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A Prudent Approach to Dividend-Stock Investing

Silver-rated Columbia Dividend Income favors companies generating steady, positive free cash flow.

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The following is our latest Fund Analyst Report for Columbia Dividend Income (GSFTX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

A cautious process and an experienced manager earn Columbia Dividend Income (GSFTX) a Morningstar Analyst Rating of Silver. Lead manager Scott Davis follows a disciplined approach that favors companies that generate steady, positive free cash flow.

Davis joined the fund in 1998, became a comanager in 2001, and assumed the lead role following previous lead manager Dick Dahlberg's retirement at the end of 2013. The fund never skipped a beat. Risk-adjusted results land in the large-value Morningstar Category's top decile during his tenure as comanager as well as lead.

Davis' prudent approach is based on his view that a predictable source of cash is the best indicator of dividend payouts. He buys stocks that have a free cash flow yield in the top two quintiles of his selected universe. Davis works with two comanagers and Columbia's central research team to select companies with steady free cash flows and a disciplined capital spending program.

The team won't hesitate to sell a stock if they think fundamental changes, such as rising competition or debt, threaten future cash flows. The team, for example, sold Verizon (VZ) in June 2017 after holding it for 15 years because Davis believed price competition had undermined the advantage of its superior network. He now favors AT&T (T) because of its planned merger with Time Warner (TWX).

The managers' valuation discipline sometimes causes them to sacrifice some upside. The team, for example, sold its position in video game publisher Activision Blizzard (ATVI) in December 2016 because they thought its valuation was untenable, despite its healthy cash flows and dividend growth. Although this approach can cause the fund to trail its Russell 1000 Index in market rallies, the team's price discipline typically offers downside protection. Indeed, the fund has lost about 15% less than its bogy during down markets while Davis has been manager. Plus, the fund has been steadier than most with a standard deviation lower than 85% of peers over the same period.

Process Pillar: Positive | Gretchen Rupp 09/18/2017
This fund's managers look for firms with steady cash flows that lead to consistent, and sometimes increasing, dividend payments. The team downplays the importance of a company's payout ratio, although it is frequently cited by some rivals as a signal of dividend quality. The team says earnings are easily manipulated, so it monitors a company's ability to continue dividend payments using free cash flow yield--a company's free cash flow divided by its market cap. Indeed, by this measure, the fund has consistently stayed ahead of its index with an average free cash flow yield about 80 basis points above its bogy for the three years through August 2017. This focused approach is executed well and earns the fund a Positive Process rating.

The team starts by ranking companies in quintile groupings, based on free cash flow yields, selecting stocks from the highest two quintiles. The team says stocks with very high dividend yields are often from lower-quality firms that can't support the payment over time, which is why it focuses on companies' cash flow. The team evaluates the firms' capital-allocation decisions, including share repurchases, acquisitions, and debt repayment. The team's priorities are apparent in the fund's average return on invested capital, which was about 20% higher than its index during the three years through July 2017.

Because lead manager Scott Davis and his team look for companies with healthy, predictable free cash flows, this portfolio doesn't turn over as rapidly as some of it large-value peers. The fund's 16% turnover ratio as of May 2017 was less than half that of its typical peer. Indeed, slightly more than one fourth of the fund's assets have been holdings for more than 10 years.

The fund is often underweight the technology sector. The team targets 70-100 holdings and limits position size to within 300 basis points of the benchmark's weighting. Sector weightings can vary by plus or minus 700 basis points, and as of July 2017, the fund's technology sector weighting was about 660 basis points below its bogy's, and the fund typically has less exposure to technology companies relative to the Russell 1000 Index. Internet services, in particular, is an area where this fund doesn't typically find attractive stocks as there are few, if any, predictable dividend payers. However, Microsoft (MSFT) was the fund's largest holding at 4.6% of the portfolio as of July 2017.

The managers don't hesitate to sell when their picks' dividends look vulnerable. They, for instance, sold General Electric (GE) last year because they worried the conglomerate might have to borrow funds or sell assets to maintain its dividend payments. Since then the stock has fallen.

Performance Pillar: Positive | Gretchen Rupp 09/18/2017
The fund has delivered impressive results under Scott Davis' tenure from November 2001 through August 2017. Overall, the fund's 8.5% annualized gain beat the Russell 1000 Index benchmark by 56 basis points and topped 92% of large-value peers. Plus, the fund was steadier than most--its standard deviation was lower than 85% of peers.

The team's cautious process requires that the fund's holdings to pay steady dividends from predictable free cash flows. This quality bias has helped the fund buffer losses during market downturns. For example, Davis' cash discipline contributed to strong stock selection within the financials sector in 2011, helping the fund top the Russell 1000 Index by more than 450 basis points during the market dip from May-September 2011. Indeed, during Davis' tenure the fund has lost about 15% less than its benchmark in down markets.

The same prudent process can cause the fund to fall behind when markets soar. During 2013, the fund gained a respectable 28.7% but still fell short of the 33.1% return by the Russell 1000. Over the long haul, the fund doesn't trail too far behind. In fact, the fund lands in the category's top quartile in 48% of rolling three-year periods during Davis' tenure. This consistent performance pattern and attractive risk-adjusted profile earn the fund a Positive Performance rating.

People Pillar: Positive | Gretchen Rupp 09/18/2017
Scott Davis became lead manager in 2012, in preparation for the retirement of prior lead manager Dick Dahlberg at the end of 2013. The transition was smooth, and the fund continues to operate as it had been. Davis is an experienced hand and had been working on the fund with Dahlberg since 1998. Davis has a long tenure with the fund's parent organization, having joined FleetBoston, a predecessor firm to Columbia, in 1985 as a portfolio manager. The team is lean but relies heavily on Columbia's central research group to provide baseline models and additional support. Davis' stable tenure and long-term record support a Positive People rating.

Michael Barclay, who became a comanager in March 2011, was previously an equity analyst. He joined Columbia Management Group in 2006 and has more than 20 years of investment experience. Peter Santoro joined the team in June 2014 and remains comanager at four other funds, including Columbia Select Large Cap Equity (NSGAX). It's a lean team that relies heavily on the experienced staff at Columbia's central research team. Davis and team coordinate with research analysts to deliver somewhat customized models to fit this team's cash-flow-centric approach.

Davis and Barclay invest between $100,001 and $500,000 in the fund. Santoro did not report any investments in the fund as of September 2017.

Parent Pillar: Neutral | Gretchen Rupp 08/16/2016
Rebranded as Columbia Threadneedle as of March 2015, this fund family continues to tweak its strategy as the asset-management business grows in importance to parent organization Ameriprise Financial AMP. Funds distributed in the United States continue to fall under the Columbia brand, while most funds sold outside of the U.S. operate as Threadneedle.

Columbia Threadneedle's culture has some strengths. CIO Colin Moore allows portfolio managers significant independence, and particularly strong strategies continue to succeed. However, it is a delicate balance between a manager's independence and appropriate oversight. The Acorn funds suffered through lagging performance periods followed by organizational changes that caused disruption in 2015.

Most of the distribution team members are newer to the firm, and they've continued to rationalize and simplify Columbia's extensive lineup. Further fund mergers, liquidations, and name changes continued through 2015 and into the first half of 2016, but the firm also launched five new U.S. funds between January 2015 and May 2016.

Manager compensation is fairly standard, but the firm deserves credit for allocating a portion of deferred compensation to Columbia Threadneedle funds. Average manager coinvestment and middling fees support a Neutral Parent rating as the firm builds a global franchise.

Price Pillar: Positive | Gretchen Rupp 09/18/2017
The Z shares hold more than half the fund's assets and are available through approved advisor channels. The shares carry a 0.77% expense ratio, which matches the large-cap institutional median fee.

The bulk of the remaining share classes offer more-attractive pricing relative to similarly distributed large-cap share classes. The Y shares are cheaper than about 75% of large-cap institutional peers. The A shares charge a 1.02% fee, which is below average for similarly distributed front-load peers. Overall, the fund earns a Positive Price rating.

Gretchen Rupp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.