Motley Fool Hidden Gems Investing - What to Do with Dividends

Episode Date: June 27, 2023

One key ingredient in Warren Buffett’s “Secret Sauce” is stocks that pay a dividend, but then you’ve got to let them simmer for a very long time. (00:21) Jim Gillies and Ricky Mulvey discuss: - Walgreens Boot Alliance’s disappointing 3rd quarter. - The pharmacy chain’s turnaround story. - What to look for in investor presentations. - Why investors are cheering Brookfield’s $4.3 billion bid for life insurance company, American Equity. Plus, (11:54) Robert Brokamp and Matt Argersinger discuss the fundamentals and tradeoffs of owning dividend payers. Companies mentioned: WBA, BN, BAM, AEL, KO, AMX, MO, HD, AOS, PLD Links: Rule Your Retirement article: https://www.fool.com/premium/rule-your-retirement/coverage/1062/coverage/2023/05/26/how-buffetts-secret-sauce-could-pay-for-your-retir/ Dividend Knights list: https://docs.google.com/spreadsheets/u/1/d/1-OPCz9pXOcgFqmbMR3wxREg4O7ws_qWW8RWqKPYn1D4/edit#gid=0 Host: Ricky Mulvey Guests: Jim Gillies, Robert Brokamp, Matt Argersinger Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hilliard. Walgreens takes its medicine and you're listening to Motley Fool Money. Joining us now in high definition, it's Jim Gillies. Good to hear you and see you. Jim Gillies. It's good to be heard and seen. Walgreens Boot Alliance disappointed investors this morning with its third quarter results, beat revenue expectations, but it slashed earnings guidance. The stock is down about 9%, 10% as of this morning. Jim, why was the market surprised that the pandemic tailwinds have worn off for this company? Honestly, I don't know. They've worn off for everyone else at this point. You think this should have as well been already

embedded in there. But you say that they disappointed investors this morning. As I prepped for this show, I got my first-ever attempt to look at this company ever. I've never really looked at it. My somewhat spicy take is they've been disappointing investors for the last decade. I don't know why they're getting upset this morning. Yeah. I think it's been cut in half over the past five years. That includes the pandemic bounce. Well, now CEO Rosalind Brewer is announcing a transformational cost management program. Jim, maybe that'll get your attention. The company is expecting $800 million in savings over the next year and taking a wide approach to healthcare delivery for growth and primary care, specialty

pharmacy. Are you buying the turnaround story here? I don't think I am. Again, I am not well-versed in this company. I've just spent about an hour and a half looking at some of the things here. But I basically approach this company as I would when I was looking at any other company, if I was going to recommend it in one of the services where I contribute. My starting point here is from the Oracle of Omaha, from Warren Buffett, which is the pithy, turnarounds rarely turn. It doesn't mean they can't, but just that they are uphill battles. In Walgreens Boots Alliance, we have a stock price that's lower than it was a decade ago. Forget the pandemic rise and fall. It's lower than a decade ago. They've demonstrated that this is a company that

can make a lot of cash when it wants to. I'm talking about significantly pre-COVID. In fiscal 18, they have an August fiscal year, so the end of August is when we're talking about here. Fiscal 18, they did about just shy of $7 billion, about $6.9 billion in free cash flow. In the teeth of COVID, compare that to fiscal year 2021, they did about $4.2 billion. Fiscal 22, they did about $2.2 billion. This is going in the wrong direction, Ricky. The last 12 months, the last four quarters, they've been negative. There's been a lot of puts and takes, a lot of acquisitions, some divestitures. But this is a company that's got about $12 billion in debt. Their dividend commitment, the yield today is about 6.7%, 6.8% after the 10% drop in the market.

Dividend commitments about $1.65 billion a year. As I mentioned, they have free cash flow negative over the past four quarters. This is a very squishy thing I look at, but it's something I look at. I looked at the earnings presentation that came along with this morning, and the best word I can use to describe that presentation is busy. They want to impress you with all the things that they've got going on. I remember back in the dimly lit days when you're in school, they would always encourage you to make your PowerPoint presentations simple, two or three or four bullet points, and your words flesh it out. That's not how these presentations are structured. To me, it's exhausting to look at this and it just seems like they want to throw so much at you

that maybe you'll be distracted by the fact that, again, this is a company where the stock price today is lower than it was a decade ago. You best like that dividend because that's all you're going to get for a while. An $800 million cost savings per year that might come to fruition, but you can't spend what you haven't yet delivered. As I mentioned, there's a lot of debt here. I don't imagine that's gotten cheaper over the past 15 months given the interest rate scenario we've been living through. Valuation multiples are essentially also trading at 10-year lows. Some of that you would expect reflecting interest rates going up. I think some of that's probable you can put down to signaling investor disquiet with what's going on here.

I look at the presentation, I look at everything they've given us and I say, don't talk to me about strong quality of earnings, which is one of the things that they actually put in there. This feels like what I like to call a Missouri stock, you got to show me. For the last decade, they just don't look like they've shown anybody anything. So I recognize I'm coming in kind of negative. I wish I wasn't, but I had no incentive to look at this company after today, I don't think. All right. Well, I think we could leave it there, Jim. Let's talk Canada a little bit. Brookfield Reinsurance, which is an arm or as you may describe it as a tentacle of Brookfield Asset Management made a cash-in-stock bid to buy American Equity Investment Lifeholding for

$4.3 billion. It is a cash-in-stock deal. Why does Brookfield, this huge conglomerate, why do they want to pay a hefty premium for this company that sells indexed annuities and life insurance? Well, because it's a pretty great business. I will say, the Brookfield, I do definitely use tentacles as my analogy. With Brookfield, you've got the mothership, which is Brookfield Corporation, ticker BN. Then you've got a host of satellite or tentacles, if you will, one of which is Brookfield Reinsurance, which is BNRE. The structure, they spun that out, I think, in late 2020, but I think they own two-thirds of it or three-quarters of it still. The reason Brookfield does this is so you can choose to invest in which tentacle you

want or you can just invest in the mothership. I own three or four of the Brookfield things at this point and just smile along with them. But this is the reinsurance deal. Reinsurance is already acquired. They already own about 18.5% of AEL as of the most recent proxy. They've been partners for a while. They've been, I think, fairly open or signaling that they'd be open to acquiring the rest of the company. I'm not very surprised by this move. What I think here is interesting, though, is AEL sells indexed annuities. What an indexed annuity is, is it pays out to the annuitant a specific rate based on the performance of an underlying market index, for example, the S&P 500. But the nice part about this is that they don't track the full gain or

loss, there's usually a participation rate. For example, if the participation rate was 80%, just to pick a number, and the annuity is indeed indexed to the S&P 500, if the S&P 500 goes up, say, 10%, the annuitant gets 8%, because 80% of the participation rate times 10 is 8%. rate. There also might be, and I don't know the specifics of AEL's contracts here, but there might also be on some of these things, it might be what's called a rate cap. Let's say the rate cap is 7%. Even if the participation rate says you should get eight, you bump up against the 7% rate cap, so you only get seven. Why do this? Well, I think it's reasonably obvious is that the company selling these annuities can essentially invest the float

coming in from annuitants into index funds. You don't even need a brilliant investment strategy, you just buy index funds, earn the index return and capture the spread between the index return and what you've rate capped and participation rated out to your annuitants. That's just a a fairly simple example at 10%, ask yourself what happens if there's a 25% year in the S&P, like the S&P just goes crazy. So it can be very lucrative. And I think it meshes nicely with Brookfield Reinsurance when they came public. They did a couple of things. They did actually reinsurance on annuities. So it's kind of, they're now taking on both sides of the risk candle here, it looks like to me. Yeah. For the buyer, it can be a very expensive

hedging strategy. Some of them, they'll even pay you an upfront bonus for buying one of those annuities, Jim. I don't know what color flag you want to put on that, but I think it deserves raising one. American Equity had some previous suitors, but for $55 a share, it seems like this one's going through. This morning, the stock was trading around $53, so not a whole lot of room for ARB games here. No. Like I said, because Brookfield Reinsurance is already, I think They're probably the largest shareholder, not named Vanguard or BlackRock, which of course are going to be index. They're just going to be index participants. And Brookfield probably can influence AEL's choice of suitor, shall we say? And I imagine they're going, hey, why not us?

And then for the broader landscape, does this signal anything about mergers and acquisitions to you? I mean, this seems to be a case where finally companies with a lot of dry powder are getting ready to use it. Yeah. I mean, I think through the pandemic, there was some dampening of a lot of mergers, especially I follow a lot of little franchising companies and what have you, or restaurant companies that might like to buy concepts. And there was a really big price disconnect during the pandemic. The sellers wanted the price they would have gotten pre-pandemic and the prospective buyers were like, well, yeah, but the world's shut down. And so, we don't want to pay you that.

And so, a lot of the companies that I follow really kind of just sat on their hands and, you know, just husbanded cash or paid down debt. And so, yeah, I mean, to me, this is yet another example of as the world has reopened as it has, you know, you start seeing companies going shopping. And again, Brookfield makes a lot of deals. and while I don't believe fully that there's no limit to their dry powder, as you call it, they've probably got more dry powder than most, or access to capital, I suppose, is the way we can better frame it. But yeah, I like to see this kind of stuff because this is what Brookfield

does through their various tentacles, so I'm a fan of this one. Hi, Fidelity, Jim Gillies. Good to see you. I appreciate you joining me today. Thank you. Investing doesn't have to be complex, but it usually takes a really long time to see any results. Matt Argersinger joins Robert Brokamp to talk about the power of owning dividend-paying stocks and the fundamentals of owning them. Quick note, Mattie references Bro's recent article a few times. It's called How Buffett's Secret Sauce Could Pay for Your Retirement, and it's available to members of the Motley Fool service, Rule Your Retirement. We'll include a link in the show notes. In the most recent Berkshire Hathaway annual letter, Warren Buffett devoted several paragraphs

to what he called, quote unquote, the secret sauce. A key ingredient in that sauce's recipe was dividends. Buffett wrote that by 1994, Berkshire had invested $1.3 billion in Coca-Cola and the same amount in American Express by 1995. And in those years, Berkshire received dividends worth $75 million from Coke and $41 million from American Express. Now you fast forward to the end of 2022, and the dividends Berkshire received had grown to $704 million from Coke and $302 million from American Express. And while the growth of dividend payouts from those two companies was definitely remarkable, investors in the S&P 500 also did pretty well. So here are the annualized growth rates of the dividends paid by Buffett's two stocks, as well as the dividends from the

S&P 500, compared to inflation since 1994. So, Koch's dividend grew an annualized 8.3% a year, American Express's dividend 7.7%, the S&P 500's dividend 6%, and inflation 2.6%. So, Matt, this may not be surprising to you, since you're the advisor for a dividend-oriented service here at The Motley Fool, but give us your take on the perhaps underappreciated role that dividends play in building long-term wealth. Yes, totally underappreciated, bro. And thanks for having me on the show. I loved your article because also underappreciated, but also maybe a misconception a little bit is Warren Buffett. You know, I think people think Warren Buffett doesn't like dividends because Berkshire Hathaway has never paid a dividend, at least as long as

he's been CEO. And so there's this feeling out there that Buffett just doesn't like dividends, but boy, does he like to invest in dividends. Not just companies that pay dividends, but as your article points out, companies that grow their dividends over time in Coca-Cola and American Express are awesome examples. When that dividend growth exceeds the rate of inflation, especially, that's the secret or the magic sauce to investing. It's something I focus on in our dividend investor service. Dividends are truly magical. If you look at data going back to the early 70s. There's various reports. S&P Global has got some data. Hartford Funds has done a report. You'll learn that companies that not only pay dividends, but grow their dividends

over many years, are really the best-performing stocks. If you look at dividend payers, for example, going back to the early 70s, they've returned about 9.6% per year. That's a full 100 basis points better than the equal-weighted S&P 500. But if you look at dividend growers, especially a couple of examples you gave, those companies have grown by about 10.7% annually on a total return basis, trouncing the rest of the market. By the way, more than double the return of companies that didn't pay a dividend over time. I know Warren Buffett knows this. We know this. It's no surprise that that's where he chooses to invest. It's probably where we should be investing as well. That's surprising because I think over the last several years,

for sure. People have been focusing more on growth stocks. Many of them don't pay dividends. So it's probably surprising that over the long term, companies that are able to generate that type of cash and grow it at a rate that exceeds inflation are actually some of the best stocks to own. Absolutely. It's where I've really, I wouldn't say pivoted, but I've really refocused my own portfolio, really the core of my portfolio around dividend companies, especially dividend growth companies. Okay, so it's nice to get paid by a company you own, but then you have to decide what to do with it, right? And most investors default to automatic reinvestment, which is basically uses the cash to

buy more shares of the dividend payer. And it's really an excellent way to build wealth because you gradually accumulate more shares, which pay you more dividends, which then can be used to buy even more shares and so on. I call it the dividend snowball. And let's illustrate it with some numbers from the DRIP calculator, DRIP standing for Dividend Reinvestment Plan, calculator found at dividendchannel.com. Let's say you invested $10,000 into the SPY, S-P-Y, SPY, as many people call it. You put in that $10,000 at the beginning of 2000, and that would have bought you 68.8 shares. But if you had reinvested the dividends, your share count would have grown to 103.2 as of the end of this May. In other words, you basically grew your share count by about 50%. But over this

period, the quarterly dividend paid by each share of the ETF grew more than fourfold in value. But you have more shares paying that dividend, so the total amount of cash that you receive grew sixfold. All told, your investment grew from $10,000 to $42,787, in large part due to dividend reinvestment. That's the power of automatic dividend reinvestment. But you don't have to do that. You have choices. Matt, what's your take on how people should decide what to do with their dividends? Yes, it's a great topic. I love your dividend snowball idea. The example that always gets me, Bro, is Altria Group. I'm sure you know this, but formerly the Philip Morris Company, and putting aside for a second how we

feel about cigarettes or tobacco, but consider this, if you invested $100 in Altria's stock in 1972, that's just over 50 years ago, that would have turned into $18,000 today. Wow. That's a remarkable turn. However, if you invested that same $100, but reinvested the dividends along the way, that same $100, I still can't believe this, would have turned into $2.8 million. What? Yes, it's mind-blowing. It's remarkable when you think about it too. The rate of smoking has declined almost every year since the mid-60s, when the U.S. Surgeon General made the famous release about the dangers of

cigarette smoking. So, Altria has not been a growth company. It's been far from it. But what it has been able to do is pay a dividend and grow its dividend over time and get that dividend snowball effect that you talk about. Now, imagine finding a company unlike Altria that actually operates a growing business in a growing industry and pays a dividend that grows over time. That would be a dividend snowball. But as to whether to automatically reinvest your dividend, I think there's some real strengths to just doing that, like doing a drip, because it's simple. It just happens without you knowing about it. It takes emotion out of it. It takes decision-making out of the equation because you're not deciding how you need to invest that capital once you get it.

I do that for a portion of my dividend stocks, mostly that I hold in retirement accounts. But personally, in my taxable account especially, I tend to do what Buffett does. I like to let the dividend cash accumulate, and then I pick and choose where to invest. It probably subjects me to more mistakes, but I like being able to target where I think I'm going to get the most growth from each incremental dollar that I invest. I like to get the cash and then deploy it later on. I took an informal survey of the folks who are analysts here at The Motley Fool. What do you do with your dividends? A large portion of them did what you did. So, sometimes automatic reinvest, sometimes be more deliberate with your

dividends. But most of the people actually just automatically reinvest, which I thought was interesting. As for me, I often do it based on where I see valuations. If I think stocks are cheap, I reinvest. If I feel like I want to build up more cash, I just stop reinvesting on most of my stocks, not all of them. Right. Yeah, I think there's merit to being tactical about your investment. Yeah. Okay. So, we've demonstrated that you can use dividend-paying stocks to build up a nice chunk of change. For most people, they're going to want to use that chunk of change to retire. So, you have these stocks that were paying dividends. Now, you could turn off the reinvestment and use those dividends to pay your bills in retirement. But many retirees will say,

I'm not comfortable with too much of my portfolio in stocks because they're so volatile. But to be more accurate, stock prices are volatile. Dividends actually can be remarkably reliable. Consider the dividend history of the S&P 500. Starting in 1958, which was the first full year for the index, there have been only nine calendar years when the dividends paid by the companies in the S&P 500 were lower in one year than they were in the previous year. In other words, they dropped. The average decline across those nine years was just 5.3% in the dividend payouts. That figure skewed by two years when the drop was really significant. In 1959, dividends dropped about 13%. In 2009, dividends dropped about 22%, by far the worst year for dividends

since the 1950s. Most recent drop was just recently, 2021, due to the financial fallout from the pandemic. But even that event, when the global economy partially shut down, it resulted in a decline in payouts of just 2.6%, and they rebounded pretty quickly. Matt, what do you say to people who may be uncomfortable relying on dividend-paying stocks in retirement. I'd say, and just exactly what you just went through, it just shows that dividends are much more reliable. So, you really don't have to worry if you're focused on the income that you're getting rather than the stock price fluctuation. And I just love the data you cited. I think a derivative of that is actually,

you can look at how dividend stocks tend to perform during bear markets. Charles Schwab did a great study looking at every major bear market since the 1970s. And all but one of them in the great financial crisis that you mentioned, the really bad year for dividends. All but one of them, high-yield stocks vastly outperformed. I think the only reason they didn't hold up in the 2007-2009 episode is a lot of those high-yielders going into the crisis were banks or real estate companies. They were hit especially hard. But look at the bear market we had last year, 2022. The S&P 500 on a total return basis fell about 18%. For example, if you look at the Schwab U.S. equity ETF dividend, for example, that's one of the larger, more popular dividend ETFs,

it fell only 3%. Having a good portion of your portfolio, even the core part of your portfolio in dividend stocks, can really make a difference during bear markets and periods of volatility. I don't think you have to worry about having a large exposure there if we're entering a recession or bear market. If you just focus on the income, like you said, that's going to be relatively consistent. That might fall a little bit, but it's not going to fall that much, and it'll probably rebound a lot faster than stocks tend to. Okay. We're talking about all the great things about dividend investing, but like everything in the world of investing, there's always good things that come with the bad. What are some of the drawbacks of dividend investing?

There are a few I can think of. One was the reinvestment risk I cited above. Do you choose to reinvest or not reinvest? If you don't reinvest, you have to make a decision. There's risk to that. If you do reinvest, maybe you're reinvesting dividends in a bad company over time and you're not following it because you're just automatically investing, and that maybe leads you astray. There's also taxes that come into play. If you hold dividend stocks in a taxable account, you do have to pay taxes. Sometimes, popular dividend-paying stocks like real estate investment trusts, REITs, they don't qualify for the lower rate. You're usually paying your marginal tax rate on those dividends. I think the other challenge when it comes to dividend-paying

companies, and this is because of the nature, I think, of the sectors, of the economy they come from, they're going to tend to fall behind and underperform when we have fast-rising bull markets. So, yeah, like you mentioned earlier, just the tech bull run that we had, those growth stocks, right? Well, dividend stocks did kind of underperform during that period of time. In fact, you can take this year as an example, where about six months through 2023, the S&P is up about 15%. The Nasdaq 100 is up around 35%. Most dividend funds and indexes I follow are pretty much flat. I think that can be discouraging if you're an investor. Sometimes, it can cause you to give up and think, I need to start chasing the high flyers, I'm falling behind.

I think that's where the mistake comes in. As we discussed, over time, dividend payers, dividend growers especially, can really work their magic for your portfolio, and you have to stay invested in them over time. I'll highlight a few things relative to what you said. First of all, I think one thing is sector diversification. The dividend payers are in a handful of sectors, generally speaking, and you saw that in 2008. If all you did was focus on dividend payers, you got walloped. You got to pay attention to that. The taxes are definitely an issue while you're working, which is why it's probably better to keep your dividend payers mostly in retirement accounts. When you retire, though, they're

great to have because of that qualified dividend. It's not only inflation-beating income, it's tax advantaged income. That's sort of the opposite side of that coin. But the one thing I think it's important to point out is that dividends aren't a free lunch. It's basically a company selling a piece of itself just in the form of cash. If your company pays out a $100 million dividend, it's basically worthless now. In most cases, the stock price will adjust accordingly. way. So, it's not like it's magical money. It's really what the dividend represents, that it's a company that is consistently generating cash and very comfortable that can grow that cash at a rate that exceeds inflation. That's right. And so, you have to

be aware that, you're right, the dividend is coming out of cash, it's coming out of the company's earnings. So, you want to focus on companies that have long-term competitive advantages, high profit margins, generate lots of cash so that they can continue paying and growing that dividend over time. It does make you need to do that extra analysis to make sure that the company that's paying you the dividend is going to continue paying it. Okay. So we've hopefully gotten the audience curious about dividend investing. How do you find good dividend paying investments? Oh, that's a good question. How much time do we have? It can be hard, but I think one area that investors might be familiar with is if you look at something like

the dividend aristocrats or dividend achievers, companies that have a track record of paying and growing their dividend for many years, in some cases, decades. There's the Dividend Kings, which have remarkably raised their dividend every year for over 50 years. It's still mind-blowing to me. I think there are limitations to that, though. One thing that I've come up with is a concept called the Dividend Knights. It uses a rule of 10. It looks at companies that have paid a dividend for 10 years, grown that dividend by a compound annual rate of at least 10% over 10 years, and maybe most importantly, beaten the market's total return over 10 years. I call them the creme de la creme of dividend

growth companies, fast-growing dividend companies that just consistently have outperformed and beaten the market. There's obviously a lot going right for these companies. Some examples include A.O. Smith, Nike, Prologis, The Home Depot, which probably everyone is familiar with. These are some of the dividend nights out there. For us in our dividend investor service, it's been a great source of ideas as we're trying to home in on the dividend growers but companies that really can stand the test of time. As we started the show off, just really consistently outperforming inflation with their dividends. If you can find those and isolate just a few of those over your investing career, just as we show with, gosh,

with Altria as one example, but Coca-Cola, American Express. I'm really trying to find those dividend growers of the future right there. As always, people on the program may own stocks mentioned in The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow.