Talk Your Book: Dividend Stocks are Cheap

0:00Today's Animal Spirits Talk Your Book is presented by Schaefer Cullen. Go to CullenFunds.com. learn more about the Cullen High Dividend Value Strategy and the Cullen Enhanced Equity Income ETF, DIVP. That's CullenFunds.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:37Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46Welcome to Animal Spirits with Michael and Ben. We are recording this on Tuesday, September 3rd. NVIDIA is down almost 9 % on the day. On no news, I guess, well, news that it reported earnings last week and news that they're selling. I don't know. I don't know what to tell you. defensive-oriented strategies today, value dividend strategies are holding up much better. Ben, is this the turn? Are we here? I guess this is why you hold defensive dividend-type strategies, too. I don't know. The pivot is always hard to call in real time, but I understand why certain investors like these strategies. And I think especially with the growing prevalence of institutions that are worried about concentration and volatility from these huge stocks and retirees who don't have the stomach for this, that much volatility anymore with all their portfolio.

1:36That's why I think these strategies will always have a buyer. Yeah, that's true. Despite the last 10 years plus, which have been really difficult for value strategies, it doesn't matter what variation, what cousin you're using, whether it's sorting by price or earnings or sales or book or cash flow or dividend yield or whatever. However you sliced it, doing anything other than tilting away from the market cap weighted index has been painful for the last decade. And to Ben's point, who knows if that continues. But on today's show, we spoke with Schaefer Collin, a company that's been managing these value-oriented strategies for four decades.

2:14And we get into how they think about constructing a portfolio, how they think about the macro outlook, some red flags to think about when you're building value portfolios. So I hope you enjoy this conversation today with Jennifer Chang. She is a portfolio manager and executive director at Schaefer Cullen.

2:34Jennifer, welcome to the show. Thanks for having me. So Schaefer Cullen is celebrating its 40th year in business. We talked to a lot of asset managers on the show. Not many of them have a four decade or maybe not going on a fifth decade. I don't know how the math works. Not many of them have been around 40 years. So tell us what's Schaefer Cullen all about? Yeah. Well, what we are all about and what we've been about for four decades is we're dedicated value dividend managers. And especially in the last 10 years or so, that's been much more difficult to find because you found so many managers that have moved to growth or style drifted to core growth.

3:12And so really the founding principles of Jim Cullen, who founded the firm 40 years ago, is based on Ben Graham and a lot of research that has shown the persistence of value alpha generation of low P.E. and high dividend stocks. stocks. And so that's the basis of all our strategies is really to find high quality companies, companies with strong balance sheets, improving returns that trade at a significant discount to the market. And so that's our margin of safety to avoid overpaying and consider what the market is missing in terms of the cheapest stocks in the market. So if you look at the past five decades, stocks trading in the bottom 20 % of the market by PE, so quote unquote value stocks, they've outperformed the market by 50 % annually.

4:07Wow. So I'm always curious for a dividend strategy that you know is eventually going to outperform. Any single strategy is going to have its times where it lags the market or it lags its category or whatever. But dividend strategies for most investors are just intuitive. So is a dividend strategy easy to sell to a certain type of investor that wants this type of more, I guess, lower volatility, more consistent. Is that strategy easy to sell to certain investors? Yes, it is. And so the largest strategy at the firm today is our domestic high dividend value equity strategy. Our clients are mainly institutions and high net worth families, individuals looking for a very conservative equity strategy with strong market capture, solid down market protection, and high income and income growth.

4:58So kind of the proverbial being paid to wait. And so that's what our strategy delivers. When you look at the rest of the market value of growth, a lot of those have been sort of indexed away, whereas dividend strategies, there's been some index component to it, But really kind of where you find the core of high dividend strategies is still amongst active managers because that's really where you can add a lot of fundamental analysis to avoid companies that are overpaying in terms of the dividend or potentially could cut their dividend. In the years from, call it, I don't know, 2009, 10, maybe through 2015 before the fangs really, really started to take off.

5:44Dividend strategies were very popular because you had 0 % interest rates. So people that had been used to receiving income through bonds weren't getting any. So it's like, all right, well, why would I take a rewardless risk with fixed income when I could clip two and a half, 3%, whatever it is from McDonald's, from JP Morgan, and yeah, I get some equity upside, I'm getting the income. But in the last decade or so, this strategy has gone out of favor as mega cap tech has sucked in all the assets. Can you talk about the dynamics of that decade versus this and where we might be going in the future?

6:18I know that was a word. I know it's a mouthful, so forgive me for the long question. Yeah. So I guess your line of questioning is that why has value dividend stocks, why they underperformed and what are the catalysts that could bring about those factors to start working again? Yeah, that was a better question. Yeah, I mean, it's true. I mean, value has really struggled over the last 10 plus years. You've had, again, the rise of these platform tech companies with relatively light regulatory oversight. As you mentioned before, you've had a decade of zero interest rates, very loose monetary policy.

6:56And then the bulk of equity flows going into index funds, ETFs. What we're seeing now, though, is this huge amount of concentration that is leading to risks where we've seen historic market peaks. So the index concentration at this point is at a five-decade high. When you look at the top five stocks, they're all tech stocks. They are now 30 % of the S &P. The top 10 stocks are about 40 % of the index. and this surge in AI and growth stocks over the last year, year and a half, has led to one of the most narrow markets in history. So the first half of this year, 2024, they're only 25 % of the S &P 500 stocks that outperformed the index.

7:42That's the lowest level in five decades. The last instance where you had such a level of narrow market breadth was in 1990. Don't say it. Don't say it. Yeah. So do you find that a lot of the stocks that you're looking at are only getting cheaper these days if they're getting left behind? Yeah. I mean, what you've seen in terms of not just the value space, but we would say even more concentrated in the high dividend space, because what's been going on with a lot of dividend stocks having fallen out of favor, a lot of ETF and factor rotations out of dividend stocks is we've just had this historic spread in terms of sentiment flows and valuations towards growth, the Magnificent Seven, AI stocks, and away from even more so value and high-dividend stocks.

8:30So by our measure, the relative outperformance of the market and growth stocks relative to high-dividend stocks and value is at a five-decade extreme where the valuations of high-dividend value stocks are now trading in the 99th percentile extreme over the last five decades. And so we think that's a real opportunity. And historically, it's been a great time to invest in high-dividend strategies like ours when you get such extremes in sentiment and valuation flows. If you break any index, S &P, Russell 1000, whatever, into deciles based on dividend yields, so from lowest to highest, there's a tipping point where, uh-oh, these stocks are yielding 13%.

9:14It's probably not for a great reason, and the returns start to fall off dramatically. Can you talk about how you control and make sure that you're not getting into these accidental high-yielders? Yeah. Historically, when you look at typical equity income strategies, you'll find the concentration of the highest dividend-yielding sectors in defensive areas like consumer staples, utilities, REITs, and then telcos within communication services. Then energy also has a lot of high-dividend-yielding companies, like the integrated little companies and MLPs. And then to a lesser extent, you'll find some high-dividend yielding sectors like financials, industrials, and then the least amount of high-yielding stocks in discretionary and tech.

9:59And really, like you said, the key to investing in high-dividend stocks is looking at the sustainability of those dividends. Companies that have less cyclical earnings and cash flows and whose management teams don't prioritize paying those dividends in terms of their capital allocation framework, those are the ones that have the risk of cutting their dividends. And so from our perspective, companies with high yield because of low stock prices, those are red flags. And oftentimes they signal dividend cuts on this horizon. And so what we found is that companies that have earnings that are falling and coupled with high debt levels, those are situations that you want to avoid.

10:41those are the ones that have the most tenuous stories. And so we're evaluating payout ratios, relative debt levels, and those type of ratios, cash flow, earnings, volatilities, and then very importantly, what happens in past recessions to earnings and dividends. So you look back at the historic volatility of those specific companies. I want to get into something you said before about trying to index a dividend strategy. And to your point, there's a lot of different ways you can look at it. Some funds look at just the yield level, some funds look at how long they've been paying dividends, have they been increasing dividends.

11:16I'm curious why you think it's so hard to index a dividend strategy and then what you might you do differently than a quantitative ETF strategy that is using certain rules to make their stock selections. Yeah. So I'll tell you what we focus on, which makes it different, Jane, and what I think a lot of the ETFs, the issues with some of the ETFs. So our approach in terms of our high dividend strategy is we focus on three things. We focus on low PE valuation, we look at high dividend yields that are sustainable, and then dividend growth. So it's really a balance. We invest in companies with low PEs because we find that that really captures investment opportunities with strong long-term appreciation potential.

12:00And then in terms of the dividend, we look at high dividend yields of at least 2.7 % because historically, those high dividend yielders in down markets provide a very good long-term down market protection and then defensiveness in those down markets. And then the dividend growth for us, that third prong is really a proxy for earnings growth in up markets. And so while we're an equity income strategy, the portfolio is very diverse. We have exposure to all sectors of the market. The issue with some of the dividend ETFs you'll find is that they're just looking at the highest dividend yielding space, regardless of valuation.

12:41So you would find companies with high yields, but you're paying 30 or 40 times earnings for that dividend yield. And so there's downside in a market scenario where you have multiples contract and a sell-off like we found in 2022. And then some ETFs that are dividend focused, high dividend focused, they tend to be very concentrated in certain sectors. So one particular ETF that's very popular, it has 50 % exposure in two sectors, financials and utilities. So you're really kind of buying sector ETFs. And so we really feel the balance of investing in companies with low PEs, not overpaying and having high dividend yields that are sustainable, that's really a unique approach that you have not found in many ETFs.

13:31How do you think about the sustainability ability to the dividend, what sort of things are you guys looking at? Yeah. So as I mentioned before, when we look at dividends, we look at the historical earnings and cash flow volatility. So we look back at recessions and down markets for that certain company. And so situations can always change. And maybe a company sells off a business that has historically been very cyclical. So that lessens the earnings volatility and therefore the dividend volatility. But we need to make sure that in past recessions and down markets, the dividends are paid because one of the worst things can happen to a dividend stock is the dividend gets cut, the stock gets cut, and you have an underperformer.

14:14So that's why we look at that. And then currently, from a current perspective and forward looking, we look at payout ratios, debt levels to ensure in industry downturns or in economic recessions or downturns, that dividend is going to continue to get paid. And then very importantly, when you talk to management teams, they always have a priority of their capital allocation. And so if paying that dividend, maintaining it, and growing it is not top one or two priority, you know that that is a potential risk that that company hits hard times. How much do you care about the history of the dividend yield?

14:52Like there's certain ones that'll be like they have they've increased their dividend for 25 years or 10 years or whatever it is. Does that matter to you with the idea that, like you said, CEOs have a hard time cutting if that's their history? It's not a requirement for us to have a certain number of years like a dividend aristocrat. It's obviously something that we take into consideration as a positive, but every equity story is unique. And so you could have a situation where a dividend was cut. One example of a company that recently cut its dividend that's been in a world of hurt is Intel. I think it did it sometime last year.

15:26If a company were to do that, is that an immediate, like, you're gone, you kick them out immediately? Yeah, that's a good question. And so a dividend cut is not an automatic sale. And we found, because we've been running the strategy for three decades, is that oftentimes, and a lot of research shows that the last 20 or 30 years, the dividend cutters, the underperformance happens before the dividend is cut because the market starts to anticipate it, worry about it. When the dividend is finally cut, oftentimes it's almost like the final, the last straw that broke the camel's back and all the bad news is out because management's been trying to avoid the dividend cut for so long and trying to do everything else.

16:10So when the dividend is finally cut, three to six months later, a lot of times, those stocks, those dividend cutters actually outperform. So it's really case by case. It's not an automatic sell. And I would say probably more often than not, we actually keep the stock and really balance the equity upside recovery potential with obviously the lower dividend and the potential for dividend growth in the future if there's a recovery story there. Obviously, you all are bottom-up stock pickers, but the Fed's actions and investor preference has a big impact on where people put their dollars. Talk to us about how you all are viewing the potential for a rate cut cycle and what does that mean for value strategies on a go-forward basis?

16:55Yeah. So what I would say in terms of high-yield effective strategies and how they perform in Fed tightening cycles. We've been running this strategy for three decades now. And historically, when the Fed raises interest rates, it slows the economy, PE multiples compress, which kind of hit the most expensive overpriced stocks. And there has been a fear that higher rates hurt dividend stocks, as well as bond yielders, because they're more competitive with dividend yields. However, historically, the defensive environment usually leads to rotation back into low beta defensive stocks. And really importantly, though, dividend growth stocks tend to do very well in higher inflationary rate environments.

17:42The 10-year dividend growth cater for our strategy is around 9%. So it's much higher than kind of even the most extreme inflation environments over the past four decades. And then if we think about in a rate cut scenario, well, dividend stocks were heard in a higher rate environment. So we would expect a lot of those sectors that were heard in that environment to outperform when the Fed cuts interest rates. So sectors like utilities and REITs, consumer staples that were heard of the last year, year and a half, because it was a concern with higher rates, higher debt levels, some of which impacted those sectors.

18:19So in terms of the companies that get hit in a rate hiking cycle, how much of that is investor preference? Oh, well, why would I buy JP Morgan or Colgate or whatever when I could just buy Treasuries and get 5 % versus are these companies like double exposed to higher interest rates because they have higher debt loads as well? Yeah. So that is what hurt a lot of these high dividend stocks, the consumer staples, utilities, and REITs the last 18 months as the Fed was raising interest rates. So you would expect that as rates start to fall and the Fed cuts, that would benefit those companies. And I think what is important to remember about our strategy is that it's a high dividend strategy, but you're benefiting even more so than bonds because there's dividend growth.

19:05So the average dividend growth of our portfolio over the last 10 plus years has been 9%. And historically, when you look at our yield at cost, since we started the strategy, It's incredible. We have a 50 % yield at cost. So that's in 1994 when we started this strategy. If you had just put your money in and allowed the dividends to grow and get reinvested, your yield 30 years later would be 50 % on the original principle. So I think it just significantly beats out bonds and other fixed income instruments. That's a really important point that a lot of people don't get. If they just look exclusively at yield to make that decision, they don't realize that if stocks are appreciating more than bonds, the growth and the yield has to be greater than inflation, right?

19:53To keep up with stocks. Right, yeah. It's a really important point. I'm always curious about the psychology of owning dividend stocks because I think there's a really big level of comfort there for a lot of investors to know that they have cash flow coming in and then that cash flow is increasing. I'm curious how you, I feel like there's a lot of quantitative investors at my client I know who will say, well, what's the point of getting a dividend when the company could just do buybacks and then you could just sell shares to create your own dividend? I'm curious how you think about the psychology of the cash flow versus trying to create your own dividends and just sell shares to do it.

20:28So management incentives over the last 10, 15 years have been definitely more focused on buybacks. And so when you look at management incentives, a lot of CEOs, CFOs, they're incentivized on ROE and on EPS growth. And that is completely manipulated, can be manipulated by buybacks. And there's been such a street focus on earnings growth, which also can be manipulated by share buybacks. And so we think that buybacks make sense in certain environments and in certain situations where your stock is cheap. Oftentimes what you do is you see management teams buying back their stock at record price levels and selling stock at record cheap levels.

21:16They're historically not great at buying back stock. And so when you look at just the historical track record, we prefer management's giving shareholders dividends and they can make that choice to buy more stock or to find better investment opportunities elsewhere. I mean, there's been so many situations where there's been a destruction of shareholder value that way. I can recall the oil and gas companies, a lot of the E &Ps and surfaces companies back when oil was$100 a share a couple of years ago, they were all buying back their stock. And when oil collapsed, they were selling stock because they had to in that environment to recapitalize.

21:59So it's a mixed record, I would say, in terms of management's record of buybacks. Can you talk about the turnover and your sell discipline? I'm always curious how portfolio managers think about getting out of an investment. How do they do it? When? What are the signals? What are the red flags to look for, et cetera? Yeah. So our sell discipline pretty much revolves around our buy discipline. So we're valuation focused. We're value investors. And so when a stock gets to be extended, mostly on valuation relative to where we think it should trade, and if we don't think earnings growth over the next couple of years is going to bring that PE multiple down, that's where we think about selling or tripping a stock.

22:42So turnover has been zero for the last five years? Well, in a value portfolio, not every stock has been a winner. But I would say that the stocks that we've been selling have been the ones that we just think are extended, some in the chip space and tech and consumer discretionary where you've had big winners. So that being said, we like to see our winners run and we don't want to trim too early. And so it's really that balance of letting our winners run. And then where we think valuations and sentiment has gotten too extreme and tenuous, that's where we would think about selling a stock. The other is a dividend cut or dividend elimination, that's another scenario we look to trim or sell.

23:24The strategy invests, it says, in like 30 to 45 stocks, so relatively concentrated. I'm curious how big the pool of opportunity set is for you. How many stocks are you looking at that could fit your watch list criteria? And how long does it take for a company to mature enough to save maybe some of these tech stocks that have been around for a while that start paying dividends out? How long it takes them to get on your watch list to see if they hit your valuation parameters? So our investment universe, US international stocks, because we can invest a sliver of around 10 % international companies, large cap companies, low valuations with high dividend yields of around 2.7 or 3%.

24:02That's historically been about 500 to 1 ,000 names. And it really just depends upon the market environment. In big up markets, where valuations are extended, dividends are lower, that pool shrinks, and we tend to be less active. And then on the flip side, when you get big market sell-offs and dividend yields rise, hopefully they're sustainable, valuations become more attractive on an absolute basis. That's when we typically are more active. So our annualized turnovers is historically around 10%. And I would say probably higher in those years where we find more opportunities, where we're kind of doing more trades and seeing more attractive valuations and dividend yielders.

24:45Another popular strategy for income-oriented investors is a covered call strategy. You guys recently launched a version of this strategy inside of an ETF wrapper that is getting on the covered call wagon. Can you talk about how that strategy works? Yeah. So we launched our enhanced equity income strategy actually 13 years ago when there weren't that many covered call strategies out there. Our strategy is differentiated because we're one of the few covered call strategies that invest with the value approach that we discussed. And also we're writing single stock out of the money call options on our underlying stock positions.

25:25And we think that this is one of the most efficient ways to run a call writing strategy. We've successfully raised about$2 billion in separately managed accounts. And then we launched our ETF last year. The portfolio, it's invested in around 35 stocks with the same investment discipline as our other strategies. The dividend on this portfolio has historically been 4%. And then on top of that, we write calls on about a third of the portfolio to generate additional income. And so our since inception yield has been around 7 % to 8 % annual. So it's a pretty attractive total yield. How is this different from some of the more popular strategies in the ETF marketplace?

26:11I'd say the biggest difference between our strategy, the enhanced equity income strategy, and those strategies are that we're the value version of these covered call writing strategies. So we're focused on value and dividend stocks, and we're concentrated in a portfolio of blue chip companies that have strong long-term appreciation potential. And our portfolio is very balanced. We have exposure to all sectors of the market. So our highest exposures are financials, industrials, healthcare, energy, whereas a lot of those ETS, they're highly concentrated in growth sectors, tech, communication services, and discretionary.

26:51And then the other differentiating factor is that our cover call writing approach, unlike the JEPI and QYLD, is really just, again, concentrated on writing on specific stocks. As opposed to the index. As opposed to the index, right. So they're generating good premiums and they have a solid offering, but we're looking at the targeted and we think efficient approach. So we're looking at individual calls that are offering the best premium and the best out-of-the-moneyness. And we're looking at minimum thresholds to deliver double-digit annualized returns on each of those calls. Whereas when you write with a complete overlay, you're oftentimes risking losing a position for literally pennies because the implied volatility is low or the stock price is too far away from the closest strike.