Question: How do you find opportunities for your dividend funds?
Will Browne: Because we have a portfolio that has a higher dividend-yield component to it, we're not, in order to create that portfolio, looking in a different place. We're looking in the same place and we're actually looking at everything in the same process, same methodology.
In essence, if you wanted to grossly oversimplify what we have done in the dividend portfolio, we have swapped some discount from the intrinsic value of the business for a yield component. I would say that almost any security that we own in the dividend account, we would own in our regular accounts were they 20% cheaper.
Now, not every stock that is in the regular accounts would be in the dividend accounts because they don't have the dividend component. And then what characteristics are they? I mean the characteristics of a business that pay dividends tend to be somewhat more mature businesses, businesses that throw off their cash. They invariably have had a long history of dividend payments, which would to some extent I think indicate a cultural commitment to the dividend. They on average tend to be a little bit more predictable businesses.
Obviously, for paper companies, the dividend is up and the dividend is down. You want steady payers at least from what we do. This fund is not about finding the highest current yield. This is about finding companies with above-average market yields that have the ability to have a rising income stream over a long period of time and have demonstrated the ability to do that in the past. Those are I think are markers, characteristics, to those businesses that are fairly transparent.
Tom Shrager: There are also companies that have been around for a long time, therefore they have a sustainable moat around them. And as Will has mentioned they are not very fast growers in general. And the mark in the dividend fund is these are companies that can grow let's say on average around 4% at the top line, have the ability to expand the margin a little bit every year, and generate enough cash flow to buy back shares. So, a stock that can grow at the top line 4% may grow at the bottom line 6% or 7%. If you add to that the growing dividend of 4.5% which is the average dividend, if the P/E stays the same, it's a very important P/E, theoretically you can get a return of 10% or more.
Question: Do you look at bank dividends differently after the financial crisis?
Shrager: It's very important when you look at the bank, at how it finances its loans. The ideal bank for us would be a bank that has more deposits than loans and then doesn't engage in a lot of the wholesale borrowing and speculating on the asset side. So you must look to see if you have a structure like this where your financing is in place; if you have a culture of conservatives, where you conservatively provision, where you don't pay your loan officers to make a lot of loans, but you incentivize them on the quality of the loans that they make; if the regulatory environment is such that they would be allowed to pay a dividend. So, you take all of these things together and put them in a pot, and if the soup tastes good, then you make the investment.
Browne: You know financial services is one of those catch-all phrases that incorporates companies in multiple industries, such as insurance, credit card, banks, you name it. We own some insurance businesses that pay very high current yield; they've been good dividend payers. Within the dividend portfolio, we would not invest in a bank--if it met some of the tests--on the hunch that somewhere down the road, they might be paying out enough income to get it to an above-average market yield.
There is enough that we can find to do. We don't need to do that. We've been making and building a position in Wells Fargo. We can basically see the return of the earning power there by virtue of the rundown of the loan-loss reserving that's going on, and we are willing to do it. But there are questions with financial-services businesses going forward. How much capital will they be required to have? How much leverage can they have? Their ability to earn high returns on equity is a function of how much leverage the regulators give them.
Then there is this question from our point of view, which led us to get out of lot of those things when the markets went bad. We ended up, I think on a micro basis, being very fortunate. We sold most of the financial businesses because the leverage was godawful. There is no way you can be leveraged 30 to 1, and feel secure. So we got out.
I mean, what we missed quite honestly was the metastasizing of it, that it would impact everything on such a macro basis, on a worldwide basis. But individually, again, as you're looking at these things today, you ask yourself, "OK, what is the capital that they're permitted to have or they're required to have? What is the leverage they're permitted to have on that? What's a likely expected return on that? Does that business make sense as a valuation and arithmetic exercise?" We haven't found a lot of U.S. banks that way.