Show Transcript
Kim Parlee talks to Bill Priest, Co-CIO, Epoch Investment Partners, about the sustainability of the strength of equity markets, the likelihood of a pullback, and why the drivers that have led to strong dividend payouts over the past two decades will remain intact.
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[MUSIC PLAYING]
- Hello. And welcome to MoneyTalk's COVID-19 Daily Bulletin for Wednesday, May 13. I'm Anthony Okolie. In a few minutes Kim Parlee will be speaking with Bill Priest-- he's the Co-Chief Investment Officer of Epoch Investment Partners-- about the sustainability of the strength of equity markets, and if the death of dividends is greatly exaggerated.
But first, a quick wrap of today's headlines.
Another blow for the Canadian energy sector. Norway's $1 trillion wealth fund, the biggest in the world, is blacklisting top Canadian energy names due to unacceptable levels of greenhouse gas emissions.
Meanwhile, the US federal chairman warned that the economic path ahead from the COVID-19 pandemic is highly uncertain and subject to significant downside risks.
In a further effort to blunt the effects of COVID-19, the US House Democrats unveiled a $3 trillion package, which includes a second round of direct payments of $1,200 per person.
Finally, the UK economy shrank almost 6% in March as the nation went into lockdown, plunging into what may be the deepest recession in more than three centuries.
And that's a wrap of today's headlines. Next, Kim Parlee's conversation with Bill Priest.
- Bill, the big question on everybody's mind is really just what's happening with the market. On one hand, the economic data is atrocious. On the other hand, you've got markets close to back to their all-time highs, just 10% below. Some stocks hitting new all-time highs. So what is happening?
- I must say, the rapid gain in the market over the last several weeks has been astonishing to most of us. We ended the year expecting a modest industrial recession, possibly a low single-digit return from the stock market. But the virus changed all of that. And what we've essentially done is to put our economy into a coma. It's a self-induced coma to deal with the effects of the virus through social distancing. And until we have a vaccine, it's going to be very difficult to have any consistent idea that this thing is truly under control.
All that said, the response of the monetary authorities and the fiscal policymakers has been this so-called bazooka effect. And we've had literally trillions of dollars thrown at this problem. Some of it is income replacement. Some of it is stimulus. But it's been enormous. And I would say that the marketplace is anticipating that this effect will simply overwhelm the negative effects from the economy itself.
That's a tall order, in my view. We have had-- in the space of three weeks, we wiped out employment gains that covered 350 weeks. We have the worst unemployment situation since the Depression. We are going to have a significant decline in GDP, a significant decline in earnings. All of this is kind of baked in the cake.
The question is-- it's the old saying-- can I look across the valley and see another peak? And the market is saying in the last few weeks, yeah, I can see that peak. Personally, I think that's pretty optimistic. I don't think it's that visible to us right now.
- So having said that, if you don't-- if you, personally, don't have that visibility, what are your thoughts about a significant pullback? I mean, could we see that, that people start to think that the big bazooka is not big enough?
- Well, I think you could have a pullback. First of all, I have to be totally honest and say I never saw this increase coming in the past month or so. It was stunning to me.
If you look at what economies try to do, it's to optimize their resources. And resources in economics 101 have often been said land, labor, and capital. You want to officially put all that together in order to get your economy to grow.
But right now, we have productivity eroding. We have significant declines in employment. So real GDP, which is simply the sum of those two variables, are declining really at an alarming rate. At what point do you have a recovery? And what does the recovery even look like? We haven't even touched bottom in terms of the economic data itself.
So my guess is when people speculate on what the economy might look like-- is it a V? Is it a W? Is it an L? Our view is it's more like the Nike swoosh. It comes down sharply, and then it goes up. But at what level, how long, it's unknown to me. So I would consider that the likelihood of another decline in the market is reasonably high.
- Let me ask you about the recovery a little more. And maybe just take me into your thinking around it, because one thing you and I talked about is, again, optimization of resources. And this is just blowing that up. You're having this mass, I'll say, localization as opposed to globalization. And then you've got different states going on with different opening rates. And so what do you-- I mean, what does a recovery look like? What are you listening for?
- Well, I think it's going to have to start with some stabilization of the employment situation. In the United States, for example, at the start of this problem, we had something like 155 million jobs. And we have vastly eliminated that number quite a bit.
And when you look at the corporate world, you've got significant changes in corporate guidance. One, 20% of the S&P 500 have suspended earnings guidance, 20% have cut dividends. The householder itself is actually selling stocks right now. The savings rate among householders hit an all-time high in April. And stocks are trading at 20-year highs of valuation measures.
There's an incongruity here, from my point of view. I just don't see how you can sustain that for any period of time. Either the fundamental side is going to get a lot better sooner than many people think, or, frankly, this valuation level of the market will have to erode somewhat over the next several weeks.
- What are you doing from a deploying of money perspective right now? I mean, what's your strategies you look at?
- Well Epoch is all about a couple of simple principles. Cash flow drives the value of any business. No cash flow, ultimately, you have no business. But it's the allocation of that cash flow that ultimately determines the value of the business.
So what we do is try to identify companies that generate what we call free cash flow, which is the cash available for distribution to shareholders after all planned capital expenditures and all cash taxes. Those companies that are effective capital allocators will return the cash that they can't use for reinvestment purposes to the owners of the business.
So we look for those companies. You can find them in many, many businesses. But I would say right now the two leading sectors for us are health care and technology. Technology and science will lead us out of this problem, ultimately.
- Bill, I want to take a look at a graph that your team put together on a recent webinar. And if we take a look at it, it shows the S&P and what the market is pricing in in terms of dividend futures, so what the expectation is in terms of the payout. And it's not pretty. It's showing that it's going to take eight years for dividends to get back to 2020 levels. What are your thoughts around that?
- Well, I think the S&P dividend futures index is an interesting point of departure. But it is a future, and it fluctuates literally every day. Earlier this year, the expectation for that future back in January was for a modest rise this year of 3% to 5%. At the very bottom, it was down nearly 40%. And now it's showing something down around 20% to 25%. And we wouldn't disagree with that.
If you think about what companies are going to do, it's all about sound allocation of cash flow. If you can reinvest that cash flow at your cost of capital or higher, you should do that. And if a company has lots and lots of opportunities to do that, either internal projects or acquisitions, they should do that, and dividends would be zero, because as long as you can reinvest at a rate above what it cost you to get another dollar of capital, that is the fastest way to grow shareholder value.
On the other hand, large mature companies very often don't have an abundance of choices, but they have lots of cash flow. So they'll reinvest until they don't feel they can earn an incremental return on their capital. And then they should return it to the owners of the business. And they will do that.
If you don't do that, if you start to get the government involved, or an outside entity, in the allocation of that capital, it's extremely negative for both innovation-- you'll wind up supporting companies that should be dead, so-called zombie companies. And there will be less wealth for future generations. So as the government starts to become your partner, you have to be very careful of its role. If it's going to be there forever, it has a lot of negative connotations.
So when you look at the dividend situation, dividends are definitely going down. If you look at history, if you go back and look at 90 years of history, the correlation of dividends and earnings is like 98%. They just kind of track one another over a long period of time. So unless one were to project that there's going to be a significant and long-term decline in earnings, there's every reason to think dividends will continue to mirror that.
Will payout ratios go up or down? Well, if they just stay the same in the long run, dividends will ultimately just start to rise with earnings. But in the short run, they're going to be down. But they usually go down only about half as much as the earnings decline is. So if earnings, for example, would be down 40% this year-- and I don't have a magic view of that-- but if it was down 40, you might think dividends would be off 20. That would not be a bad expectation.
But over time, they will start to climb back up if the world grows again. And the world should grow again. Once we have a vaccination, which I think we will have. My best guess is by the end of next year you will have a vaccine for this problem. But boy, we will have a mountain of debt. We will have a lot of things to overcome. But I do believe the worst case of this virus will be solved by science and technology by the end of 2021.
- Well, I shouldn't ask a leading question here, but I know the talk that your team gave talked about how the death of dividends is greatly exaggerated. So to your point, you see things a little more positively, perhaps. But maybe if you could just tell us a bit about a little more detail of that cycle. You mentioned that it tracks with earnings. But also, who is going to hold up well and who's not going to hold up well?
- Well, I think when people talk dividends, you have to define what a dividend is. Most of the time we think about cash dividends, but dividends can take two other forms. Share buybacks are dividends. And when you pay down debt with operating cash flow, it is the financial equivalent of a dividend, because the equity ownership of the entity is rising as the dividend proportion is falling.
But the real issue this year has been particularly-- has been around buybacks. And are they a good thing? How can you be buying back stock when you're laying off people? That kind of thing.
Well, I think if you're taking government aid, you should not be permitted to use buybacks. You should not be permitted to pay dividends. But if you're not taking government aid, it's all about how efficient can you allocate that capital to the shareholders. That's really what capital is about.
But when you-- getting back to dividends, companies should reinvest every nickel if they can earn a premium over the cost of capital. But there are many industries that can't do that. The ones that are going to be hurt the most are going to be industrials, materials, and finance. They will suffer this year. You will see their earnings down. You'll see dividends cut. And you will certainly see the elimination of buybacks for a lot of those companies.
But when you look at tech, and you look at health care, and you look at consumer staples, and even some utilities, those dividends are going to continue to go up. So some industries will be fine. Some are going to be hurt quite a bit.
We talked about it on a previous show. We wrote up something called "The Bits Versus Atoms." The best way to think about that is there's a formula often called the DuPont return on equity formula. It's profit margins times asset utilization times leverage.
And as we live in a world where technology is becoming more and more a part of what we can do, most businesses are trying to substitute technology for labor. Well, if you can substitute technology for labor and hold your revenues constant, your profit margins go up. And if you can substitute technology for bricks and mortar, basically like many retailers have done by selling their goods over the internet, your sales per dollar of assets go up. Every company in the world is trying to pursue this what I call capital-light model.
But a very interesting thing happens as you deploy this. The third component of this return on equity formula is what's called leverage, which is assets per dollar of equity. So if you were looking at a balance sheet, the left-hand side is considered your assets and the right-hand side is liabilities and stockholders' equity. To the extent I can substitute technology for labor and physical assets, I don't need to deploy these assets in the business. I can actually take money out of my business, so long as my revenues are there, and still sustain a very high level of return on equity.
You are going to start to see technology effectively increase payout ratios. When you cut through it all, you will find that companies don't need all the money to generate the same level of sales today. And your payout ratios will slowly start to rise.
Now, right now it is simply-- that observation is overwhelmed by the virus, which is just catastrophic in its import. But over time, the outlook for dividends is actually quite good, because you simply don't need all that capital to generate the same level of revenues.
[MUSIC PLAYING]
- Hello. And welcome to MoneyTalk's COVID-19 Daily Bulletin for Wednesday, May 13. I'm Anthony Okolie. In a few minutes Kim Parlee will be speaking with Bill Priest-- he's the Co-Chief Investment Officer of Epoch Investment Partners-- about the sustainability of the strength of equity markets, and if the death of dividends is greatly exaggerated.
But first, a quick wrap of today's headlines.
Another blow for the Canadian energy sector. Norway's $1 trillion wealth fund, the biggest in the world, is blacklisting top Canadian energy names due to unacceptable levels of greenhouse gas emissions.
Meanwhile, the US federal chairman warned that the economic path ahead from the COVID-19 pandemic is highly uncertain and subject to significant downside risks.
In a further effort to blunt the effects of COVID-19, the US House Democrats unveiled a $3 trillion package, which includes a second round of direct payments of $1,200 per person.
Finally, the UK economy shrank almost 6% in March as the nation went into lockdown, plunging into what may be the deepest recession in more than three centuries.
And that's a wrap of today's headlines. Next, Kim Parlee's conversation with Bill Priest.
- Bill, the big question on everybody's mind is really just what's happening with the market. On one hand, the economic data is atrocious. On the other hand, you've got markets close to back to their all-time highs, just 10% below. Some stocks hitting new all-time highs. So what is happening?
- I must say, the rapid gain in the market over the last several weeks has been astonishing to most of us. We ended the year expecting a modest industrial recession, possibly a low single-digit return from the stock market. But the virus changed all of that. And what we've essentially done is to put our economy into a coma. It's a self-induced coma to deal with the effects of the virus through social distancing. And until we have a vaccine, it's going to be very difficult to have any consistent idea that this thing is truly under control.
All that said, the response of the monetary authorities and the fiscal policymakers has been this so-called bazooka effect. And we've had literally trillions of dollars thrown at this problem. Some of it is income replacement. Some of it is stimulus. But it's been enormous. And I would say that the marketplace is anticipating that this effect will simply overwhelm the negative effects from the economy itself.
That's a tall order, in my view. We have had-- in the space of three weeks, we wiped out employment gains that covered 350 weeks. We have the worst unemployment situation since the Depression. We are going to have a significant decline in GDP, a significant decline in earnings. All of this is kind of baked in the cake.
The question is-- it's the old saying-- can I look across the valley and see another peak? And the market is saying in the last few weeks, yeah, I can see that peak. Personally, I think that's pretty optimistic. I don't think it's that visible to us right now.
- So having said that, if you don't-- if you, personally, don't have that visibility, what are your thoughts about a significant pullback? I mean, could we see that, that people start to think that the big bazooka is not big enough?
- Well, I think you could have a pullback. First of all, I have to be totally honest and say I never saw this increase coming in the past month or so. It was stunning to me.
If you look at what economies try to do, it's to optimize their resources. And resources in economics 101 have often been said land, labor, and capital. You want to officially put all that together in order to get your economy to grow.
But right now, we have productivity eroding. We have significant declines in employment. So real GDP, which is simply the sum of those two variables, are declining really at an alarming rate. At what point do you have a recovery? And what does the recovery even look like? We haven't even touched bottom in terms of the economic data itself.
So my guess is when people speculate on what the economy might look like-- is it a V? Is it a W? Is it an L? Our view is it's more like the Nike swoosh. It comes down sharply, and then it goes up. But at what level, how long, it's unknown to me. So I would consider that the likelihood of another decline in the market is reasonably high.
- Let me ask you about the recovery a little more. And maybe just take me into your thinking around it, because one thing you and I talked about is, again, optimization of resources. And this is just blowing that up. You're having this mass, I'll say, localization as opposed to globalization. And then you've got different states going on with different opening rates. And so what do you-- I mean, what does a recovery look like? What are you listening for?
- Well, I think it's going to have to start with some stabilization of the employment situation. In the United States, for example, at the start of this problem, we had something like 155 million jobs. And we have vastly eliminated that number quite a bit.
And when you look at the corporate world, you've got significant changes in corporate guidance. One, 20% of the S&P 500 have suspended earnings guidance, 20% have cut dividends. The householder itself is actually selling stocks right now. The savings rate among householders hit an all-time high in April. And stocks are trading at 20-year highs of valuation measures.
There's an incongruity here, from my point of view. I just don't see how you can sustain that for any period of time. Either the fundamental side is going to get a lot better sooner than many people think, or, frankly, this valuation level of the market will have to erode somewhat over the next several weeks.
- What are you doing from a deploying of money perspective right now? I mean, what's your strategies you look at?
- Well Epoch is all about a couple of simple principles. Cash flow drives the value of any business. No cash flow, ultimately, you have no business. But it's the allocation of that cash flow that ultimately determines the value of the business.
So what we do is try to identify companies that generate what we call free cash flow, which is the cash available for distribution to shareholders after all planned capital expenditures and all cash taxes. Those companies that are effective capital allocators will return the cash that they can't use for reinvestment purposes to the owners of the business.
So we look for those companies. You can find them in many, many businesses. But I would say right now the two leading sectors for us are health care and technology. Technology and science will lead us out of this problem, ultimately.
- Bill, I want to take a look at a graph that your team put together on a recent webinar. And if we take a look at it, it shows the S&P and what the market is pricing in in terms of dividend futures, so what the expectation is in terms of the payout. And it's not pretty. It's showing that it's going to take eight years for dividends to get back to 2020 levels. What are your thoughts around that?
- Well, I think the S&P dividend futures index is an interesting point of departure. But it is a future, and it fluctuates literally every day. Earlier this year, the expectation for that future back in January was for a modest rise this year of 3% to 5%. At the very bottom, it was down nearly 40%. And now it's showing something down around 20% to 25%. And we wouldn't disagree with that.
If you think about what companies are going to do, it's all about sound allocation of cash flow. If you can reinvest that cash flow at your cost of capital or higher, you should do that. And if a company has lots and lots of opportunities to do that, either internal projects or acquisitions, they should do that, and dividends would be zero, because as long as you can reinvest at a rate above what it cost you to get another dollar of capital, that is the fastest way to grow shareholder value.
On the other hand, large mature companies very often don't have an abundance of choices, but they have lots of cash flow. So they'll reinvest until they don't feel they can earn an incremental return on their capital. And then they should return it to the owners of the business. And they will do that.
If you don't do that, if you start to get the government involved, or an outside entity, in the allocation of that capital, it's extremely negative for both innovation-- you'll wind up supporting companies that should be dead, so-called zombie companies. And there will be less wealth for future generations. So as the government starts to become your partner, you have to be very careful of its role. If it's going to be there forever, it has a lot of negative connotations.
So when you look at the dividend situation, dividends are definitely going down. If you look at history, if you go back and look at 90 years of history, the correlation of dividends and earnings is like 98%. They just kind of track one another over a long period of time. So unless one were to project that there's going to be a significant and long-term decline in earnings, there's every reason to think dividends will continue to mirror that.
Will payout ratios go up or down? Well, if they just stay the same in the long run, dividends will ultimately just start to rise with earnings. But in the short run, they're going to be down. But they usually go down only about half as much as the earnings decline is. So if earnings, for example, would be down 40% this year-- and I don't have a magic view of that-- but if it was down 40, you might think dividends would be off 20. That would not be a bad expectation.
But over time, they will start to climb back up if the world grows again. And the world should grow again. Once we have a vaccination, which I think we will have. My best guess is by the end of next year you will have a vaccine for this problem. But boy, we will have a mountain of debt. We will have a lot of things to overcome. But I do believe the worst case of this virus will be solved by science and technology by the end of 2021.
- Well, I shouldn't ask a leading question here, but I know the talk that your team gave talked about how the death of dividends is greatly exaggerated. So to your point, you see things a little more positively, perhaps. But maybe if you could just tell us a bit about a little more detail of that cycle. You mentioned that it tracks with earnings. But also, who is going to hold up well and who's not going to hold up well?
- Well, I think when people talk dividends, you have to define what a dividend is. Most of the time we think about cash dividends, but dividends can take two other forms. Share buybacks are dividends. And when you pay down debt with operating cash flow, it is the financial equivalent of a dividend, because the equity ownership of the entity is rising as the dividend proportion is falling.
But the real issue this year has been particularly-- has been around buybacks. And are they a good thing? How can you be buying back stock when you're laying off people? That kind of thing.
Well, I think if you're taking government aid, you should not be permitted to use buybacks. You should not be permitted to pay dividends. But if you're not taking government aid, it's all about how efficient can you allocate that capital to the shareholders. That's really what capital is about.
But when you-- getting back to dividends, companies should reinvest every nickel if they can earn a premium over the cost of capital. But there are many industries that can't do that. The ones that are going to be hurt the most are going to be industrials, materials, and finance. They will suffer this year. You will see their earnings down. You'll see dividends cut. And you will certainly see the elimination of buybacks for a lot of those companies.
But when you look at tech, and you look at health care, and you look at consumer staples, and even some utilities, those dividends are going to continue to go up. So some industries will be fine. Some are going to be hurt quite a bit.
We talked about it on a previous show. We wrote up something called "The Bits Versus Atoms." The best way to think about that is there's a formula often called the DuPont return on equity formula. It's profit margins times asset utilization times leverage.
And as we live in a world where technology is becoming more and more a part of what we can do, most businesses are trying to substitute technology for labor. Well, if you can substitute technology for labor and hold your revenues constant, your profit margins go up. And if you can substitute technology for bricks and mortar, basically like many retailers have done by selling their goods over the internet, your sales per dollar of assets go up. Every company in the world is trying to pursue this what I call capital-light model.
But a very interesting thing happens as you deploy this. The third component of this return on equity formula is what's called leverage, which is assets per dollar of equity. So if you were looking at a balance sheet, the left-hand side is considered your assets and the right-hand side is liabilities and stockholders' equity. To the extent I can substitute technology for labor and physical assets, I don't need to deploy these assets in the business. I can actually take money out of my business, so long as my revenues are there, and still sustain a very high level of return on equity.
You are going to start to see technology effectively increase payout ratios. When you cut through it all, you will find that companies don't need all the money to generate the same level of sales today. And your payout ratios will slowly start to rise.
Now, right now it is simply-- that observation is overwhelmed by the virus, which is just catastrophic in its import. But over time, the outlook for dividends is actually quite good, because you simply don't need all that capital to generate the same level of revenues.
[MUSIC PLAYING]
