The Dividend Cafe - The Dividend Dilemma

Episode Date: March 15, 2024

Today's Post - https://bahnsen.co/3IEE4WR Dividend growth investing is counter-cultural. It goes against the grain of “hot dots” and “shiny objects.” It functions outside the fads and fashions of the moment. And it insists that ancient ideas like “cash flow matters” are still relevant today (amongst many other ideas). It seeks performance and productivity but not popularity. It flows from a belief system and not a crowd. It is, indeed, counter-cultural. It also is not always understood correctly. Several misnomers persist that, if better understood, could jeopardize its counter-cultural status. One of my great fears in life is that dividend growth investing recaptures its status as “the known best way to do equity investing.” All things being equal, if dividend growth investing became a consensus understanding of the masses, I still wouldn’t change my belief system one iota, but I prefer running a portfolio at 15.2x forward earnings when the market is trading at 21x … the “non-shininess” of the strategy adds value. Nevertheless, when it comes to the Dividend Cafe, it is my sworn duty to inform, educate, equip, and edify, so clearing up misnomers is not just allowed but required. If enough people read and adopt the truth, I may have to sacrifice the counter-cultural status of dividend growth, but I’ll know I did the world some good. So today, we shall clear up a couple of things and even dig into some recent history. And as is always the case with financial markets, the more you understand the past, the better prepared you will be for the future! Jump on into the Dividend Cafe … Links mentioned in this episode: TheDCToday.com 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 another edition of the Dividend Cafe. It is wonderful to be with you to be able to talk about dividends in the Dividend Cafe. I'm committed to writing about dividend growth investing a minimum of once about dividends in the Dividend Cafe. I'm committed to writing about dividend growth investing a minimum of once a quarter in the Dividend Cafe, but I don't even know why I made that commitment because I'm pretty sure I do that anyways. And very candidly, I'm writing about dividend growth weekly in ways that you may not always see. But a more explicit kind of reaffirmation of certain components of dividend

growth on at least a quarterly basis is something I've kind of committed to. And I think it makes a lot of sense. The particular inspiration today is a desire to talk about a couple objections that may come up every now and then that allow us to hopefully provide you a little bit of education, information about some sort of basic accounting terminology and just a real important conceptual framework for what equity investors are doing and talking about and how public companies work, some basic components of corporate finance that lead to this discussion around dividend growth. And so what I'm going to do is start off by reminding everybody that dividend growth is

not about a company that has profits versus a company that doesn't. It is about a company with profits that is paying it out to you or a portion, I should say, a portion of the dividends out to you in the form of a dividend or not. Now, you could say, well, no, there's other companies that don't make profit. Well, that's true too. And that is a little outside of what our general theme is in public market investment. Venture capital is not only usually pre-earnings companies, but often pre-revenue companies. In the small cap space, not the way we like to invest in it, but certainly like even in the index, and even for publicly traded

companies, there are a significant portion, if you ask me, far too many that don't have positive earnings. There can always be things that happen to even big public companies that represent a shock to earnings. Most of the time when you hear that, not always, most of the time, it's that a company was expected to make a big amount and they made less, or they had a one-time charge to something, or they had grown profits year over year, 10% one year, and then the next year they only grew profits 3%. So not only were they still profitable, but they even grew profits year over year. They just grew them at a lower rate than the year before.

So all of that's different. them at a lower rate than the year before. So all of that's different. We're basically in a debate when it comes to dividend growth. And we take a very countercultural view of this, about what to do with the profits. And so when I talk about companies that, oh, there's this returning cash flow, I sometimes am equivocating because there's two contexts for discussing cashflow. One is the cashflow the company's generating, and the other is the cashflow you as an investor are, or should be, or hopefully, or might be, or we want you to be receiving. And a company's use of cashflow then invites the optionality of a dividend payment. But a company could have positive free cash flow.

It could have earnings, profits that it doesn't pay in dividends. And rather than focus today on companies, instead of paying you some of those profits after tax profits, obviously, to you as dividends, that should companies consider stock buybacks? Should companies consider debt reduction? Should companies consider M&A? I'm going to talk instead about this idea that should companies just consider holding the cash and reinvesting it in other business ideas they have? And that has become this argument generally from very self-interested actors, namely the C-suite themselves, that, hey, why should we return the cash to you? We're going to do better with it than you are. of cash to you, we're going to do better with it than you are. So I want to start with where this argument is 100% right, that the dividend does not create a profit. If a company has $10 of value,

and they then go make a profit of one that gets put into the coffers of the company, that gets put into the coffers of the company, you now have a company worth 11. And if you as an investor have a company worth 10 and it pays you out a cash dividend of one, you as an investor now have a value of 11. 10 plus one in both environments will still equal 11. All we're talking about is whether the company is better off retaining that one or distributing that one, returning, paying a dividend or retaining, holding, reinvesting. Now, listen, I'm being simplistic here because as a general rule of thumb, we have very, very few companies. We do have some, by the way, for good reason, but we have very few companies that have a 100% dividend payout policy. Most of our companies do use some portion of their free cash flow

to buy back stock, to avoid stock dilution that share issuance from executive compensation and employee stock options represents. They have capital expenditure needs, and so they have to reinvest into the business. Sometimes they just want to hold a bit more cash to build the equity value, the balance sheet of the company. So there could be reasons as to what use of cash looks like, but we're not really debating between 42% and 56% right now. And it's rare that you're talking about 100%. We're debating about 0% versus something else. Some dividend that let's say averages about 50% of a payout from the company

earnings versus zero. And the argument for doing zero in this context today is, well, gosh, the company does so much with the money, why not just reinvest? This, again, now forces an equivocation, but not one I'm going to do. An equivocation that you need to understand the difference on. First of all, it is not true that 10 plus 1 and 10 plus 1 both equal 11 in the same practical sense to an investor. A company worth 10 that then has a dollar of profits, it is now on a spreadsheet worth 11 versus the 10 and distributing you one. There is a major difference off the top, which is for a lot of investors, let's call it roughly half. They need the one because they have to live. They have foundations of giving requirements. endowments, have giving requirements.

Pensions have payments to make to retirees. Investors themselves have cash flow needs, whether it be groceries and vacations and grandkids and college tuition and so forth and so on. But then the argument is, okay, but you have 11 the other way too, and you can and so on. But then the argument is, okay, but you have 11 the other way too, and you can just sell shares. And public stock markets give you the ability, the divisibility, the liquidity,

so you can sell shares and get the one. And what is the problem with that? Obviously, your stock does not stay at 10. Sentiment goes up and down. And someone who has a recurring cash flow need that is not getting it in recurring dividend payment, when it's being paid to you in the form of this profit distribution, they're not lowering the value of the company because it's coming from profits of the company and it is periodic let's say it's monthly or quarterly in line with the spending need of the investor then the um uh value being distributed is never at risk of being withdrawn in a negative context it can only be a positive context. But somebody withdrawing and selling shares

can't do so with any consistency or periodic benefit. And you go well, wait, we Yeah, but I want to reinvest in the value of the business because they're they're doing such great things. And look how the shares are going up. This is the equivocation of all for that. It's exactly what I do with my dividends. Reinvest them in the accumulation. I take fruit that comes from a tree and buy more trees with the fruit from the tree. And it's akin to, I've used this example, I think for 15 years now of someone getting rent checks from apartment buildings and then buying more apartment buildings with the rent checks. It's miniature compounding.

But why someone can't just live off of selling the shares systematically is that we started with an analogy of a business value and a profit, but the share prices you're selling don't function in line with the profits. They go up and down second by second. The profits didn't change of a particular business in the last 20 minutes since I started recording, but the share prices do. And what is one of the biggest drivers of day-to-day movements in the stock market that we're now talking about attaching to a checking account function for investors? Sentiment. Sentiment goes up and down all the time. Dividends only go up. So 10 plus 1 and 10 plus 1 are not the same in this case. In one case, you subject yourself to the possibility of needing 1 but having to have 11 be 8 or 9 when you get it. And then you've negatively compounded,

you've permanently eroded your base. The other example, the value of the 10 goes up and down, but you don't compound it because you don't sell it because you hold it and immunize yourself from the silly volatility around it. Meanwhile, you're receiving the one. So this is not the same thing. The investor mechanics are entirely different. But I would point out there's also a huge difference between the type of company that can pay a dividend quarterly and a company that can't. Some might have good profits, but they're highly lumpy, highly cyclical, sometimes speculative. So there is a benefit to investors when a company can periodically pay dividends in that kind of systematic and consistent and growing fashion, you are getting an insight into the company. So two companies are going to make

a billion dollars of profit. One of them is just regularly like clockwork distributing $250 million a quarter. And one of them is not, there'swork distributing $250 million a quarter. And one of them is not. There's a very good chance it's not the same thing. Now, the other company not distributing might be wildly more profitable. A few of the most profitable companies ever, not dividend payers. But I'm talking about the general financial and economic rules here, that there is a benefit across a diversified portfolio of the category or quality of companies that can do it. And no matter what company you're talking about, the investor needs become a big issue. And then I would point out finally, in this category of why the two things are not equal,

that the math of investor returns becomes entirely different around such volatility. When about half of your return is coming from something that never goes down versus about 90% of your return coming from something that almost every year goes down 10 to 15%. And at multiple times throughout history goes down 50%. And that regularly is averaged 20% drawdowns every four or five years. It's been a little less than that lately, but that's still the average for 60, 70 years. And on a very consistent basis, averages a 10 to 15% drawdown. 2000, 2002 seems like a long time ago. It was in some of the earlier years of my professional money management career. But you had a three-year period of negative returns in the S&P 500.

1974, 75, which were the first two years I was here on planet Earth, you had negative years. years I was here on planet earth, you had negative years. Even apart from I think it's something like nine times since that you had one year of negative return, a two to three year period of drawing down to sell your profits when the share prices are lower, but the companies were profitable and you're selling a piece to get what you need for your living expenses or whatever the investment cashflow need is, that erodes value quickly and violently. If we don't have long bear markets, it still does it in the middle of a good year because in a good year, the market is average 10, it's actually 14% average drawdown, average 10, it's actually 14% average drawdown, including in the years in which markets are positive. So this smoothing of profits that dividends represent matter in every practical and mathematical sense imaginable. But then finally, it is the underlying issue of okay,

well, apart from investor mechanics, let's just get to that investor who doesn't need the cash flow. from investor mechanics. Let's just get to that investor who doesn't need the cash flow. Again, those of us who are accumulating net worth and do not require fruit from the tree of our investment portfolio. First of all, if you just believe in what the underlying company is doing, the profit engine that is creating the dividends can be automatically reinvested into with the automatic reinvestment of the dividends. That not only can be done, it is what's done. It's what almost always should be done. And so that mechanical option of reinvestment that then makes a benefit, it's a curse to withdraw in downside volatility. It's a benefit to reinvest in downside volatility. So dividend reinvestment is already available.

But the equivocation I spoke about a moment ago is that we're not talking about reinvesting in the shares of the company. Hey, reinvest in our company. We're going to do great. Look how high our returns have been. You can do that now. We're talking about within the company,

what they do with the profits of the company. They're not buying their own shares always. Historically, share buybacks, when they are doing it, are either just simply offsetting dilution from employee compensation, or there's a gazillion examples of being done at rather elevated amount of periods in the stock price. But the idea is, well, we can reinvest in new business ventures. If the underlying business they do that generates the profits, think of an oil and gas

company or real estate company or industrial company or utility company that has high CapEx need. They need some of the profits they're generating to continue feeding the capital expenditures that drive the tree generation, which creates the fruit production. I'm all for it. Reinvestment of some dividends into CapEx as a means of sustaining a growing business makes sense. But above the CapEx needs, because no company needs 100% of their profits to invest in capital expenditures to then try to do something else that is only going to be profitable to the extent that all profits are turned around and put back into CapEx, rinse and repeat. That's a Ponzi scheme. At some point, there has to be a real free cash flow. And talking about new ventures, so there's the profitable activity of the company that is generating the profits from which the dividends can either be paid or not paid.

Versus saying, well, we want to not pay some of those profits or any of the profits to you because we want to now go into this other business line. The business line that was making the first batch of profits is already on the table. Now you can say, well, there's new products. Great. Okay. You guys are pretty good at consumer marketing.

Go make some more consumer products, certain technological things. But did we forfeit the law of marginal utility when we came up with this idea that all of these C-suites have infinite amounts of reinvestment opportunity from their own profit-making activities that are equally return oriented as the original activity. If there is no diminishing return to the next idea, the next idea, then why were they doing that idea to begin with? So if a company is really profitable, selling peanut butter, and then they say, Well, now we want to

go into this other deal, it's even better peanut butter, why didn't they do the other deal before peanut butter? I just made that up right now. I don't even know why peanut butter was my example, but I think you get the idea. A lot of companies can generate a lot of ideas and continue making more and more money off of it. So I'm all for it. I'm talking about a company already at scale, already at business maturation. There's a diminishing return because that's called the law of marginal utility. At some point, it starts diminishing. And the testimony in history is clear that it's not just that there's less good ideas on your 450th idea than there was on your first and second idea. It's also that empirically, companies end up doing dumb things over time, that in their pursuit of the next big thing to sustain their power, their access to bonus pool, their access to the capital base of the company that is now built up from the retained earnings they did not pay out to shareholders, that they end up misallocating capital. And

sometimes they don't, sometimes they can get things right. But the core competency of the company, we're not questioning. That's what generated the profits from which we're now having a discussion about what to do with the profits. The dividends come from the profits, the profits come from the company itself. And we're talking about what is needed to feel new profit-making ideas. And what I'm suggesting is that that number is finite. Those ideas are finite. They might be high and heavy, in which case you want a lot of money being able to go back into the company. But the notion that 100% should and 100% always should is arrogance and it's ignorance. And it destroys value over time. I think that at the end of the day, investors do not want companies to retain all the earnings they generate because profits are often needed for some purpose other than reinvestment.

Investors often need cash flow. And when that isn't needed, investors have the ability to reinvest in shares of the underlying company and accumulate over time. And companies don't want, investors don't want companies to hold all profits forever because they want to mitigate their risk. They want to monetize their investment. And they want to learn from the lessons of history that companies through time end up misallocating capital. There is a discipline that comes from rewarding your shareholders for the risk they're taking. Something has to be done with capital. The question is what, and perpetually having the company reallocate is either playing a fire

to eventually you get to a point where they do something very ill-advised um or you you and out of that you create a really bad incentive structure in my opinion for the management of company assets but it ignores the practicality and logistics of investor needs. You can't eat retained earnings. You can eat distributed profits. And where you don't need to eat from your portfolio, you can reinvest. But the discipline that comes from this alignment between shareholders and management is why I believe the notion of companies retaining 100% of earnings perpetually is perverse. And the right structure for corporate finance is healthy and hefty dividend repayments to shareholders who took risk in acquiring the

equity of the company. Little corporate finance, little practicality, little reaffirmation of the dividend growth philosophy here at the Bonson Group. If you have any questions, reach out. We'd love to unpack these things more. And in the meantime, have a wonderful weekend. I think you know where we are here in this time of year. And now we are going into March Madness, and that is not a description about the stock market necessarily, but rather the greatest sporting event on our calendar. So good luck and have fun putting your brackets together for all you college basketball fans or just good Americans. We'll enjoy March Madness, and I'll be back with you next week in the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, Madness, and I'll be back with you next week in the Dividend Cafe. Thank you. 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.