The Dividend Cafe - First Things and Humility

Episode Date: May 29, 2020

I am constantly challenging myself to get my applications of “first things” right in the investment world, but my principles themselves are not constantly changing. I say that with pride. The challenge that exists for the investment professional who has done the work of developing operative principles is to constantly evaluate their application of said principles, to alter, change, adjust, or modify as needed. And here is the other piece to that: To thoughtfully consider what it would mean to their client’s capital if they were wrong. Investing client funds as if one can not be wrong in investment application/execution/implementation is the height of arrogance. The humility to constantly check one’s work and one’s strategic thinking is a money-saving character trait. Sometimes it gets forced upon you in my business. So this week’s Dividend Cafe focuses on many first principles in investing, and many beliefs we have about executing on our principles. But it also hopefully reflects the humility that is needed in risk management. Links mentioned in this episode: 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. Hello and welcome to this week's Dividend Cafe podcast and some of you watching on video. This is David Bonson. I'm the managing partner and chief investment officer of the Bonson Group, and we're bringing you our weekly Dividend Cafe commentary. And I'm going to do my very best to cover a lot of topics. Because I'm back in the studio in our California office, I feel less time constrained.

I can go on and on and not worry about the Zoom cutting out or the battery dying or my son having to go do schoolwork or something. Now we have like our whole, you know, professional operation back and I can just ramble on. But no, we usually keep these things, you know, in a reasonable amount of time. Although as those who read the full Divin Cafe at our website will see it's a pretty long one. There's a lot of topics we cover, and I'm trying to do more of that. The feedback, by the way, was 100%. When I asked a few weeks ago, people preferred the longer version of dividend cafe or the shorter, and we got, I don't know, 50 responses, all 50 of them saying they liked the longer. And my little theory is that

I waited until the end of dividend cafe to ask for feedback. And so the only people who were reading the request were people that like the longer feedback. And so it's kind of a self-filtering response. But no, the reason that I want the weekly to be a little meatier, a little longer is because it's intended to get into something more than daily market movement or weekly market movement. I mean, I'll talk, I think, in a moment about what happened here in the markets this week. But I'm back, like as we're sitting here right now, it's nine o'clock in the morning Pacific time on a Friday and I'm recording. And so the market is not even halfway done through its Friday trading day. Well, we've been recording after the market closed on Fridays for three months because of the whole intraday market volatility and trying to make this as responsive to market movements as possible.

And certainly COVID in markets every day, that missive, we are purposely publishing after the markets close. It's meant to be a daily recap of things in the health data and the market data and things like that. But Diven Cafe has never been intended to be that and I don't want it to be. I want it to have more of a focus on principles and on bigger picture topics that allow for someone to kind of wrestle with themes and with issues and not so much short-term kind of ad hoc transitory developments. so much short-term kind of ad hoc transitory developments. That issue, that concept of themes, of principles is really what this week's Diven Cafe is kind of centered around in this sense that I believe that everyone has to start off with a worldview.

They have to start off with a set of foundational principles that they develop, and they have to develop it through a process, through time. Myself, I was trained to struggle with issues Socratically, ask question after question after question, and answer those questions to a point that it becomes formative in your life foundation. This is right now not necessarily only true to investment principles or economic principles. I think it is fair in how one wants to think about the world at large. And I credit my late father with a lot of this, but he – well, I guess if I'm being candid, he didn't really give me much of a choice. Like I was, you know, trained to think this way and I'm grateful for that. And so in my life as an investment manager, there's a worldview and there's a set of principles that were formed rigorously and critically over a period of time.

And I first, I guess, would contrast that to a very significant part of the professional investor population that I don't believe has a worldview at all or has formulated a coherent set of principles or macro assumptions by which they go about investing client capital. I think that the bulk – there are people that have a very thoughtful worldview that I think is filled with errors. But I struggle all the time with whether or not I think that's worse than those who have none at all. And I really don't. I suspect that living one's life in any category devoid of a compass is challenging. But I think that in investment management, it's particularly dangerous.

But I guess here's what I would do with that. I don't believe that the hard part is setting those first things, those first principles by which one thinks about the world. I think the hard part is translating that into an implementation to apply the principles into a specific investment plan, decisions, tactics, strategic thinking. And then, of course, in the very granular aspect of our profession, doing so in the context of financial planning, of individual emotions, of tax sensitivity. You know, there's all the kind of customized human things that play into the implementation. And then there's the investment implementation itself that assumes the one is executing properly out of the way that they view the world. And the issue that I'm kind of adding on to this now, the challenge of first principles and the challenge of application is then the challenge of humility, which is the ability

to constantly not second guess one's principles, but to second-guess one's application of those principles, to constantly scrutinize decisions and look for modifications, for adjustments, and for changes. So when I look at some of the topics we're going to talk about today, I'm humbled by the fact, but I'm also burdened by the fact that there is an ongoing need because one's views of the US dollar, one's views of oil, one's views of inflation versus deflation, one's view of long-term interest rates. Those things, how we go about applying investment particulars to some of these categories require humility because there is the, you have to invest with the possibility of being wrong. And I don't worry about investing with the possibility of my

principles being wrong, but I most certainly worry about investing with the possibility of my application of principles being wrong. It's a key distinction. And if I'm making up the number to make a point, but if you think you have a 98% chance of applying your principles correctly and a 2% chance that something could just be missed or skewed or flawed, it's important that you have an understanding of what the consequences would be if the 2% prevails over the 98%. And so that's where humility is in order, but it's also a risk management is in order. And it's a big part of our process. It's something I do feel that we've done well. I think survival is the most important thing for investors, where mistakes can happen that eliminate somebody is very different than the mistakes that happen that impede their growth or set the return

back for a little bit or something like that. You have to be durable. You have to be survivable. So there are issues that are out there right now that one can get wrong. And if they don't have the proper humility, proper construction in how they're applying all these things, they take the risk that would be more existential as opposed to performative. But let me get into this. Louis Gov, one of the great economists in my life and someone I've been reading his research and particularly his father's research, Charles, for many, many, many years.

And GovCal Research is one of the great boutique macroeconomic research firms in the world. Louis is out of Hong Kong. His dad in Paris. And they've been at this for a very long time. But Louis was one of the speakers at this Malden Strategic Investment Conference I was a part of last week. Louis was one of the speakers at this Malden Strategic Investment Conference I was a part of last week. And he gave a talk about the three things right now that have the risks. And he was basing it on his belief that it's not that these three things are going to go wrong or go different, but that there is kind of a really widespread consensus view on all three, and that even if it's only a 1% or 2% chance, to use my prior analogy,

of them going different than people are expecting, should something that the whole entire world is one-sided on believing go the other way, as unlikely as it could be, those consequences tend to be quite severe. I'm not sure I agree that the whole world is on one side of all three of these issues. But my point being that I do think it's warranted to right now when one's not thinking about what the COVID data will be next week or when what state is going to open, what percentage of restaurants next month. You know, all of those things, which, by the way, are very important in the short term. things which, by the way, are very important in the short term. But when we're thinking about the bigger picture of our macroeconomic applications, his three categories were the U.S. dollar, oil prices, and interest rates. It'd be hard to think of three broader, more significant categories in macroeconomics than those three. And the point he was making was that virtually the whole world is on the side of believing that the U.S. dollar can't go down, that it's kind of in this really, really strong vertically upward mobile move.

that there's a supply glut and a demand weakness that is unlikely to go away anytime soon, and that therefore oil prices are stuck at a low range. And then third is interest rates, that everyone is on the side of expecting that rates are very, very low and won't go anywhere but low, that they will stay at least in the short term of the zero bound for a long time and then even longer out the curve that they're going to stay, if not very near zero, then much, much lower than historical ranges. Well, I would argue that on that last one of interest rates, that is probably the consensus view, not 98%, but it's well north of 70% that would believe that, and I'm one of them. And in this case, I think it's incumbent upon me to humbly wonder what my vulnerabilities are in

the portfolio if I'm wrong, if there is a surprise inflation shock that pushes long-term rates higher, what the impact would be, which by the way, the impact would be in certain cases, both positive and negative in our portfolio. But I think it's a valid question. The issue of oil prices, I'm not sure I agree that there is a consensus view. Oil is stuck in the 20s and 30s for a long time. But I certainly am on the side that if whatever that view is, it's wrong. I do believe that oil prices, because of both supply and demand realities, will end up seeing a higher price in the later portion of 2020 into 2021, much of it depending on the scope and shape of the demand recovery. So there's geopolitics that influences it.

There's both US and OPEC and ex-US, ex-OPEC considerations. But my point being that my presumption is if a consensus view exists that oil is staying low, I think that consensus view is very likely wrong. And then on the US dollar, again, I don't know if Louie is right, that the consensus view is that the dollar is going to stay high for a good long time. I certainly agree with him that more people believe that than not. agree with him that more people believe that than not. And to the extent that we're debating long-term whether or not the dollar holds its world reserve currency power and status, I agree that there is a predominance of people who believe it will, and I'm one of them. as a predominance of people who believe it will, and I'm one of them. And I also agree that there is a chance. I would be far more open to being wrong about this and some of the other things, but I base my skepticism of the dollar losing its reserve status around not anything good about the dollar, but everything bad about

everything else. And so it's difficult for me to evaluate alternatives to the US dollar without a palatable alternative. But when you look at these three categories, I suspect that a very high portion of what people are going to get wrong economically in the decade ahead will come down to one of these three things. One's view of the dollar, one's view of oil prices, and one's view of interest rates, particularly that last one. So those are three issues that I'm going to use as a kind of framework for how we think about a lot of things for many years to come. about a lot of things for many years to come. Okay, let me change gears a little here and bring up the issue of dividend selectivity. I have a chart at Dividend Cafe. I'm going to share a data point with you now. Out of the last 46 years, the S&P 500 has paid out a dividend of less than it paid out the year before, one third of the time. And the S&P, I believe right now of its 505 companies has had something in the range of 60,

maybe close to 70 companies that have cut the dividend through the COVID moment. And so there's a lot of press right now and a lot of circulation of this idea that dividend growth is not sustainable. It's not reliable. It's a big concern. And I find it ironic because, in fact, what's going on right now is such a huge reinforcement of dividend growth. It's just a reinforcement of not trying to get dividend growth from the entire world but trying to get it selectively, which is the whole point. world, but trying to get it selectively, which is the whole point. And so you, first of all, have something like the broad market index that is filled with companies that don't pay any dividend and obviously filled with companies whose dividend is itself vulnerable. But then you even have

ETFs or passive index products who are focused only on dividend payers and dividend growers, that even they are only focused on the backward-looking metrics that provided dividend growth and susceptible to forward-looking problems because it is lacking that selectivity and that active approach. So I think that the environment we're in, far from being a warning against the concept of dividend growth, is a really substantial reaffirmation of actively pursued dividend growth. The other theme right now, and again, I'm going to go through a handful of different topics here, so forgive me as I bounce around, but I'm just doing my best to let you listeners get the same coverage of topics that we provide at the Written Dividend Cafe.

I had a huge theme of reflation, which is very different than inflation and obviously totally different than deflation, coming out of the financial crisis, and I'm very much in line with that as we finally get to some economic bottoming in this COVID moment, that the Fed efforts are geared towards reflating, and that you will see that evidenced in risk assets, commodity prices, and a lot of the economic metrics. And in fact, as you look at the last month, you can see it's not just oil prices, which have very unique and particular supply-demand differentials that has moved much higher, which by the way, oil prices are up about 70% from where they were a month ago. And that's all post the insanity and technical breakdowns of the storage and contango of late in the month. I'm saying after those things kind of smoothed out, normalized oil prices are up 70%.

But it's not just oil. Lumber, sugar prices, I believe, are up 70%. But it's not just oil, lumber, sugar prices, I believe, are up 22%, iron ore up 17% or 18%, oat, almost all the agricultural. So whether it be hard commodities, industrial commodities, or food commodities, you see this sort of reflation. And none of these prices are inflating beyond their trendline numbers or their pre-COVID normalized numbers. But as they look to kind of reflate liquidity in the market and as you get some resurgence of economic activity,

lumber being very particular to home building and construction, copper will be right there in industrial production. I think that you will see more of that. And when we look at the oil story, it participates in the United States for 20 years and went through a 15-year period of just a screaming bull market. You had a fair amount of energy infrastructure development in that first 10 years. Mostly, you just had good, stable commodity prices that went higher. But then you had going into shale and fracking, you had this really incredible renaissance of infrastructure investment and great returns for energy sector investors.

And then over the last four or five years behind volatility in the commodity price, various up and down movements in both the supply and demand curves, and of course, financial questioning of the business model of some of the upstream and midstream companies, the energy story has been a bit more volatile. But really, I do think that you, over the next 10 years, have a story that's going to be different than the last 20, but nonetheless quite compelling. And it's going to come down to the cost curves in the business, the cost around the production side of the business, their ability to continue driving marginal profitability. I believe it's entirely possible that the break-even levels for American upstream energy producers are going to come down by $10 a barrel. Now, before you laugh at it, they've come down by more than $10 a barrel over the last 10 years. Technology, efficiency, scale,

efficiencies, scale, operative improvements, also just certain newly discovered basins being more producible and explorable than previously thought. But along with the improvements in cost curve, you do have a dramatically different capital structure in both the upstream and midstream. Unfortunately, out of the COVID moment, you're probably going to see some of that improved capital structure come because of consolidation. You're going to see some of the weaker players go away, either have to have an infusion of new capital, of less volatile capital, meaning more equity, less debt, or I think more likely some consolidation into some of the more well-heeled players. But even on the midstream side, you've seen completely different capital allocation, capital return approaches, not just from COVID, but two, three,

four years before COVID, different structure to incentive distribution rights, a different structure in how the general partners are paid. And you have midstream players that have really optimized a lot of their financial engineering. And so when I look at an improved cost curve and an improved capital structure, looking out over 10 years, I become very optimistic about the space. Now, what are the macro things that could go wrong? Well, the demand side. I don't ever truly believe that global demand for crude oil is really sinking other than when you have a COVID moment that shuts down the entire economy or a recession. But to the extent that folks even have concerns about that as the world seeks more and more renewables, the fact of the matter is that natural gas is the real story here

in American energy. And that the replacement of electricity production out of coal with natty gas, the need to export, the role that liquefied natural gas plays in potentially changing a lot of our economic trade with Russia, with Asia in particular, with Europe in particular. These are major stories that have, I believe, cleaned up a lot of the things that were affecting it negatively over the last several years. And so I look out, recognizing transitory dilemmas and messiness that still exist, getting through some of the leverage, getting through, obviously, this total erosion demand they've gone through. But when I view it as a more secular story or a decade-long story, I believe this American renaissance in energy is alive and well

and very investable if done prudently. Probably no questions that are more on investor minds right now than why the market's been so good. I don't know exactly where market is right now as I'm speaking. When I sat down to talk, the Dow was down 170. It was down about 140 yesterday, but it had been up 1,100 points the two days before that. So let's say we end up finishing the week somewhere around up 800 in a course, by the way, with three to four hours to go in the market. Who knows where we will end up. But we definitely this week, we're flirting with the

higher end of my short term trade trading range expectation. So to the extent it's a very common question, I kind of think it's a really understandable and forgivable one from all investors, regular old people just wondering, gosh, I see this high unemployment. I see the market shut down or economic shutdown. Why is the economy doing so poorly and the stock market doing so well? I think it's very legitimate. I think it's a little less legitimate from people who do this for a living or folks in financial media who kind of know the answer and are either plain dumb or are dumb, I guess. I don't know. Look, number one, there is on a small scale, I'm open to some theory that there's market optimism about a vaccine, about a post-COVID life, about some announcement coming that all of a sudden we've gotten a plan for immunization and no one wants to be caught flat-footed. When you look at the possibilities that exist presently in vaccine treatments, the amount of money resources going into such development, I can understand why some may say, look, we're going to end up with a worldwide

capability of immunity out of a vaccine. Why would we not be invested accordingly in advance of that? I don't think that's the number one thing happening, but I'm willing to concede some allocation of attribution around the optimism of vaccine. But I would kind of put the next two points as a tie as to why markets are behaving the way they're behaving. And one is just simply the economic reopening, that the market is beginning to price in now and has been over the last four to six weeks. Much of what is going to be happening over the last four to six weeks, much of what is going to be happening over the next four to six weeks, which is restaurants that have been closed will be reopening, airports that had seen X in traffic are now going to see five times X. It does not mean

these numbers are going to be good. It just simply means these numbers are going to be better. It just simply means these numbers are going to be better. And the market is beginning to price that in, whether it is in retail and consumer activity or travel or food and beverage, what have you. Economic life, economic activity. So I think greater optimism around some of the reopenings, the fact that where reopenings have been allowed to advance. You look at Denmark, you look at much of Europe, you look at Japan, you then look into the United States or some of the Georgia, Tennessee, certainly Texas, you haven't seen a big pushback in what the reopenings have looked like. And there's a better optimism about economic reopening in conjunction with health reality. But then the other piece that I'd put as an equal tie with it is what, again, we always have called TINA. And I think it is

very important investors understand that people are choosing where to allocate capital between right now a lot of money going to the U.S. stock market and everything else. And they look at cash and say it's going to pay me zero. And they look at short-term bonds and long-term bonds for that matter, and they say it's going to pay me zero. And you can go on and on across different asset classes, but equities have a liquidity and they have a certain opportunity that right now has been more desirable. Are they a little frothy? Have they gotten ahead of themselves short term? I think it's very, very possible. I've said for some time I can see us over the next six months staying somewhere between 22,000 Dow, 26,000 Dow. Even that, I could be wrong on both ends, but I think that you got a big move down in March.

And by the way, that move down, March was the most volatile month in market history. This is our chart of the week this week at Divin Cafe. I think the best way to look at volatility in a practical sense for an investor is the total movement of the market gross in a given period of time. So if it's up one one day and down one the next day, that's two points of movement, right? Where if it's down 0.2 one day and up 0.1 one day, that's only 0.3 movement.

You follow me? and up 0.1 one day, that's only 0.3 movement. You follow me? Okay, the market's total movement in the month of March was 117%. And granted, there were some plus fives and some minus nines. I mean, horrific days. But when you add up the huge violence of the up and down movements day by day, bigger than October 2008, bigger than October 1987 when we had Black Monday, and greater even than the 1929 stock market crash, you had the most volatile month in market history.

market history. And so I believe that the movement higher now was equally robust, very significant, quicker than most would have expected, quicker than we would have expected. And that the range we anticipate now being somewhat flattish as we kind of go up and down around the realities and again, as I've called it now for a couple months, the grind phase of the economic recovery. Now, we do this with corporate bonds helping stocks and I say helping because even as corporate bonds have fully recovered since their March lows behind Federal Reserve support and so forth, you have major publicly traded companies able to access the investment grade bond market now at much lower cost. They've refinanced debt. They've issued new debt. They can put that debt to work in a productive capacity.

They can simply drive better margins in their cost of capital. So it is not like the Fed lending support to corporate bonds isolates the help to the corporate bond market. It generates a real push into peripheral places such as the equities of those companies. You look then into outside the U.S. stock market at the private – we had a big theme for illiquid investments entering 2020. And there was $300 billion of private credit around the time of the financial crisis ending and there's $900 billion now. And that's not counting high-yield debt or bank loans or investment-grade debt, which would make it a multi-trillion dollar universe. But just in the private equity space, you see this massive increase of available capital in middle markets and non-bank lenders that provides a lot of dry

powder. There's $176 billion of dry powder right now in private credit. You got private equity companies that have been sitting on record levels of dry powder, able to go deploy into up and coming companies, distressed companies, new companies, and they can do so with credit available on that side of the balance sheet. So I think that there is both an investable opportunity in the publicly traded private equity companies, the asset managers that are fee-based businesses. But then I also think there's significant opportunity in those products themselves, in a lot of the private credit investments, private equity investments. And that's a big byproduct of the environment we're in. Look, corporate America levered up post-crisis.

There's no question about it. A lot more debt was put on and some of that debt will end up getting liquidated and it will be problematic. But a lot of it is a productive debt that has driven marginal revenue product. It's driven profitability. It's driven innovation. Right now there may be liquidity challenges through an economic slowdown and that's where dry powder comes in and I think that these are really investable opportunities. Short term, I definitely think, and for all I know, as I'm

talking, the president's already doing his presser on whatever is going to be happening with China. Our theory, I lay this out at Diven Cafe today, is number one, there will be some short term bark that will be volatility enhancing in markets. Number two is I actually really don't think there will be real bite until after the election. And number three, I think that long-term, there will be a real strain in U.S.-China relations with American public support. So all three things can be true at once. There will be real strain long term. There will be very little action short term and there will be plenty of talk short term. In Europe, we wait till middle of June. We see a 750 billion euro recovery fund

proposed by the European Commission with the support of France and Germany and the idea of issuing jointly issued debt, effectively a mutualization done under the pretense of being an emergency activity, emergency facility. But again, I think most government emergency provisions have a funny way of becoming permanent facilities very quickly. But a potential total restructuring, total new understanding of the compact in European nations that would have very interesting effect on where they go continentally. So I've gone around the world a bit, covered a lot of our key themes, a lot of different topics. If you feel like it was sort of a kaleidoscope, that there were just too many things covered, let us know. But I think that that's probably more fair for podcast listeners to get a little taste of everything because that's what I'm doing at the Written Divin Cafe.

So appreciate you bearing with me. If you are indeed still listening, we very much appreciate your support. We appreciate any reviews you want to give us and ratings. If you would like to write a review for us and send it, it can be a horrible review or a good review. But if you do any review, send it to us. We will send you a copy of one of my books. You can pick which book you'd like. It'll be a gift from us. But in the meantime, reach out on a much more important basis if you have any questions as to how our first principles and our application of those principles, our humble application,

can be applied for you, how we're applying them for you now. We welcome any questions, any comments, any time. And thank you for listening to the Dividend Cafe. Thank you. in any way be liable for claims and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates.

Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions.