Note: This interview, conducted on December 15, 2022, has been edited for length and clarity. The interviewee’s opinions don’t necessarily reflect those of Vanguard.

Hand: I joined the Value team at Wellington 18 years ago, right out of college. As an analyst, my coverage pretty quickly broadened out to all the consumer sectors, some materials, some industrials, and real estate. Then, in 2018, I started transitioning to portfolio management and diversified portfolios, which included equity income portfolios.

Hand: The investment philosophy of equity income, employed in both of those funds, is really anchored in the 90 years or so of data showing that dividends are a meaningful part of market returns and that stocks with strong, sustainable yields outperform meaningfully over time.¹

We really try to optimize the advantage of high-dividend-paying stocks by applying a valuation framework to identify companies that have qualities and growth potential that are not yet reflected in their current multiples. In other words, what we are trying to do is find asymmetrical risk/reward opportunities—stocks with limited downside risk, good upside potential over time, and sustainable dividends. We see that mix as the best path toward good risk-adjusted returns over the long term. 

Hand: We have a really strong team solely dedicated to value investing, but we also benefit from the broader Wellington ecosystem, which includes other highly seasoned portfolio managers; a macro team and an ESG team, both of which help us see where risks may be that the markets aren’t thinking about; and our Global Industry Analyst team, which gives us access to highly specialized industry expertise.

It's a collaborative environment, but at the same time discussion and debate are important. We don’t want everyone on the team thinking the same thing, which is why we’re constantly challenging our investment assumptions with the aim of trying to get better answers for our fund holders.

Hand: We are always trying to strike a balance between valuations and quality in order to both protect the portfolios on the downside and deliver long-term appreciation potential.

If you look at the first half of the year, an awful lot of opportunities surfaced. Take the U.S. defense industry. It came into the year at a pretty inexpensive multiple, considering that it is a defensive market sector. And then hostilities broke out between Russia and Ukraine. While defense stocks subsequently soared, other stocks, including those of the German industrial conglomerate Siemens and the U.S. homebuilder Lennar, fell sharply.²

Such massive stock price moves, both up and down, enabled us to rebalance the portfolios by selling some of our higher-performing holdings and investing in the companies whose underperformance had created compelling opportunities for value investing. 

Hand: We are constantly looking at downside risks and scenarios because you just don’t know what’s around the corner. That means holding companies we believe will be able to deliver dividends and create value for fund holders even through recessions.

A great example of that is TJX, the off-price retailer of apparel and home goods. It generates 15%-plus return on capital and has a net cash balance sheet before adjusting for lease liabilities. And it has a store growth model that is not terribly capital-intensive, allowing for good cash-flow generation and sustainable capital returns. Those are starting qualities that we really like.

It has defensive qualities we’re looking for in our holdings, too. Before COVID, I think the company only had one negative year of same-store sales in 40 years. So, this is a business that absolutely offers value to the consumer, and that value is recognized by market-share gains even during periods of economic stress like the great financial crisis. Its ability to do that really comes down to its business model of buying excess inventory from other department stores and vendors. We see this recession-resilient model trading at a reasonable valuation and remaining attractive over the long term. 

Hand: I'll give you one recent example—Merck. Going into 2022, it was a good example of the risk asymmetry we look for and how valuable that is. The stock is up strongly this year in a market that’s down. And yet it’s still only trading at a low-teens P/E multiple on 2024 earnings and has a yield still north of 2.5%.²  

What has happened is that there’s been a greater appreciation for the business, the successes of its drug development and pharmaceuticals, and the long-term position of the cancer-fighting drug Keytruda—all of that has bubbled up to a higher but still discounted valuation.

Why we really leaned into Merck, making it a big position in the portfolio, is its animal health business and vaccines franchise, which are a little bit different than the standard pharma that you think about with patent risk. These businesses represented about one-quarter of the business coming into this year, but we see them growing over the next 10 years.

So with this stock, you really have what we look for—that asymmetry in risk and reward with Merck’s relatively low volatility and what we believe is a really compelling valuation for a big-yield company.

• Seeking dividend growers in an inflationary environment (article, issued January 2023)
• The people power that runs Vanguard’s index-investing engine (article, issued December 2022)
• How a contrarian seeks value in today’s volatile market (article, issued October 2022)
• Vanguard Equity Income Fund
• Vanguard Wellesley Income Fund
• Wellington Management Company