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A Solid Equity-Income Fund Is Closing

Silver-rated American Century Equity Income gets ahead by losing less.

Gretchen Rupp, 09/24/2016

American Century Equity Income stays true to its prudent philosophy. The fund focuses on downside protection and capital preservation, which causes it to lag rivals when markets rally but stand out during periods of market unrest, as seen in early 2016. Even such brief periods of solid downside protection more than compensate for longer periods of trailing in up markets. This discipline has rewarded investors over time, earning the fund a Morningstar Analyst Rating of Silver. 

Veteran value manager Phil Davidson and his team generate steady returns from a few sources. First, they supplement dividend-paying stocks with convertible bonds and preferred stocks. These are higher up the capital structure than equity and notably reduce the fund's volatility. Second, the team's stock selection emphasizes solid fundamentals, especially high returns on capital and stable revenues. Such long-term holdings as  Johnson & Johnson JNJ and Procter & Gamble PG might not keep up in racier times, but their high-quality characteristics often provide a cushion in downturns. In addition, Davidson won't compromise fundamentals to reach for yield, which means the fund hasn't loaded up on the more volatile REITs sector, a common tactic used by many of its dividend-focused peers.

The team is patient but adjusts the portfolio when opportunities present themselves. That's what happened in the 12 months through June 2016, when volatility enabled it to purchase stakes and increase weightings in a handful of trusted companies at attractive prices. For example, the fund first bought Applied Materials AMAT in 2008. When the price dipped in late 2015, the team added to its position, and the stock has gained more than 55% in 2016, through August.

The fund's peer-leading success has renewed investors' interest. Steady flows through 2016 increased fund assets to about $11 billion, and the fund will again close to new investors as of Oct. 24, 2016.

Process Pillar: Positive | Gretchen Rupp 09/16/2016
The fund's straightforward approach requires patience and discipline, and the team's unwavering consistency in carrying it out earns a Positive Process rating.

The team starts by trimming a universe of 6,000 stocks to approximately 500 firms that meet criteria on such quality factors as good returns on capital, low leverage, desirable franchise characteristics, and strong barriers to entry. This smaller group of stocks works as a long-term selection pool. Next, the team estimates a risk/reward ratio to rank potential picks. Finally, the team picks from dividend-paying stocks that are within the least-expensive half of the 500 potential holdings based on at least two of five valuation measures, including price/earnings, price/free cash flow, and dividend yield. Rather than spend time identifying new ideas, the team focuses efforts on ensuring that within the fund's current holdings, value propositions and quality characteristics remain stable. The fund's steady income mandate often leads to relatively large stakes in dividend-rich utilities and smaller weightings in information technology. Trading and sector rebalancing are key factors in risk management. The team trims winners and incorporates new opportunities with a higher chance of reversion, contributing to above-average turnover before 2013. Turnover has come down, and 2015's rate of 56% was about equal to the large-value Morningstar Category average.

Market volatility in late 2015 and early 2016 percolated attractive buying opportunities, and lead manager Phil Davidson and his team took advantage. As of June 2016, about 20% of assets had been acquired in within 12 months. The managers added a position in automotive parts distributor Genuine Parts GPC on its low valuation. Its weighting grew to about 200 basis points by mid-2016 but the managers decreased the weighting as the stock's price climbed. The additions also include a handful of energy companies added in 2016's second quarter, totaling about 500 basis points. The team isn't timing the bottom of the energy sector's decline but sees supply as a concern going forward. Market dips present buying opportunities, but Davidson has continued to hold some of the fund's stalwarts for many years. This base group of reliable, high-quality companies provides a core of stability for the portfolio; it includes names like Johnson & JohnsonJNJExxon Mobil XOMProcter & Gamble PG, and Chevron CVX, which have all been top-10 equity holdings for the past three years. In fact, about 25% of assets, as of June 2016, have been in the fund for more than five years.

The portfolio held about 22% of fund assets in convertible bonds, convertible preferred bonds, and preferred stocks as of June 2016. The historical range has been 15%-25% of assets, and most tend to be more equity-sensitive.

Gretchen Rupp is an analyst covering fund-of-funds strategies on Morningstar’s manager research team. 

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