Sonya Morris: Hello. I'm Sonya Morris, editorial director with Morningstar's mutual fund analyst team, and I'm here reporting from Morningstar's Investment Conference. And I'm joined today by Hersh Cohen, CIO of ClearBridge Advisors and manager of ClearBridge Legg Mason Dividend Strategies.
Harry "Hersh" Cohen: Lot of names to remember.
Morris: There are a lot of names to remember.
Cohen: Especially when you've changed names as often as I have.
Morris: Well, I think the key word to focus on is dividends.
Morris: You're obviously a dedicated dividend hound. I wanted to explore that idea with you a little bit further.
People seem to be clamoring for income wherever they can get it. They are going to REITs and closed-end funds. One area they seem to be ignoring are dividend-paying stocks. Can you talk a little bit about why you think that's a good strategy for income-hungry investors to explore?
Cohen: Sonya, I scratch my head as to why people are ignoring them, although when I dig a little deeper, I believe it's because people are nervous about stocks and they think stocks are this risky asset category, which they can be, obviously, and we've had two big bear markets over the last decade.
But even if you look at the last decade, where stocks went down 2% a year compounded, dividends went up almost 6% a year compounded. And so, what I try to tell people is that dividends have returned 40% of the overall market returns over the last 100 years, call it, and there's a reason for that. Companies reward shareholders' share of the profits with their shareholders.
And what you have now because stocks have had these bear markets and because stocks are neglected, what you have now are these really first-rate companies, most of which people would instantly recognize and feel comfortable about it, if they actually thought about it, because they use the products and they see the products being used, the products tend to get used up. And so, there's a constant demand. It's not like the business is going to fall off a cliff in the next quarter.
And the upfront returns available on these companies now range from being low 2% up to 5% and 6% in some cases. And when you compare that to the risk-free rate of return, call it a 10-year treasury, call it a five-year treasury, I just think it makes a lot of sense. And so, people say to me, how can I get more income with no risk. You cannot get more income with no risk.
But you can get more income with going a little bit up the risk scale without doing things that don't have as much transparency, don't have as much liquidity. You can really own great companies today where they have terrific balance sheets, high return on equity, and sustainable rates of rising dividends. And that's a good thing.
Morris: And rising dividends, too, I think is important to emphasize. You're not just looking at the size of the yield, you want to see that that dividend can grow over time.
Cohen: If you just look for the size of yield and are not careful about choosing what you own, you can run into companies like GM or Kodak, where the dividends – where the dividends can get cut. So, no, we're not just looking for the highest possible yield. We're looking for, in some cases, yields below 3% but where the dividends have been raised every year for some protracted period of time.
Morris: What about banks? How do you get comfortable with those dividends for the opacity of the balance sheet?
Cohen: Yeah. I don't – I am not comfortable with the big banks. I have never been a big fan. There are occasionally some regional banks that have really – they're overcapitalized that have maybe the potential to be taken over or to raise the dividends materially. We own a couple of those now. The one that we feel best about is Peoples Bancorp of Connecticut is way overcapitalized. They haven't done any FDIC-backed acquisitions yet.
But overall, the big banks, I am not really comfortable with them. I think I don't understand what everything on the balance sheet, how it's been accounted for yet.
And I think, what is it telling you? When the Federal Reserve is keeping rates at zero and telling you they're going to keep doing that, it's not to help the savers, it's not to help even corporations where interest rates being at 2% wouldn't make much difference. But the banks really need to reliquify. And as long as the Fed is telling you that the banks have to pay zero for their money and get some other – some rate of return above that, that kind of makes me nervous in terms of investing in them. So, I'd be careful.
Morris: What areas do you like? Are there any particular sectors or corners of the market where you're finding attractive bargains?
Cohen: There's a good cross-section of the companies across sectors. But I do love companies that make products that people want or need, where the products tend to be used up. And so, we're talking things like Heinz and Kimberly-Clark and Procter & Gamble and Johnson & Johnson.
There are a few industrial-biased companies that I think are really interesting; 3M which has consumer products that get used up like Post-its, but also make industrial products and health-care products. And they've raised their dividend every year for, I think, 40 years now. PPG, which makes paint and glass, has raised their dividend also for close to 40 years, and even in the worst of the recession they raised it by a small amount last year and the year before. But I tend to really like these great consumer type franchises as being particularly attractive.
Morris: If the current tax law is allowed to expire, the tax rate on dividends is going to go up next year. And we've been hearing it at the conference from Jeffrey Gundlach and others that we just better get used to higher tax rates in the future. Does higher tax rates spoil the case for dividend investing?
Cohen: Well, it makes it a little less attractive. And I think that there is this sort of golden age in the past eight years for dividends when the tax rate was down to 15%. When I came into the business, it was called double taxation of dividends. I've not heard that. Have you heard that term at all ever?
Double taxation of dividends meant the corporations pay dividends out of after-tax earnings and then individuals get it and they pay taxes on it. But Congress never wanted to tackle it until we had the terrible bear market of 2000 to 2002. And I think it was actually Chuck Schwab who went and convinced Bush that they ought to push for this. And so, miraculously, Congress whom I never thought would go along with a reduction in taxes of dividends, actually consented to put dividend tax at 15%.
Lo and behold, dividend started going up and the stock market started going up. I don't think it was a coincidence. And so, I think raising the taxes on dividends is not a good thing, but it won't spoil the story.
And in the 1950s, for example, when marginal tax rates were really high, very high 50%, 60%, 70%, 80%, dividends were still going up, the stock market did well and dividends still accounted for 40% of the market's total return.
So the dividend story is a good story. You get the compounding effect. A lot of people will hold the dividend stocks in their retirement accounts. You probably have to think about kind of readjusting. A lot of people hold fixed income in their retirement accounts now and stocks for capital appreciation in their taxable accounts; maybe you do a switch on that. I mean, so, I think people will find ways to adjust to this.
Is it a good thing? No. Will it be harmful? In some way. But is it devastating to the story? No. Companies actually – several companies to whom I've spoken have said they'll actually increased their dividends more because their shareholders have come to rely on their dividends, Automatic Data Processing, has said that, for example, among others.
Morris: Great. Well, Hersh Cohen, thank you for joining us today.
Cohen: Thank you.