Welcome to Inside Active podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges, and philosophies and security selection. I'm David Cohne, i lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Michael casper Us, small cap and sector strategist at Bloomberg Intelligence. Mike, thank you for joining me today. Thanks David, So, I want to ask you about equity valuations.
What is the relative appeal of stocks to bonds right now?
Well, if you look at it on an earnings our equity risk premium basis, the equity risk premium for stocks is currently negative. That's the first time since the early two thousands where that situation has existed. What this means for forward returns for the S and P five hundred, By the way, it is very mixed. Historically, There's been two major stretches where the equity risk premium has been negative October nineteen sixty eight through October nineteen seventy three.
In that period, stocks gained about one point one percent annually. The second period, however, from September nineteen eighty through June two thousand and two, there was an annualized about ten percent return for that period. So it's a very mixed situation for stocks. If you quintile or quartile sorry, the equity risk premium. Right now, we're in the second quartel, so the second lowest quartile of equity risk premium experiences
going back to the sixties. That means low single digit returns for the S and P five hundred, So not bad, but below average is how I would categorize it. By the way, if you do remove the MiG seven from the equity risk premium, you still get an overvalued situation for the S and P five hundred, and if you are to go down cap, So if you start looking at the S and P six hundred, the small cap index for the S and P, the equity risk premium
there is also similarly expensive to bond. So anyway slice it right now stocks are looking a bit expensive to bonds.
Okay, great, I think we can hear from our guests today. I'd like to welcome Wellington's Don Kilbright and Peter Fisher to Inside Active. Don and Peter are subadvisors to funds like the Vanguard Dividend Growth Fund ticker vg ig X and the Vanguard International Dividend Growth Fund ticker v I d g X, among others. Don Peter, thanks for joining us, Thanks for having us.
Thank you.
So before we dive into dividends, which is what we're going to be talking about today, i'd love to just get your thoughts, you know, on the question I posed to Mike about just the appeal of stocks right now compared to bonds.
Maybe I'll start and Don can jump in as well. I think valuations, you know, look relatively expensive. I think what the data that Mike gave, you know, reflects that. One of the things is when we think about forward returns given high valuations, it's tempting to say, but we're going to have a low single digit return, which I think is what you would apply from your data.
But it never actually works that way. You know.
Usually it's the market's either up or in some cases, or the market's expensive. It's either it can be down quite a lot. So there's a lot of dispersion in the returns that you can get. And it's periods like this when valuations are highwood you can get really negative market outcomes. The period you name, the late sixties, early seventies was a really tough time, you know for markets going into the to the lows in the early seventies.
So we just have to be aware that that's a you know, an outcome that is within the range of the probability distribution.
Great, that's a good point. And so you know, one question I want to pose at the beginning before we kind of dive into the strategy is with Don retiring, how do you currently work together there? You know, is that do you meet regularly to discuss the portfolios?
We do, so we meet as a team and Don is part of all those conversations. The thing that's changed in the last years I became the lead manager for the Dinner Growth Fund, but Don is very much still a part of the conversation as part of the four to get together and talk about the portfolio. So he will be sorely missed when he leaves at the end of the year by me, especially just we've been working together for a long time and Don's great friend and mentor.
But the team is set up so that Don is just one of those voices in the room and so hopefully we'll.
Be fine with that and when he goes, it's great well, let's actually talk about the dividend funds. What is the process of finding companies? You know, what is a day like for you?
Yeah, so the different growth approach for us, you know, different growth is our north star. We're always looking for companies that can grow their dividends, and they're two key parts of that. The first is does this business create value internally by their own investments to make the business more valuable over time. We think about that as the
value creation engine of the business. And the second piece is does that business return capital in a sustainable and growing way in the form of a growing dividend to shareholders. We're looking for companies to have both of those things. So that's always the thing that we're trying to get our hands around. The dividend growth is the measure that tells us that most accinctly. So when companies can grow their dividends as stainably, it says to us that these
are businesses the compound value. They tend to be a bit less risky than the average company in the market, and so if we can find those companies, then they have a good chance at outperforming the market and doing it with lower risk than the broader market, So that's kind of what we're after. So the day to day
for us is really about visiting with companies. We read a lot, but we also spend a lot of time talking and listening to management teams in our offices and going to visit their headquarters as well, and that's a big part of it putting together the mosaic, trying to understand how is this company going to grow, how's the industry structure that they're facing going to change, get better or worse, and ultimately what is that going.
To mean for the dividend growth of the business.
We think about how fast going to grow the dividend, Then we think about how risky is that, how uncertain is that outcome? And then we think about what's the price opportunity today for that company? And that sort of drives what comes into the portfolio.
Can I if I could add something, I couldn't say it any better, but a little bit of history might be helpful and call that the given in Growth Fund was conceived by Vanguard and the mission at that time when I took it over was to produce dividend income to the fund shareholder at a rate that would in sede inflation. By three, not knowing when inflation was going
to be. Infleation really has been quite low over that period of time, but those were the marching orders, and what has happened over time is we've recognized that that journey produces an insight on stocks that Peter just walked you through. So we started with this notion that this was a mission based portfolio that was designed with a very specific goal in mind, and it has evolved over time and it has opened so many new doors for
us in terms of compounding. So what Peter just described to you wasn't exactly where we started, but that's certainly where we are.
So you mentioned dipend growth being your north star, your main metric that you look at. Do you look at yield? Do you have a certain yield threshold that company has to meet for you to purchase it? And are there any other divnend related metrics that you used to isolate stocks.
The only in criteria that we have is that the company pay pay a dividend. We're not really concerned with the current yield of the portfolio. That's varied over time, and you know it's tending to be in then one and a half two percent sort of range, you know, looking longer term at the yield, But the yield itself of any individual company isn't what we're really focused on.
What we want to know is that the company is really focused on paying the right amount of dividend for their business and reinvesting the right amount in their business for growth.
You know.
The worst thing that a company can do is pay too high of a dividend, right because if there's money they should be reinvesting to grow the business better. They do that then give too much money back to the shareholders. On the other side, we don't want companies to be over investing in their business. We want them to be you know, investing the right amount and giving us the
access that they have back. So the key thing for us is what is the optimal amount for that company and are they really thoughtful about coming to that number. And then very importantly at the end of it for us is can that dividend number grow over time?
It's the dividend growth that we care about, you know, not not the yield.
Today.
Yield's great, glad to have that, but that's really you know, a sidebar to the main thing, which is the dinner growth.
And one point to add Remember that yield is evaluation metric, only half of which the company can control, So it can produce a lot of false positives and a lot of false negatives. And to Peter's point, it is notable because it's a value metric. But what we are have been centrally focused on is at what rate can that
dividend grow? So they're meaningful things that we look at in addition to what Peter said, where things like capability, payout ratio, are you responsibly growing this dividend, free cash flow growth.
And so on.
Yield is useful, but it can't produce false positives and false negatives, and we just want to make sure we don't anchor to it.
Yeah, let's dive into that last point a little bit more. How do you really isolate companies that can grow their dividends significantly? Is there a cash flow model behind it or something like that.
Sure, so we do model out the future that we expect for companies. The key thing is does the business itself create value? You know, is there something about this business that allows them to generate high returns on capital and excess of what they need to reinvest for growth? And if they can do that make the business more valuable every day by reinvesting in their business, and the business becomes more valuable, and therefore there's more cash next year to pay a higher DUTA.
Than they do this year.
So that ability to to you know, reinvest for growth is the first and most important thing that we're looking at. And then the second thing is it's helpful if the payout ratio you know, has the opportunity to grow over time as well.
So we're very open to that.
You know that they're voda scenario for us as a company that has a really high return on capital, great you know, moats and barriers to entry and the ability to sustain the high return on capital and stuff to invest in so they can grow the company at those high returns and then they have excess cash to give back to us along the way, and maybe there's some scope for the payout you know, to go up somewhat. That's the perfect scenario for us.
The thing that I've become sort of moniolically focused on over the years, in addition to some of the stuff Peter just pointed out, is is there low amplitude in your business? That is to say, is your business does your business compound at a predictable rate over time, and you don't have these moments of despair where your cash flow can get compromised. So low amplitude of results, low capital intensity, when they tend to go hand in hand, are also things that we want to pay a lot
of attention to. It's all about to Peter's point, it really is all about how well are you caring for that value creating engine, because if it's not working, nothing else works.
So I wanted to kind of go back a little bit. Don you had mentioned yield as a valuation metric, are there other valuation metrics both of you consider, you know, just in terms of when to enter or not necessarily trade, but when you know, just in terms of the company over the future.
We'll look at a range of valuation measures. We'll use traditional ones like pe or we prefer price to cash flow, or you be a cash flow as a measure just to capture the fact that different companies have different capital intensity. We'll use more esoteric measures when necessary, and then we do look at a discount of cash flow model just
to have, you know, another gut check on valuation. But the first thing that we really we'll key on often is just the price of something, And that sounds a little bit simplistic, but if you think about it, the businesses that we're investing in are tend to be pretty large, stable companies.
So if the price of the stock changes.
Dramatically in a short period of time, it's very unlikely that the value that business.
Has actually changed that much.
So just the share change in a stock price can be a trigger for us to want to be interested in it, and then we'll explore all all those measures. But you know, valuation is the last thing that we do. What we want to make sure we're doing is creating a collection of companies that are going to compound value steadily over time and grow their events seadily over time
and therefore hopefully outperformed slowly over time. When we find those businesses, we can have pretty high confidence usually that that's a company we want to have in our collection. The thing that's a little more uncertained is, okay, well, what's it worth? You know, I think it's very hard to know within a narrow range what any company is worth.
Just having looked at valuations over time, as you have, you've probably seen the same company trade for wildly different valuations, So it's the most uncertain piece of all of it for us. So what we want to do is make sure we're getting the right companies in there, and then we'll use valuation as the last piece to try to say, Okay, you know, how do we size this relative to something else? And I would put valuation sort of in three buckets.
I would say, there are times when valuation is your friend, there are times in valuation is your enemy. And there's a lot of time when you're sort of in the middle and you think valuation is sort of neutral relative to what I think it could be, and it shouldn't be.
A primary driver of what we're doing.
And so we use all those different valuation measures to try to bucket things into one of those three capsgories and try to as much as we can make valuation our friend rather than our enemy. But except sometimes it's going to be in the middle where it's not really a main driver of the decision.
Just to amplify what Peter said, the other subtlety in all this is that in the fund itself, and Peter will correct me if I'm wrong, but let's just say on average turnover, something like ten percent give or take implies a ten year holding period, which is in fact the empirical data would suggest that we do hold things for that long and longer. If you're going to own something for ten years and you're going to allow time to help you compound value, particularly with you've got to
give it in growth underneath it. There's not a lot of information in a two year pe ratio. There's a mismatch there. So we would have missed so much if we had gotten frightened one way or the other by valuation on a lot of the stocks that we've bonne through time. So that disconnect is something that I think Peter and I both have sort of ingrained in our heads now.
Some of the word stocks that we've ever owned were some of the cheapest on traditional valuation measures, and a lot of the best stocks we've owned were the most expensive, and if we had gotten too fixated on the valuation, it would have caused us to sell them. So we've learned, as Don said, let's focus on finding the right businesses and then valuation becomes the last piece, just to say, okay, are we do we think we're comfortable owning it at
this valuation? There are rare times when evaluation becomes so extreme that it becomes more of a driver of decision making.
But those those moments are pretty rare.
Remember, just to close the loop on yield, I think Michael, you you met, you asked about yield earlier on that you know, by and large, high yields tend to be attractive, but they can also be a signal.
So high yield were you to be.
Sort of responsive to that might lead you to a place where the market's telling you we don't think this dividends sustainable, and that's why it's valued this highly. So again, valuation is is, to Peter's point, is something that we want to deal with at the end of the process, not so much at the beginning.
Definitely makes sense. And do you consider other uses of capital? I know some dividend investors get frustrated with the company that pours money back into the business and not returning it to shareholders. And do you do you care about buybacks and things like that, other uses of capital to return money to shareholders.
Yeah.
The first thing is for the business that you're looking at, what is the right amount for them to invest? That's the first question. If you're in a business with a lot of growth opportunities. By all means you should be investing all your money. We don't have any problem with that. We may not invest in your company if you're not paying a dividend because you're investing in all but that may be the right answer for you.
That's perfectly fine. So the first thing is are they being.
Thoughtful about how they're out they're figuring out what they should be investing in, and are they doing that. That's the first thing. In terms of In terms of shary purchase, shary purchases are fine. We have no problem with the shary purchase. But it's different than a dividend, and we have to recognize that. You know, a dividend is a commitment that you make to your shareholders. Typically in the US, if you if you set a dividend, you never want
to cut that dividend. So if you think about what that statement is to a management team, that's quite a powerful statement. They're saying, we have enough confidence in the future cashless streams of this business that we're really confident we're never going to have to cut it. So there has to be some confidence in the future in the future earnings power of the company behind that, or they
wouldn't do it. A shary purchase. On the other hand, you can flex those up and down as you want, so it's a much weaker statement about your expectations for the future. So there's nothing wrong with it. If you have excess cash, by all means do a shary purchase. But the dividend is a more powerful signal signal of what's happening in the future. Because and this is to get to something Don mentioned a minute ago, because a dividend is a commitment. It says something about your business.
It says that there's a lower amplitude probably to your future expectations, is a less risk in this company, and so therefore we feel comfortable making this commitment if you pay. If you do a shary purchase, you're not making that statement. You know, it may be totally appropriate. Have a more cyclical business, and you have to do it that way, perfectly fine, but we just have to recognize it's a slightly different thing.
I've always thought about cheery purchase as something that amplifies the good things.
So there's a pecking order, right.
We want you to invest in the machine, invest in the business, great value. We want you to share that with us through that commitment. To Peter's point of a dividend and let's grow it over time, that's even better. And if you want to buy some stock back at the end of all that, that amplifies all the per share metrics.
I personally, I think Peter agrees.
I would say that the data would suggest that cheery purchases over time are not effective, They're not well done.
The data supports that, I think. But if you're willing, if you want to buy some.
Shares back after we've done those first two things, to Peter's point, go for it, because it's just going to amplify all the per share stuff.
To Don's point, think about when companies buymac shares, it's when they have a lot of extra money lying around. Usually, if you have extra money laying around, your business has done well RECs and your stock prices up. So the reality is you're going to tend to buy more shares back when your stock is more expensive. You know, it's rare that a company is able to stockpile cash and use it when their stock is cheap.
Usually they're buying stock at higher prices.
So that's the reason why there's some slippage in that in that number, it just makes you share your purchase just slightly less appealing.
So as a fund analyst, one of the things that really interests me about portfolios is I guess sector positioning. And so my question to you is the way your sectors are allocated right now or just in general, is that driven by the stocks themselves or do you kind of do any type of sector targeting.
We don't target sectors. We really build the portfolio, you know, from the bottom up. We're looking for companies that have the characteristics that we're looking for to grow their dividends, and that leads us then to tend to have biases and the sectors that we hold, and those biases are pretty consistent.
You know.
If you think about what we want, we want steady, consistent pounding of returns over time. That's going to lead us to sectors that have relatively low amplitude. It's going to lead us to sectors that generate lots of cash. It's going to lead us to sectors that hopefully have some growth, but probably not the highest growing sectors. And it's going to lead us away from things that have a lot of capital intensity, a lot of cyclicality or a really high level of uncertainty of what they're doing.
So we've tended to have a lot of exposure to things like healthcare, consumer staples. We've tended to be under exposed to things like energy, which are cyclical and capital intensive. Our banks as an area where we're typically very under exposed, and we've tended to be unde exposed to technology, which has been you know, obviously an area that's been really
attracted for investment over the last number of years. And so we've had those structural differences in what we're doing, you know, for a long time, and that tends to be how we get there. It's important to think about technology specifically. We do want every company the portfolio to be paying a dividend, and there are a lot of companies in technology that own and so that is that is limited to some degree, our ability to invest to the extent we might want to in the technology sector
over time. The good news for us is that's changing. You know, You've seen several companies in the last year, think of Meta Alphabet, Salesforce, dot Com or just three that come to buyd that have initiated dividends. So those are things that in the past we wouldn't have owned because they didn't pay dividends, and now they do, so in some sense, our opportunity sets increasing in technology, and so that's an area where I think we can have more exposure over time than we have historically.
Yeah, another thing I wanted to ask is do you ever consider companies that reduce their dividends or are currently not paying dividends but could be in the future.
We definitely consider them, we have we we don't we don't tend to buy them.
I can't dine.
Maybe you can think of an example where we've owned one that didn't pay a dividend, But we do think about it a.
Lot, and sometimes we'll actually, you know, in our conversations with them, you know, talk to them about it.
And and I think our discipline so far has been not to do that, not to buy item in anticipation of starting a dividend, but not to say that we couldn't ever do that. But it's unlikely that we that we would. But we do have conversations with companies that don't pay dividends where the metrics clearly support it, and so we have a lot of questions for them about why aren't you paying a dividend? And sometimes their answers to those questions are good and sometimes they're pretty disappointing.
But until you've actually made that commitment to constrain yourself in that way, you know, we've made the decision in the past not not to step in front of that. We have had cases though, and this happened during COVID where a company, you know, cut its dividend think of TJ tj X, because the environment was so extreme that they needed to.
It was the responsible thing for them to do.
And we've continued to hold the company through that because in our view they were going to reinstate the dividend. They should pay a dividend, but it was the prudent thing for them to do in that period of time to not pay it. We totally understood that, and so we'll sit through that in a way, you know, in cases like that, but that's really rare.
You might have other examples of that.
Yeah, I go back in time.
The only the only time that I can recall that we owned a stock that cut the dividend in addition to TJX, was back in the global financial crisis, and that was JP Morgan which probably didn't need to do it, but as you can recall, that was sort of a team decision in order to calm the industry down.
We'd like to think.
That our process is thorough and deep enough that we can spot these clouds on the horizon before before they they are on top of us. So we've been pretty successful at side stepping potential dividend cuts. To Peter's point, TJX was a it was proven, it was very well telegraphed. The game plan post COVID was very well telegraphed, so we had deep confidence that they were going to get
back on the horse as it related to dividends. But generally our approach has helped us avoid those on the rare occasion that they that they seem to be.
On the horizon.
So another question, I was pretty curious that, you know, with the strategy, if you could talk about, you know, like one specific success story, like you know, it doesn't have to be a current holding, because I know you probably can't talk about that anyway, but if you think of the past, you know, is there a company that you bought and it just worked out really really well?
You sure I can come with a few, don do you want to do, you have one in mind you want to start with.
I would have started with t j X, So I'll set that aside. Here's one.
And this is going to be boring, but I think it's really reflective of who we are and what we do. And it's and and and the time we purchased it was highly controversial, and it's Microsoft, and I'm sure it's hard for you to imagine there was a ton of controversy for a dibdend growth investor with Microsoft, but there really was when we initially purchased it.
I'm going to get my daates wrong.
But back right around when the Nokia acquisition and then was written off and you had the CEO transition, we uh, we had this idea that when when Nokia was when the when the Nokia right off was announced, I think Peter it was something like six or seven billion dollars and the stock was down substantially, and this sort of gripped the market with great fear because they were not anywhere in.
Mobile and this attempt to get into mobile.
Wasn't going to work out, and they're a they're an on prem company, and the cloud was going to all this sort of magic was happening, all all this controversy was happening, And what we concluded was that a seven billion dollar right right off which would have been which which was screening as a disaster at a company that probably had I don't remember the number, but probably fifty billion dollars of net cash in the balance sheet, It had a monopoly in the enterprise that was not going away,
and most importantly for us, a magical balance sheet with a history and commitment of dividend growth.
That it was one of the these moments.
Where we were trying to figure out what it is and not what it was and what it would be. And so that has been an extraordinarily good stock for us over long periods of time.
It is really the gold standard for what we do.
But it was a moment in time where you just had to look at a company through a very special lens, and divedend growth is a very special lens, and if you had done that, you would have had a wonderful journey and we have.
So that's one that I think is indicative of what we do.
Yeah, I was going to come to Microsoft as well, and I think people sometimes ask you're buying these companies that are well known by the market, Why do you have opportunities to buy them at valuations that allow you to perform? And it's surprising, but it happens. The market gets a narrative in its mind that turns out to be sort of simplistic or wrong. And if you focus on the fundamental metrics of the business and you look at what they actually do, you realize that there's value
there that maybe the market doesn't see. So even these I mean, it's not like Microsoft was some undiscovered company, right, I call these you know, this is things sitting in plain sight. Right, this is these are things that should be obvious to everyone. But the market gets a story
in its head and gets it gets frightened away. You know, Microsoft has capabilities and the way that they're embedded in all of our organizations is so powerful that they're able to encourage us to use the next generation of each iteration that they come up with. It's just incredibly powerful.
I mean, if you think back, for example, to what happened during COVID, we were all at home and I remember we were using Zoom, we were using WebEx and now and I don't know where you are in your organization but in our organization we use teams.
Now why is that.
It's because we have Microsoft products all over our data center and they work really well with teams. And Teams wasn't as good of a product as WebEx and Zoom, but they got better and better and better, and next thing you know, our it people came to us and said, hey, you're using teams like that. That's what Microsoft is able
to do over and over again. So when you have a period of time when people are fixated on the fact that they had the surface which is terrible relative to the iPad, they were missing the underlying power of that company.
And what do you think the biggest macro risks to your style are upcoming in you know, the next year or two.
Our style should be very resilient to most sort of market environments. I think that the challenge for us is we buy companies that are steady compounders of value, and that means that the amplitude around our portfolio is lower than it is for the broad market. So the periods of time when we tend to do worse versus the market is when the market's really really strong, when animal spirits are running wild.
You you don't want to own.
This sort of stodgy approach, right, You want to own the stuff that you can tell your friends and neighbors about and you're generating really high return. So the challenging periods for us on a relative basis versus the market are the periods of time and the market's doing great. I think about you know what we do as being like we're like the steady station wagon Volvo that you're driving with the all weather tires on it. You know, when the when the when it's really sunny outside, you
want to drive the flashy red convertible. Our job is to have a memory, right to remember that market has cycles and when it's when it's summertime, we know that it's going to be winter again, and we want to build this portfolio to be resilient in all of those environments. Uh, And we need to remember that and and stay.
True to that.
So so from a from arella standpoint, the periods of time when we're going to look most dodgy and just interesting to people is when it's summertime and people forget that there's a winner around the corner.
Ad I'd add three macro things that might spook people, and these are perceived risks I think having observed this for twenty years now, so rates are always something that people uh will focus on when they see diven end fund. So a higher rate environment makes you know, other instruments more attractive, and so people I think will feel less positive about.
The kinds of companies that we that we invest in.
Tax policy on dividends always rears its head, not always, but periodically rears its head. If tax treatment for dividend income becomes more onerous, that has that will have the perceived a perceived negative.
Impact on the companies we own.
But what we've discovered through time is that tax policy, at least at the company level, has almost zero impact on dimenend policy.
So if you're a.
Reliable dividend grow it's a very clear part of your capital allocation strategy. Taxes rarely, if ever enter into your calculus when you're forming dimenend policy.
So there'll be these perceived I think risks.
From a macro perspective, rates and taxes would be the two biggest, But what we've noticed over time is that it really doesn't impact the companies or the portfolio. To Peter's point, where I forget what you said, a Volvo, but we're Volvough and there's a lot of history to back that.
Know, not the company Volvo, but the car. Right, We're like the ugly station wagon with the all weather tires that it's not exciting, but it works for you in every.
Season, makes sense.
This is a great conversation. I wanted to thank you Don and Peter, and also Don, I wanted to congratulate you on your retirement later this year. Thank you so much, Mike. Thank you for joining me as my cost today. Yeah, thank you all. Thank you for listening. If you liked the episode, please subscribe and leave a review. Also, if you'd like to see more of our research, go to the Terminal BI Fund go and BI stocks go Until our next episode, this is David Cole with the inside Act.