Executive Summary

• Investors in Equity Income were well served in 2008. Protection was the name of the game during one of the most tumultuous years ever for the stock market, and American Century Investments’ most conservative value-oriented portfolio delivered industry-leading relative performance against its Morningstar Large Cap Value peer group and its benchmark, the Russell 3000 Value Index.
• If
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  the first quarter of 2009 is any indication, we appear to be in for another year (or longer) of extreme market volatility and uncertainty, the result of a worsening recession and a dismal profit picture, still frozen credit markets, a struggling auto industry, and doubtfulness about the government’s stimulus package. That’s a strong case for investing in Equity Income.

• But even if a different scenario presents itself and President Obama’s stimulus plan ends up igniting the next stock market upswing, that’s no reason for financial professionals to reduce their clients’ exposure to Equity Income in favor of more aggressive equity portfolios. Equity Income serves investors in up markets, as well.
• Dividend-paying
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  companies play a key role in the portfolio’s ability to provide both performance and protection. The current supply-and-demand imbalance for dividend-paying stocks appears to be an additional advantage for Equity Income in 2009.

Remember: Equity Income Is Not All Defense

While the financial press tends to trumpet Equity Income’s defensive skills, the portfolio stays with the large-value pack in up markets—even with a complement of income-producing convertible securities that typically accounts for 15% to 30% of assets. In the six positive calendar years for the Russell 1000 Value Index during the last decade, Equity Income’s return lagged that of the median for its Morningstar peer group of 451 funds by just 0.14%.

For the 225 or so large value portfolios that averaged better upside returns during the positive years between 1999 and 2008, here’s the question that financial professionals should be exploring:

What good is positive performance if it’s negated by the next market storm?

Thanks to an equity investment process that’s extremely attentive to downside risk, as well as reward, Equity Income outperformed its Morningstar median peer by a double-digit average of 11.24% during the four negative calendar years for the Russell 1000 Value Index since 1999. It’s worth noting that this 1,000-plus basis-point outperformance was (presumably) against other large value funds with a conservative bent, which makes the result all the more impressive.

This "Upside Downside" chart illustrates how Equity Income has served investors in both up and down markets during the past ten years.

The portfolio leads the Standard & Poor’s 500 Index, representative of the broad market, over the 120-month period in months of positive performance. The portfolio also has nine fewer down months. During the up months, Equity Income has provided a very respectable average return of 2.41%, 56 basis points behind the S&P 500. On the downside, the portfolio’s average decline of -2.79% is 130 basis points better than the average for the broad-market index. (For this average-return comparison, the up and down months for the portfolio and the index are strung together as if they occurred consecutively.)

The story really comes to life in the “capture” columns at the far right. Active management by Senior Portfolio Manager Phil Davidson and co-managers Kevin Toney and Michael Liss has consistently positioned Equity Income to participate in market surges during the past ten years, as evidenced by its 77% capture rate on the upside.

But what good is positive performance if it’s wiped out by the next market decline? Equity Income’s low 52% participation on the downside is a huge selling point.

Central to Equity Income’s Success: Dividend-Paying Companies

Stocks of well-managed businesses with high dividend payouts have played a front-and-center performance role for shareholders throughout Equity Income’s nearly 15-year life span. “First and foremost, quarterly dividends represent more immediate money in our investors’ pockets,” says Phil Davidson. “They’re a portion of a stock’s total return that we can essentially count on.”

Beyond boosting total returns, dividend yield is a key lever in the Equity Income team’s effort to control risk and protect gains. All other things equal, dividend-paying companies are likely to be large, established businesses with strong earnings and cash flows. Conventional wisdom says that such companies are better able to weather unforeseen downturns and continue to invest in their operations and reward shareholders. Dividends also point toward businesses with strong balance sheets that are being funded correctly—no small attribute in a continuing credit crunch.

Where to Find Dividends

For “show-me-the-money” investors like Davidson, finding companies that appear able to sustain their dividends in a recessionary economy is separating winners from losers—as well as becoming more challenging by the day. According to Standard & Poor’s, 2008 saw 61 dividend cuts totaling $40.3 billion. The first quarter of 2009 brought 44 cuts totaling $42 billion, while a record 367 U.S. companies announced that they would either cut or eliminate dividends going forward. On a payout basis, Standard & Poor’s expects the dollar amount of dividend payments to fall 18% during the second quarter of 2009 (versus a 16% decline during the previous quarter).

Where is the Equity Income team finding sustainable sources of dividend income? Three areas where higher yields appear to be more secure are consumer staples, health care, and telecommunications. Earnings there are less cyclical, and successful business models in those sectors tend to generate recurring revenues and relatively steady cash flows. That’s why Equity Income was overweight in those sectors at the end of February, with AT&T, Kimberly-Clark Corp., and Watson Pharmaceutical among its ten largest holdings. (As of February 28, 2009, Equity Income had a 4.61% weighting in AT&T, a 3.49% weighting in Kimberly-Clark Corp., and a 3.39% weighting in Watson Pharmaceutical.)

Another Silver Lining for Dividend-Driven Investors

The current supply-and-demand imbalance for dividend-paying stocks could be a compelling factor in Equity Income’s 2009 results. On the supply side, if the list of companies cutting dividends continues to grow, investors would likely pay a premium for higher-quality companies whose yields are not in jeopardy.

On the demand side, baby boomers are reaching retirement age. According to the Bureau of Labor Statistics, the number of workers in the 55-and-older group will grow by 49% over the 2004-2014 period. Once they leave the work force, baby-boomer retirees will have a greater need for current income and more likely devote a larger percentage of their portfolios to dividend-paying investments.

Summary: Here’s Where Solid Long-Term Returns Come From

• With investors hungry for any sign that a market turn may be upon us, it may be tempting for some financial professionals to place their clients in a more aggressive posture to capture the next upside cycle. But as we’ve seen, over the long term, performance and protection are the formula for investment success.
• Financial professionals will be on firm ground with their clients if they recommend Equity Income as a core equity investment in any market environment. The fund has proven it can capture attractive opportunities for capital appreciation, then protect its gains when market sentiment turns negative.

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