I think it will be dependent upon not just the pace of economic growth not just in the U.S. but likely globally. When you look at long-term interest rates around the globe, they’re low in many different markets, developed markets and even in …
CONSUELO MACK: Historically low.
ED PERKS: Historically low across the board, and our view is a real move higher will likely be dependent upon inflationary pressures that we just haven’t been seeing. Now unemployment in the U.S. is certainly an important part of that equation. We have seen the unemployment rate come down. I think moving forward where we’ll need to focus is something like labor force participation rates which also have declined, and hopefully as we see the economy improving, as we see job growth continue to develop and hopefully improve to stronger levels that we avoid kind of wage pressures. That will ultimately potentially ignite longer term inflation rate pressures.
CONSUELO MACK: In this environment that you’re describing as we all are on this global search for income, how do you weigh the attractiveness of bonds versus the attractiveness of stocks?
ED PERKS: Each situation is very unique for us, and we really focus on the individual investment opportunity. So in some instances in Franklin Income Fund we’ll actually own different parts of a company’s capital structure. We might own the common stock for a certain level of yield but also find either a convertible security from that company or maybe their straight corporate debt or possibly even floating rate corporate term loans from that company, and we’ll look to kind of optimize that exposure based upon our objective and where we think value is.
CONSUELO MACK: Where is value now? Is there any screaming value looking at what’s happened with the stock market, for instance? Tremendous appreciation. When you were on WealthTrack a year ago you recommended that we look at big dividend-paying stocks and the GEs and the Wells Fargos and I think Merck was one of them. Those companies have done pretty well.
ED PERKS: To some extent I think there’s still a lot of companies like that that continue to look attractive to us, and we do continue to hold Merck as one of our largest holdings. Another name that’s one of our larger positions is Royal Dutch Shell, and those two companies obviously are very different businesses but have a similar dynamic at play that I particularly like in this environment where we have a bit more uncertainty around the overall level of growth. The last year we really benefited from an increase in valuation levels. We might not have that same kind of luxury in 2014. So this concept of companies that control their destiny or have self-help measures, if you will, and I think both Royal Dutch Shell and Merck come at it from that standpoint. Merck, for instance, with new leadership in R&D, really looking at their portfolio and trying to revitalize that effort, showing some real promise in oncology, for example, that I think has helped that stock perform well, but we think that can continue going forward. Royal Dutch Shell under new leadership, new CEO at Royal Dutch Shell just this year also kind of looking at their very broad portfolio of assets globally and really looking where should we maybe monetize or divest some of our assets to help improve our returns. Now return on equity or return on assets at Royal Dutch Shell has been a little bit disappointing and there were some missteps clearly, but I think that’s an opportunity, and when we look at those stocks, we still have very attractive dividend yields today and, like I said, that opportunity for self-help and ultimately also companies that are growing dividends higher than where we expect, say, inflation to be. So not only that attractive yield today but the opportunity for the capacity and a track record of dividend growth. So those kind of names still stay. They resonate with us in the portfolio. I would say broadly it is an opportunity that’s still diversified across sectors and that’s what I really like, and I think that’s what stands out to me relative to when I started managing Franklin Income Fund in 2002. Now we had whole sectors in the equity market where you couldn’t find dividend yields. Information technology would probably be the biggest example certainly coming out of the Internet boom and bust. Very few tech companies wanted to pay dividends, and that’s really come full circle.
CONSUELO MACK: Now there are many more opportunities for dividend generating.
ED PERKS: Yes, yes, and that’s something that that sector in particular, very significant cash balances. Companies kind of embracing dividend payments as a way to add value to shareholders. Now many of them still also focus on share buybacks, and we do look at that in entirety. We think that’s a flexible, we don’t mandate a company should pay dividends and only pay dividends. We think there’s a lot of opportunity for companies to build long-term shareholder value through buybacks but also through investment in their business or through strategic M&A opportunities.
CONSUELO MACK: When I think of Franklin Income Fund I’m thinking your primary, your first priority is to generate income because, after all, shareholders of Franklin Income do expect … you know, for 65 years straight they’ve had dividends paid to them every month. That’s your first priority. Correct?
ED PERKS: Absolutely, and I think the name of the fund pretty much states that, Franklin Income Fund, so yeah, very focused on where can we find that attractive income stream, but in many instances our process leads us to situations where we think there’s also longer term value, longer term opportunity for capital appreciation, and that is our secondary objective.
CONSUELO MACK: When you’re talking about a stock buyback program, for instance, which would enhance the value of the shares not the payout of dividends, that’s a very important consideration as well.
ED PERKS: As long as you see the share count declining, and I think a lot of companies that buy back shares, and then you look from a perspective of how many shares outstanding, many companies you actually don’t see that total shares outstanding declining. So I think if we engage companies and see companies that propose share buybacks along with dividends, we might just hold them accountable a bit more and say, “Look, we do want to see a decline in shares outstanding,” which then translates that value and you should see an appreciation in your shares.
CONSUELO MACK: If I look at the Franklin Income Fund as it’s constituted right now and I’m thinking of it as from an individual investor point of view and my portfolio, for instance, you are de-emphasizing bonds more than you did a couple of years ago which you just mentioned and you’re over-emphasizing stocks. So is that how I’m going to generate income, and I’m thinking especially for retirees.
ED PERKS: Yeah, I think that’s still the area of the market that we’re most attracted to. We still think that that’s, at an absolute level on a yield basis, still attractive relative to fixed income, but I think more importantly, as we’ve kind of said, that opportunity for companies to grow dividends, and we’ve seen that consistently.
CONSUELO MACK: What about the price levels now of stocks after the appreciation we’ve seen?
ED PERKS: Yeah, now that is certainly something that we need to factor in the equation, the valuation. That said, even thought markets are still relatively close to all-time highs, it’s not that hard to look across the equity market and find companies that are actually 10, 15, maybe even more percent below 52-week highs, so really focusing on that research effort. We’re not buying the broader equity market. We’re really trying to identify those unique opportunities. So I still think there is some attractive value out there in the equity market, and we want to find that and emphasize that in our portfolio.
CONSUELO MACK: Can I grossly generalize that it is still in the blue chip dividend-growing, yielding stocks that would be household names? Is that still where you’re finding good values?
ED PERKS: Yeah, I think in large part …
CONSUELO MACK: Such as in addition to Royal Dutch Shell or Merck.
ED PERKS: And Merck, General Electric, Dow Chemical, Dupont. These are all significant holdings within Franklin Income Fund. Yes, many of them have performed well for us in the recent market environment, but we think going forward, particularly in that scenario where economic conditions remains favorable, these companies will continue to do very well and will continue to generate substantial amounts of cash and many of these companies, like I said, are also focused on those self-help measures which also I think will be an important boost to returns in 2014 and 2015.
CONSUELO MACK: Looking at Franklin Income Fund from … I think when you started in 2002 it was 15 billion in assets, something like that, and now it’s almost 90 billion in assets. How different is it to run a fund that size from when it was when you started?
ED PERKS: You know, I think our strategy is really exactly the same as it was, and I think really what enables us to manage the asset base is the flexibility that we have and looking across all these different markets that give us opportunity and then clearly having the resources, having a research team across the different sectors of the equity market, having an expertise in convertible securities in house, having an expertise in utilities or in corporate bonds, and that’s really my focus is really making sure that I’m tapping that knowledge base and resource that we have at Franklin Templeton and finding those unique opportunities. So we continue to feel like it’s a very manageable strategy and something that we’re able to focus and deliver for our investors.
CONSUELO MACK: And what about the fact that you pay out a monthly dividend as opposed to a quarterly one? Does that make any difference at all?
ED PERKS: I don’t think so. I mean, it’s something that certainly our investors have come to expect, and certainly I think many of them do appreciate that. I think demographics and the fact that we have more people moving to a stage in life where they’re looking for that consistent stream of reliable income that certainly the Franklin Income Fund is focused on helping them achieve that objective.
CONSUELO MACK: Five percent yield. Is that around where you are now?
ED PERKS: Yes, yes.
CONSUELO MACK: And where do you expect that yield to be going in the next year or so…
ED PERKS: Yeah, I think this is going to roughly be where we’ll be. I mean, we’re certainly very dependent upon the level of yield in the market, so I think probably the greatest influence on that will be the direction of long-term interest rates, the opportunity for higher yield over time in the fixed income markets. You know, when I look at the portfolio today, we certainly have a fair amount of our corporate bond exposure in relatively short-maturity securities over the next three to five years. So as we do move into a gradually higher yield environment, the opportunity to move that asset into higher yielding securities to earn higher yield, that’s certainly something that we’ll be able to pass through to our investors.
CONSUELO MACK: I looked at what Franklin Income Fund was invested in at yearend which I think is basically what you’re allowed to discuss. So some of the overweight sectors are utilities, energy, basic materials, health care a little bit, and your underweight financial services versus your category… the Morningstar category. So the opportunities in utilities, energy, basic materials, talk to me about those a little bit.
ED PERKS: Yeah, well, I would say with this increase in equity exposure in Franklin Income Fund over the last six to eight quarters, a majority of that did come in our increased weighting in energy, our increased weighting in materials and to some extent our increased weighting in technology. Utilities we’ve actually seen a more stable to even slightly declining weighting, but the opportunity in those sectors was really focused more around valuations, the opportunity. I think the pullback in growth expectations in some of the more emerging, faster growing economies globally created some volatility in those sectors, and that was something that we felt like presented an opportunity.
CONSUELO MACK: Some actual declines in those sectors.
ED PERKS: Yes, exactly. Either just underperformance as the broader market in many other sectors and individual companies advanced and those companies underperformed. Their relative valuation became more compelling to us. There’s always more specific fundamentals that are driving us to make investments in those companies, so we’re really not doing it from a top-down sector basis but really trying to find the individual companies that we think are interesting opportunities. We’ve spoken about Royal Dutch Shell and how they’re having this portfolio rationalization happening. That’s something that’s really attractive as well as the valuation and the yield opportunity, the dividend growth opportunity.
CONSUELO MACK: What about in materials?
ED PERKS: Oh, in materials. That’s been more driven around the dynamic happening in emerging economies, the decline in commodities and some of the real low-cost producers globally we think are set to really benefit.
CONSUELO MACK: Such as.
ED PERKS: Such as BHP Billiton or Rio Tinto, companies that have really had some flexibility looking at their forward cap ex plans to rationalize that somewhat as the commodity markets have softened a bit, companies that are turning some of that cash flow instead of investing in these projects. These are very long-lived projects that as markets approve they’ll be able to readdress and invest in those markets but in the meantime reducing costs, reducing cap ex, increasing dividends with valuations that we deem pretty attractive.
CONSUELO MACK: And technology?
ED PERKS: Technology has really been an expansion of just the philosophy around dividend payments. You know, when we look at cash on corporate balance sheets, a vast majority of that does reside within the technology industry. So I think we have an opportunity to see not just companies initiating dividends but companies and a pretty broad range of companies. We’re not just talking about Microsoft and Intel but also dynamic companies like Texas Instruments and Analog Devices that now pay dividends that grow dividends. So there’s a broader opportunity there as well across that sector, and that’s what we’ve seen. Now granted it’s gone from just maybe one, one and a half percent of the portfolio up to about five, so I would still put that in a context of broader holdings across the overall market.
CONSUELO MACK: But it’s a growth area for you clearly.
ED PERKS: Exactly.
CONSUELO MACK: One investment for a long-term diversified portfolio. The last time you were on you recommended again big blue chip companies. What would you recommend?
ED PERKS: You know, I think I would go back to utilities.
CONSUELO MACK: Really.
ED PERKS: Because I have had very few people. I think investors in general have been very disinterested in owning utilities, and I think it’s this broader theme. The concern that the markets had about rising interest rates has led many utilities to underperform. So a high-quality company like Southern which we hold in the portfolio and that we’ve held in Franklin Income Fund for several decades has really under performed. If you look over the last year, a company that’s close to 15 to 20 percent below 52-week highs yet has close to a five percent dividend yield and has a really strong franchise and a very supportive framework for regulation in their market. Now I think the utility industry you have to be careful. It’s not the utility industry it was several decades ago. There are a lot of different business models but that yield-oriented, stable cash flows of a Southern company or of a Duke Energy I do find quite appealing and a nice long-term holding for a portfolio focused on income.
CONSUELO MACK: That is music to old-fashioned income investors’ ears. That was the place they all used to go. So Ed Perks thanks so much for joining us from Franklin Income Fund. It’s a treat to have you on WealthTrack again.
ED PERKS: It was good to be with you.
CONSUELO MACK: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point goes back to one of the basic tenets of investing. It is: take advantage of the power of compounding. Albert Einstein has been widely quoted or it turns out probably misquoted for calling the power of compound interest “the most powerful force in the universe”. Whoever said it was on the right track. The force of compounding dividends, interest and capital gains over the years is impressive and it requires little action on an investor’s part except putting money in a mutual fund or ETF, especially with dividend paying stocks, and letting it automatically reinvest and grow. $10,000 invested in the Franklin Income Fund and left there for the last 65 years would be worth nearly seven million dollars today. For those of us investing now, this chart from Vanguard shows a hypothetical $10,000 investment earning 6% a year, that’s $600 annually, and that would be worth $30,627 at the end of 20 years and $102,857 at the end of forty years. The message: whatever you put in, the longer you let it grow, the bigger the pot at the end.
Next week our guest will be the Wintergreen Fund’s Great Investor David Winters who says there are excellent values to be found in global blue chips. And don’t miss our exclusive interview with the Royce Fund’s David Nadel about investment opportunities in India in our extra feature on wealthtrack.com. In the meantime have a great weekend and make the week ahead a profitable and a productive one.