Value + quality + cash flow is king

0:09Scott Kaufman:Scott Kaufman from the Dividend Kings. Welcome back to Investing Experts. Always great to talk to you. Hey, thank you so much for having me. Always great to come in. So not many people talking about dividends these past couple of weeks, I would say, since war has started and a lot of people talking about oil and energy and a lot of different things. not many people talking about dividends. How are you thinking about dividends in this particular time? So dividend investing, interestingly, has had quite the run over the last few months. If we look at even like the Schwab dividend ETFs, the big ones like SCHD, where last year it returned about 4 % over the whole year, but it's up 12 % year to date.

0:52We're seeing a large rotation from heavily growth-focused investments that were really focused on the buy-anything kind of AI trade over to investments that are overwhelmingly focused on value to the point now where we're actually seeing PE ratios that are close to what used to be growth investment PE ratios in the value space. And so we're now seeing an overextension where investors are pouring from one side into the other and now overextending what used to be good investments. And this The same is going on with the war, right? Oil prices are gyrating like crazy over whether or not, you know, oil is going to be able to go through that one specific strain or not.

1:37And so we're seeing a lot of folks rotate from one to the other. And it means that we have to be a lot more picky about the investments that we make or the recommendations that we give and be willing to exit positions that are now oversold or overbought, I should say, and move on to the side to find better opportunities elsewhere.

1:56Scott Kaufman:Because you think the shifts are going to be shifting long term? Some of these shifts are most likely going to be structural long-term shifts, right? If we think about it, the S &P 500 has kind of had muddling returns this year, going slightly positive to slightly negative and kind of back and forth. But if we look at the PE ratio that the S &P 500 is trading for, it has gained more value than earnings growth has occurred across the entire index. And so right now it's still quite expensive compared to its lifelong history, its 20-year history, and it's sitting right around its five-year P.E. ratio as far as the average P.E.

2:39ratio right now. And so there isn't tremendous value to be found as far as like value stocks versus overvaluation versus undervaluation when it comes to the index itself. Which means that a lot of these companies that were trading at 30, 40 times PE ratios because they were really excited about the growth are coming down. And we really shouldn't expect some of those companies to move back up again, especially some of the software as a service companies. their better ratios are in the 20 to 25 range than the 30s and 40s that some of them were seeing. And then on the other side of the coin though, we got some of these investments that are flying high that now are well over where they should be and they're going to be coming back down again.

3:23We use typically the 10-year normative PE ratio of a company as almost the center point for gravity for them, meaning that when a company is below that, it often gets pulled back up. And when a company is above that, it often gets dragged back down. And so we're seeing a lot of these companies that have skyrocketed past that or fallen well below that, that are going to have these corrections in the future. And we have a strong rule within our Dividend Kings model portfolio that if the 12-month and the 24-month total return outlook or expectation that we have for the company is negative, that we're not going to hold it anymore.

4:00We'll wait for those prices to come back down or for earning expectations to increase for it to be attractive again. And so we have actually exited at least one position and discussed a couple others where we decided to step onto the sideline because the price had risen so much. And now we were looking at, you know, if it was to return back to where it belonged, in our opinion, only like a 3 % total return from now until the end of 2027. And that's just not attractive for us to keep holding on to when there's other opportunities that are out there.

4:29Scott Kaufman:Would you share what that is, what that example is? So we actually released a public article on Enbridge talking about how it's a high quality company. We don't think there's anything wrong with it, but it's overpriced. It's moved beyond its standard ratio that companies that it trades for. And part of that is the run up over expectation of commodities and the value rotation of people leaving growth and moving into value. Then now, in our opinion, it's overpriced for where we think it should be. And so when we did our outlook on it, from now until the end of 2026, at least when we sold it, it was a negative total return expectation.

5:07And at that point, we don't want to lose money just to hold on to something that's quality. We'd rather find something else that's quality that we can see returns from that continue to grow.

5:15Scott Kaufman:So alternatively, is there something, let's say, in the software side or a sector that maybe that isn't looking as good to you, but a specific name or a specific trajectory of a stock has done well to your surprise, perhaps? Yeah, so we've seen a lot of software companies or AI-focused investment companies that have sold off extremely heavily. Like you think of Paychex or ADP, the automatic data processing, even some of the other software-as-a-service names that have sold off heavily. I think it's interesting that Facebook, that Meta really hasn't moved that much, even though they're pouring a ton of money into AI as well.

5:57And they're still right there at their 10-year PE ratio. They really haven't sold off and a lot of these other companies did heavily. When looking at anything like a software as a service company, I'm going to be looking for a company that has extremely large positive cash flows. You don't want a company right now that needs to tap into debt or needs to tap into the public equity and sell shares to continue their services. Because right now, most of those markets are closed to them because of the concerns around private credit and then the concerns around just AI disrupting everything. You want to look for positive cash flow companies, things like Intuit or even Paychex or ADP, where these are heavily cash flow positive companies that don't need the debt market, don't need public equity, and they're actually buying back their shares.

6:42And those buybacks, these values are going to add tremendous value in the future as earnings continue to grow.

6:47Scott Kaufman:And what else would you say maybe about the energy space or about names and sectors that you think are going to take the lead in this, as you say, in new structural change? When it comes to the energy sector, we've kind of had an interesting year because oil at the beginning of the year was expected to have a relatively poor commodity performance year. They're expecting that supply would continue to outpace demand this year and next year and potentially into 2028 start seeing that reverse as a trend. And then the Trump administration's actions within Venezuela opened up what many thought was going to be an abundance of more inexpensive and cheap oil, especially for the U.S.

7:28market. And so then oil continued to get depressed, especially Canadian oil prices versus American oil prices. And a lot of Canadian oil is the heavy type of oil that we can also get from Venezuela. And now with the military action in Iran, we're seeing the opposite, right? oil skyrocketed above$100, dropped back down to the 70s again, is moving back up, because there's a lot of question about that seaborne oil that's coming from that region. My focus, again, is cash flow is king when you're looking at these type of investments, and companies that have a low break-even price per barrel of oil are going to produce the best returns over the long run, especially if they are in regions that have low exposure to the same type of risk.

8:14There's not a lot of investments perhaps in the Middle East or some of these other places that are a little less stable regionally. And so I like Canadian National Resources, CNQ, or even EOG Resources, where they're heavily North American focused. They're extremely low break-even points for them. So they're going to benefit from all this upside that we're seeing right now, but they are going to be fine if it all comes back down again to where it's been over the last few months prior to this. And they're also very focused on shareholder returns as far as buying back shares or having dividends that are growing or having sustainable dividends.

8:49Because some companies get tempted to hike their dividend quickly when there is a Goldilocks period like this, only to have to cut it in the future. And typically, companies that stop their dividend or cut their dividend underperform for a number of years, those peers who consistently raise their dividend or initiate a new dividend. And so we're really looking for quality names that are going to consistently grow.

9:16Scott Kaufman:Given that there are so many factors at play, what leaves you concerned and what maybe will have you rethinking or maybe changing lanes in your investment strategy? You know, with talk of oil prices, with talk of what that means for interest rates and inflation and what the Fed does and all of these kind of moving targets and unknowns. How, I guess, along the way, how are you thinking about that? And what would come along that would make you change course? So we try to very much avoid what I like to call Icarus syndrome. If you know, like the Greek myth of Icarus, right, where he was told, don't fly too high because the sun will melt your wings and you'll fall into the ocean and die.

10:01But a lot of times what we forget was he was also given a warning not to fly too low because then the ocean spray will wet his wings and he'll still have the same outcome. And we're seeing a lot of investors, especially retail investors, that fall into both categories. We've got some who are chasing the high. They did it with AI. They did it with Bitcoin. They're doing it with value stocks now where they're jumping on after the initial rise. And they're going to be the investors who get unfortunately burned when things rotate again. And then we have a number of investors who got burned who are now doing the opposite and they're investing in extremely low risk things that are trailing what inflation is going to do.

10:41And so they're kind of falling into what I call Icarus syndrome because they're either going way too high or they're going way too low. And they're failing to kind of hit that middle ground that provides the best long-term returns. And it's why retail investors and even a lot of funds fail to outperform the markets in general over the long run because they either get too exuberant or they get too cautious. For us, we always look for value and quality first. As much as we want dividends and we're always buying dividend paying securities, especially ones with long dividend growth histories, value and quality always comes first.

11:15And so we've picked up some services of software companies into our model portfolio that right now aren't doing as well as other holdings that are more energy focused, but we know that the quality of them is going to shine through in the long run. Fundamentals typically take about 18, 24 months at the minimum to sometimes even four or five years of the long run for fundamentals to really determine your portfolio performance over the long run. So you have to be a patient and willing to be consistent investor to really be a data-driven fundamental focused investor like we are in Dividend Kings. And so the biggest part for interest rate changes as far as oil prices is likely going to cause higher inflation, which would reduce the chance of interest rate cuts.

11:56It's really going to govern what kind of interest rates we expect or demand from our fixed incomes out of our portfolio. We're going to keep a focus on heavily discounted but higher yielding, especially qualified dividend paying fixed income that kind of makes that bedrock of income for now as far as dividend income and not be willing to accept as low interest rates as we may have been if interest rate cuts were going to come as readily as we initially expected them to. Now, if interest rates do start getting cut, if we see a new Fed governor that comes in and really kind of shakes things up, we may be willing to drop the floor of what we want from our fixed income side.

12:35But until we actually see the proof of that happening, we're going to stay stable on that side of things.

12:41Scott Kaufman:Appreciate that. Anything else that you would add to the concern column, things that you're concerned about? Being afraid of missing out. FOMO is a huge thing that we're seeing with some investors. We're seeing a lot of concern out there about now people are wanting to buy a lot of energy-focused names. And simply because of the recent news cycle, we went from Venezuela to then private credit in the sell-off of service companies to now war. And so people are endlessly chasing the news cycle. And they're failing to look at the quality of the companies and only kind of buy what they think is going to be the next news.

13:19And that's really dangerous, partially because the news is so unpredictable, right? You wake up one Saturday morning and there's a new company that is being toppled, or there's a new thing that's coming out as a news article. And we have to remember that news is designed to sell commercials or designed to get your focus focused on that. And so it's better to focus on the quality of your investments and the quality of what you hold over chasing the news cycle and being willing to accept that the company you have is quality over the long run. And so my biggest concern is when people are jumping back and forth and trying to chase what's going on, looking for the best return possible in trading.

14:00But a lot of times trading kind of burns you over the long run as you get exhausted from that or you find middling returns or poor returns doing so.

14:07Scott Kaufman:Is there anything that you feel like is being completely misunderstood right now? I would say there's quite a few private credit investments that are, for example, like Blue Owl Inc., OWL, that is getting beaten up heavily in the market. But so is BlackRock and some of these other private credit, but also private asset management companies that are being sold off heavily that seem to have nothing related to a lot of the riskier debt that we are seeing out there. Last year, we saw First Brands and its bankruptcy. And then JPMorgan Chase's CEO, Damon, said that there was potentially more credit cockroaches to be found.

14:48And there really hasn't been this wide-scale credit default issue that some we're predicting may come. It's not uncommon when we have economic weakness for there to be an uptick of defaults, even though default rates remain relatively low. And a recession typically is kind of the same as clearing all the ash out of your fireplace, right? You can only burn a fire for so long before the amount of ash that's in there kind of chokes out the fire that you want to have. And so you have to stop, clean it all out, get new wood in there and get it burning again. And that's what a recession does for the economy.

15:24It kills off the weaker companies, the zombie companies, the poor credit companies, so that growth can resume. And you can only delay a recession for so long. And so the longer it takes for a recession to occur in some form or another, the more you're going to have a buildup of this, this poor quality that's floating out there. but a lot of these asset management companies are extremely well structured extremely well capitalized and we're seeing that there's an expectation for them to have more assets under management in the years forward but we're seeing them being sold off as well where they're not trading at the values that they historically have or even near their 10-year values where that center of gravity is going to pull them back up again and so blue owl kind of is getting hit on both sides they're they're into private credit they are connected to data center and ai development and so they're kind of getting the one-two punch that's beating them down way more than really what they should be because their loss rate is extremely low and the companies that they work with are companies like Meta that aren't really selling off and so we're seeing this kind of dichotomy there between the the fear that we're seeing in the market as far as these scenarios and then a company that doesn't really meet those expectations but still being sold off like it does And we're seeing other places where credit-related investments like collateralized loan obligations, there's a ton of CLOs being produced in the market because there's a demand for the debt for them, but that's causing an oversupply in CLO equity, which is really killing the CLO-related funds that are really popular on Seeking Alpha.

16:57right Oxford Lane Capital Eagle Point Credit Company and then you know you have XAI Investments which is focused on their debt and CLO Investments which is XFLT all of these are being kind of decimated because their NAV is declining and they for years have enjoyed a high premium to NAV so then they could constantly issue out new shares which would attract new shareholders which would allow them to cover their distribution which wasn't sustainable to begin with and they kind I've enjoyed this cycle of virtue, where as long as you're at a premium, you can keep issuing new shares to people and keep paying an unsustainable yield because the new shares covered that yield for you.

17:35But now they're trading at massive discounts because they were forced to cut their distribution and investors are no longer interested in them as much, which is dropping them to a discount to NAV. But now their asset value is declining because there's a oversupply of CLO equity in the market. And it's kind of creating the opposite of a circle of virtue where now it's a circle of destruction where they've lost investor confidence, they cut their dividends, their nav is continuing to decline. And there's really where the bottom is that it's going to be, it's unknown. But it's one of those situations where investors kind of got caught up in the Icarus syndrome, they chased that yield to its maximum potential.

18:14And then when the music stopped, there was no chair for them anymore. And it's one of those situations where even though there's not high defaults in the credit market, unfortunately, supply and demand is causing the value of what they hold to fall too short.

18:29Scott Kaufman:What would you say about bonds? So I'm kind of fall in the realm of a lot of bonds are attractive to a point. We're not seeing a huge amount of defaults personally across what I'm seeing in the bond space, but also bond yields remain relatively low and somewhat unattractive given their taxable nature as far as the interest that they pay out, even though they're relatively low risk. I would prefer sometimes to take a step up into preferred equity, get a little more risk exposure, but get a significantly better yield, especially when you start factoring that you can get QDI paying preferred securities that are giving you 6 % to 7 % or even upwards of 8 % from financial securities or financial institutions that are low risk institutions themselves, right?

19:17Regents Financial offers them, You've got Bank OZK out in the Western United States that's offering securities that have massive coverage and significantly better tax characteristics for investors who are looking for that kind of income or stability in their portfolio without having to dive into bonds and the added fees and the taxable interests that are on them. The municipal bonds are attractive, but again, they're often in the 3 % to 4 % yield range. So unless you're in quite a high tax bracket or you have a ton of QDI dividends coming in, they're not going to be a huge benefit for you unless you're in a high tax state.

19:58So bonds as a whole kind of works as a buffer, but I almost prefer to use preferred securities as a buffer for the greater returns, even though you're taking on a little bit more risk depending on the company you're buying. I think investors need to understand, kind of like what I mentioned at the beginning, that the S &P 500 isn't likely going to give you the double-digit returns that we've enjoyed the last few years, largely because those returns outpaced earnings growth. And so this year, even though some were hoping for low double digits or even high single digit returns, until we see more earnings growth to kind of catch up to that, I wouldn't expect the S &P 500 to provide you with a outsized return like we've enjoyed over the last number of years.

20:44Because otherwise the average return, the S &P 500 would be significantly higher. I had a friend who was an analyst that said not every company can be above average or else average would be wrong. And so not every year's returns can be above average or else the average would be significantly higher. And we've enjoyed large double-digit return years for multiple years in a row, but the average is in the 7 % range. And so we're going to have to have some lower or negative return years to balance that out again. And I think the way to play it is to play cautiously, but not so cautiously that you're diving yourself into the ocean and you're not striving for the sun.

21:25And investors have gotten very used to a period of low interest rates where then they were forced to find higher equities and then a period of higher interest rates where then debt was offering a lot of better yields. And they've kind of gotten to both extremes. and now we're kind of in a place where interest rates are more in the middle. They're not as high as they were when the Fed hiked them quickly, but we're also not at the zero interest rate era anymore. And so we have to find quality and embrace the fact that quality is going to win over the long run versus perhaps chasing after covered, called ETFs that benefit most when the market is sideways or negative, but miss out on participating when the market is upwards.

22:09or funds that have unsustainable or imaginary basically yields that are paying out those yields to attract more investors, not to actually benefit all investors. And so balancing that by finding quality and focusing on good values is important. We see a lot of people discussing whether a company is good or bad as far as its metrics, and that's great, but then they fail to look at the value of what they're paying for. right and so they'll buy an overvalued company and then when that value comes back down to a normative level they're like man this company's been terrible it's like no the company's not terrible the entry point was terrible and conversely if you get a great entry point in a bad company you can still see good returns simply because the the value was trading at a discounted value compared to what it should be potentially and so every every kind of time you look at an investment, you need to screen it for quality, but then you also need to screen it for the value it's trading for to make sure that you're getting something that's not overpriced.

23:12But also be willing to buy things that are at a discount. A lot of people will say that they love to shop sales. You know, like you go to the store, I love getting a good deal on something when it's discounted or on sale. When it comes to the stock market and something's on sale, they're like, I don't want to touch that because it's dropped. But arguably, that's the time that it's on sale and it's worth buying more so even though it has dropped in the last 12 months, 24 months, if it is going from overvalued back down to undervalued again. And so I would say don't be afraid to buy things that are on sale that are quality companies like Visa or MasterCard or some of these companies have been caught up in being oversold because they were overvalued.

23:53Don't be afraid to buy those so long as they're quality. And if you're afraid of more downside risk before there's upside, put them on a watch list on your Seeking Alpha profile or put them on a watch list with your brokerage. And when they've seen some capital upside again, when it seems like the bottom is in and they're starting to climb back in, at that point, it's a great time to buy so you don't have to necessarily get all of the returns, but you're also avoiding some of that downside. And so ensure you're getting quality, make sure you're patient and understand what you're buying is not just the price of what you're buying, but you're buying the value and make sure that your price to value situation is worth buying into.

24:32Scott Kaufman:Appreciate it, Scott. Appreciate this conversation. As always, Scott Kaufman, you write under Treading Softly and your investing group is The Dividend Kings. Happy for you to share a bit more where investors can get in touch with you, what subscribers may expect from The Dividend Kings or what you're kicking around over there. Happy for you to share that. Yeah, thank you so much for having us. We are actually having at this moment in time through the month of March, an opportunity for investors to be part of our service for only a dollar for the year. What we're doing is anybody who joins in the month of March and does the$30 for a month long trial.