A Guide To Dividend Investing

May 23, 2020

On this week’s podcast, Karl Eggerss welcomes John Keeton, CFA to discuss dividend investing.  John gives the audience several items to consider when buying a dividend stock.

 

 

Karl Eggerss:                      Hey, good morning, everybody. Welcome to the podcast. This is Karl Eggerss and this is Creating Richer Lives. Just a reminder, our website is creatingricherlives.com and the show is brought to you by Covenant Lifestyle Legacy Philanthropy. And in just a little bit, we’re going to be talking all things dividends. We’re bringing John Keeton in. He’s a Chartered Financial Analyst here at Covenant, and he’s never been on the podcast before. I think this is his podcast debut. So we’re going to bring him in, in just a little bit and discuss everything about dividends because we’re seeing some really juicy dividend yields, we’ll call it, meaning if you buy a stock, what is it going to pay you in a percentage terms? Some of them are paying 4,5, 6%, maybe even higher. Is that a good thing? Is that something you should be looking for?

So we’re going to discuss things to consider as far as if you are interested in that and where does it belong in a portfolio and should you be interested at all? But first, let’s chat about the markets real quick, because we have really a good week that got off on a really strong footing. Monday, the Dow Jones was up over 900 points due to potential good news from a company called Moderna. That was up over 1000 at one point. It was interesting because, according to Bloomberg, Monday’s open, when the market first opened, it was the most lopsided in history of the New York Stock Exchange’s Uptick Minus Downtick Index, which hit 2049, and that goes all the way back to 1990. So basically, everybody was buying, all stocks were going up. It was pretty interesting to watch, and it’s a big deal.

If we have a vaccine, that means that you don’t have to worry about this, but there’s a lot of question marks. There’s a lot of question marks with everything. When is it going to come out? Is it going to be safe? What about people that don’t take a vaccine? The number of people that were in the study, there’s a lot of things to take into consideration here. And, to me, what’s interesting is I don’t ever like to really see the market bounce just on some type of news event like this, because if they come out with some negative news regarding Moderna, what do you think is going to happen? The stock market’s going to fall on that. So I don’t like these news driven days. Very, very strong. Gave back about half of those gains on Tuesday, really for no reason. The market just kind of sold off into the close and very strange, there wasn’t any rumors, I don’t think.

But Wednesday, we got back every bit of Tuesday’s losses. And it was kind of a quiet week. We saw more bad news as far as the unemployment is concerned with 2.4 million people file for unemployment. Now, what was really interesting and maybe sad and scary all at the same time is that the previous week was revised down from 2.981 million to 2.687 million, so you’re talking about a 300,000 difference, about a 10% difference, and that was a revision. The bulk of the revision were because of a posting mistake from the State of Connecticut where an extra zero was inadvertently added to their number. Don’t we have computers to be doing this? I don’t understand, but we ended up seeing really late in the week some talk again about China tensions. And I’m getting more and more comments lately about just how can the stock market be sitting at these levels?

And there’s a couple of things to think about in the big, big picture here. Number one, my personal opinion is that, we probably should be sitting somewhere between the lows and somewhere between the old highs. To go to new highs, I would be surprised if it did that. I’m going to give you a caveat in a minute. And it’s just because, look, when we were at the old highs, the markets were not cheap to begin with. So when you factor in unemployment and reduction in spending in this economy that’s going to improve, but in a longer term gradual pattern perhaps, it doesn’t seem like stocks would justify those levels of the old highs. Now, should they be at the old lows? No, because we are opening things back up and a lot of this was temporary, not permanent. That’s the key. The market was pricing in a permanent situation of almost a depression. That’s off the table, in my opinion.

So I think the markets should be somewhere in between. But when we talk about the market, you’ve got to break it up. Because if you look at dividend paying stocks, if you look at small companies, if you look at value, anything like that, they’re still way off their highs. So we’re not talking about just tech specific or just the standard and Poor’s 500, the large cap growth. If you look at that as “the market”, then you’re right, it doesn’t seem like the market would be justified at these levels. But there’s plenty of great opportunities in the market. Now, putting all that aside, should the market be at these levels? The big caveat I mentioned earlier is the Federal Reserve and the Treasury and the amount of not only fiscal but really monetary stimulus we’ve seen, that stimulus is unprecedented.

And we know and you know, go back and look at history, when they pump money into the system, markets tend to go up. Is it possible the market is going up purely based on that and has nothing to do with the reopening? Maybe. Could it surpass the old highs and get a valuation that’s crazy and then markets get very expensive? It is possible. And that’s why we always need to keep an open mind, and it goes back to diversification and it goes back to not thinking you know something and swing in your portfolio to reflect that view of yours, but rather say, “Could I be wrong? Could I be wrong? And if so, I need to own some other things.” That’s really what diversification is all about. And part of that diversification are dividend stocks.

As I mentioned earlier, we have John Keeton, who is a chartered financial analyst and all around nice guy, and it’s his first time on the podcast here with us. And John also holds a Masters of Science in Finance from the University of Houston. Graduated with honors, which basically means that he’s smarter than I am. And so we are going to welcome him into the podcast and try to keep up with them. But we are going to discuss something today, I mentioned it earlier at the top of the show, we’re going to talk all things dividends. The pros, the cons, especially during this time with the market volatility. Can it play a part in a portfolio? How you should really think about it. So, John Keeton, welcome to the podcast,

John Keeton:                     Karl, thank you very much for having me here.

Karl Eggerss:                      All right. Well, let’s dive in. You brought this topic up to me off air and you and I have both had some calls recently from various folks just asking about, “Wow, I see because stocks have fallen that there’s some companies out there paying a 5, 6, maybe even a 7% dividend. How can I go wrong with that? Should we be waiting more towards those types of companies, whether it’s in a basket or individual?” So I think it got your brain going. Let’s really dive into dividends and talk about it. So where do you want to start with this? Do you want to talk about, really, where do these dividends come from? People think it’s kind of magic fairy dust from these companies, but it’s coming from the company themselves.

John Keeton:                     Yeah, Karl, you took the words right out of my mouth too, because there are individuals that are out there, investors, who do believe that dividend is just the mailbox money that they don’t necessarily understand the effect of what a company is doing when the dividend is actually distributed. So, for instance, when you think of a company who does distribute a dividend, it’s coming from retained earnings. So this is income that has been generated by a company that they have a choice. They can either return

John Keeton:                     The money back to a shareholder, or they can take those dollars and reinvest it back into the company for future growth. And so at the end of the day, when a dividend is distributed, it actually lowers the value of a company. And so you will see that when a dividend is distributed, that the price of the stock actually comes down the same amount as the dividend that was distributed. And so clients and investors may not necessarily see that move because prices are moving constantly throughout the day, every single day. But in essence, what you are seeing is you are seeing that the price is coming down exactly the same as that dividend distributed.

Karl Eggerss:                      That’s a good point. I mean, it’s no different than if I gave you a $100.00, my net worth just dropped a $100.00. And to really complicate things, when a company pays a dividend out to you, if it’s not in an IRA, the shareholder’s paying taxes on that. So it’s not a super efficient use of funds, but it’s something that’s been around for a long time. And some companies, older companies, and we know a lot of them that are 50, 70, 500 year old companies. They’ve been a consistent dividend payer and there’s really no going back and they really have to keep that going because that’s what they’re kind of known for. And there’s a lot of people that rely on that income.

But to your point, how many companies do we know, especially in the technology space that don’t pay a dividend because they’re in a growth mode, they’re in the S curve of the growth mode of the company, and they know paying it out is not productive to shareholders. But it does bring people comfort to know that I’m getting some of my money back, I’m making some money back, as opposed to something that’s in a black box that until I sell it, and have to find somebody to sell it to at a higher price, I don’t know if I’m going to make money on this investment.

So income does play a big part, and we’ve stressed that on this podcast for years, and I know you’re a proponent, we’re talking about specifically dividends today and just the mechanics of it.

John Keeton:                     Yeah. And so really Karl, what it is, is just trying to find that middle ground and that nice balance for each investor to have growth opportunity type of investments in their portfolio, but also have securities that are generating a yield, whether it’s interest payments on a fixed income side, or if it’s dividend yields, when it comes to your underlying equity holdings. And so that’s where you just want to find a nice middle ground that is there that also makes sense to that particular investor’s overall financial plan. Because as you mentioned, there is a tax component that is there to the investor. They’re having to pay a tax on that dividend. And if that investor needed those dollars to maintain their lifestyle, well, that’s a fantastic way, especially if it’s considered what is a qualified dividend, which you could be taxed just like a long term capital gain. t’s very similar, if it’s considered a qualified dividend.

But there are other dividends where it’s considered ordinary. And so if it’s an ordinary dividend, you also have to be mindful of that, because that’s going to be more ordinary income tax. So investors just need to be aware of what they are investing in, and knowing the difference. And so they can make that best decision for themselves. Yeah. So Karl, just to add to the point as well, too, the conversation that we have with clients at Covenant is we do have a conversation when it comes to the dividend yield, and just yield overall, but we actually take a more of a total return approach.

And so looking at if you have a stock, or a mutual fund that’s invested in equities, that has an overall dividend yield of call it two to 3%, we take that into consideration, but we also look at the price appreciation expectation. And so we look at whether that might be a total of a seven or an 8% type of total expected rate of return. We take into consideration more of that total return, and not necessarily just the dividend yield that is there, because a company could easily be, of course can be providing that five and 6% dividend yield, but you also have to take in consideration the price appreciation capabilities of that particular stock as well. And so that’s just one thing that we do for clients at Covenant is taking more of that total return into consideration.

Karl Eggerss:                      Yeah, that’s a good point. I think we know, we won’t name names, but there are technology companies that have never paid a dividend, that have been some of the best total returns for people in human history of stocks in the last 10 years. At the same time, there’s plenty of great dividend companies, but their stock hasn’t appreciated, let’s say in the last 10 years. So all you’ve received is the dividends, and that may be okay, but the point is that when you look at the comparison, and it was more tax efficient to own the non-dividend paying company. And the other thing is what we’re going through with the COVID-19 crisis is that there are companies to your point that have been stalwarts, aristocrats, paying dividends year after year after year. And then there’s a major disruption in their business because of this, things that they’ve never seen before, and they’re having to either drop their dividend dramatically or cut it.

So when you see a 5% dividend, it is not a CD. It is something that they have to declare every quarter, and the Board of Directors gets together and says, “Do we want to do this or not?” Or other management of the company-

John Keeton:                     And Karl, what you’re talking about-

Karl Eggerss:                      -and they can change it.

John Keeton:                     Oh yeah. And I apologize for interrupting you there, but when you think of this unprecedented time, if I only had a dollar for every time that I’ve heard this over the past couple of months in terms of the environment that we’re in, but I was a part of this industry back in 2008, 2009. And there was a lot of things being described as unprecedented times. And so when you think of companies that have cut, or even just gone ahead and suspended dividends, we’ve seen close to 50 companies so far cut or suspend dividends this year that are held in the S&P 500. I was reading an article just the other day that 200 companies, of course, inside the S&P, outside the S&P, that have cut dividends so far this year.

When you compare what took place in ’08, ’09, there were closer to 150 companies during that span of call it a year and a half, where dividends were either cut or suspended. And so it’s just another point again, to just be mindful of not necessarily just looking at a dividend yield for a potential investment, there’s other moving factors that are there. And perhaps we can dive into some of those specifics here on this particular call, but you know what Covenant is doing when we are looking at underlying equity exposure, we like the approach of companies growing dividends. And that, even in this particular environment over the past couple of months, I was reading that there’s closer to call it 50 companies who have actually increased their dividends during this time period. And so those are the opportunities that we like better when it comes to companies that do have a dividend yield, are companies expanding and growing their dividends.

Karl Eggerss:                      Yeah, it’s really important, because let me paint you a scenario. You have an 80 year old widow of a husband who worked at a large blue chip company that pays a dividend. And she literally goes to the mailbox every quarter to get that dividend check. And every quarter, or every year, she’s getting a 8% raise, a 9% raise, a 6% raise, a 12% raise. There are situations like that where their income literally is going up way faster than inflation, and they don’t pay as much attention to the price of the stock because they’re literally living off the income. And those are great scenarios.

I think not only are dividend growers important, yes, there are some companies that, because the price of their stock has fallen and their dividends the same, your dividend yield is increase. So there are some good opportunities in there. But to your point, you don’t want to just focus on that. There’s not only high dividend payers, there are dividend growers. There’s also dividend initiators. That is a group of companies that just have started a dividend. And they’re at that part of maybe they’re still growing quite well, but they are a large company that can establish a dividend, and maintain it. And so they may pay a 1% dividend right off the bat. And you say, “Well, that’s not great.” Well, what if

Karl Eggerss:                      Increasing it by 20 or 30% a year.

John Keeton:                     Sure.

Karl Eggerss:                      And there are a lot of companies that are in that spot. So I think if you were even looking at dividends, having these really compliment each other as part of that. But I think you’re right. I think when you’re looking at income, not only do you have to look at, or total return, I should say, not only do you have to look at the dividend income, there’s interest income on a bond portfolio, there’s real estate income. And then there is a part of the portfolio that is just pure capital gains. And that’s sometimes where you get your most growth, that you will get your most growth over the longterm.

It’s not from the income, but it very much depends on every client situation, where they’re at in their life, what they’re looking for. But I do see the same thing you do, which is we see these high dividend yields I think a lot of people are buying companies that pay a high dividend. And the reason they do so is because the stocks dropped and there may be a reason the stocks dropped, and you may not want to buy those high dividends because it’s a temporary or fictitious number, because they could very well cut it in the next quarter two.

John Keeton:                     That’s right. And so when we think of historically how dividend yields have been, just over the past 20 years. Just as an example, the S&P 500. It tended to be right at about that 2% dividend yield overall on average for the past 20 plus years. Now, we saw it drop a little bit. It may be lower to call it around 1%, and that was back in the dotcom era in the late ’90s. And I think that is because, to your point with like an Amazon, that the S&P was so heavily weighted technology, that it caused the overall S&P dividend yield average to come down a little bit. But during this same time period as well too, you saw the 10 year treasury go from, call it, a 7%, back 20 years ago, to where it is today, which is 70 basis points.

And so on a relative basis, what you were seeing, you could have been in a treasury for 7% 20 years ago, still getting a 2% dividend yield. Today, dividend yields are still looking to be, on average for the S&P 500, right at about 2%, when we are less than 1% on the treasury for 10 years out. One point could potentially be is that in this low interest rate environment, would companies be more compelled to if they cut or suspend their dividends, do they maintain that lower dividend payout because of this particular environment that we’re in, being a very low interest rate environment? And our thoughts here at Covenant is that we believe that we could probably be in a lower rate environment for a good amount of time, too. So multiple years going forward. And so just other things to be considering when we’re thinking of overall interest rate environment and just dividends in general.

Karl Eggerss:                      Yeah, those are good points. And I think that’s partially why there is this even more of a really demand for higher dividend yield is because people know they can’t get their old return they could get in CDs, in money markets, in good old fashioned US bonds. So they’re saying, “Well, I can go get good income in the stock market.” And that may be why, with interest rates plummeting in February and March and April, why the stock market has recovered so quickly is because there’s literally no yield out there right now. And you have these people flocking to anything that pays income in the stock world. We’ve seen, to me, elevated valuations in things like consumer staple type stocks, utilities, those types of companies that have been known to pay good dividends are very expensive right now. And maybe they deserve a big premium because of the fact that there’s nothing else to compete.

So I think that is something that’s caused that. And I know Justin Paul, our CIO and myself, when we did our economic review video, which you can see on our YouTube channel a couple of weeks ago. When we did that, we showed a chart of how much a money market paid and savings account paid at the time. And prior to the financial crisis, you could sit in a money market or a savings account and beat inflation. And you can’t do that, even though inflation is low right now, you can’t do that. Hence, people have to go out on the risk scale. And what it’s causing, as I think what you’ve been saying is, it’s causing a little perhaps sloppiness on the part of investors where they’re reaching for yield and maybe not knowing the actual dangers that may come along with that.

John Keeton:                     Sure.

Karl Eggerss:                      In fact, one thing I would recommend folks do, if you are researching a stock for dividend yield, or dividend increase in whatever it might be, look at how much they’re paying out of their earnings, their free cash flow. Are they basically just there to function as a dividend payer? Are they really there to grow the company and pay some of the profits back to the shareholders? And it’s amazing when you see the trends developing, a lot of these companies are in existence to pay dividends. They’re literally paying almost everything out, and that’s a concern.

John Keeton:                     Sure. I would agree with that, very much so. Because when you think of a company and you think of an overall investment, you want to be able to see earnings grow. And so when you just have a company that is taking all their retained earnings and distributing it out as a dividend versus reinvesting into the company. Now, granted, we’re talking generalization here. But you do want a company that is growing earnings. And so when you have a company that is distributing all earnings out, that’s a good indicator that the company doesn’t necessarily have a strong feel about where future growth is coming. So they’re pushing back and distributing back those earnings back to that shareholder that is there. But it’s a very good point that you did share there, Karl.

Karl Eggerss:                      I would also point out too, if you own a stock right now that has been either cutting or eliminating their dividend, research it a little bit because it may not be the opportune time to sell. It sounds a little counterintuitive, but a lot of companies will eliminate their dividend. The stocks already fallen. And when they eliminate their dividend, the stock actually starts going back up quite a bit because they’ve saved that money and now they can make it. And so I’ve seen that time and time again, that there’s usually a better time.

You’re wanting to get out of a stock because they’re cutting their dividend. And as soon as they eliminate it, the stock tends to go straight up for a while, and then you get a better chance to sell. So it’s really interesting. So just again, all of this takes a lot more analysis and to what you said earlier, which is people start with a screen, “Show me all the stocks in the S&P that are paying over 5% dividend yield and those are the ones I’ll buy.” And that’s a bad way to do their analysis.

John Keeton:                     Yeah, I would agree. No, there’s a lot of moving factors and parts to take into consideration. And Carl, to your point about the story about the widow, elderly widow. Think of now an elderly couple that have had this individual stock that they have held for multiple decades. And so the cost basis on the stock is so low that… Don’t listen to this message here and think, “Oh, wow. We have to consider selling.” Because maybe perhaps the forecast of earnings isn’t going to be growing as much. But the cost basis is so low that if they were to sell it, they would realize all of that gain.

One thing to take into consideration is that if someone were to pass away, there is something called a step up in basis. And so that means what you paid for the stock, call it 20 years ago, may have been at $2, and now the stocks at $10. Well, there’s an $8 unrealized gain that is there and you don’t necessarily want to sell and realize that gain and pay the tax. If and when, unfortunately, it sounds very morbid to say that, but when we do pass away, the underlying holdings that we have do step up in basis. So you wouldn’t want to go ahead and realize something and incur that capital gains tax. You may consider waiting until that step up does take place. So just another fact to consider.

Karl Eggerss:                      Or let’s say that same couple’s given $10,000 a year to charity, why not give $10,000 worth of stock, keep the cash in your pocket, which you can reinvest in a different stock if you’re wanting to diversify, what have you? So there’s many, many tactics to take, as opposed to just selling it right off the bat, paying the taxes, and then giving it away or whatever.

John Keeton:                     Absolutely.

Karl Eggerss:                      Yeah. I think the other thing that I’ve noticed is, correct me if I’m wrong, but it seems like back in the ’20s, ’30s, ’40s,

Karl Eggerss:                      It was very common for most companies to pay dividends, and that was just a common thing. And I think we’re still maybe in that mindset, but there’s plenty of companies who don’t pay dividends, and maybe never will, and they’ve been successful, as we’ve said.

I think what’s interesting about this, is I was looking at a study that showed that, during bear markets, dividend stocks, the ones that pay dividends, tend to be more defensive and hold up better. And that may make sense, right? Because those people that are relying on that income, like the widow, they’re not going to sell that. They have to have that income. But we haven’t noticed that really since the great financial crisis, we haven’t noticed that dividend stocks hold up any better than non-dividend payers. So something in the marketplace may have changed. So that’s something to take into consideration, that they’re not always safer. And so, do you have any comments about that?

John Keeton:                     You know, Karl, and you highlighted it a little bit earlier on the call too, where, in this environment where interest rates are so low, that investors out there are having to stretch, stretch for yield, stretch for a return, and so perhaps not valuing that dividend approach as much. And with technology, that has just been fantastic. The performance of technology just in the past couple of months by far has outperformed year-to-date or over the past couple of months.

And so, that’s what we’re seeing as well too, is that there’s really no place to run to generate more return. And it’s really just one area, and it is to take on more risk within your portfolio. And that might be one reason why that more of the growth-oriented type of companies that have lower dividend yields have outperformed more of the value companies that you mentioned that have maybe perhaps a higher dividend yield.

Karl Eggerss:                      Yeah. No, that’s a good point about technology because when we look at the biggest five companies now, they’re all technology. When we looked at the five biggest companies in 1975, they were five very distinct companies in very different spaces, and most of those paid dividends. And because the five biggest companies now are technology companies, and some pay dividends, they’re pretty low though, they’re not known for that, they’re known for innovation, building new plants, patents, all of those types of things, and they’re not paying out big dividends.

And I think when you think about kind of the known stocks, like for example, if you were to ask a hundred people walking on the street what companies would they invest in if they weren’t even investors, and they would probably list off some of the technology companies because we use it, we know it.

And so I think there is something to that, that investors are kind of changing their tune to, and I don’t want to mention names, but some of the old guard, these aren’t your grandfather’s companies. And so, the character of the market has changed a little bit. And I do think at the end of the day, that companies, you pay too much for something, you penalized, and you pay a reasonable price for something, you get rewarded. That will come into play. But some of these companies might deserve a premium temporarily, as we’ve said, whether it’s a utility company paying a great dividend, or a technology company because of what they do not paying a dividend. They may deserve a premium temporarily, but just be careful.

And I think what you’ve underscored is diversification, total return. We’re not saying don’t do dividends and we’re not saying only do dividends. It’s when you say, “I don’t like mutual funds,” or, “I only buy companies that have dividends,” when you have these only statements or never statements, I think that’s when you get into some issues in a portfolio.

John Keeton:                     Sure. I completely agree with you. And that’s where, we at Covenant, we would love to have that conversation with anyone that’s out there to identify all the different factors and all the different moving parts that are there so you can make the best financial decision for you and your family.

Karl Eggerss:                      No, that’s a great point because we know there’s a lot of creative ways to get retirees income without just buying dividend stocks. And so oftentimes, people do come in, “Why do you have 90% of your net worth in the stock market?” “Well, that’s because I buy dividend stocks because I need that income.” “Well, what if we were to show you maybe a safer way, or potentially a safer way to diversify and get the same amount of income?”

So there’s all types of things outside of the stock market that can provide reasonably good income and just diversify a little bit, and perhaps lower the volatility. And again, dividends play a part in there for sure. But like you said earlier, why not have dividend growers versus the highest dividend?

John Keeton:                     Completely agree.

Karl Eggerss:                      Well John Keeton, one of our Covenant advisors, and on the leadership team with me as well, and a CFA, thanks for joining us and I hope you come back.

John Keeton:                     Well, I hope I did good enough and got your approval enough to come back, but what a great thing to do. So thank you very much, Karl, for having me here.

Karl Eggerss:                      You got a great face for podcasts, so I think you’re going to make it.

John Keeton:                     Thank you. I don’t have your laugh though, so that’s not going to cut, but anyway, thanks again, Karl. Great to be here on the show.

Karl Eggerss:                      All right, John. Thanks a lot.

John Keeton:                     All right, take care.

Karl Eggerss:                      All right, well thank you again to John Keeton, my guest this week, discussing dividends, all things dividends. And if you want to go back and listen to it, of course you can. We transcribe it so you can read it in a blog. Share this with somebody. If you know some people that are asking about dividend stocks. How do they work? What should we be looking for? Refer back to this interview with John. That would be great. And we always appreciate you listening on Spotify and iTunes, and actually, it’s called Apple Podcasts now. It’s not called iTunes. Apple Podcasts is how you listen to these. But we’re on all those streaming platforms for podcasts, so you can go on there. Leave a rating. That would be great, as long as it’s a good one. No, I’m just kidding. Not really kidding, but kidding.

All right. Don’t forget, you can go to creatingricherlives.com.

Hey, happy Memorial Day. We thank all of our veterans out there, both those serving now and those that have served in the past. We appreciate you very much. So have a great weekend, everybody. Take care, enjoy yourself.

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