Shannon Zimmerman: Let's just speak broadly about the market, right now. You're a stock investor and so, there's a kind of incentive that goes for all stock investors: The market always looks attractively valued if you're selective in terms of the stocks that you choose. What's your view though of the market broadly. Is it overvalued? Fairly valued? Is it hard to find opportunities now relative to a few years ago?
Michael Clarfeld: Yes, I think that's a good question. So, I think, you're right that there is an inherent tendency among investors or people to sort of fall in love with the things they follow, and so, equity investors may always find equities attractive. That's it, I think actually our track record would demonstrate some differences there. If you look back at, our track record probably with [ClearBridge manager Hersh Cohen] in the late 1990s, when equities were incredibly overvalued, Hersh was over 20% cash. So, when we see huge disconnects, we're not afraid to take significant stances like that.
Today, what we see in the marketplace is we believe you got to separate a little bit the short term and the long term. From a long-term perspective, we believe that equities are attractive these days. At about 14 times earnings, we think on a stand-alone basis that's a reasonable place to be at.
Zimmerman: Near the historical norm.
Clarfeld: Near the historical norm, that's right. And when you compare them with alternative assets--fixed income, real estate, or what have you--we think equities stand out as being very attractive. So, on a long-term basis, we're very constructive on equities. From a short-term perspective, we're also very cognizant of everything going on in the world, whether it's things in Europe, political issues in the United States, and what have you, those headlines will drive short-term volatility.
So, we try to be mindful of that a bit. But certainly, the bigger driver of our investing decisions is our long-term assessment. We try not to obsess too much about the short-term goals. And so our focus really today is on that longer-term view, where we believe that it's an attractive time to be putting money to work in the equities.
Zimmerman: Within the equity universe, though, some pundits have argued that there is a bubble for dividend-paying stocks. And you guys are focused on those; it's an equity-income fund. What's your view of that? Are dividend-paying stocks the new bubble?
Clarfeld: It's a good question. One, that we're getting a lot. And one that that to some degree, we find a little surprising. In the sense that many of the stocks we are focused on are very large-cap companies. So, it's not a small segment. The idea that some people who are starting to allocate money there are going to really change the pricing in the marketplace sort of surprises us. More importantly I guess the answer is we do see a few areas of dividend stocks where we see some higher-than-expected valuations. We think particularly at the highest-yielding end of the spectrum--on the utilities side or with telecom--we think some of those are a little richly valued.
But what we are really focused on with [Legg Mason ClearBridge Equity Income Builder] is about compounding dividends over time. We believe the power of dividends is not simply the upfront yield. But it’s the combination of the upfront yield and the ability to grow that dividend over time. And what we see today, where we find the most attractive investment opportunities, is in high-quality dividend payers--companies that might be paying 3%, a nice yield, but not astronomical, but can grow that at 7%, 8%, or 9% a year.
Zimmerman: How do view vet companies for that possibility, that they are going to be able to not only sustain their current dividend, but grow it into the future?
Clarfeld: I think that’s the core of what we do in terms of analyzing a business. When you are analyzing business, to understand that, again everything starts at the balance sheet. Is it well-capitalized? And that tells us [whether the company is] going to be able to avoid getting into financial challenges. So we start with a well-capitalized balance sheet. Then it’s an assessment of the business model, the marketplace the company participates in, and sort of the market structure.
So in order to be a company that's going to be able to raise its dividend 7%, 8%, 9% a year, you have to be in a growing marketplace. It's got to have reasonably healthy growth. And then you have to be able to translate that revenue growth into earnings growth. So that means having attractive returns on invested capital and free cash flow. And then the last piece would be having a management team, who knows how to allocate capital and who is going to do that in a value-creating way.
That’s sort of the analysis we put together today. So getting back to an earlier question: Is there a bubble in dividends? We think some of the highest-yielding components of the market from a dividend perspective do seem maybe a little fully valued. But the sweet spot of what we look for--which is significant dividends, attractive dividends, but really dividend growers--we don’t think they are overvalued at all. We continue to think they are very attractively valued and set up to do very well for the foreseeable future.
Zimmerman: Mike, thank you very much for being here today.
Clarfeld: Thank you very much. It's my pleasure.
Zimmerman: For Morningstar, I'm Shannon Zimmerman.