DAVID BAHNSEN: We are, right now, living through a period where for a lot of companies, a generous dividend to shareholders is considered a sign of weakness.
A lot of technology companies say hey, if we're paying big growing dividends, that's us admitting we don't have anything better to do with the money. We don't have new innovation. We don't have new product.
Where I view it as a sign of maturity, I view it as a sign of evolution in a company.
My name is David Bahnsen and I am the Chief Investment Officer and managing partner of The Bahnsen Group, registered investment advisor in Newport Beach, California and New York City, managing about $1.6 billion. And I have written the book, The Case For Dividend Growth: Investing In A Post Crisis World.
What's your dividend growth investing thesis?
The basic thesis of the book, obviously, is intended to drive the belief in the growth of dividend stock investing. But it comes from the reality of the last two decades. And this is two totally different lessons. The first decade of this new century and in fact, new millennium, was what we would call the lost decade. A period in which there was a zero percent real return for investors. If they went to bed for 10 years, they woke up and they've made no money. And the reason for that is because the market dropped about 50%, it went up 100%. And then it dropped 50% again.
So, in the first decade, you had wild volatility in the midst of a bust, then boom, then bust cycle the dot-com crash and the Great Recession financial crisis being the bookends of that god-awful decade. And then the last 10 years being essentially the recovery period from that aforementioned decade where you had the Federal Reserve allowing for unprecedented amounts of monetary accommodation. We had a zero-interest rate policy for the bulk of the last 10 years. And we went about three different rounds of quantitative easing, which essentially was the Fed providing a significant amount of liquidity into the corporate economy, which most certainly provided a wonderful boost to asset prices along with the great recovery in earnings and private enterprise doing what it does best, which is fix itself.
So, you've had basically until last year a decade of no down years and over-tripling of stock market prices. So, in both decades, I think you have the potential to learn the wrong lesson about what the next 10, 20, 30 years of equity investing may look like. And yet in each decade, I think you also have a microcosm of a lesson in how dividend growth performed. And my suggestion is that the next 20 and 30 years will not look like the last 10 or the 10 that preceded it, but perhaps more like the 50 years that we had, at the end of the 20th century, which was again, periods of bad times and recessions and periods of good times and expansion.
But through it all, companies that are thriving and companies that are not even surviving and an investment methodology that was set to focus on companies growing their free cash flow and growing the dividends from that free cash flow they paid to us investors would have outperformed in any of these cycles and would have outperformed with far less headache, anxiety intention. So, my belief is we come off of the really euphoric recovery period post crisis is that hopefully, we have learned some lessons about what investing is generally not like, it is generally not like a tech boom, as the dot-com bust was preceded by and it obviously is not usually like the Great Recession financial crisis where equities dropped 56% in a matter of a year and we go into the deepest recession we've been in since the Great Depression.
But even if it were, the fact of the matter is that for dividend growth investors, they came out of it unscathed. So, I make the case for that philosophy of investing, with both the historical understanding and a view towards the future.
What's the historical context?
So, the historical context is important when one looks at the total return that they can expect as an equity investor. I did not write the book to suggest that equities are now about to underperform for the next 20 to 30 years relative to what they've done the last 70, 80 years. It's entirely possible they will and of course, the opposite is possible too. I'm agnostic about that. But I did write the book to suggest this- that if equities are going to achieve the same return they have historically, let's call it 9% a year on average- and that goes back to the Great Depression- it's going to do it in a different way than it's done before. Because the vast majority of the years in which equities have been achieving a 9% return average, they've been doing so with about half of that return coming from dividends.
The dividend yield of the S&P 500 for the vast majority of the 1940s, '50s, '60s and all the way through the '70s and so forth was above 4%, sometimes over 5%. So, you were getting something in the range of about half your return from income and half your return from price appreciation. As a matter of fact, if you look at the reinvestment of those dividends for an equity investor historically, there is no argument to be made that the total return of the investor was anything less than 80% from the dividends when you factor in the compounding of that reinvestment.
So, we know that historically, it's been a major role in the returns stock investors get. But the fact of the matter is that the current yield on the S&P 500 is less than 2%. If someone invest $10,000 in the S&P 500, they're going to get about $180, $190 of income annually. So, that speaks to both lower dividends being paid from a lot of companies and the higher price level and a higher valuation in the market. Now, maybe we're going to get 9% for the S&P 500 the next 20, 30 years because the appreciation will now be 7% and the income will be close to two and so you get nine.
But my suggestion is that in an environment in which dividends make for a much lower percentage of the return expectation of a stock investor, you have to assume A, there's a possibility you face of little low return than you've historically received and B, that return will come to you with more volatility. The dividend, the portion of the return that comes from a dividend is inherently less volatile because it can't go below zero. Now, maybe every single company cuts their dividend to zero or some nonsensical, bad event like that, but they don't cut the dividend to negative five or negative 10.
The higher portion of your return coming from price appreciation, the higher volatility you're taking, because prices by definition do go up and down, including below zero, obviously. You historically have had a much higher reliance on dividends as a stock investor. And we are right now living through a period where for a lot of companies, a generous dividend to shareholders is considered a sign of weakness. A lot of technology companies say hey, if we're paying big growing dividends, if we have after tax profits and we're giving it back to our shareholders, that's us admitting we don't have anything better to do with the money. We don't have new innovation. We don't have new product.
And they view it as a weakness where I view it as a sign of maturity. I view it as a sign of evolution in a company that yes, there is a phase in which some of those really great innovative technology giants at one point, wanted to reinvest every penny back into the company, because they were making the iPhone and they were making new processor chips at Qualcomm, and they were making new software and operating systems at Microsoft. But the fact of the matter is that those companies I use as an example, because they did exactly what I'm talking about, they grew up and all of a sudden, your Qualcomms, Apples, Intels, Ciscos are some of the great dividend payers in today's stock market. 10, especially 20 years ago, they wouldn't have dreamed paying those dividends.
That's the history I'm talking about. Investing into companies that have achieved critical mass have a reliable business model, dependable, recurring free cash flows, and then a culture and a management philosophy that says we want to return a healthy portion of those profits to our shareholders. That becomes the aspiration of I think the next era of dividend and equity investing.
When should investors own dividend stocks?
An interesting consideration is at what point an investor in their own process ought to be thinking more about dividend-oriented companies as opposed to high flying growth stocks and things of that nature. And my answer is going to surprise a lot of people, because one may believe hey, when you're in your 20s, go take a flyer on some of these hot dot tech stocks. And then when you get older, you need income, then that's when you settle and go for your boring dividends. But let me tell you an anecdote here. This, to me, is fascinating.
Can you think of a company or a couple companies that would have been less interesting and investing in in the 1990s than Procter Gamble and McDonald's? Procter Gamble, being this great consumer brand giant that makes diapers and toothpaste and laundry detergent. And then of course, McDonald's being this real estate behemoth that also happens to sell an unfathomable amount of French fries and cheeseburgers. I assure you and I was, myself, investing in a younger person in the 1990s. The dot-com stuff that was firing up 100% every other week was what people were very focused on understandably so. And McDonald's and Procter Gamble were considered our grandparents types of companies.
But here's the thing, if you, right now, had been investing as a young person in the '90s in McDonald's, Procter Gamble, the dividend that you're getting now every single year is equal to 100% of what you would have paid for the stock at the beginning of the 1990s. Your year over year over year cash flow is at 100% yield on original investment in both McDonald's and Procter Gamble's case if you go back to the early '90s and there's different back testing and dates and so forth where you'll find that data.
So, yeah, certainly, I understand the argument for why there's a generational or cultural association with the way people may want to invest. But to me, a young person and an older person have this much in common even if they may have a lot of differences in their style and age and personality and whatnot. They're both investing for a return of cash in the future. And this is what I lead off the book with, talking about, is the Epiphany I had that all investors with zero exceptions are investing for the return of cash. Some may want the cash to come years and years after they've died. Some may want it over in periodic installments over a long period, maybe an endowment, maybe a retirement income, some may want it as a lump sum, I put in money here, and then I pull it out for college tuition there.
But the point being whether it's short-term, long-term, periodic or lump sum, nobody cares about investing for the sake of esoteric growth. You want Apple to go from 50 bucks to 500 bucks because you do at some point, either you or your posterity plan to sell the stock and have cash on hand or better yet, the recurrence of cash flow that the stock is generating. The fact of the matter is that younger people who had invested in utilities a generation ago versus the NASDAQ with all of its huge runs up and the Fang and the dot-com and all of the amazing things that have happened in this digital revolution, reinvesting dividends from the utility sector has generated a higher return over time than the NASDAQ.
Why do you favor dividends over stock buybacks?
The subject to share buybacks is in the press a lot these days. And this was perhaps one the most difficult chapters for me to write because I admittedly write a chapter in the book as to why I favor dividends as a capital return strategy over share buybacks. So, in a sense, it sounds like I'm one of those stock buyback critic guys. And yet, I hesitated to write it because the last thing I want to be associated with is the present era of critics in stock buybacks who happened to maybe be getting a couple conclusions right for entirely wrong reasons.
So, I am not in the war on stock buybacks because I believe stock buybacks represent a means of returning cash to shareholders, when in fact, that money could be going into giving employees more wages. Now, maybe it could be going into giving employees more wages. I would like to think that the stewards of the business are responsible to make the decision as to how they can fairly adequately and in a motivating fashion compensate their employees. But we're all begging the question with this conversation, stock buybacks and dividends and any number of things a company can do with cash presuppose you've achieved your profits. You had your revenues, you had your expenses, and now there's profit. Hey, what do we do with it?
To say, don't do stock buybacks, go hire more people, go build another plant, go pay people more wages, well, that's just saying that let's not make as much profit as we did, let's make less profit. Okay, well, that's fine. You can make less profit, maybe they should, maybe they shouldn't. But my point is, we're talking about what one does with their profits. You already established, you have some degree of earnings as a company, now, what is the right thing to do in the stewardship of your corporate Treasury with the profits that you've generated?
The fact of the matter is that today's attack on buybacks is mostly a Marxian class warfare attack. It is not an investment argument. But I'm making an investment argument that from the vantage point of being a shareholder, I'd rather get the dividends than the stock buyback for the simple reason that the dividend is real, I hold it in my hand, and it derisks my investment. Every time I get paid every quarter, I'm receiving some compensation for the risk I took as a long equity investor. With stock buybacks, I'm compounding the risk. There's more going in and more going in and so forth. And that, of course, can work out very well. It also can work out very not well.
There's another problem with stock buybacks. And that is you don't know what they're going to do and when they're going to do it. They announced an authorization and that's the last you hear of it. They're under no obligation to execute on the authorization. And the fact of the matter is they very often do not. They authorize a certain amount of shares to be bought back and then they execute that up to the portion of stock that they gave out to executives, stock options, employee restricted stock, things of that nature which is important. It's a good function to replenish your capital stock through buybacks, but as a matter of returning cash to shareholders, with a dividend, I can buy groceries. I can't buy things with stock buybacks.
So, you have a mechanical deficiency that dividends don't face. All things being equal, are there companies like Apple and Boeing whose free cash flow generation is so monumental that they do a quite a bit of both? Well, there is. I'm all for it. But I don't buy the argument that stock buybacks have replaced dividends as an efficient way of rewarding shareholders.
How are high yield and dividend growth stocks different?
A very important part of the book and one I went to great lengths to try to achieve some degree of clarity is the distinction between a high yield stock, a high dividend stock and a dividend growth stock. And oftentimes, because this has been the philosophy of investing I've espoused privately and publicly for many years, people will say, oh Bahnsen, you're that dividend guy. And I'll say, well, hold on, you're missing a word, I'm a dividend growth guy. There is a category of investing that you might call high dividend investing which is not only not the same as what I'm describing, it has the potential to be the exact opposite.
Look, if you have a company that's trading at $100 a share and it's giving you $4 a year in dividend, and that stock drops to 50 bucks but it's still paying you a $4 dividend, you got an 8% yield, except for I got bad news, you're down 50%. That's not what we're looking for, what we call accidental high yielders, that they're only a high yielder because the company is performed backwards and as a function of math, the numerator is being divided into a lower denominator. What we want is a high growing yield because the actual cash dividend is self-growing. They're raising that dividend year over a year. And they're raising the dividend year over year because their free cash flow is growing year over year.
Now, is it possible a company with growing dividends and growing free cash flow can also see its stock price drop? Obviously, it is. It's rare and it's of a much lower magnitude. But it can happen and particularly in a period like '08 when everything in the world goes down. But I'll tell you two interesting anecdotes about 2008 for a dividend growth investor. A, there were two companies and only two companies in the Dow that were up in 2008 as the whole world was ending and Lehman goes bankrupt and cats and dogs are falling out of the sky, Walmart and McDonald's. If one were in dividend growth names from the S&P 500 in 2008, they received more cash in 2008 than they did in 2007.
In other words, even with an S&P down 40%, they got more money out of dividends than they did the year before. So, I think that dividend growth represents an intrinsically defensive strategy. And the high yield names represent a very high-risk strategy for the simple reason that they're very often future dividend cutters, the very opposite of a dividend grower. And so, we're going to get a yield that goes from 4% to 8%. We want it to be because that company has doubled the amount of dividend they're paying out, not because the stock price is dropped in half.
How do you think about asset allocation?
One thing that people ask me a lot is from an asset allocation standpoint, where dividend growth might fit in, and my firm, we only manage money on a custom basis, every client has a very tailored portfolio. But the reality is, is that we have to go about setting