Falling yields underscore the value that companies which consistently increase dividend payouts offer to equity investors.
Highlights from the 9/11/2019 ClearBridge podcast
The current environment
Jeff Schulze (JS): There's been a monumental shift in U.S. monetary policy over the past year. The Fed has gone from raising interest rates to cutting rates. Even with the stock market near all-time highs, we've seen increased volatility and some meaningful drawdowns, and long-term interest rates have fallen dramatically.
A lot of that is due to recession fears. Is this a slowdown or is this a recession? Do you think rates are going to stay at these levels or move higher from here? And really what's causing this distortion?
Peter Vanderlee (PV): There are certainly fears about the potential for a recession. An inverted yield curve is signaling that there is some stress due to macroeconomic factors, such as the implementation of trade tariffs.
Yet stocks are actually quite well positioned in this environment. Right now, there is over $15 trillion worth of debt with a negative yield. That's unprecedented. Bonds do not provide much income, if any. Stocks do, however, and the dividend yield of the S&P 500 exceeds that of the 10-year Treasury note.
JS: Currently, about 60 percent of the S&P 500 have a dividend yield higher than the 10-year Treasury – and 47 percent had a dividend yield higher than the 30-year Treasury note-- much higher than even during the financial crisis.
PV: That's right. This is unusual. And, with the cost of debt coming down, the overall weighted average cost of capital for corporations is diminishing, and, as a result, the future cash flows are being discounted at a lower discount rate, and that can actually lead to higher prices. From that perspective, stocks are well positioned.
Around 2% GDP growth for our economy is actually quite healthy.
Couple that with the fact that we're not in a recession. In fact, the growth rate is still fairly solid. Around 2% GDP growth for our economy is actually quite healthy. Corporate earnings are poised to grow over time, and, yes, there's risk to the growth rate, but earnings multiples are not necessarily high. So, I think the environment we're in is conducive to being constructive on stocks, notwithstanding the risks.
John Baldi (JB): If you look at the consumer metrics like employment and wage growth, these variables continue to be very strong. Remember, 2/3rds of the U.S. economy is consumer driven. I'm not saying that's a leading indicator, but the financial health of the overall consumer would tend to be supportive of the kind of growth we see today. The risks appear to be on the investment side with respect to businesses, as we weigh the uncertainties surrounding trade.
Dividend stocks in a late-cycle environment
JS: What qualities do you look for in dividend stocks, especially in this late-cycle environment?
PV: We certainly look for quality and by that we typically mean market leadership—i.e. companies that are the #1 or #2 player in their space. We also look for strong balance-sheet companies that generate a lot of free cash flow, companies that have quality management teams in place, that have a proven track record of creating shareholder value over time.
And obviously we look for a very strong dividend profile, in the form of an attractive upfront current yield and the ability to grow that dividend to stream over time.
JS: Dividend growth matters now, because it can help sidestep the lower interest-rate environment that we're seeing with the Fed, right? It's like having a negative duration component, because you're getting a higher income stream at a time that yields are coming down across a lot of different asset classes.
JB: Yes. We focus on a company's ability to grow over time and hence support a profile that would at least protect the dividend stream in an inflationary environment, in a deflationary environment, in a whole host of scenarios.
JS: And if you look at a lot of the research that's come out since 1990—through a lot of different investing environments—dividend growers have provided the best return profile and the lowest volatility profile compared to companies that have not changed their dividend, that have paid no dividend at all, or were dividend cutters.
You talked about the qualities you look for in dividend-payers. What are the risks you try to avoid?
JB: The overarching thing that we avoid from the start is any company with a high payout ratio and a high level of leverage. You can have one or the other, but, in most circumstances, you cannot have both.
Also, we tend to focus on avoiding any material binary risk on an outcome, such as, for example, a biotechnology company whose future hinges upon the successful FDA approval of a certain drug. We also try, from a holistic standpoint, to minimize sector weightings that are reliant upon a single factor risk. For example, the exploration and production sector within energy and its reliance on the price of oil.
Defensive characteristics of dividend stocks
Heading into a downturn, companies with strong balance sheets can make transactions that can drive considerable future value, in a way that weaker firms cannot.
JS: ClearBridge's recession dashboard has moved from green to yellow, signaling caution, but we're not at red quite yet. Besides dividend income, what can dividend stocks offer in the way of defensive characteristics?
JB: It starts with the underlying strength of the balance sheet and the company's ability to weather a downturn. Heading into a downturn, companies with strong balance sheets can make transactions that can drive considerable future value, in a way that weaker firms cannot.
PV: Market leaders with strong balance sheets have typically fared better during downturns. And let's not forget that quality dividend payers continue to pay out even during downturns, and that helps cushion the blow during downturns; it's another measure of downside protection.
JS: Yes, if you look at dividend contribution to total return, during rough market environments, like the 1930s or 2000s, dividends represented close to 100 percent of the contribution to the markets during those timeframes. Plus, a lot of consistent dividend growers can give you much better downside capture.
Balancing income and growth
JS: Let's talk about the growth quality of dividend stocks. How do you balance the need for current income with the need for dividend growth?
PV: Our research has shown that dividend growers tend to outperform over time. And we see dividend growth as very important as it signals that free cash flow is growing, which is ultimately how a company creates wealth for shareholders over time.
Importantly, today we think the prospects for dividend growth remain strong -- payout ratios are still modest by historical standards and balance sheets are in very good shape. But we also look for attractive current income as a counterpoint to dividend growth; we typically favor an overall yield that is 50 to 100 basis points above the S&P 500.
JS: How much room do you think there is for dividend growth at the moment? You know, if you think about payout ratio, it was 90 percent back in the 1930s. Currently, it's around 35 percent. Do you think once we get through the next downturn, buybacks get a little bit more of a bad name, and that that payout ratio could potentially go up with rates being where they are?
PV: Well, payout ratios can go up for the wrong reason, which is earnings decline. Obviously, you need a cushion, which is why having a conservative payout ratio is particularly helpful during downturns, because the dividend is not necessarily at risk. So, we do look at that carefully. We don't like scenarios where payout ratios are very high precisely because during a downturn, if earnings take a hit, the payout ratio may become unsustainably high. That can lead to a dividend cut, which is something we want to avoid like the plague.
That said, if you look at the S&P 500 as a proxy for the market, 35 percent is not historically a very high number. Historically, it's more in the mid-40s to high-40s. So, we're well below historical levels here in terms of payout ratios. Combined with overall healthy balance sheets and abundant free cash flows in corporate America, that tells me that the prospects for continued dividend increases is strong.
You have 76 million baby boomers that need some form of retirement income, and dividends can help them.
Let's not forget that demand for dividends is rising because it is so difficult to get any kind of meaningful income stream. I mentioned over $15 trillion of negative yields in bonds. You have 76 million baby boomers that need some form of retirement income, and dividends can help them.
They also need inflation protection. Yes, inflation is benign at the moment, but it still does erode your principal. Dividend growers can in principle offset the pressure from inflation, and that's exactly what these provide.
JB: There are certain sectors where scrutiny on the sustainability of payout ratios among both investors and regulators has come full circle since the financial crisis. I think about the banking industry as a whole. These companies go through annual stress tests where the Federal Reserve shocks unemployment, shocks economic growth, shocks trading losses and judges these companies' ability to maintain payout ratios at current levels But it's being looked at all over the place. This, to me, is a lesson of the financial crisis that is very beneficial from an investing standpoint.
Stock buybacks versus dividends
JS: Obviously, 2018 saw record buybacks. I believe there was over $800 billion worth of buybacks last year, which is a 50 percent increase versus 2017. We're not on quite that pace in 2019, but it's still a healthy run rate of buybacks.
If you look at buybacks, it was essentially considered a form of market manipulation before 1982. In that year, the SEC came out with a safe harbor for companies to buy back shares under Rule 10B-18. Some more context…between 1927 and 1981, dividend income accounted for 60 percent of the overall annualized returns of common stocks. Since 1982 and the introduction of that rule, it's only about 25 percent of the annualized rate. So, do you think that this is a good use of shareholder capital or do you think that dividends will come back into vogue once we get to the next recession?
PV: In a capital allocation framework there can be room for both. Buybacks make sense when the stock price is depressed but make less sense when the stock price is not particularly compelling. And what we have observed is that the pace of buybacks is high during periods of strong stock market performance, but less so during downturns.
JS: So, the exact opposite of what you're supposed to do.
PV: Exactly. It's akin to buying high and not buying low, which is not particularly helpful. Dividends, on the other hand, are much more stable and companies are loath to cut them as it signals stress in the business. Shareholders depend on dividends being steady, so cutting them is disappointing and companies don't like to disappoint.
Also, I would point out that buybacks can be announced, but not necessarily be executed. So, there is no real commitment in announcing a buyback to follow through. And what we've seen happening also in quite a few cases is that buybacks are not necessarily all what they're cracked up to be from that perspective.
Remember that buybacks are also used to offset dilution from, say, stock option exercises and stock compensation, which is essentially a disguised form of paying employees and management. As such, it's more of a compensation expense and is not necessarily reducing shares outstanding to the degree you would expect. In that sense buybacks is more like dating and dividends is more like marriage.
The Federal Reserve Board (Fed) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price.
Gross Domestic Product (GDP) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The dividend payout ratio is the percentage of earnings paid to shareholders in dividends.
The Food and Drug Administration (FDA or USFDA) is a federal agency of the United States Department of Health and Human Services, one of the United States federal executive departments. The FDA is responsible for protecting and promoting public health through the control and supervision of food safety, tobacco products, dietary supplements, prescription and over-the-counter pharmaceutical drugs (medications), vaccines, biopharmaceuticals, blood transfusions, medical devices, electromagnetic radiation emitting devices (ERED), cosmetics, animal foods & feed and veterinary products.
Rule 10B-18 is a Securities and Exchange Commission (SEC) rule that provides a safe harbor, or reduces liability, for companies and their affiliated purchasers when the company or affiliates repurchase the company's shares of common stock.
The Securities Exchange Commission (SEC) is a government commission created by Congress to regulate the securities markets and protect investors.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.