What 3 Managers Think About Dividend Stock Investing Today
Managers from Vanguard, Columbia, and J.P. Morgan discuss variable dividends, share buybacks, and what high inflation and rising interest rates may mean for dividend stocks.
A version of this article first appeared in the July 2022 issue of Morningstar DividendInvestor.
For me, one of the highlights of the 2022 Morningstar Investment Conference was a panel on equity-income investing. Morningstar’s associate director for U.S. equity strategies Tony Thomas moderated a discussion with three longtime portfolio managers of such strategies: Scott Davis, manager of Columbia Dividend Income LBSAX, Clare Hart, manager of JPMorgan Equity Income OIEIX, and Don Kilbride, manager of Vanguard Dividend Growth VDIGX. These strategies aren’t managed with a primary focus on current income, yet for the most part, they’re swimming in a pool of dividend stocks favored by many income-focused investors.
Some of the topics they covered included:
I’ve arranged several of the managers’ most pertinent comments, which have been edited for clarity and length, by topic.
Some companies—especially those in energy exploration and production—have introduced a variable component to their dividend payouts. As David Meats, Morningstar’s director of equity research for energy and utilities, has noted, variable dividends make sense in this industry because these companies have committed to boosting their returns to shareholders, yet the cash flows are directly driven by commodity prices. By using a variable approach, E&P companies have the ability to return more cash to shareholders without making a commitment to a fixed dividend rate that might prove to be unsupportable. Both of these trends—the commitment of E&P companies to increasing cash returns and the mechanism of variable dividends—were addressed by the panelists.
Hart: “They actually have a lot more respect for the shareholders now, I think, than they did in the past. And I think a lot of these companies really did it in the right way, where they increased the dividend, but they had sort of a variability element depending on what’s going on with the commodity price and how much extra free cash flow they do or don’t have.” (Two such energy companies, ConocoPhillips COP and EOG Resources EOG, were among Hart’s top 20 holdings as of May 31, 2022.)
Davis: “It used to be you put everything back into the ground. ... The variability of the dividend—I think that makes so much sense. I think they’ve thought this through and said, ‘OK, we’re not going to tie ourselves to a fixed payout,’ but (with) the variability they’re returning the cash.”
Hart: “I just think, again, versus even 10 years ago I just think it’s such a seismic shift in terms of how a company thinks about its shareholders.”
Learn more about this trend in the article ”The Pros and Cons of Variable Dividends.”
For income-focused investors, the discussion about share buybacks often addresses the idea that the dollars devoted to buybacks could have instead gone to dividends. But Hart considers share buybacks to be a separate component of the capital allocation equation: “I think about dividends as returning money to shareholders. Some management teams talk about the money they return to shareholders and include buybacks. But I put buybacks in another bucket. If you’re doing buybacks, it’s versus M&A. So, if the company’s doing an acquisition or buying a piece of something, I always want to know, how does that offer better returns to me as the equity investor versus buying back your own stock?”
She continued, “I’m an equity investor, too. I don’t cringe when I see my company’s buying back stock. I’m not jealous that they’re not giving me more of a dividend, because I’m thinking to myself, well, I’m an equity investor. They see value as well. But I am not opposed to buybacks if they’re done carefully at a good valuation and not dressed up in lieu of something else.”
Davis: “Sometimes buybacks are just used to offset options, quite frankly. It’s really just dealing with dilution. If it’s done right, you have a sense of what the intrinsic value of your firm is. But oftentimes, it’s not really thought through. It’s sort of automatic, where it doesn’t seem to matter where the price is. I find banks interesting, because the times when most should be buying back their stock, they can’t buy, because they’re not allowed to. I’m sure Jamie Dimon [the CEO of JPMorgan Chase JPM] would have loved to have bought stock back two years ago.”
Davis: “On the inflation issue, bonds obviously are important. We used to talk about TINA stocks: “There is no alternative.” Well, if you get bonds going up, there’s going to be an alternative. One reason inflation is of interest is that it has an impact on interest rates. The Fed is basically dual-mandated. They’ve solved the unemployment problem, and now they have to deal with inflation.”
Kilbride: “There’s two dimensions to the question, one easier to talk about than the other. The bigger dimension, which I think is trickier, is how do investors perceive dividend approaches in a world that’s changing insofar as inflation goes? What I’m more certain about is how we think inflation’s going to impact the companies in our portfolio. In a world where we’re experiencing inflation for the first time in a long time, you’ve got to circle back to your companies and try to figure out who’s got the ability to weather this. You want companies that you think can negotiate their way through that—they can pass it along or they can even price for it. The list of companies that can do that sustainably really gets narrow. Any company that can price successfully has got to be doing it from a basis of innovation or brand or a product that is a small percentage of their customers’ expense but very important. We’re trying to think about our companies in those dimensions.”
Davis: “We want to be very careful about real versus nominal. I may have a situation where sales are up because prices are up, but they’re actually selling less. I have to be aware of things like that. This should be a time where people that are in our business of equity selection should be able to do a little bit better, hopefully. But I do think it’s going to be a tricky period.”
Kilbride: “In my view, the most important job any management team has to its financial shareholders, not all stakeholders, is to spend our money well. Job number one is to invest in your business and make it more valuable over time and create value and then take that value and give it back. There are multiple ways to do that, share repurchases and dividends being the principal. We prefer dividends, obviously.”
Davis: “I agree with Don. We don’t try to tell you how to run your company. But what we do think a lot about is capital allocation. How are you going to use that free cash flow that’s generated? Are you using it in a shareholder-friendly way or not? You should be able to articulate a dividend policy. What are you thinking about as far as payout ratio? How capital-intensive is your company? How cyclical is your company? What do you think is sustainable? What we’d like to see is growth in the dividend in line with the growth of the free cash flow of the corporation. We really don’t want you going out and announcing a 50% increase if you can’t afford it.”
Hart: “We owned Pfizer PFE a long time ago when they paused their dividend because they were doing M&A. They were quick to say they were going to bring it back on line within one year’s time, but that gave us some pause. The dividend’s really important in what we’re doing. For a company to decide to do something instead of the dividend— to me, that is difficult. The financial crisis was a bit different. A lot of banks put their dividends on pause; eventually, they were required to by the regulators. That was the first time that I had to think, ‘What do I do about a company that’s actually not going to honor its obligation?’ But it made sense, because as one of those management chiefs told me, ‘Clare, it’s not that we can’t pay the dividend, but we don’t really know what’s going on, and nobody does.’”
Davis: “The question is, why did they cut the dividend? If it is because of real fundamental deterioration, my hope is I’m not around that stock by the time that becomes evident. A lot of it is pretty simple math, not rocket science. In my mind, the dividend is supported by free cash flow from operations. There are times when we’ll allow that to slip. But historically, if that goes on for some time, that is a classic type of dividend-cutting situation, where you’re either borrowing money or you’re selling assets to pay it. And most dividend cutters go down before the dividend cut takes place, so you’ve got to figure it out. The average dividend cutter is down 20% 12 months going into the dividend cut in absolute terms.”
For more insights from top managers and industry experts, see the special report, 2022 Morningstar Investment Conference.
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David Harrell has a position in the following securities mentioned above: PFE. Find out about Morningstar’s editorial policies.