A Simple Yet Well-Executed Approach to Dividend-Paying Stocks

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T. Rowe Price Equity Income has stuck to its playbook, earning a Morningstar Analyst Rating of Silver.

The approach is simple yet well executed. Manager John Linehan invests in undervalued dividend-payers. But unlike some equity-income funds, absolute yield is not the only driver here; valuation, the quality of management, and company fundamentals also matter.

Indeed, Linehan prefers holdings to have various paths to success and is willing to take a long-term view. Embattled Wells Fargo WFC has weighed on returns amid questionable sales practices and regulatory fines, but Linehan has stuck with it, arguing there's not as much downside relative to other banks and that its attractive franchise, dividend, and share repurchases make it compelling in the long run even if it is not a quick turnaround. Indeed, turnover has stayed under 20% on his watch, reflecting a more patient view than the typical large-value Morningstar Category peer, which trades twice as much.

But patience doesn't mean complacency. Indeed, Linehan recently publicly opposed portfolio holding Occidental Petroleum's OXY bid for Anadarko Petroleum APC, which he thinks is a departure from the company's strategy and would harm its balance sheet. (The fund also owned Chevron CVX, a larger market cap company that was also bidding for Anadarko.) This action indicates the strategy's benefits extend well beyond yield to analytical insights that are a staple of T. Rowe's research process.

The trade-off of this fundamental approach is that it is not always inherently defensive. Indeed, the fund fared worse than the FTSE High Dividend Yield Index in 2018, a period that punished value-oriented strategies especially hard, with picks such as bankrupt PG&E PCG and Adient ADNT further weighing on returns.

Yet 2018 is just one year. The strategy's downside performance looks more in line with its Russell 1000 Value Index. Linehan has gotten off to a good start since his 2015 appointment and is sticking to a method that worked during his previous tenure at T. Rowe Price Value TRVLX.

Process Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/02/2019 This fund has stayed true to its roots under manager John Linehan, and he's executed well, earning a Positive Process rating. Linehan looks for companies trading cheaply relative to the market, industry, or historic norms. The portfolio consists of firms that offer at least a modest yield and the potential for price appreciation, which he seeks by buying out-of-favor names in a variety of sectors. Nearly all of the fund's holdings pay a dividend, but absolute yield is not the main objective; the fund's yield hasn't been notably high relative to equity-income large-value funds, but it is likely to land in the top half of the large-value category over time. The fund continues to look a bit lower-quality than many equity-income peers, sporting a higher debt/capital ratio and lower returns on equity and assets. It remains diversified, with 100-120 holdings. But while his predecessor occasionally held some cash if bargains were scarce (which weighed on performance in the post-2008 bull market), Linehan will likely keep cash below 4%.

Linehan's process at T. Rowe Price Value from 2003 to 2009 didn't emphasize dividends as much as this fund, and it didn't hold up quite as well in market declines (though it did fare better than the Russell 1000 Value Index in both up and down markets). However, since taking over here in 2015, he has maintained the same approach that fund investors have come to expect.

The fund's yield ticked up in 2018 to its highest level in several years, though that wasn't purposeful. Rather, John Linehan lets bottom-up stock-picking drive the portfolio, which encompasses a variety of inputs. Blue chips such as Kimberly-Clark KMB and Verizon Communications VZ sit alongside more opportunistic plays, including some occasional picks that don't pay a dividend, such as Stericycle SRCL. Linehan thinks a new CEO can turn around its business and added to it at what he considered an attractive valuation.

As of March 2019, the fund's sector weightings weren't too different from the Russell 1000 Value Index. The fund had slight underweightings to energy and healthcare and had above-benchmark stakes in industrials and materials. In recent years, the fund has benefited from holding on to some names that have become more prominent in growth portfolios, including Microsoft MSFT and Boeing BA. However, the fund remains squarely in the large-value section of the Morningstar Style Box.

Meanwhile, Linehan's willing to have a long time horizon with names that may take awhile to play out, with turnover typically well below 20%. He is also willing to engage with companies. In April 2019, he publicly opposed portfolio holding Occidental Petroleum's bid for Anadarko Petroleum, which he thinks is a departure from the company's strategy and would harm its balance sheet.

Performance Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/02/2019 John Linehan is off to a good start. With the fund handily beating the Russell 1000 Value Index and large-value category on his watch, it receives a Positive Performance rating.

Since Linehan took over in late October 2015 through April 2019, the fund's 10.6% annualized gain beat the Russell 1000 Value Index's 9.9% and the large-value Morningstar Category's 9.3% and maintained an edge on a risk-adjusted basis. It has slightly trailed the FTSE High Dividend Yield Index, though this strategy is more value-oriented and not solely yield-focused.

The fund hit a rough patch in 2018, losing 9.3%, or 1 percentage point more than its Russell 1000 Value benchmark. In a year not favorable for value investors, stock-specific hiccups such as Adient, State Street Corporation STT, Gilead Sciences GILD, and others piled on. The fund's loss stung worse than the FTSE High Dividend Yield Index, indicating that the strategy isn't as defensive as pure yield-focused options. But during Linehan's tenure here and previously at T. Rowe Price Value, his charges have typically fared better than the Russell 1000 Value Index in pullbacks.

While Linehan's record here is still fairly short, he posted good results at T. Rowe Price Value. He led that fund to an 8.3% annualized gain from April 2003 to December 2009 versus the Russell 1000 Value Index's 6.9% and this fund's 7.2%.

People Pillar: Positive | Katie Rushkewicz Reichart, CFA 05/02/2019 An experienced manager and a solid analyst bench lead to a Positive People rating.

John Linehan succeeded Brian Rogers, manager of this fund since its late-1985 inception, on Oct. 31, 2015. Linehan joined the firm in 1998 as an industrials analyst. He has experience running money, having led T. Rowe Price Value to peer- and benchmark-beating results from 2003 to 2009. He has also comanaged T. Rowe Price Institutional Large Cap Value TILCX since 2004, though arguably much of his time from 2009 to 2015 was devoted to his role as head of U.S. equities. He vacated that managerial role upon the succession announcement in 2014, which gave Linehan time to re-engage with the analysts. He started weighing in on the portfolio a few months before the official transition. He also took on the role of CIO of U.S. value equities in early 2017.

Linehan has access to a deep analyst bench of more than 100 globally. The analyst team is a huge strength. It has seen some turnover in recent years, including in the healthcare sector, but the firm has managed through such changes well and maintains a stable investment culture.

Heather McPherson is associate manager; she previously held the same role at Gold-rated T. Rowe Price Mid-Cap Value TRMCX and now comanages T. Rowe Price Institutional Large Cap Value alongside Linehan and Mark Finn. Linehan invests over $1 million in the fund.

Parent Pillar:

Positive | Katie Rushkewicz Reichart, CFA 10/01/2018

T. Rowe Price remains best-in-class, earning a Positive Parent rating. The firm's success is rooted in its fundamental approach to active management and deep analyst bench. Investors benefit from managers' generally long tenures at the firm, well-planned manager transitions, reasonable costs, and attention to capacity. Many top executives, including CEO Bill Stromberg, rose from the analyst ranks, which helps keep a focus on investors at the forefront, even as the firm expands its distribution footprint outside the United States and bolsters its technology resources. The investment side has received resources, too. The multi-asset team has grown in size, reflecting its importance to the firm's future beyond the esteemed target-date lineup. Despite headwinds facing active managers, T. Rowe remains a powerhouse within U.S. and international equities. Fixed income is an area to watch. Several long-tenured managers have recently retired or will do so soon. Sound succession planning has smoothed the transitions, but the firm needs to ensure the bench remains deep. While high-yield and municipal bonds remain bright spots, the fixed-income team has not yet shown sustainable success in inching beyond its conservative bottom-up approach at some core strategies. Plus, the firm's foray into alternatives is unproven. Overall, though, T. Rowe Price retains the sensible and investor-focused culture that has long driven its success.

Price Pillar:

Positive | Katie Rushkewicz Reichart, CFA 05/02/2019 The no-load share class, which holds the majority of assets, is priced below average relative to similarly distributed peers; its 0.65% expense ratio is well below the 0.89% peer median. The institutional shares are also priced below average. A small portion of assets is housed in the advisor and R share classes, which have average expenses. The fund's relatively low turnover keeps trading costs down. Overall, shareholders benefit from reasonable costs here, earning the fund a Positive Price rating.