You know how I look for the presence of Google/Alphabet stock and the exclusion of Facebook stock in a mutual fund as a shortcut signal for finding talented mutual fund managers? I feel this way because such a decision means that a growth stock manager is relying upon earnings growth more than P/E expansion to build wealth for investors because the wealth rests on a foundation of more permanent value. Put another way, it is a lot easier for a stock’s P/E ratio to go from 80x earnings to 40x earnings than for earnings to go from x to 0.5x so I would rather own investments that require the latter rather than the former to produce failure.
A similar signal that I use to evaluate the strength of a mutual fund’s management is whether there is a willingness when necessary to close the fund to new investors. Things like the T. Rowe Price Capital Appreciation Fund, the Fidelity Magellan Fund, the American funds, the Sequoia Fund, and the Vanguard Windsor Fund closing to new investors at moments throughout their history are strong indicators that the management team has the passive investor’s best interests at heart because they are turning down easy, free money in favor of fulfilling their duty to give the best performance possible to their investors.
It is also moral in the way my first example is not. If an investment management team chooses to load up on Facebook stock, well, it is just an investment strategy disagreement with me. No big deal. Plus, they are getting the current laughs as Facebook’s stock performance has been superior to many of the stocks that I consider to be excellent long-term investments.
But closing a fund actually requires a choice between your own short-term financial interest and those of your clients, and your duty to avoid the seduction of personal enrichment at the expense of your clients is a factual situation that reveals your moral character in the marketplace. The Catch-22 is that you will want to invest with a manager after an announcement that the fund is closed to new investors, and investors actually in the fund aren’t already there because the management demonstrated that it is willing to close to new investors (unless you’re someone who is investing in a re-opened fund.)
This brings me to the announcement that the Vanguard Dividend Growth Fund (VDIGX) is closing to new investors.
In their press release, Vanguard’s CEO Bill McNabb offered the following: “Vanguard is proactively taking steps to slow strong cash flows to help ensure that the advisor’s ability to produce competitive long-term results for investors is not compromised. We have long been committed to protecting the interests of our funds’ shareholders, and demonstrate this conviction by closing or restricting funds to stem further growth.”
I like it. The Vanguard Dividend Growth Fund currently has over $30 billion in assets. If the fund comes up with a good idea, it will have to sink $1 billion to $3 billion into it for the effect on fund returns to be noticeable. Put another way, the Vanguard Dividend Growth Fund has reached the point where the deployment of a superior strategy will involve finding 5-10 stocks per market cycle that have a market cap of at least $10 billion and can absorb regular purchases for six months or longer without moving the market. This is doable, but is coming within nodding distance of Giant Blob territory.
If you’re not someone who is already invested in the Vanguard Dividend Growth (VDIGX) but is still looking for something actionable to take from this discussion, I suggest you pay attention to the Dividend Growth Fund’s core holdings. You’ll see: Microsoft. Nike. UPS. Costco. Colgate-Palmolive. These are not businesses that you purchase if you want high current income. They are businesses with low dividend yields that you buy because there is a strong earnings per share growth kick that gives you a lot of capital gains and future dividend growth that matches the earnings per share. I think these are the right general characteristics to prize.
As a bit of relevant history, it is worth remembering that the Vanguard Dividend Growth Fund (VDIGX) was not born with that name but was instead founded as the Vanguard Utilities Income Fund that had a mandate to invest 100% into utility stocks. It did okay in that capacity, giving investors nearly 4% annual dividend income that coupled with 2% capital appreciation to give investors 6% annual returns.
Unfortunately, this was the 1990s, and utility stocks were most certainly not in fashion. Freshly issued stocks were giving investors higher one day returns than the utilities index generated in an entire decade.
In December 2002, the Vanguard Utilities Income Fund repurposed itself with the name the Vanguard Dividend Growth Fund and has delivered nearly 10% annual returns since then. But you know what I find interesting? During the first five years, the fund had almost 40% of its money in telecom and utility stocks.
As of its September 2016 disclosure, the Vanguard Dividend Growth Fund indicated that it had 0% exposure to the telecom and utilities sector. Think about that for a moment. Almost $30 billion in diversified assets under management, and not a single dollar of that has worked its way into the telecom or utility industries. That action speaks as loud as any words I can write here–it is quite difficult to find fair value among the traditional high-income bearing class of investments.
Right now, I’m pretty impressed with the Vanguard Dividend Growth Fund. The management team is setting a good example by putting the interests of clients ahead of its own pockets. I like the fact that it is still providing current investors the opportunity to add to their holdings and reap the benefits of their 10% annual stewardship since 2002. I like the philosophical lessons it imparts to the rest of us about preferring high EPS growth investments that pay dividends right now. I think the fund also offers a pragmatic lesson about knowing when to abandon the strategies of the past when they don’t work any longer. The Wellington team that manages the fund deserves a tip of the cap.