Talk Your Book: Utilizing Dividends for Income

0:00Today's Animal Spirits Talk Your Book is brought to you by Franklin Templeton. Go to FranklinTempleton.com to learn more about the Franklin U.S. Low Volatility High Dividend Index ETF, ticker LVHD. Again, check out FranklinTempleton.com to learn more. 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.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:44Welcome to Animal Spirits with Michael and Ben. On today's show, we had Chris Floyd. Chris is a VP and Portfolio Manager for Franklin Templeton Investment Solutions, Lead Portfolio Manager for International Large Cap and Small Cap Factor Equity Strategies. a mouthful. But he helps run the rules-based components of a lot of Franklin Templeton's ETFs, factor-based approaches. Today, we're talking about their low vol, high dividend strategy, which I think, we didn't get to this on the show, but I was going to talk about this. Demographically inclined, this is a perfect sweet spot type of fund for retired investors, correct?

1:21Yeah. Remember, man, I wish we brought this up. Low vol, min vol, that was the hottest factor in 13, 14. Yeah. Before the pandemic that that was, there was a lot of, it's funny how we get into the cyclicality of this stuff. These factor strategies come into and out of fashion quite a bit. But when you have a raging concentrated bull market in tech, this is kind of strategy that can go left behind, but that cyclicality that there's going to be a time period where low vol and min vol is so hot again. Yeah. You just know it's coming. Not an investment advice, but the worst thing that an investor can do is switch from factor to factor, strategy to strategy, whatever it is, just based on what's performed well over the last couple of years.

2:05I just remember one of the first factor presentations I ever saw, Cliff Asnos was giving a speech. This is like 2009. And he said, listen, if you're going to go into one of these strategies, you can't time them. So if you're going to be in a factor strategy, you have to stick with it. And you're going to have the ups and downs and the rollercoaster ride, the overperformance, the interperformance. But the big thing is that you just have to stick with it and rebalance into the pain. Yeah. So, all right. Here's our conversation with Chris Floyd from Franklin Templeton.

2:33So, Chris, one of the challenging things about investing with any strategy is that nothing works all the time, every time. You help manage a fund that is cyclical or counter-cyclical, however you look at it. But it's going to kind of do its own thing just because of the space that you're in, this low vol, high dividend equity spot. How do you as a portfolio manager and maybe an educator to your clients get used to the fact that this is a type of strategy that's going to be cyclical? Yeah, it can be frustrating at times is probably the best way to put it. We don't recommend this as necessarily your core holding, but we think that this is a great diversifier to what most people probably already have in their equity allocations within their portfolio.

3:19Just to be upfront about it and describe the strategy, this is what we would call a defensive equity income portfolio. The goal being to deliver a steady stream of income by investing in companies that have high and sustainable dividends while also providing lower risk than the underlying cap-weighted benchmark or than you'd find in a typical active equity portfolio that many investors are holding. And by doing that, we think that this is a great supplement to what would be kind of your core allocation because it allows investors to pick up income if they're investors that are looking for that.

3:57Investors closer to retirement, for example, or investors that recognize that over the long term, dividends are an important part of the total return for the market overall. They've been less of a focus, I think, for investors and for the market overall. Certainly in the last few years, we've seen stocks that pay dividends significantly lag, especially if you're thinking about it in the US relative to the Magnificent Seven, just as a simple example, where your dividend yields there are going to be non-existent or close to zero. By the same stretch, the beta of the portfolio is going to be lower than that of the underlying cap-weighted benchmark.

4:34It's more of a low-risk portfolio that we're trying to deliver. We think over the long run, you end up at roughly the same endpoint. It's just that this is designed to give you a smoother path there, lower highs and higher lows, I guess is probably the best way to put it. Yeah. This is a boring portfolio. I don't mean it pejoratively. It just is. It's more defensive in nature. And listen, the stock market is not necessarily... People are not looking for excitement all the time. So this certainly has a place for those people. When you say lower risk to not give your compliance department a heart attack, this is if the market all is equal, nobody knows for sure.

5:10But if the market falls 20%, you would expect this to fall less just by the composition of what's in here. So for example, the benchmark is 8 % consumer staples and utilities. And the benchmark that I'm talking about right now is the Russell 3000. This portfolio has 45 % invested in consumer staples and utilities. And we'll talk all about this in a second, but I want to start talking about utilities. Utilities had a really tough stretch for two reasons. And you could tell me if there's more reasons that I'm not thinking of. Number one, these are very much a competitive product for bonds for investors who are looking for income.

5:48So if interest rates go up and you can get a risk rate of 5%, well then, okay, the 4 % dividend yield is less attractive. But number two, utilities are companies that typically carry a decent amount of debt. So it was investors' preference for debt over equity with the double whammy of higher cost of capital. Now, and I'll get to the question in a second. So now we're at the point in time where utilities are absolutely on fire. And some of the narrative that's coming out of that space is that these are beneficiaries, I guess, like everything else, of AI. These GPUs are very energy intensive, and they're going to be heavily reliant on companies like utilities that provide power.

6:33Can you talk about, just sum up what I said? What did I get wrong? What's going on in the utility space right now? Honestly, that question went on for so long, I'm not sure I could sum it up. But I will do my best. Boom, roasted. To your first point, which was that with market yields where they are, with cash yields where they are, that's a competitor for utilities and any other really high dividend stocks. That's absolutely the case. I think with cash where it is close to 5 % in the money market fund, that's a competitor for any equity allocation or bond allocation for that matter. if you're someone that is a little bit more cautious or doesn't like where markets have gotten to, thinks markets are extended, isn't particularly enamored with where fixed income is relative to rates.

7:19I think there's no question that money market funds are a competitor for everything. I think when you look at this portfolio or you look at how high dividend yielding stocks, whether they're utilities or otherwise, have behaved over the last few years, I think that rate environment has been a headwind certainly in 2023 and 2024. I don't necessarily think that I would agree with that statement if you go back over the longer term. And when we looked at how this strategy was likely to perform in different market environments and how it has performed in market environments, high-dividend stocks in general have not always lagged when rates are high or when rates are rising.

7:56It really depends what else is going on in the environment. And also, because this is a low vol portfolio, you get the combination of those two factors determining how this portfolio is likely to behave relative to the underlying cap weighted benchmarks, for example. So if rates are high or rising and that makes investors fearful of upcoming recession or that the central banks have tightened too much, like we saw in 2022, the low vol piece of this portfolio will serve you well, even though rates are rising and you would normally expect high dividend stocks to struggle there. So that was a very long answer to the first part of a very long question.

8:36So you'll have to go next. Sorry. I'm curious about the AI part too, because is that narrative fair? Does that make sense to you? And did your boring fund some modern sexy because of this? I would hesitate to put it in that category. I mean, we've certainly seen a handful of utilities behaving like AI stocks recently, your independent power providers, like your Vistras and NRG and so forth. I don't think that's necessarily representative of the entire utility space. They are still regulated. They are still fairly boring for the most part, which is why we find them attractive in a strategy like this.

9:14So I think there's a little bit of that in the utility space, but I don't think that if you look across the broad spectrum of different stocks and companies out there, that that's necessarily the case. We also have a non-US version of this and we don't really see that sort of behavior outside the US either. So it's to some degree a US only phenomenon right now. Okay. So we're the only ones who get crazy about stuff like this. I mean, it's great if you buy those utilities and ride them up, but I caution there. I'm curious that you mentioned the sustainable piece of the dividend. Maybe this is a good lead into your process here and how it works.

9:46How do you define the sustainable piece? Are you looking for dividends that have been increased by a certain amount or payout ratios or certain yield? How do you define that? Yeah. So we're mostly looking for companies that are... The first cut is companies that are amongst the highest yield group in this space entirely. Beyond that, we want those high yields to be sustainable. A company that you see that just has a high dividend yield might have that high yield for two reasons. It might be the numerator in that the dividend is increasing, but it also might be the denominator in that the price is falling.

10:23And a lot of times if a company just has a high dividend yield and doesn't have any strong fundamentals behind that, the market's telling you, hey, this dividend is likely to be cut. So we don't look just for high yields. We look for companies that have high yields and have the earnings power to support those. So it's more of a payout ratio type of analysis that, as you alluded to that's going on there to make sure the companies have been able to sustain their dividends in the past. It's a backward-looking and forward-looking indicator that we're using to look at, has the company been able to sustain this dividend, cover this dividend by its earnings in the past or by its profits in the past?

10:58And is it anticipated to continue to be able to do so in the future? I would imagine that the payout ratio for these companies that you're talking about is fairly consistent within each company. So in other words, it's not going to swing from 40 % all the way up to 70%. But is there a level that you could just say like, okay, this is sort of our sweet spot or does it really depend on the sector of the industry group? Yeah, it really varies more across the sector in the industry group, but anything that's over one is going to be eliminated from the portfolio because we just don't think that's sustainable and we want to be as conservative as possible.

11:30There's a lot of different opportunities out there that pay high sustainable yields. So we err on the side of being conservative. If a company has a quarter or two where they're paying above their earnings power, while it may be sustainable in the long run, they might be able to supplement it with debt to continue to pay it. We think there's better opportunities out there and we'd rather be conservative and eliminate that stock from the portfolio and replace it with something else. You mentioned the payout ratio for the bottom line. I'm curious, when you're looking at the payout ratio, are you thinking about the bottom line or is this more free cash flow or somewhere in between?

12:08What are you looking at? Because it's a rules-based process, it's reliant right now on the bottom line earnings. We looked at, should we use operating income or cash flows instead? There's a fair degree of, well, there's some manipulation that can go on there and there's some degree of just wanting to be conservative. So for example, a company has good operating income and then there's a non-cash write-off or something in a particular quarter, you might say, well, that's a one-off and this company should be able to continue to support its dividend going forward. That may be true, but we also think of that as a sign that management has made a mistake essentially.

12:50If you're getting a big write-off, something is not at its strongest level. There's there's something, there's a story behind that. And again, we'd rather just err on the side of conservatism where we're trying to run a lower volatility portfolio. We'd like to see those sorts of things not happen. So we look at the very bottom line just to capture every single thing that's going on. And again, there's plenty of opportunities out there. So if companies are having non-cash write-offs that affect their bottom line, don't really affect their operating income, arguably they continue to support the dividends.

13:24We'd rather just err on the side of caution and move them out of the portfolio and replace them. There are two ways to look at low volatility factor. I guess some people might call it min vol as well. The price component where the price doesn't move around a lot much and then the operating measures and financial statement component. Do you target either one of those things or is it just that kind of a byproduct of companies that pay out regular dividends? It's both actually. If we were to just have the sustainable dividend piece of it, you would end up with a portfolio that is almost by nature lower volatility, but using those market-based indicators of volatility as well as a nice complement to the operational sustainability that you see from choosing companies with high and sustainable dividends.

14:06So those two really, really work together. So we look at trailing one year price volatility as one indicator, again, preferring companies that have steady price returns. We also look at earnings volatility back through time for the last three years and also anticipated over the next two years. So it's a bit of a mix of market and operational volatility that we're using to, again, making sure that we got companies that are paying high and sustainable dividends and that also exhibit lower risk characteristics. The third largest sector holding this portfolio is REITs. I'd be curious your take on the real estate market.

14:40Of course, there's different parts of it. One that's been under pressure and highlighted recently is commercial real estate. I'm sorry, office real estate specifically. Talk to us about the REIT sector or I guess like share class, whatever it's called, whatever the legal term is. Where do you see opportunities there? Yeah. When we have our exposure to the REITs right now, and you look at the subgroups within that, we have much more exposure to the things that not surprisingly have been more stable or are expected to be more stable in the current environment. So very little exposure to office REITs, much more exposure to things like storage or apartment REITs or gaming REITs.

15:18That's really where the bulk of our exposure is in those. Some of them much more specialized, things like gaming, those tend to be a little bit more specialized REITs. What's a gaming REIT? Essentially, they're owning the land underneath casinos or a casino or gaming property can turn the land into a REIT. I'm not an expert on it, believe me. All right. So just zooming out into the broader macro outlook where we are today in the cycle. And of course, nobody knows exactly where we are in the cycle, but just your take on, I guess we'll go to the mag seven and how a portfolio like this contrasts with what somebody might have inside of their index fund.

16:02Yeah, absolutely. One of the things we've seen is that the cap-weighted indices themselves are about as concentrated as they've ever been going back at least 30 plus years. The last time we saw anything even remotely like this was during the TMT bubble. And you can argue about whether the companies are more profitable or better run or less speculative than they were back then. And I think there's absolutely some truth to that. And there's more earnings power behind this. But if you take just the top 10 companies in the index, they're up over 35 % of the total weight in the benchmark right now.

16:37And that's well above what we've seen on average over the last 30 years, well above what we saw even during the TMT bubble. And not surprisingly, you look at the returns of the index. And again, those are being driven predominantly by those top 10 or top whatever number you want to apply it to. That is outperforming dramatically the rest of the benchmark. And yes, there's some AI to that. During COVID, there was some sort of the online shopping type plays and the work from home type plays that were contributing again to these same companies that I'm sure everyone's familiar with. But we think that if you are investing in a traditional sort of active mutual fund or an index fund, you're about as poorly diversified as you possibly could be.

17:28And we think that this strategy is a great way to add some diversification to your equity exposure. In an environment like this, where things are more concentrated, the gains are more concentrated, the stock's more concentrated, is your beta at the S &P 500 even lower than it normally would be? Is your beta decreased in recent years because of this concentration? Probably a little bit lower than it has over the long run. But we've typically seen it around 0.7. I think it's a little bit lower than that right now, precisely because that's going to be related to the performance of the cap weighted benchmark that's being driven by those mega cap stocks.

18:06So yeah. So not only are the sectors quite different, the sector weightings, but the average market cap of the companies in this portfolio is significantly lower than the median or average market cap in the index. Is that because do these companies that tend to be more stable in terms of their price and their fundamentals, do those tend to be smaller companies or what's driving that? I think there's two pieces to that. One is what I was just talking about where the top end of the index is very concentrated. And if you're looking for income, that's not where you're going to find it at all. Those kind of mag seven stocks are paying all of them less than 1 % dividend yields at this point.

18:51Some of them are just introducing dividends. Some of them still don't pay any dividends at all. So if you're looking for income, you do need to move away from that. I think we designed this product all along with the idea that yes, you'll find some attractive, sustainable dividend payers in the large cap space, but why limit yourself to that when there are also plenty of attractive stocks in the smaller cap space as well? So when you look at the sort of average or median market cap profile of the portfolio, we're definitely lower than the benchmark. If you look at small cap stocks in general, I don't necessarily know that it's fair to say, so for example, if you look at the Russell 1000 yield, it's about 1.3 something percent.

19:31If you look at the Russell 2000 yield, it's a little bit higher, but only a couple of basis points higher. So on average, the large versus small indices, the dividend yields are about the same. But if you look at the stocks within those that actually pay a dividend, you're getting on average a 3.7 % dividend yield for the stocks that pay a dividend in the Russell 2 versus only 2.5 % in the Russell one. So of the stocks that do pay a dividend right now, the, the ones in the, the smaller cap indices are, you know, on average, more attractive or a better hunting ground potentially. I think the S and P 500 dividend yield now is like 1.3%.

20:06It's very low, but there's just like psychological impact, not only with investors when it comes to dividends, but corporations where they have a really hard time cutting back on dividends. That's like the last line of defense for a lot of them. I'm curious if you have any idea, why are corporations still like that considering that there are so many other companies now that just don't pay any dividend at all, especially in the tech sector? Why are so many blue chip companies still beholden to paying out dividends like that and increasing their dividends as well? I think it's primarily a signaling mechanism.

20:37If you're cutting your dividend, that's a signal that something isn't quite right, whether it's your current earnings and cash flow or your future earnings and cash flow. And I think it's somewhat of a historical, I mean, in a perfect world, if you were paying a modest dividend and you got an incredible investment opportunity for your company that would more than justify eliminating the dividend because your returns on that potential investment were significantly higher, investors should be completely indifferent to that decision or they should applaud that decision because in the long run, your stock price is going to reflect that.

21:15But I think in practice, the academics don't always play out that way. And like I said, it's more of a signaling mechanism where if you're cutting your dividends, A, you're going to lose potentially investors that were holding your stock for the dividends. Some of that's just an almost mechanical thing where if it's an income fund or an income seeking investor, they're going to potentially look elsewhere. And some of it is investors waiting for the second shoe to drop. Oh, they cut their dividend. What's the bad news that they're not telling us yet? All right. One of the things that we've always talked about is that if you look at it on the end impact on investors, a share buyback or a dividend is basically the same thing, right?

21:57Yep. Absent any tax implications, yeah. Yeah. In a vacuum, it's kind of the same thing, but share buybacks are really volatile. They're all over the place. Companies are more than willing to cut back on them, but they're not willing to cut back on their dividends in a lot of ways. And I think to your point, it's maybe just an artifact of this is the way we've always done it. And it is that signaling. So we're just going to continue to think that way because we don't want to have that psychological hit of cutting the dividend because that can be kind of like, okay, now they're really in trouble.

22:22Absolutely. And there's a certain class of investors, probably those in retirement primarily who are dependent on that income and don't necessarily want to have to change their equity allocations or sell stocks and buy stocks. They'd rather just have that steady and consistent dividend than having to make other transactions in their portfolio. So for them, having a sustainable payout or sustaining your current payout is one of the things they're primarily invested for. Chris, such a good point. People have made the observation that dividends and share buybacks are economically equivalent and maybe dividends are even suboptimal from a tax point of view, but nobody wants to create their own dividend, right?

23:03If somebody's like, well, you could just sell shares and create your own dividend. Well, nobody wants to do that. And one of the beautiful things about dividends is you know when they're showing up, for the most part, you could count on how much is showing up. So even though there might be economically equivalent from the end investor's point of view, they're just not. Yeah, I think that's exactly right. I think that's actually why we see some folks using the LVHD type strategy as a fixed income alternative. You get your steady and consistent payout like you would from a bond, but built into that as well, you've got some ability to offset the effects of inflation through the equity exposure and through the companies being able to grow their earnings and so forth and support that dividend into the future.

23:48So it's a little bit of both for investors who are worried about inflation, but want a steady, consistent income. So LVHD is a rules-based ETF. You're not shooting from the hip, waking up each morning, deciding which stocks to increase your exposure to or which to kick out. But with that said, I am curious behind the methodology with which these companies get added to or removed from the portfolio. Yeah, absolutely. It is, as you said, a quantitatively run passive products in that we build the index. The underlying index is those sustainable, high dividend, low volatility companies. And then the ETF just tracks that.

24:28That's mechanically how it works. The team that we're a part of, we manage all of our portfolios in a systematic fashion. And some of those are traditional active mutual funds or active portfolios where you're trying to beat the benchmark. We have a quantitative model that we use to pick stocks that looks at the same types of things a fundamental investor would look at, whether it's valuation, quality, growth, and so forth, but doing it in a disciplined and rigorous manner. And we brought that same type of style to this, partly because in an ETF, this was started back in 2015. There was no such thing as an active ETF at that point.