The Dividend Cafe - We're All Ideologues Now

Episode Date: August 21, 2020

This week we look at … • The week that was in the market (and get ready for the final week of August ahead) • Really, truly unpack why dividend growth investing is so important, and why the dividend itself is such a small part of that, and yet such a big part of it • The deflationary nature of debt, and how all that works … A special feature! • Valuations in the stock market, here, and in third world countries • China. Enough said. • The state of the economy (as we do every week) • Politics and Money (as we also do every week, even when it hurts) • … and so much more With our thinking caps on, let’s jump in to the Dividend Cafe! 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. This is David Bonson. I am the Chief Investment Officer at the Bonson Group and I actually am recording in Newport Beach this morning. I'll be flying to New York City tonight, but I'm recording at my house in Newport, not at the office, because I was so deep into my reading and writing this morning that I decided to get this recorded quicker as opposed to later, and there's a good reason for that. I think you're going to

find what we're going to discuss here today a little meatier than normal, but not in a boring or dry way or hard to understand way. I mean, at least I'm hoping that it will help kind of unpack some things that we talk about a lot and explain them and provide a little bit of new information that will give you a better understanding of the whole investment world. And certainly the written version at DividendCafe.com, I think you'll find a really helpful kind of sequence to how to think about a couple major topics. So those two major topics that I address this week are the way we view dividend investing, the way we view the benefits of companies that have a certain strategy or policy around growing the cash flow distribution

they make to us investors, and then the whole entire concept on which the world turns right now of where we are in global debt and where we are going. And you cannot really think of too many things that are in the investment world, certainly in the economic world, that do not one way or the other run into this topic. One looks at the health of various companies. It has everything to do with the indebtedness or lack thereof of those companies,

maybe the profitability of those companies, which intersects with their debt level. But most of the time, people intersects with their debt level. But most of the time, people talk about worrisome debt. They are talking about the country and oftentimes other countries too, global debt. In fact, the irony of it is when we talk about U.S. debt and its very problematic nature, we usually are not talking about what is even a worse debt situation in Japan or in Europe or in other parts of Asia or even within the U.S., not the federal debt, but some of the city and obviously state debt that is frankly on a micro level more mathematically worrisome than even the federal debt. So there isn't really a place to hide

when we talk about the overall debt story. And yet I'm more and more convinced that either investors in their worry about debt don't have an ideology or a framework of understanding to figure out what it means to them as an investor. There's a kind of obvious factor of it just sounds really bad and that becomes enough of a framework. Or perhaps they do have an ideological framework and it's the wrong one. You know, there is a belief that more and more debt can be a very good thing because it then builds up this sort of stimulative effect that then can drive some economic activity.

And what I want to do is be able to help people understand the difference between productive debt and unproductive debt. And so it may seem like I'm all over the place. I'm actually not because these things all intertwine quite a bit. Let me get a few things out of the way because I don't want you listening to the podcast or watching the video to not get some of the basic market things we cover at dividendcafe.com. So as I'm sitting here, the market is flat maybe down a little bit on the week, about a hundred points.

And each day this week, actually it's up or down movement. It looks like we had two or three updates and two or three down days, depending on where we go today, was actually pretty small movement as well. So one of the lesser volatile weeks we've had in quite some time, more or less right around 100 point or less moves each day, resulting in more or less 100-point move on the whole week. So that's pretty healthy and normal, it would seem. Gold is off a few percent on the week. It's off 6% or 7% from recent highs. The bond yields, the 10-year fell down seven basis points this week from 71 to 64. So that pushed treasury prices higher. And i don't think there's anything super significant that yield curve though had been steepening and it definitely flattened a bit

this week uh there is a chart of dividendcafe.com that i think is significant because we still do have this top heavy reality to market indices that does not allow for people to capture the full story although the the stories uh the delta has started to come in a little bit, you still have the top five companies in the S&P 500 up 43% since the beginning of the year and the bottom 495 companies down 3%. Now that was down 6%, so there's been some narrowing of that spread. But at the end of the day, you don't really have the full story of the average stock in the market when these cap-weighted indexes are just so skewed by four or five companies.

Let me stay on the debt theme and come back to some of the stuff I want to say about dividend growth. And I'll explain why I think dividend growth fits in the debt conversation as well. Fundamentally, people need to make a decision in a macro sense, long term, big picture. If they believe the way you would invest a portfolio, if you believe the great concern of the next three, five, and especially 10 years is going to be inflation versus deflation will be different. I do believe dividend growth represents a potential and very effective

antidote to both. But I also believe that deflation is so far and away more likely to be the pandemic, pun intended, that investors deal with versus inflation that some significant mistakes are likely to be made. I would say that a big mistake that could be made is just ignoring the national debt, the growing excessive governmental debt. But I don't think there's a whole lot of people, at least other than politicians, who are doing that. I think that most investors do view the debt rightly as problematic. However, I think that they often are viewing it as problematic in the wrong way or for the wrong

reason. And that's where this distinction I want to make between productive and unproductive debt becomes very important. The truth of the matter is that you get with growing debt a persistent misallocation of resources. It constrains growth because you have to move from productive allocation of capital, its most natural and organic place that capital want to go to, into the servicing of debt. And sometimes that debt can be productive in its use. So a company that borrows money to go out and buy another company that's going to in turn generate even more profits, when that all goes well, that can be a very productive

story. The government though, of course, is not generating debt to create any income. They may be doing so to create income on a national scale, meaning keeping people employed. There may be a social safety net. But at the end of the day, I don't think you're going to find very – you may find people that believe it's sometimes necessary, but you won't find very many people that believe it's ever ideal, that that represents the most optimal allocation of capital. And so when that movement of capital, that redirection of resources takes place, you've moved from a more productive use to a less productive use, and that creates a sort of deflationary challenge.

You often have a vicious cycle take place where because of an event we're worried about, you get deflationary pressures, say COVID or financial crisis, then you counter it with more debt, which then creates more of the same, more of this unproductive use of capital, and it constrains growth. Excessive debt should not necessarily be defined by the nominal or absolute amount of debt. And we know this from the way we view companies themselves. We could very easily, I'm not going to go into individual company names right now, but we could very easily look at hundreds of billions of dollars market cap companies with hundreds of billions of debt market cap companies with hundreds of billions of debt,

but massive corporate profits and massive return on assets and return on equity, and say that that debt is being used productively even when it's a very high level. Look at other companies with much less debt, but that are not generating an income stream from the debt that is leading to a sort of death spiral for the company. Happens all the time. Again, the reason I bring that up is just to make a pretty simple point. It's the level of debt that most people are worried about when it should be the use of debt, the productivity of the debt. And it is that declining productivity of debt that government debt inherently creates. As you get more debt in Japan, America, Europe, et cetera, for any amount of these decades that we've been building up more and more debt, you see what we call the marginal revenue product,

a way of measuring the productivity of the debt just continue to decline. And so it's a diminishing return that creates this deflationary pressure in the economy. Well, I'm sure I've lost some of you by now. I hope not, because this is why it matters. It really puts the burden on us to find companies that are being productive to invest in when the overall country is not being productive. But it also puts the framework and how we think about the national economy and how we think about money supply and how we think about interest rates

to presume a disinflationary environment. And this is where I believe people miss the boat. If you look at money market rates, you look at bond yields, and you assume these things will be coming back higher or will be much higher or will be normalizing, even in this diminishing return of the debt environment that we're in, then you're going to allocate your fixed income portfolio more optimistically than you should. You're going to assume another opportunity is coming for higher yields and coupons

than I would suggest is coming. And yet, if you do presume that we, A, have constricted growth going forward, that makes current productive assets more valuable. but it also makes the stream of cash flows that more stable companies produce more valuable, more likely to persist into the future. And then, of course, it does make the premium you get from a higher dividend yield versus the low yields in the bond market and cash markets that I'm arguing are going to stay low. It makes those not only superior income streams you can get now, but growing income streams in the future much more valuable. Whereas in theory, if one believed that you're going to have this significant inflation and then therefore significant pickup in interest rates, you may say, well, if I wait

it out, I'm going to get really good yields again in the bond market. But of course, the national debt in our country went from well below $10 trillion to well over $20 trillion since the financial crisis. And bond yields have done nothing but go lower and lower and lower, money markets and CDs. There isn't a very rational reason to believe those bond yields are going to come higher but the argument is well maybe they will because inflation will come and of course that doesn't sound very optimistic to me either because even if you're getting more yield more interest income your cost of living is going higher as well but no in fact, that higher interest income is not coming for the

reasons that I'm suggesting to you, that we're in this disinflationary cycle and that the more we understand that as a byproduct of the unproductive use of debt, the more we can then make decisions on a macro and a micro level that will suit the needs of our portfolio. So if right now we want to take a little break and say, yeah, he's right. I, this was very boring, very dry. I didn't understand it. No problem. Shoot me an email and insult this talk. I will not be hurt whatsoever. If on the other hand, you think you're starting to understand it, you want to kind of take a little time with it. All of this is written out in better form, a little more concise, a little more, um, a little more organized at divincafe.com.

But then also shoot me an email, ask to unpack this better because I want to be able to make the connection as to why we're allocating the way we are going forward. Now, when I talk about the inherently unproductive use of government debt, that does not presuppose that all corporate debt is productive. Corporate America is levered up higher as well. My argument is that in some cases, there's zombie companies that are staying alive because they now have a very low cost of debt. And that's not very healthy because, yeah, I guess it's good for those companies and their stakeholders or employees or shareholders to stay in business. stay in business. However, it also represents capital that doesn't get allocated to a more productive place in the economy. So those distortions may seem in the short term to be helpful, but longer term they're not. And this is something that Hazlitt's broken window fallacy

that Bastiat wrote about the 19th century. you have to always remember how important it is in economics to focus on the impact of something on what you can't see just as much as what you can very clearly and visibly see. That, I think, allows for a more intelligent interpretation of the reality on the ground. But beyond the fact that it distorts capital and potentially keeps alive unproductive or suboptimal enterprises versus diverting resources into things that are more productive and more opportunistic.

You also then have to distinguish as an investor where those companies are going to be able to grow cash flows from the debt they've taken on. Because that's the only way to avoid the leverage going higher. You can have higher debt without higher leverage when the debt is productive, when the debt is leading to a growing income stream. Maybe the income stream the debt creates just breaks even. The added debt creates added profits that are equal to the amount of the servicing of the debt. You're running in place. That's neither good nor bad. It can't really last that way forever. At some point, you're going to make a break. But oftentimes, debt can be used to go into something of more productive behavior. And this is, of course, what really optimal private

equity investing is intended to do. It's what a lot of companies, publicly traded companies and their balance sheets, use debt as a vehicle for growth. And they either get it right or they get it wrong. We have to make decisions on the rightness and wrongness of that based on how we see companies treating their capital return to shareholders. And the sustainability of that capital return is very largely dependent on how they're managing that balance sheet. And so this to me, when I look back to the companies in corporate America that have cut dividends in 2020 in response to the

COVID affair, many of them had awful external circumstances take place because of what happened with COVID and they were directly impacted by the shutdown of travel, the lockdowns of the economy, things of that nature. Many were already living on the edge and just on the margin, if you had something tinker with economics growth or the revenues of the business, it forced them to have to cut the dividend because they didn't have the safety, the cushion from either their balance sheet or their income statement. It's always a leverage issue. So when you look at the reliable dividend payers in the S&P this year that ended up cutting their dividends, meaning they were reliable dividend payers in the past that have

now cut, they had something in the range on average of close to three and a half times leverage, the net debt divided by their earnings. But when you look at the companies that sustain their dividend, they've had about half of that on average, in between one and a half and two times leverage. So in that sense, you can say it's not as hard as it looks. Viewing the leverage rates and the cushions that these companies have is the easiest way to evaluate the safety of the ongoing dividend. But of course, when things are really good, that higher level leverage, it becomes very

opportunistic. It is generating higher net income, and that becomes very attractive. generating higher net income, and that becomes very attractive. So having that sort of risk-reward balance, having an understanding of the prudence and wisdom of corporate management, but then also this is where the qualitative part comes in, the cultural commitment to growing the dividend. Will management make decisions that are geared towards preserving the dividend, or does management make decisions that are reckless around the sustenance of the dividend? Not to mention the sustenance of the whole business. not the cause of success. That when a company manages its P&L, it avoids reckless M&A, unproductive use of debt, makes good strategic competitive decisions. They're in a position of greater profits that are reliable, from which they can then go pay more dividends. So everything I talk about with debt, deflation, unproductive, et cetera, is about a vicious cycle. Everything I talk about

in corporate America with a growing dividend and decisions that help feed the dividend that then become a reward us investors get through that profit dividend is about a virtuous cycle. This is the story of finance. You will have virtuous cycles or you will have vicious cycles. And virtuous cycles will end very well and vicious cycles will not. And that to me is the underlying lesson that I want those that invest with the Bonson Group and those that listen to or read the Dividend Cafe to comprehend that we are in the business of creating sustainable virtuous cycles and avoiding vicious cycles.

The great vicious cycle are the debt deflationary sovereign stories in government indebtedness. How we apply that in our worldview into investing going forward will have a lot to do with what investor outcomes are going to be for years to come. So on the shorter-term basis of things, this week the Democrats nominated Joe Biden officially. He gave his acceptance speech in the Democratic Virtual Convention. Next week is the Republican Convention.

Polls remain very similar to where they were in August of 16. Nationally, Hillary Clinton's lead was pretty close around where Joe Biden's lead is. There are some polls that have Biden up four, some that have him up 10, some that have him in between, so an average of about seven points in the national. But then in some of the battleground states, his lead's a little bigger than where Hillary Clinton's was. And so we all are aware of the facts. There's 10 weeks to go. The polls are either wrong or they're right, or they sort of are right on the facts now, but they can change in 10 weeks.

I guess that's probably the best camp an investor should be in, is not assume that they're all wrong polls and not assume that they are currently predictive. Assume that they dictate some facts on the ground now, and yet those facts on the ground could change, and that's why it's difficult. The Senate itself, as I've unpacked individual polling, I put it for you at dividendcafe.com, looks very tight. I really do believe it's going to come down to one or two seats that break the tie on the center of power in the United States Senate for which party will have such power. So that's where things are right now, short term. The election story is going to

be the prominent story going forward. The COVID story I'm writing about in covidandmarkets.com, but it's pretty universally understood now that cases have dramatically declined about half of their peak levels, which is absolutely amazing. Also, not necessarily unexpected from a scientific level. Once you start seeing a wide penetration of infection, you get that greater immunity in the society. There's still pockets where cases are high, hospitalizations are way down, mortalities are way down, but ultimately for economic growth, we're getting much better economic activity, but not full economic activity

for all the reasons you probably already know. Please do read DibbinCafe.com. There's a lot more into it this week. I really enjoyed writing it this week. I enjoy writing it all the time. But as I say from time to time, there's certain weeks that it was particularly special for me, and this is one of them for a variety of reasons so I'm off to New York later tonight and look forward to come back to you next week we're going to continue plugging away on behalf of our clients doing our very best to make prudent decisions in the reality of the world we live in which is right now a disinflationary one suffering through excessive debt and trying to find companies and opportunities that don't to To that end, we work.

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