Motley Fool Hidden Gems Investing - The Dividend Returns

Episode Date: March 24, 2024

For decades, dividends have been out of style. History suggests that may soon change. Daniel Peris is a trained historian, a portfolio manager, and the author of many investing books, including his latest, “The Ownership Dividend.” Deidre Woollard caught up with Peris to talk about why he believes we’re about to witness a resurgence of dividend investing. They also discuss: The coming return of the “cash nexus.” Semantics, and how academic finance differs from a real-world balance sheet. Why free cash flow is king.  Host: Deidre Woollard Guest: Daniel Peris Producers: Mary Long, Ricky Mulvey Engineers: Chace Pryzlepa, Tim Sparks Companies discussed: META, CRM, BA, FHI Learn more about your ad choices. Visit megaphone.fm/adchoices

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you know, the rest of this decade, where equities will have to compete for investor support the same way cash, fixed income, government securities, private equity, real estate have on the basis of a cash nexus. The cash nexus came back very quickly in 21, 22, 23 to money funds, to fixed income instruments, to government securities. Hasn't come back to the stock market yet. Everyone is still content to harvest capital gains, growth, growth, growth. I'm simply saying the forces that led to that dominant paradigm over the last 40 years, I think have played themselves out. I'm Mary Long, and that's Daniel Paris, a senior portfolio manager at Federated Hermes

and the author of a number of investing books, including, most recently, The Ownership Dividend. My colleague, Deidre Willard, caught up with Paris for a conversation about why dividend investing is due for a rebound. They discuss a timely announcement from Meta, the relatively recent rise of buybacks and the coming shift from Wall Street efficiency to Main Street efficacy. Well, we were talking a little bit before we hit record here, and it seems to me that like this book is coming out at the perfect time because as I was reading it, more companies started reinstating their dividends. So interesting timing for you. Yeah. And, you know, you can be good or you can be lucky and often

good passes as the rubric of luck or the other way around. I'll just claim I was lucky. The book was published on January 31st. The very next day, a prominent tech company, which the book calls for them to begin to pay and increase dividends, Meta, announced the dividend the very next day. So, somehow or other, Zuckerberg, Mark Zuckerberg, got a copy of the book and in 24 hours read it, agreed with it, and got the board to agree as well. I love it. Well, I want to start sort of back in the beginning of the book, because you have this great definition of dividend investing as those who want a cash-based relationship as opposed to a price-based relationship with the companies they own. So you make the point that's a smaller and smaller group over the past,

certainly the past 30 years, maybe even before that. Why? What caused that shift? Yeah. So I was, as you pointed out, trained as a historian and I ended up changing careers and moving into finance. And I maybe naively read all those finance books and took the CFA. And I, again, perhaps naively took it seriously. But chapter one, and frankly, more than chapter one of all of that training, treated the issue of cash flows to investors as kind of central to the ownership of an asset. Anyone who owns, non-financial people who own real estate, rental real estate, farmland, anything naturally assumes indeed that, unless they're pure speculators that their reward, as it were, is in the income stream that they get. And hopefully,

as it were, technically, the net present value of that income stream is greater than what they paid for it or roughly at least in line. And then I get into the US stock market where I have all of this training in line with that thinking and all of this historical experience in line with that thinking. And wow, US stock market doesn't operate that way. There's little, if any, income stream from the market as a whole. There are corners of the market that have robust income streams, but much of the market doesn't. And everyone seems content with that. And as a historian, I'm asking the question, wow, okay, this is the current paradigm. Where did it come from? And how likely is it to continue? And the historian in me came out and started looking at

what were the trends that led to the decline of income streams investing in the stock market for income streams, as opposed to just buy low, sell high, repeat frequently. Now, I'm not naive about some time in the past that everything was about the income. There are always speculations, always buy low, sell high, repeat frequently, always companies that cannot and should not pay dividends for a variety of reasons. But on the whole, the US stock market, along with most other markets and most other assets, it's characterized by the income stream that you get from them, rising income stream, high income stream, low income stream, whatever. And the US market had moved away from income streams in the 1990s and for the last couple

of decades. And so, the first part of the book addresses why that happened. And in doing that and considering why the market had moved away from income streams, I then came to the conclusion that, well, the factors behind that, that paradigm really had suddenly come to an end kind of in a dramatic fashion the last three or four years and that we are well-situated for a paradigm shift. where the return of the cash nexus will, again, be kind of the norm from an investment perspective. It's not anti-growth. It's not value versus growth. It's simply the return of basic business

math. Chapter one of your finance book will once again apply in a way that it has not for three decades. Well, if you were writing chapter one right now, it might be that investors are considering the returns is what they get when they sell a stock. It's not that income stream going forward. So given that we're maybe experiencing this new shift, how does that change the investing landscape as a whole, especially considering what we've seen in the last few years, which is massive growth and everybody wonders, you know, when should I sell? Yeah. So I might have timed Facebook or Meta correctly, but obviously I'm sort of early on in this transition, this paradigm shift that is occurring. There's no evidence of it. In fact,

the announcement made by Meta had a 10 to one ratio of buybacks to dividends. The announcement by Salesforce had an eight to one ratio of buybacks to dividends. So both were introducing dividends, which was a nice deal, but they were doing more in the way of buybacks. I'd like to think that with the publication of the book, that these companies are all going to come around exactly the way Facebook and Salesforce did within a few days of the publication of the book. But that's not realistic. And as you've seen the characteristics of the stock market year to date, this is being recorded in the middle of February, middle of March, excuse me, of 2024. There's no evidence of a paradigm shift year to date. It's all about

non-dividend paying stocks and we'll call it growth. So again, it's a bit of a canard, growth versus value. And so, yeah, I'm a little bit early. I got the symbolic tip of the hat from Facebook and Salesforce, but I think it's going to play out over the next several years, the rest of this decade, where equities will have to compete for investor support the same way cash, fixed income, government securities, private equity, real estate have on the basis of a cash nexus. The cash nexus came back very quickly in 21, 22, 23 to money funds, to fixed income instruments, to government securities, hasn't come back to the stock market yet. Everyone is still content to harvest capital gains, growth, growth, growth. I'm

simply saying the forces that led to that dominant paradigm over the last 40 years, I think have played themselves out. So, it's not going to turn on a dime for investors, but I think over the next several years, you're going to see more of the tech companies doing what these did and more significant. You basically see the S&P 500 payout ratio and yield move up as more companies shift cash in that direction. Where's it going to come from? It's not starving investment. There's plenty to go around. We have close to a trillion dollars a year in buybacks, a trillion. So there's plenty to fund buybacks, plenty to fund dividends, plenty to fund investment in the business. The defining characteristic of this paradigm from 1980 to

2020, call it 21, 22, has been the rise of the buyback. And I think that just the pendulum will swing more towards the middle and away from the extreme, all about buybacks, minimal dividends to something that's a little bit more balanced. Yeah. I want to talk about buybacks because you just made that point with Meta and Salesforce, that they pay small dividend, bigger buybacks. And you make the point in the book that buybacks should not be considered the same way as dividends and that they didn't really occur in history. They're sort of bunched together on a lot of earning statements as we're returning cash to shareholders and it's the dividend and the buyback together. They're not the same. So what's behind the rise of the buyback?

Yeah. And this is where I kind of get into the weeds, but I think they're kind of important weeds. And you are exactly correct. The semantic likening of dividends and buybacks as we're turning cash to shareholders really, as a person who cares about words, really, really bothers me. One goes to shareholders, the other goes to share sellers and is of little, if any, benefit to shareholders. The source of that conflation, you have to go back into the academic finance. There are two chapters in the book that are about academic finance. If you are inclined to skip those chapters, feel free. I will not be offended. But those two chapters deal with how this all came about. And in effect, the founding fathers of modern finance working

the 50s and 60s, prior to the creation of buybacks as a practical investment characteristic, they created a structure. And the key characteristic is that they claim that investors are indifferent between a capital gain and a dividend payment. Now, interestingly, in the academy, it is a capital gain versus a dividend payment. In reality, it has to be a harvested capital gain. You cannot fund consumption with a capital gain. You have to fund consumption with a harvested capital gain. And a harvested capital gain may or may not be there. It involves thousands of people, involves the stock market, the stock market being in a good mood, et cetera, and involves a process of selling your asset. You don't benefit from a capital gain on your

brokerage statement. It may make you feel good, but there's no way you can do anything with it unless you actually sell it. Whereas a dividend payment is a business outcome, not a stock market outcome. But in any case, the academics in their shortcuts said capital gain, dividend payment, investors can be indifferent to them. And again, in a blackboard environment in 1952 or 58 or 59 or 61, in the University of Chicago, they can afford to be indifferent because that's the blackboard environment. But in a real world environment, investors can't be because A, it's a harvested capital gain and one is a business outcome and one's a market outcome. But when you start with that base, then buybacks appear really decades later. It's not that hard

to think about, okay, this buyback phenomenon didn't exist when modern finance was, academic finance was being worked out. But if you think about it, it's actually not that hard to shoehorn the buybacks in and create an academic link between buybacks and capital appreciation, that buybacks generate capital appreciation. It may be true, may not be true, but on a blackboard, it can be done. So there you now have investors should be indifferent to a buyback generated so-called capital gain or a dividend payment. And that's how the Wall Street, the CEOs in Wall Street can use that phrase of returning cash to shareholders through buybacks or dividends. again, either as a historian or a business owner or someone who cares about the English language,

and sadly, I happen to be all three, none of that withstands scrutiny. Yeah. Yeah. I think that's very true. But looking at the situation right now, so much of the growth comes from this handful of companies. We keep giving them different names, Fang, Magnificent Seven. So the landscape right now is completely different. If things shift, does that mean that it'll be a more equal playing field? Will people start to invest in a wider variety of companies? Because right now, so much is hanging on so few companies. Yeah. There's a lot of discussion about the broadening out of the market. And I think the ability and inclination to pay a dividend will play a role in that

broadening out. If what I've written in the book comes to pass, investors will have more options. That's the good news. The bad news is investors will have more options. So, you know, it'd be harder choices to make. But I think that the ability to distinguish among companies based on their distributable cash flows is a good thing. I mean, who foresaw some of these companies, you know, some of the best growth investors in the world, say those based in St. Petersburg, Florida with a very well-named investment product, they missed one of the, you know, the leading single stock. But I almost feel like the variances, to use a technical finance term, the variances, the degree of outcomes that one occupies as a dividend investor in a stock market

is narrower than the degree of outcomes one encounters as a stock market investor in a stock. You can go to zero or go to a thousand as a stock market investor. And it can be sometimes it's hard to tell which one's going where. Whereas with the income stream, some are better than others, some are at risk, some are growing, some are lower payouts, some are higher payouts, but the variances are lower. And I think the market's extreme range of variances, this is a theme running through the book, is a function of interest rates dropping for 40 years. That's really the theme that runs through the thread, that runs through the book and ties everything together. And therefore the question becomes, what happens when interest rates

stopped going down for 40 years. So while the rates were going down, risk was constantly lower, leverage was encouraged. You had profitless businesses or just not ready for primetime businesses, SPACs, other things. And there was really, with the discount rate close to zero, the risk rates perceived to be very, very low. It's hard to distinguish between an old established company and a startup with no revenue or minimal revenue. And it muddied the waters, made kind of analytical distinctions hard and choosing harder. Now, with interest rates have stopped going down, risk rates have stopped going down. I draw a distinction between the two. And risk rates being some sort of mid-single digit or higher number,

companies are all going to have to compete on the basis of cash. And either they have the cash or they don't. Either they really are successful. Now, let's look at a couple of those FAANGs or MAGA companies, MAGA 7 companies. Some of them are extremely profitable and the cash flow shows it. A couple of them are surprisingly not. They shouldn't pay a dividend. They couldn't afford to pay a dividend. It would be unwise for them to pay a dividend. So I think this will help in the analytical process, getting us back to, for lack of a

better word, somewhat untechnical term, less crazy environment where you can be able to compare investments based on their distributable cash flows, keeping in mind that certain companies, very good investments, may not have distributable cash flows. they're either genuinely startups or distressed companies or turnarounds, higher risk, higher return. Cash is not part of the equation there. But on the whole, what happened was the main part of the US market over 40 years got pushed more and more in the direction away from cash, lower cash returns, more buybacks. I think the pendulum is simply going to swing back and you'll be able as a dividend focused investor or a cashflow focused investor, an income seeking investor,

have access to a lot of companies, very good companies that currently, and for the last 15 years have been unavailable. In the book, you said even companies that pay dividends, they're not paying a lot of dividends at this point. So what do you think has to happen in order for the companies that have a low dividend to start increasing those? Yeah, I think the straight up asset allocation 101, they're going to have to start competing on a cash basis, the return of the cash nexus, and have to start competing for investor attention. And it was in various points over the last 30 years on the basis of investor attention or eyeballs, clicks, H200 or A200, I forget the name of the chips of NVIDIA, whatever the case may be. But over time, I think we're going to need to compete on a cash basis and that will push up payout ratios.

Payout ratios have been hovering around a third, 35% for 10, 15 years. There are blips in that when there's a periodic crisis, 2020, the financial crisis, which affected bank or financial institution pay ratios, but pay ratios plummeted and then have been kind of moving sideways at a low level for a while. But I think they will move up. And I just think the bloom is off the rose for buybacks. They're not illegal. They're not immoral.

I'm not in favor of the government's new policy, proposed policy. Probably won't go anywhere if taxing buybacks at the corporate level at 4% rate. Taxation is rarely the solution to a problem. I'm more in favor of kind of sunshine is the best disinfectant. And just, again, after 40 years, it's very clear that the buyback machine works really well for Wall Street. I just don't see that it is particularly good for Main Street. The other important factor is the maturation of the NASDAQ companies.

They were justifiably not paying dividends in the 80s and 90s, maybe even in the aughts because they were changing the world. Is it changing the world? that took a lot of capital and so forth. But now, and there are tremendous engines of innovation and wealth creation for the United States. But now, 40 years in, you see these large companies, they're clearly mature. Some of them are periodically in value benchmarks, go figure. And they have the ability to pay a dividend and begin to treat minority shareholders exactly the same way any other business would. That's seen as a radical comment, but Facebook had the guts to do

it. And as did Salesforce. And I think more software and service companies will move in that direction out of pressure to attract investors who now with the return of the cash nexus, because interest rates have stopped going down, will begin to demand that. And it'll be tremendously useful. Again, we've talked about the FAANGs or MAG7, tremendously useful to see those who can afford to pay and those who can't. And again, some of those companies, enormous companies, it doesn't take more than 10 minutes of analysis to say, you know, that company shouldn't pay a dividend. They can't afford to, despite their size. Yeah. Yeah. That's really interesting. That's a good point too, because

at least in the last maybe a couple of decades, having a dividend was also sort of a sign that the growth part is over. The growthy growth era is over. We're now a mature company and we're paying a dividend. And it sounds like what you're saying is that's not the right metric anymore. And I want to talk a little bit about metrics too, because you talked in the book about dividend yield and about other metrics for assessing the overall prospects of a company? Because it seems like the last couple of decades, we have mostly the metric of how much is it going up and is the valuation too crazy? But what else should we be layering in there? I think going forward, the free cash flow is important. We're coming into a period of capital

intensity for the United States. It means companies are going to need to spend more to do the same thing. We underinvested for decades. We outsourced it all to China. We imported deflation via Walmart. Worked really well until it stopped working. And three or four years ago, it stopped working in a big, big bang. And you're seeing companies have to, I'm going to say vertically integrate, not in a traditional sense, but just spend more on their quality control, the value chain of their operations. And you're going to see a lot more. Boeing is a great example. They spun off their fuselage business 15 years ago to make their optics and their cashflow look better. Now they're going to have to buy back their fuselage business because they're going to have

to buy back their fuselage business. They are in a complex manufacturing operation. They need to have greater quality control over the business. They're going to do so by friend shoring and buying back their business. It's going to cost money. So the question will become less, you know, those revenue numbers, then who is going to be able to navigate a more difficult environment? The regulatory environments become more difficult. The globalization environments become much more difficult. The political environment in the United States, it's the only thing we can agree on is a disaster. And there is no consensus at all. The global neoliberalism is over. So I think companies are going to need to spend more to do the same. I refer to as the shift in the book from Wall

Street efficiency, which is where you outsource everything to make your own balance sheet light and pretty to Main Street efficacy. And that's what Boeing's going through now. They're shifting from Wall Street efficiency to Main Street efficacy. They're going to have to. And I think they're not alone. Lots of other corporations are going to have to spend to shore up there, whether it's vertical integration or quality control, more on their people, plant property and equipment. Even service companies are going to have to have greater control over their service offering. The pendulum swung too far. So I'm looking for a lot of companies to spend in that direction. That doesn't mean it's anti-growth. It's just simply saying the pendulum swung too far

in terms of really of outsourcing or asset light businesses. And we're heading into a phase of investment. That is not the same thing as being anti-growth. It is simply saying we need to be a little bit more efficacious, not just efficient. In the book, you said that a portfolio that's not taking dividend risk might be leaving cash on the table. You know, thinking about dividend cuts in general, we saw a ton of them during the pandemic. That was sort of a system shock. So you sort of made the case that, you know, we might see more dividend cuts and the dividend cuts aren't really something that we need to be afraid of, that if we're having more dividends, there's going to be more flexibility than maybe there has been in the past? Yeah, that's a great question. It's a little

bit counterintuitive and people are sometimes shocked to hear me say it, but the way I phrase it is as a dividend investor in a stock market, I take dividend risk in order to generate dividend return. You have 30 or 40 different income streams. Other people would refer to them as stocks, but 30 or 40 different income streams, you mix them up and you get a very nice outcome income stream for the investor. But in order to maximize the income, it's possible that one or two of those streams will fail. You can reduce that risk by taking those out and having a lower yield. And then you can do it again and again and again until you have no income stream or you have a 0.5 basis point income stream. It's pretty safe at that point. And it probably grows rapidly,

but it's immaterial. So at a certain point, in order to generate income from a non-income oriented investment platform called the U.S. stock market, you take dividend risk. And as I think about that, I handle that with diversification, 40 income streams in most portfolios. That handles that. But if I were creating this universe from scratch, I might do it a little differently. Diversification works really well. It's fine. But I might do it a little differently. A lot of U.S. companies follow the U.S. pattern of quarterly payment and an increase. and they feel that it is a very bad thing to change that pattern. They're right because as an individual income stream or stock, they will be punished if they cut the dividend. Again,

from a portfolio perspective, that risk is not very significant, but company management doesn't like that. Their hands are tied a little bit with our culture of dividends. There are other options that I think the return of the cash nexus will encourage companies. You can see them on the margins of the stock market, but I think it's something that investors can look for and say, wow, that makes sense. That is a lower base payment and special dividends from companies that are highly cyclical. You do see that periodically in the energy space. You also see it periodically in family controlled companies when they maintain a certain dividend and as cash builds up and they don't spend on something, then there'll be a special dividend since they control

it as a family-controlled enterprise. They're paying themselves. They're paying themselves. So that's an option. There are other options you see sometimes in Europe of very strictly observed payout ratios, but strictly observed so that if earnings are down one year, the dividend is down that year. So it doesn't create a creeping high payout ratio. So let's say you have a 50 or 60 or 70% payout ratio. If earnings are down in a bad year because of something bad happens in Europe, so is the dividend. There's no incremental pressure on the company. The dividend could go down. Again, easily, easily handled from an investor perspective with basic diversification, 20, 30, 40 holdings, but painful from a company perspective. And the

optics and the media aren't good about that. But so I would, if we do move to more of the cash nexus, which I believe is inevitable, I also think that it's likely there'll be some greater variety of options available. And that helps the companies, helps the investors, I think, as well in managing the income streams. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long.

Thanks for listening. We'll see you tomorrow.