December 2019 IssueLong scroll reading

North Star Dividend Fund (NSDVX), December 2019

By David Snowball

Objective and strategy

For North Star Dividend, generating dividend income is the primary goal. Capital appreciation comes second. They pursue that goal by investing primarily in dividend-paying small- and micro-cap stocks. They typically target stocks under $1 billion in market cap, which is quite low even for a small-cap fund. Their preference is for stocks yielding over 3%.

The fund’s strategy has them seeking companies with market capitalizations of less than $1 billion that pay dividends, have a history of paying and increasing dividends, and have high free cash flow and attractive values, as measured by their EBITDA earnings.

Adviser

North Star Investment Management. Founded in 2003, North Star is headquartered in Chicago. They provide financial planning and investment management for individuals (both high net worth and not-quite-high net worth) and institutional clients, as well as advising the four North Star funds. The firm has about 25 employees who, collectively, own the company. 

Managers

Eric Kuby and Peter Gottlieb. Mr. Kuby joined North Star in 2004 and has been their Chief Investment Officer since 2005. Mr. Kuby holds an MBA in Finance as well as a BA in Economics from The University of Chicago.

Mr. Gottlieb founded North Star in 2003 and serves as their president.  He’s got a lot of experience in the financial industry. Mr. Gottlieb earned his BA degree from the University of Michigan, School of Business.

On whole, the team manages about $1.4 billion, with $305 million between the four North Star funds, all of which they manage together.

Strategy capacity and closure

Mr. Kuby reports that “We feel comfortable we can go up to $300 million without compromising the discipline. Probably a bit higher.” Most of the strategy’s assets reside in NSDVX, which is right around $80 million.

Active share

98.93. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The “active share” research done by Martijn Cremers and Antti Petajisto finds that only 30% of U.S. fund assets are in funds that are reasonably independent of their benchmarks (80 or above) and only a tenth of assets go to highly active managers (90 or above).

NSDVX has an active share of 99, which reflects a very high degree of independence from its benchmark Morningstar Small Value Index.

Management’s stake in the fund

Messrs Gottlieb and Kuby have each invested between $100,000 – $500,000 in the fund. None of the fund’s five board members have chosen to invest in the fund or, for that matter, in any of the 47 portfolios for which they have responsibility.

Opening date

May 31, 2013. The Dividend Fund is the successor to the North Star Dividend Fund, L.P., a limited partnership that had been in operation since 2010. They transitioned to a mutual fund because that “was preferred by our investors primarily because of the daily liquidity and lack of K1.”

Minimum investment

$5,000 for “I” shares, with no minimum for the more expensive “R” shares. The fund is available through relatively few brokerages, though they can be accessed through Fidelity, JPMorgan, Pershing, TD Ameritrade, and Schwab.

Expense ratio

1.43% for “I” shares and 1.67% for “R” shares, on assets of $76.5 million

Comments

There is unambiguous evidence that, in the long term, value trumps growth, quality trumps not, small trumps large. For much of the last decade, none of that has been borne out in the markets. Growth has led value by the greatest margin in a century and the large caps have beaten small in five of the six years since NSDVX’s launch. At the extremes, Morningstar’s large growth category has been outperforming its small value ones by 1000 – 1600 bps over the past one, three and five year periods.

That imbalance is unlikely to persist. The dominance of growth over value, or value over growth, frequently lasts for a decade – as it has now – and then reverses, with the downtrodden style decisively outperforming for years. Likewise with small caps, though the length of dominant stretches is shorter and more variable.

We are, at the same time, likely nearer the end of the 12-year bull than its beginning. Market reversals and market volatility are likely ascendant. One question is how best to prepare for the market’s next phase. One answer is North Star Dividend.

North Star occupies an unusual niche. It’s one of four dividend-oriented small-cap funds. The fund’s primary objective is dividend income, and its investable universal is small- and micro-cap stocks that are both dividend-paying and dividend-growing.

By Morningstar’s scoring, they are a four-star small-cap value fund where they stand out because of their dividend focus; they have a yield of 300% of the group average. By Lipper’s reckoning, they are an equity-income fund where they stand out because of their small-cap focus; they have, by far, the lowest average market cap of any fund in the group.

Their distinctions are, we think, a source of strength.

There’s a large universe of dividend-paying small-cap stocks which few explore. There are 6500 stocks with market caps under $1 billion. Of those, 1150 have a positive dividend yield with 600 yielding 3% or more. About 200 have grown their dividends over the past five years.

North Star is actively seeking out the 40-50 best. They prefer “simple businesses to understand with solid-to-improving financials.” Two strategies are at play. First, they’re looking for companies that pay substantial and growing dividends. Their argument is that the income provided by dividends is much more predictable than a stock’s capital appreciation, so those stocks tend to be steadier and better-performing. Part of that superior performance comes from the strengths of the firms’ management teams: “we generally find that corporations that have a long history of paying dividends may be more attentive to managing capital structures appropriately in order to maintain dividend payments.”  Second, they’re looking for high-quality companies which they operationalize as firms with lower than average leverage ratios and higher than average return-of-equities. In short, evidence of less debt and better capital allocation decisions.

Finally, they impose a series of structural risk controls. Positions are capped at around 5% of the portfolio. They tend to build positions slowly, which they describe as a “nibble and bunt” approach. They attend to ESG concerns, which they explain this way:

It’s not a top priority, but is something we keep in mind. We don’t think businesses that are bad for society or poorly governed are good businesses to invest in.

Turnover is low, 11% over time, but they’ll sell if there’s a dramatic change at the firm.

The fund has, so far, achieved their goal. Morningstar awards them four stars. We used the fund screener at MFO Premium to compare them to the 104 funds in Lipper’s small-cap value category. In broad terms, since inception, North Star beats the small-cap value universe in every measure of risk, return, and risk-return tradeoff that we track. When ranked against individual funds, it combines top tier total returns with the best downside protection in its peer group. It almost magically marries exposure to some of the market’s smallest stocks with the creation of one of the group’s highest dividend yields.

  Absolute Relative
Return 6.8% 18th out of 104 SCV
Max Drawdown 18.6 13th
Worst 12 month return -12.6 9th
Sharpe ratio 0.55 3rd
Sortino ratio 0.84 3rd
Martin ratio 1.04 15th
Downside deviation 7.1 1st
Down month deviation 5.7 1st
Bear month deviation 5.0 1st
Yield 2.4 5th
Average market cap 544 9th smallest

All data for the trailing six years, through October 31, 2019, per Lipper Global Data Feed at MFO Premium.

There are small-cap value funds with higher returns, but those returns come at the price of substantial jumps in volatility and downside risk. For all of the small-cap value funds with six-year returns greater than North Star’s, we calculated the jump in volatility you might encounter.

  North Star Top tier %age diff
Return 6.8 8.0 18
Standard deviation 10.9 15.0 37
Downside deviation 7.1 9.8 38
Down month deviation 5.7 9.2 61
Bear month deviation 5.0 7.9 58

On average, you gain 18% higher returns at the price of 40% higher routine volatility and 60% higher volatility in months were the market has declined.

Bottom Line

This strikes us as an exceptional fund. Including its years as a hedge fund, it has a long history, and a sensible, conservative approach to an otherwise volatile, underfollowed set of stocks. It has offered exceptional returns with remarkably strong downside protection. For investors seeking income, or just managed volatility, from small-cap stocks, North Star Dividend is very much worth adding to your due-diligence list.

Fund website

North Star Dividend

© Mutual Fund Observer, 2019. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.
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About David Snowball

David Snowball, PhD (Massachusetts). Cofounder, lead writer. David is a Professor of Communication Studies at Augustana College, Rock Island, Illinois, a nationally-recognized college of the liberal arts and sciences, founded in 1860. For a quarter century, David competed in academic debate and coached college debate teams to over 1500 individual victories and 50 tournament championships. When he retired from that research-intensive endeavor, his interest turned to researching fund investing and fund communication strategies. He served as the closing moderator of Brill’s Mutual Funds Interactive (a Forbes “Best of the Web” site), was the Senior Fund Analyst at FundAlarm and author of over 120 fund profiles. David lives in Davenport, Iowa, and spends an amazing amount of time ferrying his son, Will, to baseball tryouts, baseball lessons, baseball practices, baseball games … and social gatherings with young ladies who seem unnervingly interested in him.