The Vindication of Value

In American Century's growth-oriented shop, Phil Davidson's is the quiet voice of dissent. His numbers, however, speak for themselves

By James A. Anderson

Phil Davidson is outnumbered. An old-school value-stock picker, he and a team of eight portfolio managers of like stripe make up only a third of the roster at American Century, a Kansas City firm decidedly tilted toward growth. His bosses label Davidson's portfolio "equity income," with no mention of the "V" word. Davidson even says a good number of his colleagues roll their eyes at companywide meetings whenever he outlines his modus operandi.

If 2001's numbers are any indication, maybe they should prick up their ears instead. Davidson's American Century Equity Income portfolio (TWEIX ), a member of BusinessWeek's elite mutual fund A-list, is up 5.3% year-to-date, even after the brutal Sept. 7 sell-off. That's a staggering 22.3 percentage points better than the Standard & Poor's 500 and enough to leave his growth-oriented colleagues at the office a ways behind, too.


  Davidson keeps his aims simple. One goal is to maintain his portfolio's yield 2 percentage points above that of the S&P 500. His reasoning is a basic staple of value investing: The income thrown off by his fund's equities helps compensate shareholders for the time they may wait for a stock to appreciate. And a look at the Equity Income's 3- and 5-year numbers show the strategy has been a boon. Davidson's 14.6% average annual return over the past 36 months, as of the market's Sept. 7 close, is almost 10 points better than the S&P benchmark, while his 15.4% showing over the past five years outdoes the index by 3.2 points.

The income cushion -- Equity Income's yield is 3.5%, vs. 1.2% for the S&P 500 -- is also a shrewd tactic for down markets. Equity Income has kept ahead of the index during every correction of more than 5%, Davidson boasts. "I think that's because we try to understand the downside risks of the positions we take and are on the lookout for any traps in value stocks we pick up."

It helps that Davidson has stayed true to his value-investing stripes, says Morningstar analyst Bradley Sweeney. "We saw a good many value managers stray in years like 1999," Sweeney recounts. "They'd call it moving toward 'relative value,' but it was more a case of them poaching growth stocks to keep up with the market. Here's a case of a portfolio that has remained consistent and benefited from it."

While Morningstar lists Equity Income as a midcap value offering, Davidson says he's willing to mix it up, with equal positions in large-, mid-, and small-cap companies. Just look at the composition of his portfolio for the past year. Davidson says that when smaller issues looked cheap in 2000, he upped his bet on that market segment and boosted small caps to a 45% weighting in his stock portfolio. Now that small-caps have rallied during most of 2001, Davidson has slid back to roughly equal stakes in all three capitalization groupings.


  Davidson says his team starts their picking process with companies that have a market capitalization of $1 billion or so. Next, they apply a number of traditional value measures, such as price-to-book value and price-to-cash flow, with a goal of whittling that initial list of stocks down to a group that's set in the cheaper half of the market. "We also focus on stocks that offer the best relative yield on a historical basis," explains Davidson.

Once they're through the screens, Davidson and crew look at the companies one by one. "We have a quality bias, and what separates this fund from other value funds is our emphasis on fundamentals," he says. "We want to avoid things such as structural problems or competitive issues. We also want to steer clear of weak balance sheets -- that's a sign that a company's position is unraveling and that in some cases its dividend might be in jeopardy."

Those criteria tend to steer Davidson's hand away from higher-priced sectors, such as technology, and into industries that typically fill value portfolios. Not surprisingly, Equity Income's largest sector stake is in bank stocks, which made up 5.6% of the fund's assets at the beginning of August. Heavy electrical equipment (5.5%), telephone shares (4.9%), and forest and paper product companies (4.6%) were the other sectors in which it was heavily invested.


  There's another secret to Equity Income's yield. Davidson opts to maintain a sizable stake of the fund's assets in convertible bonds, where 22% of the fund's assets are now parked. Convertibles serve Davidson two ways. First, they generate a steady flow of income that buoys the fund's return. Also, they offer Equity Income upside when the stock market is rising and buffer the portfolio during bearish streaks.

Cooper Industries (CBE ) has given Davidson's fund a big boost this year. He says the maker of electrical products, tools, and hardware has always been a "high-quality, investor-oriented cyclical." Nevertheless, during the first quarter, when the slowdown started to leave prints on the U.S. economy, Cooper forewarned the market that its outlook had clouded, and its stock promptly dropped from its $40-a-share range to closer to $30. Davidson swooped in on the stock, which was then yielding 4.4% and selling at a depressed 9 times earnings vs. the 25-or-so p-e the S&P 500 was then fetching.

By taking a stake at the end of March, he managed to build a position at an average cost of $34 a share. In July, Cooper received a takeover bid from toolmaker Danaher Corp. (DHR ) and then bolted to the upper $50s. The stock closed Sept. 7 at $54.55 a share.


  WGL Holdings (WGL ), while a solid position for Davidson the past few years, has been something of a laggard in 2001. Davidson says the company, whose utility, Washington Gas Light, heats and lights the nation's capital, has been the victim of market neglect. While bigger and bolder power producers have hogged the headlines this past year, WGL has stuck to its businesses and seen its stock dawdle. Davidson remains faithful, however. He says a 4.6% yield, a clean balance sheet, and a stock priced at 1.7 times its book value suits his criteria just fine.

"The company is serving an area with above-average growth and has nothing hidden in its balance sheet that might destroy its value," he adds. Davidson first started buying WGL in the first quarter of 1999 and has paid an average of $25.50 a share. He feels that fair value for WGL, which closed Sept. 7 at $27.02, would place the stock in the mid $30s.

As good a 2001 as he has had so far, don't look for Davidson to toot his own horn anytime soon. "I have to look at value investing as a game of singles and doubles, not a game of home runs, so a lot of what we do isn't going to seem very glamorous," he says. Besides, Davidson doesn't want to rock the boat at headquarters. "Some of my best personal friends are guys on the growth side," he admits.

Anderson teaches journalism at the City University of New York. Follow his Mutual Fund Maven column, only on BW Online

Edited by Patricia O'Connell