Why dividend stocks may be getting a second look by investors

[AUDIO LOGO] A rough start to the year for equities head investors taking a closer look at dividend paying stocks to play a little defense. With the wider market rallying throughout the summer, is there a higher appetite for risk, and is that putting a chill on the space? Well, our feature guest today says that, heading into the fall, we may see some renewed interest in dividend plays. Joining me now is Kera Van Valen, Portfolio Manager at Epoch Investment Partners. Kera, great to have you on the show. Sorry for the delayed start, technology being what it's being. Let's get your outlook for the space right now. What are you seeing? Yeah. Well, thank you for having me today. I think one of the key things that we think about going into the fall is there is certainly no shortage of uncertainty. We have stubbornly high inflation. We have rising interest rates. We have a slowing economy, leading to questions about whether or not we're tipping into a recession. You still have new COVID variants. And then you have Russia's invasion of Ukraine, which then revives conversations between the conflict between China and Taiwan. So we think there's a very strong place for more defensively oriented equity stocks and equity portfolios in general. Volatility is likely to remain high. The structural support that you saw for the more speculative growth names is gone. That structural support being extremely accommodative central bank moves in the most recent years, we think it's going to come back to being focused on companies that are generating sustainable free cash flow, that have cash flow today, that are going to continue to grow the cash flow into the future, and that consistently rewards shareholders in the form of dividends. And we think that will continue to be valued as, again, there's no shortage of uncertainty. A lot of conflicting data out there, whether it be strong employment numbers. But at the same time, you hear the lower end consumer is stretched as stimulus is gone and the inflationary pressures are felt, whether it be Walmart commenting, AT&T saying people are delaying paying their bills, et cetera. It's certainly a lot of conflicting data. And we think that more defensive, income-oriented stocks are well-positioned to help navigate through this uncertainty. GREG BONNELL: Yeah. Over the years, when I've talked to people who do take a look through at these income plays, the dividend paying stocks, the one message that always resounded my ears were, OK, these might be turbulent times. We don't know what's going to happen next in the equity market, but they're getting paid to wait to see what happens next if you're in these dividend plays. I think that's a fair observation, but I'd say it's twofold. Not only are you collecting the income, but it is an equity strategy. Therefore, earn equity, a stock that you're holding, so it can continue to grow. So as the company faces growth, you can capture productivity. The companies will continue to grow, so you do get paid that income along the way. But you also get to participate in rising equity markets. GREG BONNELL: When it comes to dividend investing strategies as well, there are obviously companies that pay dividends, and that falls within this screen. But then there are dividend growers as well. Is that part of the screening when you're taking a look at these names, saying, well, it's one thing to pay a dividend? Are you growing the dividend over time? Yes, it is absolutely important to have the growth. The growth is what allows for the sustainability of dividend payments over time. Without the growth, you're essentially paying a liquidating dividend and that just cannot be continued forever. You need the growth in the underlying fundamentals of the business or the operations of the business to sustain the dividends over time, so growth is extremely important to the sustainability of dividends. GREG BONNELL: I think investors are going through the platform probably screening for yield some, yields can be rather eye-catching. Are there some dangers there? I mean, that's the beginning of the exercise if I'm going to screen for yield. We're actually going to do an exercise tonight later on the show. But then you start to wonder, OK, why is the dividend yield so high? Sometimes, can attractive be too attractive? Absolutely, which is where the sustainability of the dividend comes into play. So simply screening on high yields might mean that that dividend is not sustainable over time. The market might know they're facing secular growth challenges. There might not be room for reinvestment in the business, and those dividends would not be sustainable over time. And the last thing you want to do is invest in a high-income-generating security only to have that income disappear. So you do really need to screen out companies that are just simply paying high dividends because mainly reflecting the challenges and the growth opportunities going forward. GREG BONNELL: All right. Good stuff as always. Let's talk about some of, I guess, the disciplines that you follow at Epoch in terms of doing this kind of investing. How do you sort of set up your criteria when you're looking through the space? KERA VAN VALEN: Sure. So, again, we've touched on some of it, which is growth is extremely important. You want to find companies that have sustainable and growing free cash flow coupled with management teams that emphasize returning cash to shareholders in a disciplined framework. So the capital allocation policies is very important. We like to think in the mindset of a CFO. How does the company generate the pre-cash flow, and how do they allocate the cash flow? That's truly how you're going to determine the value of the company over time. By all means, if you can earn above your cost of capital, you should be reinvesting in the business. You should be making acquisitions. That is the fastest way to create value. However, there is not an unlimited supply of opportunities to earn above your cost of capital, so it's very much about the discipline of returning any excess free cash flow to shareholders in the form of dividends, share buybacks, and debt reduction. So we want that combination of a capital allocation framework that emphasizes cash distributions back to shareholders, but the growth element is critical in terms of the sustainability of the cash flows over time. GREG BONNELL: When investors are making these choices, they're listening to company earnings calls or trying to get a sense of where management is taking the company. What would be some warning signals? What are the kind of things you don't want to hear from management if you're looking at it in terms of an income play? Sure. You want to know that that dividend is coming from a reoccurring source of cash. So there has to be a balance of reinvesting in the business or making more modest bolt-on acquisitions, and that's what we would want to be hearing. So where the challenges are is when you need to borrow to fund your dividend, you need to sell assets in order to fund the dividend. Those are not sustainable. Large, transformational acquisitions that are outside of your core competency, that could also cause you to have to revisit your dividend plans. But it's really trying to understand from management what is the credible growth story over time. It's not investing for each quarter. Over the long run, how do you think about capital allocation? You can earn above your cost of capital. You can reinvest. If not, it's a discipline of returning any excess cash flow to shareholders in the form-- from our perspective, dividends actually can be dividends, share buybacks, or debt reduction. All three are ways to return the cash to the shareowners of the business. So actually, when we think about dividends, we think about the cash dividends, the share buybacks, and then also paying down debt. GREG BONNELL: Are there certain sectors that make more sense in this kind of strategy? I know we're going to do a deeper dive a little bit later into them. But sort of from a 10,000-foot view, are there certain areas where you say, well, of course, this is a more stable area if you're looking for income plays? KERA VAN VALEN: Yeah. I would say traditionally and historically you might have leaned a little more into telecom, utilities, staples. But the truth is it's become a lot broader. You can find income-oriented stocks across a variety of sectors. And actually, one of the benefits of technology, as companies are reinvesting in the business, you can actually invest less absolute dollars to get the same level of productivity, which means that free cash flow is higher, which allows companies to sustain higher dividend payout ratios or return excess cash in the form of share buybacks. So we are finding you can find income-oriented plays across all of the sectors. And that's something that we, quite frankly, look for within our portfolio, is to be as diversified as possible. Now, does it lean towards more telco within communication services? Yes. Or pharmaceuticals within health care? Yes. But you still can find across a variety of sectors income-oriented stocks, which is quite exciting. And even within the technology space, if you combine dividends and share buybacks, you can find a lot of tech stocks that continue to return cash to shareholders quite consistently in the form of dividends and share buybacks year after year. 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