The Pursuit of Equity Income

The 2022 Morningstar Investment Conference in Chicago brought together three veteran dividend investors. Scott Davis has managed Columbia Dividend Income GSFTX since 2001; most share classes of the $36 billion fund have Morningstar Analyst Ratings of Silver. Clare Hart has run JPMorgan Equity Income HLIEX since 2004; most share classes of the $48 billion fund are rated Gold. And Don Kilbride has managed Gold-rated Vanguard Dividend Growth VDIGX since 2006; the fund had $53 billion in assets as of June.

The strategies all earn High ratings for Process owing to consistent, well-defined approaches. Davis looks for firms with durable cash flows that support steady dividend payments. Hart seeks competitively advantaged firms with dividend yields of at least 2% at purchase and modest payout ratios. Kilbride focuses on companies likely to grow their dividends, ideally at the rate of inflation plus 3%.

The panel took place on May 17 and was moderated by Tony Thomas, Morningstar’s associate director for U.S. equity strategies. The discussion reflects market and valuation information as of that date. It has been edited for length and clarity.

Tony Thomas: When you think about your end investor, who comes to mind?

Don Kilbride: When I first started managing the fund, the principal objective was to focus on retirees, people who were interested in a growing stream of income that exceeded inflation—a pretty easy bogy to beat back then and until recently. But it’s evolved. As the concept of dividend growth has become more popular, fund shareholders include those who are interested in capital appreciation. I’m a big shareholder, and I’m not retired. I’ve got young kids.

Scott Davis: We take a conservative total-return approach. About 70% of our investors actually reinvest the dividend. A lot of them are probably 50 or older. Those are the people that have accumulated wealth. They want to participate in markets, but they don’t want to lose it. One of my largest accounts is an overfunded pension plan, and it isn’t about the dividend. It’s about downside protection. Rule number one in a down market is lose less, and rule number two is don’t forget rule number one.

Clare Hart: People use our equity-income strategy as a conservative approach to investing in equity markets, broadly speaking. But the mutual fund pays a monthly distribution, and not everybody reinvests that. In my mind, there’s a little old lady going to the grocery store, and that’s her money. That resonates, that there’s someone who might be relying on that income.

I also think about—especially in markets like this, like COVID, the global financial crisis, the taper tantrum—the retail investor who might not have access to all the resources that, say, an endowment can call upon. That retail investor who looks at the screen on a given day at lunch and says, “Oh my gosh, the markets are down, I’m just going to sell everything.” To that person, downside capture’s really important, so they can see they aren’t getting quite as bumpy a ride. My goal is to make sure that people stay invested in the markets, especially when things are tough.

Thomas: How do you benchmark strategies like these?

Kilbride: The mission is to deliver performance that’s consistent and predictable to the fund shareholder. As a result, we are agnostic to benchmarks totally and thoroughly. We have two benchmarks that look very different from one another. There’s the Russell 1000, which is the broad benchmark for a lot of the institutional accounts I manage. The mutual fund has a custom dividend achievers benchmark. It’s never been helpful to me to start with a benchmark and to assess how I’m doing relative to that. My goal is to compound wealth for the fund shareholder over long periods of time. That’s what I’m trying to focus on—delivering that mission of dividend growth to the fund shareholder.

Davis: Our official benchmark’s the Russell 1000, which was established more for screening purposes. When I’m put into a store, I want to be able to shop all the aisles. I have my definition of what value is, and I really don’t need Russell or S&P to tell me what that is. If you remember, for example, bank stocks at one point after the financial crisis became growth stocks, because they had very high multiples and had lost a lot of book value. That made no sense. For us, it’s what we pay for a dollar’s worth of free cash flow.

We also have an internal benchmark, because I can’t own non-dividend-paying stocks. I’m a big fan of Warren Buffett, but I can’t own Berkshire Hathaway BRK.A, because it’s a non-dividend-paying stock. So, we don’t own it, which has hurt us. I find it sort of ironic, because most of the stocks that he owns are dividend-paying, but he hasn’t decided to pay one yet.

For us, it’s about risk-adjusted returns. I started my career at a trust bank, and I have that sense of fiduciary responsibility. I’m very aware that I’m running other people’s money.

Hart: I look for quality companies at a reasonable valuation that pay a minimum 2% yield at time of purchase. What I consider success is to make as much money for people as possible while staying true to our mandate. In terms of benchmarks, some people use the Russell 1000 Value, some clients use the Russell 1000, I have investors in the U.K. that use the S&P 500. I have no control over how Russell and S&P build their benchmarks. It’s hard enough to find a quality company at a reasonable valuation that pays a dividend yield. [Thinking about] what benchmark it’s in? That’s not going to deliver value to people. My objective is to do what I say I’m going to do.

Allocating Capital

Thomas: How do you think about share buybacks? Some argue that shareholder yield—the dividend yield plus share buybacks—is important. I think all three of you are skeptical about buybacks.

Hart: I think about dividends as returning money to shareholders. Some management teams include buybacks in that. But I put buybacks in another bucket. If you’re doing buybacks, it’s versus mergers and acquisitions. 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?

I don’t cringe when I see my companies buying back stock. I’m not jealous that they’re not giving me more of a dividend, because I’m an equity investor, too. I am not opposed to buybacks if they’re done carefully at a good valuation.

Davis: Sometimes buybacks are just used to offset options. If it’s done right, you have a sense of what the intrinsic value of your firm is. But often, it’s not really thought through. It’s sort of automatic; 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 because they’re not allowed to. I’m sure Jamie Dimon would have loved to have bought stock back two years ago.

One of my favorite questions of a CEO is what was the average price that you bought back your stock at over the last five years? I remember talking to the CEO of Pfizer PFE when the stock was $15 a share, and he told me his average price of buyback was $70 a share. That gets you scratching your head.

Thomas: Don, to what extent do you engage with companies about their dividend policy? You’ve said that you’re not an activist, but you are a “suggestivist.” What do you mean by that?

Kilbride: My job is to try and produce investment returns for fund shareholders. It is not to run big companies. I’ve never run anything in my life, not even a lemonade stand, so it doesn’t ever make sense for me to tell highly intelligent, driven, talented people how to run their companies. But I sure will offer a suggestion if they want me to offer a suggestion.

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 repurchase 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 we do think a lot about capital allocation. How are you going to use that free cash flow that’s generated? Are you using it in a shareholder-friendly way? 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?

When Amgen AMGN initiated its dividend, I was out in California with their senior management and spent a lot of time talking about what [they were] trying to accomplish with this dividend. What is the message that you’re trying to convey?

We’ve done it with Lam Research LRCX. It was fascinating, because they were tired of being owned only by tech funds and hedge funds. Every time you got some rumor out of Asia about chips or something like that, their stock was up or down. We tend to be long-term shareholders, and they recognize that. So, they sent their whole team—CEO, CFO, head of research and development—and we learned a lot about them. We had a company called Celgene that visited us and spent about three hours with us talking about it. They didn’t take our advice. They sold out to Bristol-Myers BMY. But they did listen.

We walk them through our standpoint. We’d like to see growth in the dividend in line with the growth of the free cash flow of the corporation. We don’t want you announcing a 50% increase if you can’t afford it.

Thomas: There have been questions about whether energy companies allocate capital well. Are you more comfortable with the energy space now?

Hart: For sure. It was Jim Mulva at Conoco COP who started the conversation around focusing on returns to shareholders instead of solely on increasing production. It maybe doesn’t sound like a seismic shift, but for the energy companies, it really was. This was a number of years ago, and more and more companies have adopted that principle. They’re not going to just keep pumping out barrels that are not economic. It sounds silly when you say it out loud. Why would they? Because for a long time, that’s the way they conducted themselves.

There’s a lot more capital discipline within the energy space. And part of that is companies initiating dividends. To their credit, some of the energy companies that are paying dividends now came into our offices at J.P. Morgan when they were thinking about a dividend. And we’re like, “OK, but remember, you’re connected to a commodity. You have to have both the intention and the ability to pay the dividend. It’s a recurring commitment.” And I think a lot of these companies did it the right way, where they increased the dividend, but they had 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.

Davis: Just an example of this: We have EOG Resources EOG in our portfolio.

Hart: We do, too.

Davis: They announced that they’re going to return 60% of their free cash flow to shareholders. That was so different. It used to be you put everything back into the ground.

I was having dinner with David O’Reilly, who was CEO of Chevron CVX, in New York one night, and I asked him what he thought the price of a barrel of oil would be. He said, “Scott, between $35 and $150 a barrel.” When he said that, with all his geologists and economists, I laughed, and I realized how volatile that product is.

The cash flows of corporations like EOG are so dependent on the price of oil. At $95 oil, they can produce a 14% free cash flow. At $75, it’s a different story. So, the variability of the dividend makes so much sense.

Factoring in Inflation

Thomas: How are you factoring in inflation and higher rates as you look at the companies you invest in?

Kilbride: There’s two dimensions to the question. The bigger dimension, which I think is trickier to talk about, 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 consistently 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.

We’ve got a portfolio of businesses that have through the years been successful at growing their dividend at a substantial rate—in many cases, over 10% [annually]. That doesn’t happen by accident. That happens because they’ve got a business model that grows as well. Very often, that’s because they’ve got a business that they can price for.

Davis: On the inflation issue, bonds obviously are important. We used to talk about TINA—there is no alternative [to stocks]. 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. They’re not going to stop until they see that crack. What that changes is the discount rate. When I value something, the risk-free rate of return is one of the things I think about.

I do worry right now. We know already that people with incomes of $50,000 or less are feeling the pain and are starting to make choices. And I think we’re going to see more of that.

One of the things that we’re looking at a lot is the margin structure. We went to an industrials conference where everybody in the room told me they could get pricing. I’m thinking to myself, let’s see what happens six months from now or a year from now. That could be a very different story.

We’re seeing pretty good increases in inventories. So, we’re asking a lot of questions: What is the makeup of your inventory? What [amount of inventory] is work in progress? What is raw materials? What is finished goods?

We want to be very careful about real versus nominal. If sales are up because prices are up, but the company is actually selling less, I have to be aware of that. This should be a time when people that are in our business of equity selection should be able to do a little bit better. But it’s going to be a tricky period.

Thomas: What is the merit of active management in the equity-income or dividend-growth space?

Hart: You have someone managing to a specific mandate that you agreed to—that’s why you bought the fund. As long as that person has a track record of consistently doing what they say they’re going to do, when things get tough in the market, you don’t have to wonder what’s going to happen to you. If the market’s going down, you’re not necessarily tethered with an anvil to something that’s going down. No one loves volatility. I think equity-income investors probably like it a little bit less than other people.

Everybody always says it’s a stock-picker’s market. And when the market’s always going up, how do you prove it’s not? But in environments like this, where things get choppy, you see who really has pricing power, or who’s just saying they have it under the guise of a little inflation. Who can deliver?

Davis: It really is sticking with your discipline. This is a time where you better know what you’re doing and why you’re doing it. We stick with looking at free cash flow and what we’re paying for a dollar’s worth of it. It’s sort of the Jerry Maguire of the investment world: Show us the cash.

One thing I’ve learned in my career, in down markets especially, is that larger companies do matter, because a lot of them have the experience, and they’ve been through it before. The second thing is that liquidity matters an awful lot. People underestimate the importance of liquidity. And quality, but you better be able to define it. For us, it’s cash earnings, not reported earnings. It’s looking at profitability margins, structures, return on assets, turnover of assets, and balance sheets. People forget about balance sheets. But when you get into a tough time, you don’t want to forget about the balance sheet. When things are good, you don’t pay a lot for a good balance sheet. I equate it to homeowners insurance. It doesn’t cost you a lot, but if you come home some night and your house is ablaze, it’s got to be in place. You can’t do it afterward.

In 2020, people thought dividends were defensive. Dividends are not defensive. What’s defensive is quality.

Thomas: Don, as a manager of a Vanguard fund, what’s the value of active management in this space?

Kilbride: There’s plenty of room for both active and passive. I don’t know that we have to come down on one side or other of the debate. But the value proposition with active management is that active managers are forward-looking. They don’t rely too rigidly on history or on any other metric to build their portfolios. The mutual fund that I manage has 43 names. Most indexes are 10 times that. I think that’s the real differentiator between active and passive.

Digging Into the Details

Thomas: What questions do we have from the audience?

Audience question: When it comes to dividend-growth investing, how attractive are foreign markets compared with U.S. markets today?

Kilbride: The dividend culture’s much stronger outside the U.S., particularly in Europe. My background and my strength are large-cap U.S. dividend-paying companies, so that tends to be where we do all our stock selection. There’s a growing desire for dividend growth in the U.S., but the culture clearly is more profound outside the U.S. for a variety of reasons—more family-owned companies, for example, or older businesses where that’s been a much bigger part of the value proposition.

Audience question: In which industries or sectors are you finding the most attractive opportunities for your style of investing today?

Davis: We were putting a lot of money into healthcare. It is our largest sector right now. Toward the end of last year, healthcare companies were trading at below-market multiples, with great free cash flow. We bought a company called AbbVie ABBV; that’s been a great one for us. We owned Eli Lilly LLY, and that’s done incredibly well. We own UnitedHealth UNH and Anthem [now called Elevance Health ELV]. Those names have done well. With the move that they’ve had, I have to reconsider a little bit. But you still have some names. Look at a Bristol-Myers. I’ve had my differences with them in the past, but it has a 9% free cash flow yield right now. They have a follow-up to [anticoagulant medication] Eliquis and a good balance sheet.

Industrials are interesting as some of them have come down. We own Union Pacific UNP. One of the neat things about Union Pacific is with diesel prices at over $5, they become more attractive than intermodal, and they get to pass that cost through. We also think some of the technology area has gotten hard-hit. Some of the semiconductor companies interest us.

Audience question: How do you deal with companies in the portfolio that cut or pause dividends as part of a spinoff or M&A activity?

Hart: We owned Pfizer 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, but that gave us some pause. The dividend’s really important in what we’re doing.

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 about, 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 they cut the dividend. If it’s because of real fundamental deterioration, my hope is I’m not around that stock by the time that becomes evident. In 2016, we sold General Electric GE because I thought they would have to cut the dividend. We sold Kinder Morgan KMI, because we figured out that it was much more dependent on oil prices [than was thought]. Dividend cuts are often timed to actions taken by ratings agencies like Moody’s. We knew once Kinder Morgan was put on credit watch, the company was going to have to make a choice.

It’s 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. The stock of most dividend cutters goes down before the dividend cut takes place, so you’ve got to figure it out [early]. The average dividend cutter is down 20% 12 months going into the dividend cut.

The COVID crisis was a little bit different. We had TJX TJX in the portfolio, and they had to shutter their stores. But we knew that management team, and we knew [the dividend cut] was to preserve capital strength. They reinstated the dividend. And there were others where historically we sold. We did figure out Disney DIS was going to cut because of the parks [being closed], but all of a sudden, streaming became more important, so we looked pretty dumb on that one. But we stick with the discipline, and the discipline is if we think that your cash flows are impeded to the point where you’re going to have to cut your dividend, we’re not going to be in your stock.

Kilbride: If I understood the question right, how do we view a company that takes a dramatic corporate action that requires a dividend cut? We want to try to avoid companies that have to do something so dramatic to enhance the value of their enterprise that they need to sacrifice the dividend. That’s not a model that we should be engaged in. So, hopefully, we never have to be making that choice.