The Dividend Cafe - The Case for Active Dividend Growth

Episode Date: June 1, 2017

The Case for Active Dividend Growth by The Bahnsen Group

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson, Chief Investment Officer and Founding Partner at the Bonson Group. Memorial Day led to a shortened market week and it has not really led to a shortened Dividend Cafe. It is one of the weeks where the podcast version is not going to quite capture the content of the written version because we have an awful lot of charts that I think are really helpful at thedividendcafe.com. However, from a podcast standpoint, we have a lot to say, so listen on and we'll get all our important parts covered. As always, reach out with any questions or comments.

We love hearing from you and happy to address anything else you'd like us to address. No controversy in this part of the stock market. It's a fair and becoming old controversy when it comes to the broad stock market as to when active management is superior to passive index investing, when it is, why it is, what to do about it, etc. But when it comes to the dividend growth orientation that is at the hallmark of what we do at the Bonson Group, consider some of the following realities that point, in our opinion, to the necessity of active management. We do know that dividends are still being paid out as a lower payout ratio of total earnings than historical levels. What we mean by that is there's room for more dividend growth throughout the market. The market is averaged over a long period of time,

roughly about a 49% dividend payout ratio, and we're currently at 42%. Now, that 42% is quite a bit off of the lower levels we've seen over the last 10 years. But all that to say, there's room for growth in how much of earnings is being paid out. And only an active approach, we think, will capture some of that opportunity. We know that dividends are a pivotally important part of a total stock market return, regardless of the price performance in recent years. years of really what's just a handful of non-dividend paying stocks that have really improved the overall averages returns because of how strongly some of these selective names that don't pay dividends have performed. But we have a chart at Dividend Cafe this week that goes through each decade from the 1930s all the way to the decade right now and shows the total price

percentage change where dividends came in and what percentage of total return came from dividends suffice it to say the number is unbelievable dividends representing um basically a 59 percent portion of total return we and that's by the way when they're not reinvested. When you add reinvestment of the dividends, which gets a little more complicated, the number even skyrockets from there. We see the increase in dividends that have been paid out since the financial crisis and the trend line up of total dividend dollars. And as you see, about $400 billion of dividends coming out of the S&P 500, whereas at the bottom of the financial crisis, we were well below $200 billion. So there's an

incredible dividend growth taking place, but we know it isn't coming from the whole market. So selectivity becomes very important. And then a really interesting thing, even as there's this dividend growth taking place, a growth in dividend payout ratio, a growth in dividend dollars, there is not an increase in the number of companies that are paying increasing level of dividends. This is really the great point about selectivity, that we essentially now are four years in where the number of S&P 500 stocks paying a dividend has either gone down or stayed flat, has not moved higher. It's easier to catch companies that are adding or growing a dividend when you are in a recovery

phase, but at this point of the market evolution post-crisis, the active management is just so important. In fact, more than half of the companies that pay a dividend do not even pay a yield that's higher than the 10-year bond yield. It's roughly 57% who pay a dividend that are paying one lower than 2.3%, which is approximately the current 10-year treasury yield. And then we know that since World War II, nothing has grown and been such a better defense against inflation than dividend growth. So actively managing for dividends versus mere passive stock ownership has not just trumped inflation, it has walloped it. Dividends per share of the S&P 500 since World War II are up 65-fold,

where inflation is only up in that period 12-fold. So you have a greater than five-time surpassing of inflation from just the dividend alone, the dividend payment alone out of the index. Fundamentally, dividend growth can not be indexed in the way a broad basket of stocks can because of the dynamic nature of payout ratios, free cash flow growth, management's commitment to dividend growth, and income statement quality really requiring active work. So that becomes our job and why we are such huge proponents, not only of the philosophy of dividend growth investing, but the necessity of actively managing around it.

The slippery truth about oil. I'm old enough to remember 25 whole days ago when oil traded below $44, May 5th to be precise, on fears that the OPEC production freeze may not be renewed in the cartel's May meeting. And we saw the massive move over the next two to three weeks, up 18% in oil from $44 to $52 as the market priced in the reality that supplies were not persisting where rumors had suggested and that the production freeze would in fact be renewed in some sort. So why, you ask, has oil dropped from $52 to just below $50 when the actual OPEC reduction of production did in fact materialize. Well, partially besides the permanent reality of buy the rumor, sell the news, but there also was a real technical

movement as bullish trades had to be unwound. We believe that all technical and trading particulars notwithstanding, fundamentals underlie a bullish context for oil prices, as oil exports from OPEC countries are declining, and when combined with these production cuts will push prices higher or at least sustain them. All of this is, of course, contingent upon demand not softening, and we've seen no evidence of weakening demand at all. Much more relevant than whatever it is CNBC is talking about. We wrote a piece at our marketepicurian.com property this week about the importance of capital structure right now. The underlying points of the piece are more appropriate for Market Epicurian. And for those that are interested in these deeper

dives, please do check it out. But the point I want to make here is the amount of corporate debt outstanding from lower rated corporate borrowers. Now, defaults are quite low, spreads are extremely low, and the size of this debt really does need to be understood as a relative component to the size of the larger economy that we have now, more profitable corporate environment than we have now. However, at the end of the day, the reality is that the total amount of high yield debt, basically from low rated corporate entities, has basically doubled since the financial crisis, since right before the financial crisis.

the financial crisis, since right before the financial crisis. We were sitting at about $650 to $700 billion of total outstanding junk bond debt, and we now are sitting at close to $1.3 trillion. The way all this plays out is unknown, but what we do know is that companies' management of capital structure matters. They're converting from debt to equity, how their earnings hold up to prove robust enough to justify debt levels. These are crucial things, and we're watching them very carefully. Valuations for the long term. One of the major problems with valuation concerns is that there's literally no correlation, none, with valuation concerns is that there's literally no correlation, none, between valuation and short-term market action. Valuations are extremely significant

when it comes to long-term returns, but for those trying to speculate on weekly, monthly, quarterly, and even a yearly outcome, there's no telling when expensive asset classes may simply choose to get more expensive. Another challenge for valuation-conscious investors like us is that there are always a plethora of different valuation metrics to choose from and they do not always tell the same story. We believe that there are three major valuation tools that are superior to the rest and yet each of these right now provide a vastly different story and justifiably so. Consider the metric

of equity valuations relative to bond yields. They suggest stocks are massively undervalued, and clearly this metric has been winning the day for some time. Price-to-earnings ratios, a very traditional one, the market multiple, the PE, suggests that stocks are fairly valued, maybe a little above fair value, not massively undervalued, not massively overvalued, but right there above their range of normal historical level. total size of the US stock market as a percentage of the overall economy. And it would suggest stocks are quite overvalued. We're sitting right now on a Wilshire 5000, an index of 5000 US publicly traded stocks, trading at 128% of the size of the overall economy. Not near its all-time high necessarily, which was back pre-2000 in the biggest dot-com bubble and whatnot, but really dramatically higher than it had been. So all that to say,

history is filled with different valuation metrics telling conflicting stories at different times, but investor sentiment, meaning the contrary indicator of euphoria versus fear, is still the best indicator we have for valuation confirmation. equity withdrawals in our chart of the week and why we are watching with a little trepidation, a little concern around a pickup in the amount of borrowing people are doing out of the equity of their homes again. Like many of you, we're still snake bitten from that sort of horrific period of violent home equity withdrawals that led to the financial crisis. But we're nowhere near that level. There's a chart there that illustrates that. We encourage you to check it out. We leave you this week with a famous quote from Cicero. It is not by strength or speed or swiftness of body the great deeds are done, but by wisdom, character, and sober judgment.

but by wisdom, character, and sober judgment. What we would add to this quote is that we live in an environment where wisdom, character, and sober judgment trade at a discount. We also live in a world where they ought to trade at a significant premium. Whether it be in the high pillars of society, culturally, politically, or otherwise, or in the very specific world of professional advisors to whom we entrust our deepest, darkest parts of our life, medically, financially, etc., there is a need for wisdom, character, and judgment that is impossible to quantify.

We have various theories as to why society is less focused on character than past eras would have understood, but we often feel somewhat handcuffed in our ability to disseminate these value system messages. What we know in our business life is that wisdom creates and a lack of wisdom destroys. Character is the foundation for trust and lack of character leads to instability. And when it comes to sound judgment, experience matters, commitment matters, and sobriety matters. To all these things we work. Thank you for listening to this week's Dividend Cafe. Thank you for listening to the Dividend Cafe, financial food for thought. The Bonson Group is registered with Hightower Securities, LLC, member FINRA, MSRB, and SIPC,

and with Hightower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities, LLC. Advisory services are offered through Hightower Advisors, LLC Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are

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