Drew Justman, CFA, serves as a Portfolio Manager on Madison Investments’ covered call, dividend income and value strategies. He has been working in the financial services industry since 2001 and joined Madison in 2005.
He earned his BBA in finance and economics and M.S. in finance from the University of Wisconsin-Madison, specializing in the Applied Security Analysis Program. Prior to joining Madison Investments, Mr. Justman worked at Merrill Lynch.
In this 3,478 word interview, exclusively in the Wall Street Transcript, the Madison Investments Portfolio Manager details his firm’s investment philosophy and his personal top picks.
“Madison Investments is 100% employee owned. We were founded in 1974, so we’ve been around for a long time. We manage just under $19 billion as a company; a little less than $9 billion of that is on the equity side, which is where I work.
And really what we’re known for is, we like to participate in up markets and protect capital in down markets. In fact, our company has trademarked the phrase “Participate and Protect,” and what that means is we’re willing to forego a little bit of upside in the strong markets in order to make sure we protect capital in the down markets.
We think by doing that over a full market cycle, we can hopefully outperform our benchmarks while taking on below-average risk.
So downside protection is what we’re really known for, and that’s something that we really focus on here on the equity side and throughout the company.
I should also say, we’re located in Madison, Wisconsin, hence the name Madison Investments.”
The investment selection is process oriented:
“The Dividend Income approach comes from a background of serving bank trusts and conservative clients that wanted equity market exposure and also an income stream.
The question that we try to ask and answer is, how do we achieve good returns and high income and growing dividends and avoid big drawdowns in bear markets?
Avoiding big drawdowns in bear markets helps clients stay invested throughout the full cycle when they might otherwise feel like getting out, and this is critical in order to generate strong long-term returns. And so the answer to that question is, we buy high-quality, large-cap, blue-chip stocks with above-average dividend yields when they’re out of favor. So that’s the background and the 10,000-foot view.
I’d like to talk a little bit more specifically about our process.
The first step in the process is we screen all U.S. traded stocks, and we identify the stocks that have a market cap that is greater than $2 billion and a dividend yield that is 1.1 times the S&P 500 or higher. This produces an investable universe that is around 200 to 250 stocks in most market environments.
The second part of our process is we apply our “relative yield screen,” and this is something that we think is unique to what we do; we’re not aware of any other managers that do this.
Let me explain what relative yield is. Relative yield is a stock’s dividend yield divided by the S&P 500 market yield. Each stock has its own normal historical range. We’re long-term investors and so we like to look at a stock’s relative yield range over 10, 15, 20 years.
We find that when a stock price is low, its relative yield is high, and conversely, when stock price is high or expensive, its relative yield is low. And we think by buying stocks when relative yield is high and selling them when relative yield is low, that is a sustainable, repeatable process that takes the emotions out of the investment decision-making process.
So relative yield is kind of our secret sauce, and that’s really how we identify when to buy and sell stocks.
The third step in our process is we perform bottom-up fundamental analysis of the relative yield candidates that we identify.
Stock prices that have high relative yields means their valuations are generally attractive and stock prices are down. It’s our job to determine why the stock is down. Is it due to a temporary issue, or more permanent or terminal issue?
We want to invest in companies where we believe the issues are temporary.
Within the fundamental analysis that we do, we really focus a lot of time on the following things: First, does a company have a sustainable competitive advantage? This is really important; I’ll get into that more in just a second.
The second thing we look for is, does a company have a strong balance sheet? And then the third thing is, does the company have a history of consistent dividend growth?
We want to construct a high-quality portfolio that has stocks that have all three characteristics.
We want to own stocks that have sustainable competitive advantages, otherwise known as wide moats. Morningstar provides moat ratings for many companies; 35 out of 42 holdings, or 83% of the portfolio, are rated wide moat by Morningstar, which is the highest rating it gives.
That compares to 25% for the S&P 500 and 13% for the Russell 1000 Value Index. So that’s one objective metric we use to try to define high quality.
And then we also look at strong balance sheets. S&P provides financial strength ratings, and 36 out of 42 holdings, or 85% of the portfolio, is rated A- or better by S&P, compared to 33% for the S&P 500 and 22% for the Russell 1000 Value Index.
I’ll also add, 100% of the portfolio is rated investment grade.
And so those two factors — sustainable competitive advantage and strong balance sheet — we use as objective metrics to try to highlight the high-quality nature of our portfolio.
We also want to find companies that have a consistent history of dividend growth. We’ve observed that stocks with wide moats, strong balance sheets and a long history of dividend growth tend to hold up better in bear markets and market corrections, and that’s really important for protecting on the downside.
The last step in our process is, we identify these stocks and we build a diversified portfolio of 40 to 50 high-quality, large-cap, blue-chip names with above-average dividend yields.
These are household names like Home Depot (NYSE:HD), Johnson & Johnson (NYSE:JNJ), McDonald’s (NYSE:MCD), Procter & Gamble (NYSE:PG), Pepsi (NASDAQ:PEP) and Verizon (NYSE:VZ), just to name a few.
We have a rule of a maximum weight of 5% in a stock, and we have a sector rule of 2x the S&P 500 sector weight or 20%, whichever is greater. We believe this allows us to be different than the underlying index, but also won’t penalize our portfolio too heavily if we are wrong on a stock or a sector.
So that’s our process.”
Get the complete picture by reading the entire 3,478 word interview with the Madison Investments Portfolio Manager Drew Justman, exclusively in the Wall Street Transcript.
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