Dear Valued Clients and Friends –
I think most people know that the way someone interprets the political scene is largely determined by their own political ideology (as it should be). Apart from the personality aspects that may enter the fray, most people have a set of views, beliefs, and values that play into how they vote. It is part of the diversity of thought and perspective that is commonplace and healthy in a liberal (free) society.
But of course, ideas, beliefs, and values exist outside of the political sphere, too. This week I read one economist (who I like a great deal, though disagree with him on almost everything) say that COVID could end up being a huge blessing to the economy, as long as Keynesian stimulus efforts are maintained worldwide, and even pressed further, not just in the urgency of the moment – but as a new framework for economic growth. Inversely, he warned, if Keynesian stimuli prove to be just a “flirtation instead of regime change” we may be in for real trouble. Fair enough. He may be right or wrong, but his economic assessment is clearly an offspring of his economic worldview.
Others fear inflation and geopolitical distress – and they do so for ideological reasons. Still, others fear delayed economic growth brought on by the longer-term misallocation of capital that shorter-term remedies often create (you could pretty much put me in that camp).
There are any number of thoughts on where the economy may be headed short term and long term, and any number of combinations of outcomes that could (and will) play out. But there is one camp above all else I would avoid – and that is the camp that claims to form their forecast and perspective devoid of any ideology – of any governing ideas, beliefs, and values. The unaware ideologue is worse than almost any kind of ideologue.
Nixon famously said, “we’re all Keynesians now …” Well, guess what. We’re all ideologues now, and that is okay. It makes for more honest, revealing, self-aware, self-conscious, consistent, rational, coherent, and useful dialogue.
Packed into all the competing ideas and beliefs (and conclusions that come out of such), there are good economic ideas and bad economic ideas. And these things all carry tremendous investment implications. Investment decisions that are presented as devoid of a belief system and set of principles are called darts, and they are being thrown around at will. Finger-in-the-wind investing is financial gambling, and it is all too common in this day and age.
So we strive to bring you the Dividend Cafe each week, rooted in a set of investment principles that are themselves rooted in economic beliefs, ideas, and values. We are pretty self-aware of our own ideological commitments. The investing world would be safer if more people would do the same.
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 into the Dividend Cafe!
Market Redux
The market is down about 100 points on the week coming into Friday morning, so pretty close to flattish, with just modest down days and modest up days creating the flattish like week in equity markets (DJIA). Gold is down about 3% on the week and 7% since early August highs. The 10-year treasury yield dropped from 71 basis points to 64 points this week, pushing bond prices higher, but impacting financial stocks.
Top heavy
The basic reality of the market remains this … Overall cap-weighted indexes have gotten high led by very few names, but the “average stock” in the market remains well below pre-COVID levels and even below the beginning of the year levels.
*Strategas Research, Daily Macro Brief, August 21, 2020
Not as hard as it looks, or is it
I do agree that there is a lot of work required to avoid companies that cut their dividends in portfolio management. It helps when that is actually one’s investment objective (as it is ours), but it still requires intense quantitative and qualitative analysis to do it right. That said, when one looks at the reliable dividend payers in the S&P 500 this year that have cut their dividends, they have averaged 3.3x leverage (net debt divided by EBITDA), whereas the dividend growth companies that have sustained their dividend have averaged a leverage rate of HALF of that (a range of 1.5-2x). Sometimes dividend cuts are regulatory (remember the financial companies in the aftermath of the financial crisis). Sometimes they are the result of a shock to a business model (think of the airlines and theme parks this year). But more than anything else besides a company either not being that committed to their dividend to begin with, or paying a fake dividend (i.e. paying it from borrowed money or the company balance sheet vs. actual earnings/free cash flow), the number one cause of a dividend cut is always and forever excessive debt.
It is not so easy as just saying, “we will avoid highly levered companies.” Investors love leverage when things are good. In certain parts of the cycle, those more levered companies produce the best results. But indeed, when the tide goes out, that leverage is revealed as the cause of all things painful and problematic.
The Effect, not the Cause
Higher dividend-paying companies have tended to outperform the whole stock market in basically every calendar decade for fifty years. The last few years have seen a price-performance in high multiple, big tech companies buck that trend, fueled by low rates, multiple expansion, and technological innovation. Expensive stocks don’t generally pay dividends (they don’t want to, and they can’t afford to – think about it – if a company trading at 50x earnings paid out HALF of its earnings in dividend, it would yield 1%; it is simply not enticing for high multiple companies). But history has been clear about the superior performance over full cycles of dividend-paying companies vs. the alternative. What I can never cease repeating is that the dividend is not the cause of the superior performance, but the effect. Meaning, yes, the dividend’s cash flow creates a reinvestment over time which is powerful in the total return. But ultimately the dividend is an action that transcends words from management about the resilience of the business. It is a signifier of consistency and stability, and an incentive to responsibly steward the company’s business, its balance sheet, its P&L, and its strategy – towards the repeated award to shareholders.
Why is Excessive Debt Deflationary?
Let me quote from an economist who has influenced me immensely, Dr. Lacy Hunt: It reinforces “a persistent misallocation of resources, constraining growth as productive resources needed for sustained growth will be unavailable.” This is the fundamental issue behind a vicious cycle of deflation – the debt used to counter deflationary challenges reinforces the problem that one is trying to address. Key resources are re-allocated to service debt, and that means they are not being allocated to their most productive use. Ergo, constrained growth.
Defining Excessive Debt
I am more concerned with unproductive debt than excessive debt, but I suppose a better way to say it is that unproductive debt is excessive. Our total domestic debt excluding leases and pension obligations surged to 260% of GDP in Q1, much higher than even when Lehman failed in 2008. It is not the mere existence of the debt that is problematic – it is the diminishing return from what is done with that debt that compresses economic growth. We have a fairly productive use of technology and even natural resources in our country, which helps offset some of this to a small degree, but what we have is a weakening of economic growth (i.e. disinflation) as more resources are steered towards unproductive functions than productive ones. This is what makes the debt excessive.
And I would add, not just in terms of why this debt level becomes unproductive, but exacerbates a deflationary cycle – it suffocates the velocity of money (the second key variable in the inflation formula, the other being the money supply). A climbing money supply (we have that) multiplied by a declining velocity (we have that, too) is not inflationary. A high productivity in the economy (requiring optimal capital allocation) pushes the velocity of higher (demand and use of money).
Is government debt the only kind that can be unproductive?
Of course not! Corporations and individuals can misallocate capital, too. Companies tend to be better allocators of capital than governments (self-interest, etc.), but the basic principle of defining unproductive debt as excessive (economically speaking) applies across each sphere of society. Companies that use debt productively do not suffer from higher debt levels, as the leverage ratios do not rise because the debt is offset by growing assets and income streams.
But governments cannot use their debt to create a growing income stream. Does that make sense? It is the most important thing on this subject. A company may use debt to buy an asset that will then, in turn, produce revenue (otherwise why would they be buying it?). In our own households, I bet we all can think of the difference between unproductive debt and productive debt. That same mentality should be applied to other spheres.
In conclusion:
(1) When a company adds to debt, we must evaluate if the debt is productive or not
(2) When a country runs up debt, it is inherently not productive (no counter-acting revenue stream)
(3) Unproductive debt stifles growth, which is, by definition, disinflationary, and holds interest rates down. The low growth level and high debt level then require low rates, which requires more actions to hold them down, which perpetuates the self-reinforcing cycle I have described.
Debt creates an increase in spending now, and a decrease in spending later – unless the debt is productive. This is an eternal truism. The lack of that productivity in increasing debt is why we are in the deflation camp, not inflation.
Creative Instruction
One final point – when companies with excessive debt not engaged in productive behaviors stay alive because of external interventions (say, the Fed or the government), there could always be a situation where that company rights the ship and becomes productive and successful. But even that is not without cost … Capital was allocated to an often unproductive operation that allows it to stay an operation, and therefore capital was NOT allocated to a more productive one). In other words, even when a company stays afloat from intervention, the cost is what you don’t see – the capital not allocated to the more productive operation.
I bring all this up for investors and clients because our underlying philosophy of productive growth must drive our understandings of balance sheets and income statements, both from the companies we invest in, to our application of the fiasco that is national and global debt.
An emerging truth
It remains crystal clear to us – that U.S. equity markets are not cheap in valuations (the ones provided here are trailing, not forward), largely because of Fed interventions in holding down the risk-free rate. But it also remains clear to us that on a relative basis, the same metrics applied to emerging markets reflect categorically more attractive valuations. Without the headwind of an appreciating U.S. dollar, is the valuation tailwind combined with the demographic tailwind of EM about to resume its pre-2015 reality?
China Update
The President had called off last weekend’s trade talk meetings with China, postponing indefinitely what was to be a “six-month check in” on the phase one trade deal. Promises around intellectual property are believed to be on track but purchase commitments are believed to be heavily lagging. But then by Thursday reports were that some status talks were back on …
Economic Report Card for the Week
Industrial Production increased 3% in July, the second-biggest monthly increase in history (the first largest was the month before – June). Now, this is highly deceiving, because these “month-over-month” increases were coming off of an insanely low baseline. About half of the March/April decline has now been recovered. Auto production increased by 28% in July. Oil and Gas rigs will need to start coming back online to really see some capex, industrial production, and mining categories moving. In the meantime, capex is providing some hope and encouragement in pockets, or at least mixed signals (skewed to the good).
It is clear that the insanity of March/April is behind us in terms of non-activity in the marketplace, but as much as the trend is decisively higher, we still have a ways to go to get restaurants and bars back to pre-March levels. It will take some time.
Now, as for the jobless claims and overall labor picture, this chart shows how it has gotten “less bad” week over week, and yet, remains high as so much of the hospitality industry has not been fully re-opened.
*Bloomberg, Daily Brief, August 20, 2020
Politics & Money: Beltway Bulls and Bears
- Joe Biden accepted the nomination to be the Democratic Party candidate for President this week in a virtual/remote convention. The Republican convention will take place next week. The next ten weeks will be ground zero for the Presidential election. At this juncture, Biden’s lead in the national polls ranges from 4 points (CNN, Rasmussen) to 10 points (Economist), with others in between (The Hill/Harris). This lead is more or less the same as Hillary Clinton’s lead (nationally) in late August 2016, though the lead Biden has in polling in some battleground states is higher (Florida, Michigan, etc.). There are basically three camps around the polling right now:
- The polls accurately reflect Biden’s decisive lead
- The polls are all fake and stupid
- The polls may be close to right now, but don’t necessarily capture where the race could go, or how some undecideds feel
- I don’t have a prediction on any of that. I expect a grueling ten weeks ahead. And going without big live events and normal campaign events is not something we have experienced before in our country.
- Based on polling alone, Daines in Montana and Ernst in Iowa appear most likely to keep their GOP seats, and Tuberville appears very likely to pick up the Alabama seat. However, McSally in Arizona and Gardner in Colorado are behind in polls, which means that Collins in Maine and Tillis in North Carolina will very possibly be the make or break races for which party will have the majority in the U.S. Senate (of course, if it ends up 50/50, whichever party wins the Presidency will have that majority via the VP’s tiebreaking vote)
Chart of the Week
Yes, we feel pretty strongly (see above) that companies sustainably growing dividends are more secure and more stable enterprises, often revealed to be such during the bad times. But some vulnerable companies do cut dividends during bad times. However, when the going gets rough (financial crisis, China fears, COVID, etc.), stock buybacks get cut – a lot – and certainly a lot more than dividends. The blue line below does not even reflect companies in our universe of intentional and stated commitments to dividend growth. Just across the whole equity universe, the difference between how companies approach dividends and buybacks in tough times is stark.
Quote of the Week
“Patience is the companion of wisdom.”
~ Augustine
* * *
I suspect some people may look at my opening letter this week and wonder if “ideological” investing is overrated and even dangerous. It actually could be if someone confuses categories of ideology. Biases and prejudices and group-think and cognitive dissonance are not ideologies. Preferences are not ideological. What I very specifically mean is the set of principles one adheres to in the context of investing money. I hope that distinction is clear, and I hope these weekly commentaries in the Dividend Cafe will continue to shine a light on what a comprehensive investment worldview looks like, and how it ought to be manifested in the context of a portfolio.
For many people, the ideology behind a portfolio is nothing more than, “I like what went up yesterday.”
Ideas have consequences.
Have a wonderful weekend, and do not hesitate to reach out to us about anything you read this week.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
The Bahnsen Group is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, SIPC & HighTower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through HighTower Securities, LLC and advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee.
This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of HighTower Advisors, LLC or any of its affiliates.
