Ticker Symbols

OAEIX (Class A) OCEIX (Class C) OYEIX (Class Y) OEIIX (Class I)

Investment Advisor

OFI Global Asset Management, Inc.


Subadvisor

OppenheimerFunds, Inc.

I Want Information

Yield, Valuation, and Patience

Oct 29, 2015

Oppenheimer Equity Income Fund

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Q: Would you give us an overview of the fund?

I have been with OppenheimerFunds since 1994, more than 20 years. OppenheimerFunds originally had a sub-advisory relationship with Oppenheimer Capital, but in the summer of 2007 the fund management responsibility was shifted back in-house. 

Our asset selection is driven by our desire to tilt our fund to generate significantly higher than average net dividend yield than those of our peers. And in addition, we tend to use convertible securities and structured notes for about 10% to 15% of the portfolio.

We are benchmarked against the Russell 1000 Value Index and we currently have $5.5 billion in assets under management in this strategy. Moreover, we have small asset size under management in a variable annuity product using the same strategy. 

Q: What is your investment philosophy?

We focus on yield and valuation. When I took over the fund, just before the financial crisis, we were experiencing a completely different interest rate environment. My focus then was to generate an above average dividend yield when interest rates were between 3% and 4.5%. 

Today, we target our yield at or above the Russell 1000 Value Index, net of expenses. Right now, the U.S. 10-year Treasury bond is yielding slightly above 2%, so anyone with a savings or checking account in the bank is getting essentially zero growth. 

The Russell 1000 Value Index, our benchmark, is yielding a little higher than 2.5%. In our equity fund we look to generate a yield north of that, and unlike U.S. Treasuries, we provide exposure to the equity market, which also provides a capital appreciation opportunity. 

An equity income fund has a range of target options to generate income through dividend: stable dividend, rising dividend, or no dividend. Managing the fund is a balancing act combining all three. To target a yield at or above the Russell 1000 Value Index means that we cannot own many stocks that do not pay dividends.

To us, if you have done your homework and have a good idea, you need to give it time to grow—you need to go against the crowd. Over time, that is what yields good total returns.

Our non-dividend-paying stocks represent less than 5% of the portfolio. If there is a name that does not pay a dividend and that we nonetheless find compelling, we have the choice of either owning it outright or creating a structured note on it. 

There is a place in the portfolio, too, for stocks with stable dividends that are either growing modestly or not growing at all. These typically make up about one quarter of the portfolio—generally telecom, some utilities, and a few other high-yielding names here and there.

Historically, we have been overweight in telecoms. Speaking candidly, that hasn’t been good for us from a total return perspective, as the yields were likely too high relative to where interest rates were, but there has been an attractive dividend yield and perhaps modest capital appreciation as the yields are revalued.

Ideally, a large portion of the portfolio comprises names with decent dividends of 2% to 3%, with the potential to rise. 

Yield, as well as total return, has been historically important to shareholders. We believe that valuation is also important. Personally, I think the market tends to overpay for growth. I have nothing against growth stocks, but the research I have done over the course of my career indicates how difficult it is to sustain an above-average growth rate. 

We believe in patience. Fundamentals do not change that rapidly, yet many investors demand otherwise. To us, if you have done your homework and have a good idea, you need to give it time to grow—you need to go against the crowd. Over time, that is what yields good total returns.

Q: How would you describe your investment strategy and process?

Our overall objective is to find above-average yield and stocks that are attractively valued, where we have a little bit of a differentiated opinion and we can get an attractive total return.

We are big believers in free cash flow, as that affords companies to do good things with it: pay and grow dividends, buy back stock, or make beneficial acquisitions. 

I have two dedicated analysts who work with me. We each have decades of experience. The number of names we have owned or looked at is substantial. Unlike small cap, in the mid- to large-cap value universe, while there are new names all the time, they do not change dramatically.

We have screens for valuation, earnings growth, balance sheet, and free cash flow, and we leverage both internal and independent resources. The challenge is to sift through all this different information to identify the best ideas. 

One of the analysts on my team is responsible for all of financials, a little bit of consumer, and a little bit of healthcare. The second does energy, utilities, materials, and industrials, and I cover the rest.

We maintain a consistent approach and philosophy, but as the market evolves, we are also opportunistic. We have some deep-value names, some growth-at-a-reasonable-price names, and some broken-growth stories.

If we identify a deep-value name that is significantly out of favor, without growth, which we think is restructuring, where we can make 50% over two or three years, that would fit us. We maintain a diversified portfolio, so some sectors, like healthcare, which may not contain many deep-value names, may represent more of a growth approach.

Two of our bigger healthcare names are Pfizer Inc. and Merck & Co Inc. They are trading at reasonable valuations with above-average dividend yields, good balance sheets, and some optionality. It varies by sector and what type of market we find ourselves in.

A normalized price-to-earnings ratio is somewhere from 14 to 15 times. Anytime you get higher than that, it’s a riskier environment. When I look at valuation, I want to look at current P/E with the historic but also compared to the market. I do not want to make a relative bet that something is cheap if priced at 16 or 17 times earnings when in fact the market is trading at 18 or 19 times earnings.

Not all sectors and stocks are appropriate to look at on a price-to-earnings basis, and so we also look at price-to-book, enterprise value to EBITDA or operating earnings. 

Q: Can you illustrate your research process with the help of some examples?

Let’s look at Citigroup Inc. as one illustration. It’s our biggest holding, one we’ve owned for about five years. In late 2008/early 2009, we felt the government had drawn a line in the sand. To prevent the system from imploding, they forced these financial companies to raise a lot of capital.

As the economy began to regain its footing and credit began to peak, we got interested in certain financials. We owned this mandatory convertible Citigroup Inc. security because it had a high yield. We felt it was over-capitalized and there existed a huge credit tailwind. They were not growing; the balance sheet was shrinking and so the excess capital was increasing. 

Our thinking all along has been that ultimately the company would begin to return some of the excess capital, as their peers had done. This year Citigroup was finally able to increase the dividend as well as buy back some stock.

Looking back, we underestimated the regulatory overhang. Looking forward from today, there is a good credit environment, yet the balance sheet is still not growing and it is still over-capitalized. They are trading below tangible book and we think the regulatory burden peaked last year and there is also the possibility that interest rates will rise.

The valuation on a price-to-book and price-to-earnings basis was appealing. There was a return of capital, accelerated dividends, and at some point there will be rising rates, which will give them relief on the net interest margin. So we will continue to watch and see whether it rises to our price target. 

We set a price target when we initially buy anything. Our turnover is about 30%. If a stock gets there quickly, we likely trim or sell all of the position. If it gets there more slowly, say, in six to 12 months, we roll forward our expectations because we take a longer-term approach. 

Q: Would you share another example?

Another example would be auto stocks. We got involved with Ford before they paid a dividend, about two or three years ago. We created a structured note as a way to get exposure to Ford and get some income. Our thinking on autos was a little bit like the airline business. The auto business was a domestic industry that restructured during the crisis, primarily through bankruptcy, and was now fundamentally better than it had been pre-crisis.

Ford reduced some capacity domestically and improved some labor issues. It was, at its core, a better business, coincident with a sharp drop in sales in 2008 and 2009. They had a lower break-even, coming off a depressed sales base, and there was an old fleet on the road.

They had significantly improved their balance sheet by refinancing and paying off some debt. Their cash flow was stronger, so we got interested in the name before they began paying dividends. We felt the group would be revalued higher as the industry returned to normal levels, companies began to pay dividends, and as balance sheets continued to improve there was share repurchase potential. We felt we would see the same restructuring in Europe that we’d seen in the US. 

With Ford we saw a cheap valuation of high-single-digit price-to-earnings ratio. They were cheap on enterprise value to EBITDA. The balance sheet was in excellent shape. They had approximately $20 billion in net cash. They had some debt but they had a lot of cash. They restructured the U.S. business, they had a new competitive advantage with their aluminum truck and the business in Europe was improving somewhat.

Over the last couple of years, Ford has increased its dividend yield to about 4% or 4.5%. We saw attractive valuation, what we considered to be an improved industry, better cash flows, more free cash, a healthy U.S. business, and then an improving European business.

There exists some skepticism that the business is no better than it used to be. We underappreciated that skepticism. But if companies can demonstrate maintaining a high level of profitability, even if China is slowing, even with a strong dollar, ultimately they will be revalued higher.

So, we have been patient and are hopeful that as faith increases in the industry being fundamentally better than it was, these companies will have lowered their break-even points, generate a lot of cash, offset some weaknesses here and there, and still deliver good returns.

One of the challenges of being a value manager is being attracted to the cheaper names, which have issues, either real or perceived. It takes time for that to change. 

Q: What is your portfolio construction process?

We take a bottom-up approach. We want to generate an attractive yield with a portfolio that can generate above-average returns. We do not mind having fairly sizeable under- and overweights. We have wide sector bands. And our rationale for having 1000-basis-point bands on any sector is that certain areas have groups that have low correlation. 

We are cognizant of where our bets are and we want to make sure we sustain conviction. Our biggest overweight at the moment is in consumer discretionary. We are levered to an improving economic environment. We have stocks in the auto and retail sectors and some homebuilders. 

On an individual stock basis, we have a 400-basis-point active weight maximum vs. the Russell 1000 Value Index. We monitor that. And our risk department monitors our tracking error vs. our benchmark, as well as the risk ratio.

We have been underweight more in defensive bond proxies over the last few years and overweight in more cyclical areas. We have been expecting rates to rise for some time. We do not see a great total return in utilities—we think the valuations are high. And we have been underweight some of the staples. There is simply little to no growth in any of the food and staple stocks. 

Q: How do you define and manage risk?

With customers growing more and more concerned about volatility and risk-adjusted returns, portfolio and risk management have become even more important.

We focus on diversification and having anchors in the portfolio, as a certain amount of both active share and risk are necessary to outperform. When the fund performs differently to its peer group and benchmark, I want to understand why that is and be comfortable with it, to firmly believe that we are making the right investments.

I treat each situation independently. If something goes down 20%, we don’t buy more. Instead, we reevaluate the situation. If we think something has changed and we find competition for capital where there’s a better idea, we swap out of it.

We triangulate our conviction with how far out on the limb or in the tails we are. Our internal measures help keep us cognizant of where we are. Each Oppenheimer fund has a different tracking error and risk ratio, which we monitor internally against the benchmark. Our fund’s risk ratio is approximately 10%.
 

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