The Dividend Cafe - What Makes a Good Stock? - TBG Investment Committee - 9/17/19

Episode Date: September 18, 2019

4/5ths of The Bahnsen Group's investment committee tackles this week's outlook on the Fed and interest rates, the dicey situation with Iran and the market's response, and most importantly; What makes a good stock?

Welcome to the Dividend Cafe, financial food for thought. Okay, happy Tuesday, everybody. My name is Daya Parnas from the Bonson Group's Investment Committee. I'm here joined by Robert Graham, Brian Seitel, and Julian Frazzo. Unfortunately, we are missing our Chief Investment Officer, David Bonson, today. He will be missed. We're going to have to figure out how to get through this without him. But fortunately, I have some pretty smart guys around me here, so we should be okay. We're going to split up this podcast into two sections. The first one, it'll just be a general macro update. We're going to go through the Fed meeting tomorrow, the inversion, the 10-year, the oil spiking, energy stocks, how those

have been catching a bid, and what all that means to our portfolios. In the second half, we're going to talk about our stock selection process, how we think about companies, how we define quality, a little bit of cash flow, price. Hopefully it doesn't get too technical and you just get a general insight into our kind of thinking. But to kick it off, we'll start with the first half and we'll go into the Fed meeting. So Fed meeting tomorrow. Julian, what do you think? That's right. Fed meeting finally happening. Actually, the meeting over today. So meeting today.

But what we care about is the rate announcement and the press conference that will be tomorrow. The market expectations have moved dramatically, actually. So as of today, the implied probability of one cut is only 65%, and there's a 35% chance of zero cut. But I guess it's coming pretty late, and I would say that I think it's pretty guaranteed that we get a cut tomorrow. And the reason is that the cost of's pretty guaranteed that we get a cut tomorrow. And the reason is that the cost of disappointing the market would be too high. The Fed doesn't like to do that. So the market is implying one cut.

I think we get one cut. What's more interesting probably will be the language around further cuts will be whether it's a consensus decision or not. Remember the last meeting, there was 100% consensus behind the decision to cut. So it will be interesting more to see what they have to say at the conference, during the conference and in the press release, rather than I think the cut is given. And those probabilities you said have moved. Yeah. Is that primarily... What has caused that? The move is really a reflection of the massive move in, I guess, risk assets.

We came from a period of uncertainty with people thinking about recession, with the trade war, and with the change of dynamic on the trade war and with the change of dynamic on the trade war, they've seen a massive change the last two weeks, basically. The market are back to pretty much all-time high. Volatility is back to 15% from mid-20s. So there's been risk on. And because of that, people are thinking, well, maybe we don't need a cut, actually. Yeah, yeah.

That's what it sounds like. It's interesting because, and David talks about this in the Dividend Cafe, how it's mainly really perception that's driving most of this, even though there hasn't been really a stamped out trade deal or negotiation. It's been kind of just rhetoric. I mean, is that enough to prevent the Fed from easing too much? Well, I think that as the pendulum swings, it sort of goes one way and then the other. I think it was a little overdone probably with 10-year yields in the 140 range. And within a week, just like Julian said, we've got risk back on. Stocks are up 4%. And yields have gone from 145 to 182, something like that today in a matter of a week.

And so markets have spoken, and they're moving in anticipation of some Fed easing and some okay economic data. And so I think you're right. I do think we get a 25 basis point cut. But I don't think it's necessarily needed per se from a fundamental perspective. I think it's almost more on a relative basis to the rest of the world. It's hard not to at this point. The yield curve is still inverted

as far as difference of Fed funds to two-year to 10-year. I mean, twos and tens I think are slightly above. Pretty much equal. How much can they fight it when China's easing considerably the EU as well? So they only have limited options in terms of keeping rates where they are sometimes, right? That's right.

Because the EU last week actually with rates pretty much at zero still managed to cut rates by 10 bps, which is kind of, you know. Right, the basis points on the department, right? Exactly. So you have to look at, you know. Another $20 billion a month too. Exactly. And as you said, the yield curve is still inverted.

So I guess one cut is guaranteed. The question is, do we get another one by the end of the year? I think the market is still implying high probability that we get two cuts. And I think that it will all come down to inflation. Like we've got the ability to kind of look at the data, or at least the Fed does at this point, and say, things aren't so bad here. The rest of the world is easing.

We're behind a little bit. The curve is inverted. Let's go ahead and cut as an insurance policy, that type of thing, to try to keep pace. But they can kind of get away with doing that because there really isn't a whole lot of inflation. And I think if that paradigm starts to change, then they're in a tougher spot. They're not there now. And so that's why I think that you will get a cut tomorrow. And I think probably before the end of the year.

And they're going to be looking at core inflation for the most part too, right? So these oil shocks aren't going to be as much of an impact on it, right? Yeah. And it's picked up a tad. I don't know if you guys saw that data. The core inflation, when Q3 numbers came out. I'm not sure if it's enough to do exactly what you said. So, yeah, I don't see much inflation.

But at the same time, I don't know how the Fed's going to respond. But like you said, I think there's a cut of 25 pips, maybe another cut. And that's pretty much what we've been saying this whole time. Do you think that there's any new information regarding the Fed or the Fed cuts that listeners need to know? What do you guys think? Well, I think it's interesting on the probability on those futures, on the odds. I mean, they were 99% for a 25 basis point cut. Now they're 65, something like that.

So markets are speaking in that way. It's moved a lot. Yeah. I mean, I would say on top of this Iranian, and I know we'll talk about oil, but that probably gives maybe a slight tilt towards going ahead and erring on the side of cutting too to keep pace with what markets are expecting. And then also there's this higher energy price. What about as far as inversion goes? There's a fact that the curve is still flat. I know it's not exactly inverted anymore as far as the 2 to 10 goes.

How is that affecting conversations that, and I'm interested in what Robert and Brian have to say here because they manage a lot of relationships, but is that causing, potentially you get a new client, and I'm making this scenario up, so I'm stumbling a little bit here, but they have a certain risk tolerance and you may need to kind of move them to the higher end of their risk tolerance in order that they may meet their goals. Maybe you're having to put a little more risk on their portfolios.

Are you having a stretch? And if so, what are those conversations like? You know, I don't think we would ever really stretch in regards to a client. I see a lot of the conversation coming inbound about that. You know, there's still a hunger for yield out there, but I think to some extent it could be dangerous to say, okay, you know, you need XYZ in the future, we're going to allocate you beyond what your risk profile would suggest. So I think there's a fine

line there. Now, there's a difference also with that, perhaps, and then talking to someone about having more equity exposure, because on a risk reward basis, equities are probably still preferable to a lot of the more traditionally, asset classes down the road. So I think we have to be careful about that conversation in terms of we're not pushing people past what risk they should be taking for the risk that they want necessarily, but we are making sure that they're taking the right risks in asset classes. Yeah, and I think at the end of the day, it's fundamentals and it's valuations and it's client goals. It's those three things.

And so we position portfolios around those things. Would we go negative or zero in a bond portfolio just because rates are low? We'd probably underweight it. But as far as removing the asset class, I don't think that makes sense for most investors. And it's not something that we would do. But we're cognizant of that. And you have to just kind of set and mute expectations a little bit. Returns in a bond portfolio are just not going to be what they have been so far in 2019. It's been a great year, but expect something lower.

And we'll have high credit quality, we'll have low duration, and we'll take advantage of the situation, and things will change and evolve over time in that market. But yeah, the allocation is massaged around, like we talked about last time, tactical, kind of a tactical overlay on what's going on in the world. But as far as a dramatic sort of all-in, all-out, really timing the market, I don't think that's really what we're about. Right. So more of a portfolio approach is needed. And you're saying, just to summarize, that you're not exactly having to shift on a broad allocation as a response to this current market environment, but it's really about setting the expectations around returns, especially in fixed income.

But obviously you wouldn't want to remove treasuries altogether because there's still that correlation benefit, and it is a flight to safety asset class. Sure, yeah. Yeah, very much so. Yeah, I couldn't agree more. Portfolio approach, that we are in the communications business and trying to communicate what we do to our clients is just as important as knowing what to do. As far as, so what about oil? Moving on to oil spike.

That kind of snapped eight days. Supply disruption in history maybe, right? They're saying 5.7. I mean, that's amazing. I mean, beyond the sophistication of those attacks, I'm not an expert in that kind of thing, but they hit the Saudis at exactly the right places. I mean, not giving any credit to them because that's horrible. It's a Malavon.

But, I mean, it's unprecedented. I've never seen anything like that in my lifetime. So it was just the right facility? It seems that way. I mean, I've been trying to dig into exactly what these are. They're refining facilities. Some of these things can take two years to get up and running again or to build from scratch.

I mean, they're very complex types of facilities. It's removal of the sulfur and sulfurite from oil. Yeah. And the market reaction was pretty mild, though, if you look. I mean, the WTI is already back to 58 today. Yeah, that's right. And if you think about who is most impacted, actually, China.

Oh, yeah. China is going to suffer from that much more than U.S. or anyone else because 25% of their oil is coming from Iran, also from Saudi. So I guess probably it's not too big of a concern here. I mean, in some respect, we're kind of winners from this thing. I mean, we can ramp up capacity pretty quickly over here. We're already the largest producer by 3 million a day. I think we're 15, 16 million barrels a day.

So, you know, and a terrible gross overlining, I guess, with the higher prices is that when you produce a lot of the stuff that's selling at a higher price, you know, it's not necessarily a negative thing. Whereas, to your point, importing nations, that's tough. It's a double whammy for China. You're devaluing your currency. Oil is priced in dollars, so there's that. And then also you're importing a bunch of it,

and so it's kind of the double benefit. Remember what happened too recently when we saw some commodity prices in China escalate. We saw pork, soybeans, and then what do they do after those things jumped? They made some concessions with the United States on those, right? So, I mean, if they take the same approach with regards to petroleum products, that could be another victory for the United States. Natural gas exports is one thing notable. I guess the question or the worry we should have is,

is this just a step into, you know, escalation of, you know, more... I can tell you John Bolton's saying, I told you so. He left the White House, and then a day later, they're striking the oil facilities over there. So you kick out the hawk, and you get the wolves coming in. But wouldn't that help the trade talks as far as, wouldn't that kind of put pressure on China to try to make a deal? I think, I don't know if that's a second derivative,

but I guess probably the first thing people would be worried about is like, okay, is the U.S. going to war in the Middle East again? And that could be pretty bad news for the markets, you know, thinking risk off again. This is not priced in a war, I guess, in the Middle East. I think we'd test lows on those yields again if that happened. I hope it doesn't. I don't know. I don't know all of the – there's not enough information to make a call there yet

as far as an escalation with Iran. I think they're still trying to prove definitively if that's where they came from, but I think it looks like it did. So we'll have to see how that unfolds, and we'll be diligent in making sure we're keeping on top of that. So maybe it's a temporary supply shock. Maybe it lasts a little longer, it looks like. When you say – how did oil respond today? Yeah, I mean, it spiked to like low 60s and then it's back down 5% today.

And it's back down a little bit. So, I mean, I guess it looks like the market can take it. Or maybe it's temporary, maybe it can take it. Yeah, so as long as you have more disruption and escalation, you know, and then, I mean, we're still talking about oil in the 60s, you know. We're very talking about the 60s. We're very far from a level where we should be really worried. So it's more, I

think, the risk that we don't know what the Saudis and the U.S. are going to, what the reply is going to be to that, the answer to that. Are you going to retaliate? Do we have to do something? Business as usual. It's not clear yet. Yeah, it's not clear how all the market participants are going to react, all that

interplay. And as far as our energy stocks yesterday, they caught a bit of a bid. Is this the catalyst that they needed? I was happy to see that. Yeah, I mean, it's probably, I don't know if that changed too much in terms of the long term outlook for these stocks. I mean, it's just like they're reacting in sympathy to the oil price moving up in the short term.

But I guess it's been the last few weeks, it's really been more like about risk on. And some of the more cyclical or some of the sectors that have been underperforming lately have done very well. So financials and energy, so two of the sectors we like have outperformed. If you look at this month's XLE index, which is the energy components of the S&Ps of 8%,

the financials are 5%. And that's in the market. That's up, I think, 2%, 2.5%. And that's even before, you know, if you look at the index, the energy index, that was even before this. Yeah, exactly. It was already sort of on a relative basis moving higher.

And I think a lot of what we do and the stuff that we own, those positions in the portfolio, it's again, comes down to valuations and fundamentals. And we like them because they're relative to other sectors. They look cheap and they look attractive. And that thesis has been playing out both with financials and energy. Yeah.

And they're defensive. I mean, it would be great for these stocks to have the whole $100 barrel, but that would be great for these stocks to have the oil at $100 a barrel, but that would be really bad for a lot of other stocks, right? So I guess you want it at the right level for everybody. Yeah, especially, well, you know, on CNBC, they were talking about how airline stocks and any kind of company, it's going to affect different sectors.

Like if oil was at $100 a barrel, I mean, I'm sure different sectors would be impacted differently. So as far as the fundamentals really haven't changed, we still love the fundamentals. It's good that some of these stocks are getting more attention, but it's not something we care about too much. It's too short-term. They'll rebuild.

Aside from some other skirmish or some other escalation that it's hard to really predict, then I think that it's kind of short-term. I'm glad they got a pop this week, but like Julian said, they're already kind of moving back a little lower, and it'll all kind of settle out. And what makes sense from a valuation standpoint? Yeah, yeah, absolutely. Well, I think that about covers it. Anything else macro-related that you think is? I know, obviously, some of these topics we've talked about at some length, but some of them are worth reiteration.

But anything new? Not really. I guess I'm looking forward to the earnings season that's starting in October, like around October 10th. So we're just like a few weeks away now. And that will be interesting to talk about and see how companies are doing, how earnings have developed over the last third quarter

and going into the last quarter of the year. Yeah, that sounds good. Yeah, I agree. We'll get back to some good old-fashioned stock analysis and some fundamental research and get into it maybe next week or two. Speaking of stock analysis, that is the second portion of our talk. So we just wanted to just discuss briefly about how we look at companies, what we consider

a quality company, and maybe we can just go around here. You know, everybody's got qualities in the eye beholder. It's like beauty. How do you look at a company? What do you think is a great company? And then we can move on to talking about price and how to marry that. So I like mature businesses, frankly. I like those that are generating stable cash flows. Maybe something I don't like, because in a lot of meetings, whether it's with corporate clients,

what not, I get questions about random companies, not to name any stocks, but maybe to mention something I don't like. I don't like companies that have a very strong tie-in with a personality or, a personality or a founder in place because I think that can sometimes lead to a little bit of financial sleight of hand, right? So when you're – and nothing against the great, you know, founders of companies of the past and even the present day. But when I see a company that is, you know, releasing reports or they have analysis and it's tied specifically to an individual or a couple founders, that's somewhat or actually significantly a detractor from what the company's actually doing in a lot of places. And, you know, thankfully, none of our holdings have that, what I would call, issue. But that's something that I think people should be wary of. Look at a stock or a company for what it is, not for who's necessarily running it as a

single entity or person. Yeah. Yeah. There's a few names that we can name. But yeah, a lot of those CEOs get a lot of press and some of it isn't great press. And you can think about it as the horse and the jockey

analogy. That's right. If you could pick one, you would probably pick the horse. It's great if the management and the company are on par and both fantastic. But if the management or CEO specifically is getting too much press or has an overwhelming influence on the stock, either through ownership or other means, it might be influencing things in a way that may not be in the shareholder's interest. That's something we would very much

view as a negative. And we've owned companies like that in the past. And again, I'm reluctant to mention names. So, Brian, what do you think about that? No, I mean, for me, and I think for all of us, it comes down to fundamentals. I mean, we're bottom-up guys and gals. So, we're looking at things on the income statement and the balance sheet. We're looking at companies in the financials first and kind of going up from there. And things I like to look at are, you know, growing free cash flow over time. I like to look at the dividend rate and the payout ratio that is being covered, how much money is coming in the front door to how much is actually being paid out to the dividends. I like to look at the growth of that income over time, and I like to see a real commitment for management,

that that's sort of the bread and butter of that business, to kind of grow those cash flows back to clients. And then I like to look at valuations. Where is that company relative to the sector, relative to market in general, relative to its historical multiple, and see if it's expensive or cheap that way. And then on top of that, we would do a sector overlay and some other metrics, too. But it comes from the bottom up.

So we're talking about fundamentals, valuations primarily. Got it. Yeah, some timeless principles there. So you're looking at all those fundamentals. And I'm interested to hear what Julian's going to say in a second, but how do you marry that with price? Do you just look at some PE ratios? Yeah, there's other, but you can look at just the PE ratio and derive whether you think the price that it's currently trading at is expensive or not. You can look at the track record, the history of where that stock has traded from a multiple perspective and a share price perspective and make your judgment there.

I mean, there's dozens and dozens of different ways to look at it, but it all comes down to what's the price and how much is coming in as far as earnings. Yeah, there's a lot of companies on our watch list that we love, but unfortunately the price is a little high and we have triggers set. Where we have to trim. Right, where we have to trim. Yeah, or the other way around. There was a recent example I can think of this week where we love the company, and it's

performed everything that we ever thought it would, and it's fantastic. It's hard to do. It's reluctant to trim, but valuations get to a point where it makes sense. Yeah, risk management dictates exactly that. So, Julian, I know you're itching. Go ahead. Yeah, no, I mean, I was going to say, you know, I guess the ideal company is the one that I guess you want to own

and you feel good, you know, going to sleep owning it, that you're not going to have nightmare about, you know, something happening. So you feel, you know, when it goes against you, when the stock price goes the wrong direction for some reason, you're confident buying more because you're confident of the quality of the asset. And I guess my job, you know, your primary job is really to do this bottom-up analysis. And so I've done that for all the companies we own.

I also do it for some of the companies we'd love to own. And there are some amazing companies that we'd love to own. And you just have to wait for the right price, the right entry point to buy them. So that's part of it as well. There's a lot of nice companies out there that we don't own at the moment because we have to wait for the opportunity to buy them. But I guess the different steps or metrics that I would typically look at,

I mean, I've just put them on the list, but, you know, every time I look at a company, I guess the first thing we look at, is it a leader in its industry? So we want a company that's, you know, that has barrier to entry, that's a strong market share, that's in a dominant position. So that makes it very hard for someone else

to, you know, to come and disrupt the business and hurt the business. So that's, you know, first thing. Then, you know, is it an industry that has tailwind or not? A good example is the tobacco industry. That's an industry that's dying. Do you want to be in that industry? Probably not.

And there's healthcare, medtech. That's an industry that's growing, so it's probably a good industry to be in. That's very important, of course, the industry you're looking at. And then, I guess, competitive advantage. Is it a company that has an install base, scale of operation that make it very hard to replicate for someone, again, to come and disrupt the business? Then about, I guess you mentioned management team.

I guess management team and main shareholders, what you want to make sure is that your interest as a minority shareholder are aligned with the management and with, you know, if there's a majority shareholder. So, like typically like companies that are owned by a government, you know, you have a lot of them in Europe, like they have different agenda, they're not necessarily going to run them for profit for minority shareholders. So that's quite important as well to make sure you have the right alignment of interest. And then I guess you go into the strategy, which is okay, now you have a company that's quite important as well to make sure you have the right alignment of interest. And then I guess you go into the strategy, which is, okay, now you have a company that's doing well, but where are they going? What are they doing with the cash that's generating?

Are they reinvesting in a business to grow? Are they doing M&A? If they do M&A, you have to think about they could use that cash buying back their own stock or reinvesting in a business. So if you do M&A and you take the risk of integrating a business, you want to make sure that it's worth the risk. So it needs to bring you a higher return on investment than you would do otherwise buying your stock or investing in your own business. I think it matters in how much they do, too. There's an M&A component that's fine. If that's the sole way that they're growing, then it's not fine. And I can think of some names that we've talked about quite a bit

there, but M&A when it's strategic and it's creative, makes sense. M&A when that's the only thing they've got to grow the business is probably not something we like. Yeah. Plus you have execution risks. So I guess something that's more like add-on M&As, or I guess we would prefer, or, you know, that, you know know bank uh i guess uh you know they're taking a huge gamble every two years by doubling the size of the business um and and then i guess um you know we look at financial so we're going to balance it which means you know how strong is the company is it going to survive the next downturn you know is it as it goes you know strong cash position not too much leverage? And then into earnings,

understanding earnings, the top line gross driver, earnings driver, and of course, going down from earnings to dividend and free cash flow, which is at the end of the day, what we care about is how much of this earning we're going to see ourselves as equity holders. And I guess when we get all that, finally we get a company that we like, doesn't mean we can't buy it. Then it's about waiting for the right point, entry point to buy it, I guess. Yes, very much so. So that was a bit long,

but I guess this is really what all the steps we have to... No, there's a lot of things that have to come together for us to pull the trigger on a company. Like Julian said, the list is pretty long. And when we're looking for a company, it's very easy to say no. I mean, there's a company I can look at, the balance statement or whatever the financials, the income statement, the negative free cash, or they're, like you said, they're serial acquirers that have no internal way of growing. They have to buy their way to grow a company without staying power. And it's very quick to say no.

But saying yes takes a long process and takes a good amount of time to fully understand the company. And there's a lot of things that have to come together. And there's five of us to agree on it. And there's five of us to agree on it. Yeah, so there's a bit of a process. So there's that. So there's a bit of a process. But I think, well, I'll go ahead and give my version of quality.

And obviously there was a lot covered there, so there's not a lot left out. But I think talking about, you know, Brian was talking about free cash flow growth, making sure the margins are there, making sure the shareholder alignment is there. The company's got to have a competitive advantage. Like Julian said, it's got to have an economic moat. That's a very, very commonly used term. And an economic moat isn't something that is constant. It's always either shrinking or expanding. So you want to make sure that that company, and let's say their moat is created from, I don't know, a number of things, brand equity. You want to make sure that they are making investments in that brand, increasing quality of whatever product they have, either through marketing or efficiency or whatever it may be. That's why the strategy of the management is so important,

understanding the direction they're headed. So, yeah, so I think really understanding the competitive advantage, really understanding the competitive advantage, really understanding the industry structure. I mean, you can have a great company that has a great product, that has a great moat, but the competition through easy capital or whatever it is, is extremely fierce and the industry players are dead set on doing whatever is possible to increase market share. And maybe that's not an industry you want to be a part of when you know prices are going to zero or, you know, given the intensity of competition.

So there's many things that we look at. And at the end of the day, the price has to be right. So there's a lot of companies that we're waiting to buy, like we said, given the price isn't yet there. So we're always looking for bargains. And when we find them, it's a great thing. And we're very happy. And it's a company we're going to hold for a long time. Absolutely. So I think that, is there anything, what do you guys think? Anything you want to add as far as what we look at as far as the company goes? I think we can kind of keep going on and on.

I think we've got the gist of it with Julian's. Don't get me wrong, I'm all for doing that because I love this stuff. Yeah, this might only go on four hours. Needless to say, there's a lot of metrics and a lot of things that we look at. Valuation is a big part of it. Bottom-up stock selection is what we do. We tend to be more of a value investor because of those things, and that would be kind of a general summary.

I guess you could say the result of all this analysis, and we end up owning 30-something stocks, that when the S&P is trading at 70 times P, because we have more defensive, more value stocks, we are lower P. I think our portfolio P is around 13, 14 times P. We have a beta of 0.8, which is, again, lower than the market.

And the dividend yield, that's pretty much twice the dividend yield of the S&P, so generating about 4% yield. And that's a reflection of the type of stocks we like to own while you sleep well at night. So what you're saying is we don't own the index? We don't own the index. We definitely don't own the index.

Very intentional, and I think it comes out with all those numbers. Sleep well at night like that. Stocks that we wouldn't mind holding through practically any environment. Exactly. Survivors. Survivors. Well, I think that about sums it up. Hopefully some listeners got something out of that.

Hopefully it was insightful. David Bonson, if you're out there, we miss you. And we will be doing this weekly. So looking forward to our listeners tuning in next week. So thank you very much. Sounds great. Thank you for listening to the Dividend Cafe, financial food for thought. The Bonson Group is registered with Hightower Securities LLC, a member of FINRA 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.

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