Dividend Stocks Going Back to Blah?

As the Fed increases interest rates, bonds are starting to become attractive again. That may mean that the dividend stock boom we've seen lately is about to wane.

In this episode of MarketFoolery, host Chris Hill talks with Total Income's contributor Ron Gross about the popularity of dividend payers, what to look for in a dividend stock, and spring-cleaning your portfolio. Find out Ron's tips on portfolio management, when it might be time to sell a stock, some important things to keep in mind about the popularity of dividend payers, when being a Dividend Aristocrat isn't necessarily a good thing, and more.

A full transcript follows the video.

This video was recorded on March 27, 2018.

Chris Hill: It's Tuesday, March 27th. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio today, from Total Income, Ron Gross. Thanks for being here!

Ron Gross: My pleasure! Always.

Hill: [laughs] I'm laughing because we're taping this early, you and I are each on spring break this week.

Gross: I'm literally not here.

Hill: Neither am I. And this is our second attempt at taping this. We had a little snafu. That happens.

Gross: I may have said something that seems silly.

Hill: That happens. Every now and then, we like to pull back the curtain a little bit and people know, we don't do a lot of editing, but every now and then we'll do a second take.

Gross: Yes. Very rarely. I do want to state that.

Hill: We'll get to our respective spring breaks in a minute. Tim Hanson and I had talked about this on yesterday's episode, this idea of springtime, spring cleaning. When I think about spring cleaning when it comes to investing in stocks, I think about portfolio management, which is something that you are much more experienced at that than I am, so I wanted to get some thoughts from you about how you look at your own portfolio. Some people are very involved, and they're looking on a weekly, if not daily, basis at their portfolio. Some people who work at this company that I've talked to say, "No, I actually have a calendar reminder, and every month and I'll check, and otherwise I don't want to do it." When you look at your stock investments, what is your process?

Gross: The general process usually revolves around December, which allows me to take a look at my portfolio and decide if I want to do any types of rejiggering, and that usually would mean selling, because I'm investing throughout the year. But, selling could be for tax purposes, to offset some gains with losses, to take some gains that I've been waiting to take. And that gives me a good opportunity to actually look at all my stocks. Now, I'm pretty much on board with all my stocks at all times. This is what I do for a living.

Hill: I was going to say, it's is your job.

Gross: So, I'll certainly sell stocks during the course of the year when needed, whether my thesis is busted or if the stock has gone to the moon and I no longer think the return potential is there. But, I like to use December as the time to take a step back and think through the portfolio. An important thing that I do, and I think everyone should do, it's not just about investments and, for me, it's the December time period. It's actually about what's going on in your life that you may need to take into account when thinking about portfolio management. 

An example for me, since we're not here, I'm actually on spring break right now touring around colleges with my son, which means he's going to be going to college in about a year and a half. That's a lifestyle situation where I need to raise cash and not have that money at risk in the stock market, because that could jeopardize me being able to pay bills. So, I will sell to take money off the table and keep it safe, so I could pay for his first year, maybe even second year of college, because I don't like to have money at risk in the market if I need it within the next three years. So, that's a very important thing, I think, to take into account. It's not just, is this stock overvalued or undervalued, do I want to own it or not. It's, what's going on in my life and am I appropriately prepared for that?

Hill: And to be clear for any listeners who may have any hint of confusion, when you say money so that you can pay for the first year and maybe the second year, that has to do with time in the market, not your optimism or lack thereof that your son will make it to his second year of college, right?

Gross: [laughs] Thank you for clarifying in case he listens to the show, which he does not. No, I fully anticipate he will make it through all four years very smoothly. No, I would hate to have a big chunk of money, having to write a big check, and all the sudden the stock market makes a 20% correction, and then I have to find that cash somewhere else suddenly or pay it out of my monthly cash flow or something like that. I would prefer to keep it nice and safe and ready to deploy on his behalf.

Hill: When you are selling stocks, you mentioned that you would sell a stock if your thesis is busted, if it has run up to the point where you feel like you've made a gain and you think that maybe a little over-enthusiasm is happening with the stock. Are those the two main reasons that you historically have sold?

Gross: Yes, for sure. And the thesis-buster part of it is not always as cut-and-dry. There's some investors for sure who will say, "The original reason I bought this stock is no longer accurate, therefore I'm selling." It's not as cut-and-dry for me. It's, what is the new thesis, and is the new thesis something I want to be invested in? The old thesis is done, it's dead, it's inconsequential to me. What's the new thesis? And is there potential to make outsized returns in this stock, higher than the general market or the S&P 500 over long periods of time? Again, we're not traders here, I'm not a trader, I hold stocks typically for years and years and years. But, there comes a time where if I don't think it can put up an 8-10% annualized return going forward, then I could probably redeploy the capital elsewhere, sell the stock.

Hill: For a good stretch of time now, dividend stocks have been ... I was going to say in vogue, but I actually don't like that phrase.

Gross: That's fair.

Hill: But, I think it's fair to say that dividend stocks have been more popular over the last five years or so than they have historically been, and a big part of that is that bonds have been far less attractive. Is that coming to an end? Because with interest rates ticking up, it really does seem like bonds, at least in terms of people paying lip service to it, bonds seem like they're creeping up in attractiveness and I'm wondering if it's coming to an end for the super-popularity of dividends.

Gross: I think that certainly makes sense. If you buy into the fact, and it's a fact, so we should, that they've been so popular because there was no other yield, and if you wanted yields you had to invest in stocks, then when the reverse happens, then by some law of physics of which I'm not smart enough to quote, the reverse will happen. Now, it's going to happen slowly, because interest rates go up slowly. We just had a rate hike, the Fed funds rate, last week, and they're signaling that there will be two or three more this year, three more next year, with the goal of having the Fed fund rate at around 3.5% in 2020. Right now, we're around 1.5%, so that's a pretty big jump. That makes other interest rate investments more attractive relative to stocks. 

However, there's an offset here, and the offset is that companies are now flush with cash really like never before, and they will continue to be flush with cash as a result of things like changes in the tax code. And they are increasing their dividends very significantly. And they're doing that partly because they have a lot of cash and they don't know what to do with it. And when it comes right down to it, dividends are a capital allocation decision by management. Do we invest? Do we buy back our stock? Or do we give cash back to shareholders? And they have been raising the dividend to shareholders pretty significantly because they have plenty of cash. They don't necessarily need it all for the business. And there's probably also some of this, "We want to remain attractive relative to bonds, and to do that we need to raise dividends."

Hill: Alright. In terms of dividends for people who are looking at their portfolio and realizing, it would be nice to have some exposure to dividends that I don't really have right now. What are a couple of things that people should look for? Because again, it's been a great run for dividend stocks not just because of the relative attractiveness compared to bonds, but also because, some of these stalwart blue-chippers that, the main reason you want to own shares is because they're paying a dividend, some of them have actually done well as a stock.

Gross: For sure. The dividend aristocrats we sometimes talk about are those S&P 500 companies that have increased their dividend for 25 consecutive years, there are some amazing companies in that list. In the past, people thought of companies that pay dividends as kind of mature, sleepy companies that no longer have any real growth potential, and that's why the companies have chosen to pay out a dividend. It's not necessarily the case right now. As I said, companies have so much cash that they can afford to kind of do both, invest in their own business, invest in growth, and return some capital to shareholders. So, some of those dividend aristocrats are a great way to go. 

The yield on the S&P 500 right now is relatively historically on the lower side at 1.8%, approximately, on the S&P 500. That's partly because stocks have had a great run, and the way the math works, when stocks go up, dividend yields go down. But, as I said, companies are continuing to increase their dividends, 5%, 10%, 15% year after year. So, you get some nice growth on the dividend side. You invest in some really high-quality companies that have really great capital allocators at the helm. And that's a recipe for a pretty nice portfolio.

Hill: The dividend aristocrat thing is interesting to me. I wonder, once a company achieves that, 25 years, do you think that becomes, is that automatically ingrained in the culture of the management? I don't know, I sort of feel like if I was CEO of a company at a time when we had been doing that and we passed the 25-year mark --

Gross: You'd keep it up.

Hill: Well, not only would I keep it up, but I would be tempted to say to the board, "By the way, whoever's the next person to sit in the corner office after me, make sure they keep this streak going." Do you think that's built in?

Gross: I think that's fair, but I also think it's more about the company itself and how much cash flow it produces and how it makes perfect sense for them to continue that plan. However, there's certain times where household names, companies we've grown up with, turn for the worst, like General Electric and it becomes time to really say, "I know we've paid a dividend forever, but we have to do something here to save the business." And you would hope whoever's at the helm does what's right for the business and doesn't just keep a dividend in place because that's how it's always been done.

Hill: No. That's a great point. Just to be clear, you don't get a trophy for being a dividend aristocrat.

Gross: [laughs] You don't?

Hill: I'm curious about conversations that happen behind closed doors, but the larger point, which you touched on, is that it goes to not just the ethos of the company, but it goes to the role of the management, which is, you're capital allocators, and we're entrusting you to make smart decisions, whether it's paying a dividend or making acquisitions or anything else. 

Gross: As a shareholder, you would theoretically not want a company to pay you a dividend if you believe that they could invest in their business at really high growth rates and give you a really nice bump in the stock over years to come. Then, when things slow down, the capital allocation decisions can change.

Hill: Alright. Before we wrap up, you're doing a college tour.

Gross: Yes.

Hill: Is there a particular school you're interested in seeing? Regardless of your son's interests. Or, is there a place on the itinerary where you think, I'm interested to go here?

Gross: We're starting in Michigan and ending in Florida, so we'll be hitting all kinds of weather. I'm going to be the sentimental guy here and say, getting into Michigan also allows me to see my daughter, who's at the University of Michigan, so I'm really looking forward to that. 

Hill: It's going to be colder, though.

Gross: Where are you right now?

Hill: I'll be in Central Pennsylvania.

Gross: Oh, that's lovely! I hear they have the best resorts and beaches. That's awesome!

Hill: The white sand beaches in Central Pennsylvania don't get a lot of attention.

Gross: Under the radar.

Hill: Maybe it's time that they should.

Gross: Yeah. Well, enjoy!

Hill: Thank you! Thanks for being here!

Gross: My pleasure!

Hill: As always, people on the program they have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery. The show is mixed by Austin Morgan. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!