The Dividend Cafe - Everything There is to Know about the Stock Market

Episode Date: July 9, 2021

Today I am going to do something an investment manager who writes about investing all the time ought to do more – I am going to talk about the market. Now maybe you think I do that all the time, and you’d be right. But truth be told, my investment writing is very purposely peppered with the stuff I think most matters to investors – behavioral practices, monetary policy, evergreen principles, foundational truths. The markets are to be found in and through all of it, but in Dividend Cafe, I rarely am just saying, “Hey, here’s the skinny on the stock market.” I do plenty of that day by day in the DC Today. What I want to do in the Dividend Cafe today is just look at the overall stock market – why we feel the way we do about it, why most people offering a short-term point of view are totally full of it, and how we view the present environment. I believe you will find these insights counter-cultural, and that ought to pique your interest. DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to this week's Dividend Cafe. I want to welcome you listening to the podcast as well as those of you watching the video sitting here in the New York City office. It was a short week because of the Monday holiday for Independence Day, but it was a very weird week. And I'm about halfway into the market day here on Friday. And it looks like for all this hubbub, we're going to end the week kind

of flat. We had a big down day and then a big up day and then a big down day and now a big up day. And anything could change the next few hours of Friday activity. But the chart sort of looks like a W. And that's what this week has wrought. And so you go enhance volatility. I'm talking about all the things going on day to day in the market in DC today. And the DCtoday.com is where we want people going for daily market action, what went up, what went down, and why, and what the Fed's doing, and public policy,

all those types of things. And here at Dividend Cafe, I want to continue talking about the concepts, the principles, the beliefs, the macroeconomic factors. You could call it higher level stuff, but I think it's extremely important as foundational to understanding everything else that goes on day by day, week by week, and also just stuff that happens inside of our portfolio. But what I want to do today is talk to you about the stock market. And you could say, well, you talk about that all the time. And I do. But I really do believe that the approach I'm taking right now, this is not something I do a lot, where I want to give you kind of our perspective on how we think about investing in the stock market. And one of the reasons that I'm making a distinction between what I'm about to talk about

and what we usually talk about is that I don't believe we invest in the stock market for our clients. As a general rule, when we have exposure to stocks and we have significant exposure, billions of dollars of exposure, my view is that we own things that are called stocks, but I don't view it as the return and the risk coming in the same way it would if someone just said, I'm buying the market. We believe that the risk and return characteristics are a byproduct of the individual companies that make up a portfolio. Now, is there overlap? Is there correlation? Of course there is, and sometimes significantly so. But the distinction is still important because of what I want to try to explain right now, which is that when somebody says, what do you think about the market? almost always mean today, next week, this month, maybe this season and more nebulous timeline around it. If they ever just meant, what do you think of the idea of buying the market long-term

and holding it? I'm actually not against that idea in theory. It's not what we do, but to the extent that one is simply saying, I think across a very wide and diversified, high numerical quantity of companies, that in aggregate, the collective profits of those companies are going to go up over time. So I want to buy it now and then over time later get a higher return from those profits having grown inside that massive basket of stocks. I think that over time, profits of well-run companies go higher. When you put enough together into an index, the winners overcompensate for the various losers, and you can end up doing just fine. However, what goes along with the growth of the profits inside of a market index is the valuation that goes on top of them.

So if the day in which someone says I'm entering in the market, it happens to be trading at a lower valuation and over a long period of time, that valuation goes higher. You're going to get a better return if it's kind of at an average multiple and it goes higher or lower over the years, that's fine. And then you get the profit growth. That's what you're investing in. But if you're entering at a period of very elevated market multiple, you may still end up with a profitable long-term hold. You're going to get this growth of profits over time in your basket of stocks that we call an index. But the return may be lower than historical expectations because you entered at a higher valuation and the math of that has to play out over time. And there's tons of historical precedent for this.

You get above average returns when you enter at a low valuation. You get below average returns when you enter at a higher valuation. But ultimately, the long-term returns, you're trying to just get growth of profits over a long period of time. Fair enough. That is very rarely what anyone means. And they say, what do you think about the market? They're mostly talking about in a shorter timeframe, something that might be more cyclical, might be more seasonal, and ultimately what will move stock markets or will move an index in a period of time that isn't really long term is the multiple.

It's the valuation. And so I think the vast majority of people, their investment plan is actually driven by hoping that valuations go higher. I just don't think most people think of it that way. I don't think most advisors present it that way. But the source of the return is, look, if your profits grow 5% per year and the multiple drops in that time period from 26 to 20, you haven't made any money, right?

The profits went up, but the value on them went down and you get a kind of offset over three, four, five year period. So really, you were looking at a period of time where you're saying, hey, something might be at 15 times and I think it's going to go to 18 times earnings or it might be at 25 times and it's going to go to 18 times earnings, or it might be a 25 times, I think it's going to go to 30. I don't believe valuations are a great tool for market timing, just because I think something might be expensive at a point in time. It doesn't tell me what it's going to do next week or next month. But my point is that we get removed from this question at the Bonson Group because we are agnostic about short-term valuations across a

broad index and that broad index being something we don't own because our investment philosophy is not on trying to get the collective profit growth over a long period of time from a whole bunch of companies. We're really selectively focused on individual companies. So what we think about the market long term is very much positive because of markets long term historical record, and the fact that markets indexes represent free enterprise, they represent a collection of companies that over time, we believe in aggregate winners minus losers are going to equal profit-making enterprises. Yet, we believe that so much of the return comes from multiples, from valuations, things

outside of one's control that we think, and then that factor of entry level becoming so important that for us, we want to focus on what we consider the best and brightest, the very selective companies. In our case, it's anywhere from 20 to 30 is what I've kind of averaged as a portfolio manager for many years now that we think have very defensible businesses, that has a management team that we like and respect, that has the financial metrics that we care about. And again, you know, I'm going here, so I may as well just do it, that are taking their profits and sharing them with us, the shareholders that are providing that reward through the form of an actual compensation that is regimented, it's routine, and it gives us monetization to de-risk our

investment over time. That's what a dividend is. That's what we believe in. So then you say, okay, well, look, your stocks that pay dividends, they have a PE ratio. They most certainly do. When the whole market's PE is going higher, there's a good chance a lot of yours are. Very true. When the whole market's PE goes down, there's a chance yours is going lower. Very true. We're not using that PE ratio as the source of the return. Now, do I happen to believe that our P-E, our multiple valuations may drop less in a period of multiple contraction? Most of the time, not always. I do. I think that's a byproduct of having less cyclical businesses, less levered businesses, more consistent businesses evident in their repetition or free cash flow.

I think there's a lot of reasons to argue that that impact of valuation contraction, of PE contraction, is less felt in our types of companies than in the market at large, most of the time, not always. But even apart from that consideration, the point is that what our objective is, is to buy investable businesses that happen to trade in a public market, have daily liquidity, and yet we're focused on the health and attractiveness of the business itself, not what the PE ratio is evidenced in stock prices. And so it does, by implication, lead to a sort of agnosticism. You could almost call it an apathy as to what overall market movement may be in a month or 90 days.

Now, let's say I can enhance the return of what we're doing with individual companies that are focused on dividend growth and select enterprises that kind of meet our criteria, I can enhance the return of that by having an outlook on the overall market. There's a few problems. My overall market outlook is going to be highly fallible. It will be wrong at times, it'll be right at times, and this is true of everybody else. It will be wrong at times, it will be right at times, and this is true of everybody else. These one week and one month and one quarter periods not only have no direct import to what we're doing, but even indirectly, they're subject to fallibility. But also, not just fallibility in the sense that we all make mistakes in our analysis, our analysis can be spot on and markets may just not care. Markets never seem

to be all that particularly impressed with our IQ, in case you have not noticed. Markets are in the business of humiliating otherwise smart people. What I have tried to do, and this is an act of humility on my part, I mean that. This is a byproduct of being humbled by markets and by reading from others in history who have been humbled by markets that you do not gain an edge by trying to guess. And that's what it is. It is speculation as to what a short-term market movement might be. You can apply a fundamental analysis and say this is what ought to be happening and you can be right, but that doesn't mean it will happen within these shorter term windows. What we believe does always play out through time is the delivery of return that comes from free cash flow generation.

Profit making doesn't always drive all of it. One can capture the return available from profit making through an index. That requires a very long term timeline. And yes, unfortunately, it does require the entry level to be right. And the entry level just cannot be right. You can say, well, stocks were expensive a year ago after COVID kind of went away. And so therefore, what if people had avoided them? And they would have missed out on a ton of return. And yet then on the other hand, those people that did come enter right at March of 2000, and it took them a decade to kind of get back to even.

So you have periods where not entering can be the wrong timing mistake, and entering can be the wrong timing mistake. And that's okay if that's not part of your investment policy. It's okay if it's not what you're needing to happen for your return. But when you're deciding to go index, particularly the lump sum of money, and you're not going to have the capacity to add more to it. So the individual financial planning parameters here matter quite a bit as well. But my point is that the entry level, the PE of a broad market, these things are totally separated from what we're trying to do. So then when someone

says, what's your perspective on the market? I have my long-term perspective I've given you. And in the short term, I have a perspective of humility and agnosticism. Yet I also have plenty I can say about what various headwinds and tailwinds may be. And if someone wants me to comment on the fact that we've lost a little bit of a defensive hedge in monetary policy, that if there is to be this really unexpected disruptive event in risk assets, traditionally we've relied upon the Fed to cut rates or the Fed in more recent years to throw quantitative easing. We don't have access to policy tools.

They've already exhausted. That needs to be factored into one's calculus. I can look and see an economy that is full steam ahead, but it's clearly in a kind of second half of a V-shaped recovery. There's a lot of uncertainty as to what things will be like on the post-COVID run. There is a lot of positive things I could share. a lot of positive things I could share. Primarily, I can make an argument for why U.S. CapEx, U.S. manufacturing, a new renaissance of productivity,

I certainly can make an argument for why it's needed, and I can make a half argument for why it may even actually come. But then we're up against macroeconomic pressures, the debt I talk about so much, the disinflationary pressures that come with that. So in the end, this notion of trying to handicap what the market's going to do in a given week, this is the job of financial media. I don't blame them for it. And if I have to give a short-term opinion on what's going on in the here and now, as long as I don't say, therefore buy, or therefore don't buy, as long as what I'm saying is it's commentary on in the here and now, as long as I don't say, therefore buy or therefore don't buy,

as long as what I'm saying is it's commentary on the economics that largely has to be applied in the context of investment principles. This is the trick. And I think I could have saved the entire podcast by just saying this sentence first. Why would you apply a short-term perspective to a long-term asset? The stock market is not a goal to meet short-term financial needs. I love stocks. I love companies and I love free enterprise as much as anybody you will ever meet in your life. But I don't think that a spending objective someone has in six months should be met with stock market returns between now and then. And the reason is it's gambling. It's silly. You don't have the ability to responsibly price in that risk reward in such short periods of time. These are what we call long duration assets, and they ought to be applied to long duration goals.

What are the long duration goals most people have? It's a periodic stream of income for a period of time. That's where dividend withdrawers, I think, are very natural investors in our worldview. Endowments, pensions, these types of things have long duration. Some people say, no, no, no, I'm buying a boat in six months, and I got X, and I want to have something more than X in six months. What do we do? And this is where the Bonson group will not throw that money into stocks because it doesn't meet the duration characteristics of what we believe about the asset class. It doesn't match properly your goal with the solution. Answering the question, what do you think about the market

right now, is effectively a mismatch of goal and solution. What do we think about the market as it pertains to your financial goals? Well, we believe in a handful of companies, a good portion of which we hope we'll own forever. Some of them, things will change and we'll end up having to exit a position because the facts, the thesis that we're investing in now changes later. That will happen. We favor lower turnover, not higher,

but we react as needed. My point being that we have a long-term perspective on our clients' financial goals and what the needs are and what the way is to get there. And what we think the market will do in the coming months, I just want to constantly remind people, we think markets could at any point correct because markets have throughout history at any point corrected. That's what they do. If people don't know that that can happen, if people say, hey, I want to put my money in now, but I need to know there

won't be a correction in the next three months. You should never, ever, ever, ever, ever, ever, ever invest. Because at any point, if this kind of elevated PE ratio of the S&P at 25 times comes down to 15 times, it doesn't change the fact that in the next three months, something could happen that could make it drop further. So the possibility of imminent correction is always out there. Is it more heightened now than at other points? Well, of course, yeah. Market prices are elevated. There's signs of froth in certain areas of the market, speculation, kind of weird behavior. Overall, the whole market level, not excessively, there's not a ton of euphoria

in terms of equity flows, what I call that taxi driver phenomena, which in the day and age of rideshare is totally obsolete. But for those of us old enough to remember, it was 1997, 98, 99, the so-called taxi drivers giving you dot-com stock tips and that type of stuff. During the housing crisis. There's famous stories of the bartenders buying five condos and things like that. So whatever your metaphor is, to make the point, that type of silliness is not prevalent. It is in isolated pockets. And I talked about what some of those spaces may be. But all that to say, I don't have an opinion that ought to be actionable as to what an investor does in the immediate short term because my goal is to buy companies i believe in that i believe in

regardless of these factors we're talking about that i think i can properly match to a long duration goal that's what we're trying to do that's what i think about the stock market that's what i think about the companies we're buying within it, those great dividend growers that are profit-making enterprises. This is the stuff of human action, my friends. It's the stuff of human flourishing. Thank you for listening to and watching The Dividend Cafe. Reach out with any questions, any time.

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