The Dividend Cafe - Freedom Tree Planted in the Soil of Ideas

Episode Date: July 2, 2019

Topics discussed: A Pregnant Pause in the Trade Tirade Dividend Cafe; How it All Began Emerging Markets equals Earnings Growth Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. on Wednesday, a special day because of the 4th of July holiday. And we understand that people are going to be breaking away for a long weekend and are not going to want to hear my voice about anything, let alone about high yield bond spreads and quantitative tightening and things of that nature. So certainly we get that and appreciate it. And we hope that bringing you the podcast a couple of days early helps you. Okay, in terms of our agenda today, we are going to be talking about quite a few things. A really refreshing reminder on our underlying dividend growth philosophy, a substantial recap on the Trump-China truce, latest from the Federal Reserve, and

a whole lot of other things I'm really excited for you to consume here in the Dividend Cafe. Let's start with that G20 meeting between President Trump and President Xi, where the script was basically followed precisely as we would have anticipated. It really did result in essentially the best possible outcome for investors. And when I say possible, I mean what was actually in the cards for this meeting. It was really never going to produce finality or ultimate clarity. That was not really on the table. But I think that the brief talk went well enough that, look, they are suspending additional

tariffs. They put a pause on the new $300 billion of what was largely consumer products that were going to be tariffed, as previously threatened by the president. And they agreed, China, that is, agreed to large purchases of American agricultural products. And we don't know the details of that, but they at least have signaled a willingness to increase that as these negotiations continue. And the Hawaii ban has been temporarily lifted, which I think has a lot of implications on the technology supply chain. So by all practical definitions, we're talking about a ceasefire, but not yet a resolution. The prior tariffs, of course, continue, unfortunately, but no new tariffs are being imposed yet. The investor takeaway, I think, needs to be obvious. If you look back to the Buenos Aires meeting last December, declarations of progress and

unity are good, and they're better than the alternative of escalating tariffs. But we're obviously at risk of a quick and unexpected reversal at any point. For until a deal is done, and we really do not know what gaps still exist in the negotiations, the macro risk of uncertainty cannot be taken lightly. In fact, if one believes that the ultimate deal will only happen when pain reaches a point that forces one or both parties to get a deal done, you could argue that truces and pauses merely delay the pain that may prove necessary to create finality. Well, how did the market respond? It opened up 250 points Monday morning, but not surprisingly, it closed the day up just 100. As I'm recording here

right now, we're kind of flat on the day, up a tiny bit, middle of the day Tuesday, near the end of the day Tuesday. China's market has rallied as well. The Nikkei in Japan has ripped higher. So a good risk on environment. Well, what else needs to be said? There is not a trade deal between the U.S. and China. There have been pauses before that ultimately did not lead to the resolution market participants are waiting for. And our view has been and continues to be that a deal will get done. And that was our view, even at the peak of the uncertainty back in May, but that the timing of finality is totally unknowable. It would be completely reckless to not assume that volatility is still very likely from this

point forward. As if anything, the market expectation is even more vulnerable now to headline risk and setback. Well, get ready for this refrain too. Well, if the Fed was prepared to cut rates as insurance against the trade war, maybe this makes them less likely to cut now. It's a flawed refrain because the Fed's recent talking up of a rate cut never had anything to do with the trade war. It was and is buyers' remorse over the last couple of rate hikes and what they did to credit markets, the liquidity.

Inflation expectations remain well below their target, and that will be the rationale when they go forward with the rate cut, despite the trade war issues seemingly de-escalating. Well, let's recap 2019 real quickly before we go on to our next topic. The first half of 2019 is obviously done. It represented the strongest half of a year performance for the S&P 500 since 1997. And by the way, adding to last year's theme of all-time high phobia, feel free to note that the 33% return of full year 1997, the 28% return of 1998, the 21% return in 1999. So you have a precedent in the past of people wondering if we had reached a peak before we reached a significantly higher peak, to put it mildly. The month of June this year was the strongest June for the S&P since 1955. And it was the strongest June in the Dow since 1938. The bond market, by the way,

has not been left out of the party itself. The index, the bond, what used to be called the Lehman Ag Index, advanced over 5.5% for the first six months of 2019. And that, of course, was led by collapsing interest rates across the term structure. The top performing sectors in the S&P 500 were technology up 27 percent, consumer discretionary up 22 percent, industrials up 21 percent. The worst performing sector was health care, which was still positive over 8 percent, and energy, which was still positive over 8%, and energy, which was still positive over 13%. Look, the Q4 2018 collapse was followed by a V-shaped recovery in Q1 of 2019. And then the May drop in 2019, last month, was followed by a V-shaped recovery in June

of 2019. last month was followed by a V-shaped recovery in June of 2019. So there's a chart to this effect showing two different V's of the S&P 500 at DividendCafe.com. Go check out the chart. You want the visual illustration of the foolishness of market timing. Okay, let me talk Dividend Cafe for a second. The history and philosophy around dividend income. It's very important to a whole lot of things in a macro setting right now. Dividend income was 60% of the return of the stock market from the 1920s all the way into the 1980s. The dividend payout ratio of U.S. stocks, the percentage of earnings that companies pay out as dividends to their shareholders averaged 90% before World War II. It's less than 40% now.

In Japan, it's barely 30%, by the way. In Europe, it's a little over 60%. But with share buybacks, the percentage of capital returned to shareholders, meaning dividends and share buybacks put together, is close to 90%. But that number is heavily skewed by a few facts. that are not actually return to capital shareholders, but more offsetting shares issued via options and restricted shares in executive compensation. So as I go to great length in my book to kind of lay out, share buybacks are not an affront against humanity or a substitute for proper management of a company. Share buybacks are a mode of returning cash to shareholders and they have their place. Companies that want to have cash in the future do not buy back shares

when they should be investing in their own company. That's what people like to say right now in the present political environment. The fact of the matter is they continue investing in their company, capital expenditures, to steward the company that they have. The issue for us, though, is what makes for the best outcome for us as investors in terms of what our own financial needs and goals are, the best way to get there. And in this, I think the

record is abundantly clear. Investors receiving a continual flow of dividends that are growing year by year enjoy not only the mechanical benefit of compounding via reinvested dividends, but they enjoy the consistent, generous, and pragmatic benefits of growing cash flow. And of course, that cash flow can be spent. They reflect underlying companies who have higher quality businesses and business models, And this generally means a lower volatility experience in owning the companies. The macro factors that drive the economy and even the stock market as a whole matter. And we allow them to inform the weightings we give to different asset classes in our client portfolio allocations.

in our client portfolio allocations. But as much as macro factors matter, nothing will ever be more important to an investor than the growth he or she is receiving and the dividends they receive from their investments. That focus ought to alleviate and in fact eliminate the tension one feels in the cycles of macroeconomic news. At the end of macroeconomic news. At the end of the day, we are invested in real companies at the Bonson Group, and those companies need to have business models that continue to perform

even when the macro environment is not favorable. We want to invest in companies that continue growing the income you receive as a percentage of what you paid for the investment year over year over year over year. That forces, excuse me, the forces that create this economic reality, growing free cash flows leading to growing dividends for us, do not move at the speed of light. They do not make headlines. They do not generate clicks. Can you imagine if the leading news headlines in financial media on a given day were, today XYZ company saw all of its employees wake up, go to work, execute on a defensible business plan, ignore their market multiple, and deposit their daily revenues in the bank.

Execution, discipline, patience, avoidance of excessive debt, season management, alignment with shareholders. Well, let's just say these things are not the things that web traffic and Twitter followers are made of. But they absolutely are the things investor success is made of. Follow the dividends. Look at a line of the annual dividend payments received from an investment from a point in time to a future point in time and see what that line looks like. It is less noisy, but more telling. So who does dividend growth work for exactly? Only two types of investors, those who need or want cash flow now and those who will need or want cash flow later. That, my friends, covers everybody. Now, I talked quite a bit about our fundamental principles of dividend growth,

but let me speak a bit of our fundamental principles on emerging markets investing. The currency risk, by the way, in investing in emerging markets, and I should point out that many emerging market investors from 1999 to 2007 would happily refer to it as a currency opportunity, not a risk, because it worked in their favor back then. Well, that currency risk requires some sort of offset to make it all worthwhile. The geopolitical risk is no different, and actually perhaps more consistent. You know, currency goes up and down. Geopolitics is a constantly looming source of risk. But what is the rationale for the currency and geopolitical risk of investing in the emerging markets? Earnings growth, always and forever earnings growth,

tied to the secular theme of a growing middle class in the miracle of evolving free enterprise. This is not an either-or predicament. You do not have to pick if you like earnings growth or demographics. The rationale for emerging markets investment is the earnings growth made possible by the demographic realities. made possible by the demographic realities. To apply a focus on net profit margins, high return on equity, high return on investment capital, to the opportunity set in emerging markets is where we believe the most optimal risk-reward profile exists. We have not had a decade of disappointment in either the earnings story or the demographic story of emerging markets. We've just had a decade in which the currency realities cut into the price benefit of these stories for those denominated in the U.S. dollar.

This is unavoidable and unmistakably transitory. It does warrant a lower allocation to the space than we otherwise may be tempted to have, just from a risk standpoint. But where we can find high-quality growth at prices that support investor returns, we want to be invested. And from telecom to the banking sector, the emerging markets offer multiple opportunities of such. Now, what is our outlook on the U.S. dollar?

I mean, one thing I know to be much harder than predicting stock prices or interest rates or the direction of gold is predicting the movement of any currency, let alone the world's reserve currency that is the U.S. dollar. The shorter the time frame, the more impossible it is. But fundamentally, we do know that with the twin deficits the U.S. runs, a budget deficit that's through the roof and a current account deficit that is about 5% of GDP, you generally should see a weaker currency, not a stronger one. Why has the U.S. dollar bucked this trend? Because we have attracted massive foreign capital to plug those deficits, period. How have we attracted such large amounts of foreign capital to plug those deficits, period. How have we attracted such large amounts of

foreign capital? The normal factors, rule of law, property rights, interest rate differentials. Can this trend continue? Well, sure, in theory, but in practice, the deficits have expanded despite strong economic growth. A hawkish Fed is now churning dovish. It becomes harder and harder to justify a strong dollar in this environment. A flat or choppy dollar has actually been the trend as of late, and that's with nothing good to say about euro or yen for some time. Again, at DividendCafe.com, we have a really interesting chart showing the trend of the U.S. dollar over the last 10 years. And particularly showing, even despite some choppiness up and down, the flat line that has kind of surfaced into the dollar over the last four years. Well, I am going to have to leave it there here for the week.

At DividendCafe.com. We also drive a little bit into the issue of liquidity in the marketplace. The chart of the week is fascinating. It looks at the average PE by decade of stocks and where we are now, but it also does the same thing with bonds and with real estate. And it gives you kind of an ability to look at a valuation across each asset class, decade by decade, to kind of better understand the context in which we're presently investing. I do want to wish everyone a happy 4th of July. It's one of the most conflicting holidays of the year for me in that I absolutely love it. I cherish the country's founding.

And I believe from the bottom of my heart, International Day, to celebrate our independence and the principles on which the American experiment began. And yet, I can't ever shake my dissatisfaction with how many people just treat it as a generic off day, a mere fun occasion, some form of vacation day, devoid of any reflection on the aforementioned realities. The birth of America and the fertile environment our Declaration of Independence gives to the aspirational society are not irrelevant topics to investors. The inalienable rights laid out in the founding documents and the entire concept of the pursuit of happiness provided the very DNA that we are invested in to this day. Free enterprise, the pursuit of a better life, the framework by which great businesses can be created and great innovations achieved. At the end of the day, the investable universe all comes down to the pursuit of happiness. Even if one actually parked all their money in a bank savings account, the interest is only generated because the profits earned from stocks, and even rental

income from real estate. There is no rent money without a profitable endeavor inside the office, warehouse, store, etc. All are a byproduct of the free and open marketplace protected by a government created by the people. The Declaration was a profound statement of an entirely new way of thinking about the human person, that he or she was endowed by their creator with inalienable rights, about the relationship to government, and about the formation of a civil society. Today, we not only invest in a world made possible by the world-changing events of 1776, but we enjoy a political and religious freedom that the world has simply never seen prior to that great day. I do wish everyone a day of barbecue,

picnics, the beach, fun, and rest, but I just wish that all who live out the day to those ends appreciate that when they are enjoying the fruits of a freedom tree planted in the soil of ideas, that they will appreciate that those ideas change the world forever on July 4th, 1776. Thank you for listening to this week's Dividend Cafe. We hope that you will reach out with any questions or comments, and we look forward to coming back to you again next week. with any questions or comments, and we look forward to coming back to you again next week. Thank you for listening to The Dividend Cafe, financial food for thought.

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