The Dividend Divide

Paige Henderson: Hello and welcome to SpringTalk. I'm Paige Henderson and I lead the Resilient Global Equity team. We manage international core global and international equity income strategies here at Allspring. Today, we're taking a closer look at dividends. For some investors, these payouts are the crown jewel of equity investing, offering a steady stream of income. For others, they're distractions from the bigger picture of growth and equity investing. Joining me today are two experts from Allspring investment teams. First, we have Bryant VanCronkhite, senior portfolio manager and co-head of our Allspring Special Global Equity team. Alongside of him is Jim Argabright, senior portfolio specialist and co-head of the Rising Dividend Group within the Core Equity Platform team. Thanks for coming today.

Bryant VanCronkhite: It's great to be here.

Jim Argabright: Great to be here.

Paige: Well, today, I thought we want to debate a little bit and kind of dig into how we see dividends. And we obviously have some different perspectives on that. Historically, equity assumed to have an income. And if you look back to the 1920s as much as into the 1970s, equity could have had the same or more income even than bonds. It wasn't until we got to about the 1980s when value and growth as investment philosophies arose. And growth in the U.S. is one of the things that differentiates the U.S. market from the other markets because it's perfectly acceptable in the U.S. to have companies that don't pay dividends. And then, finally, I think when equity income became a thing on its own right, it does provide income and equity. And then in 2004, with the Bush tax cuts, the tax code treated dividend income on a, on a level platform with capital gains. So, I think that that was an important point in the history of dividends. Jim, did you have any other, thoughts on dividend history?

Jim: Yeah, sure. Maybe a little bit of perspective on how long dividends have been around. So, dividends, actually the first ones paid here in the States pre-date our Revolutionary War. But those surprisingly to me, anyway, were not the first to be paid. Actually, the Dutch East India Company started paying dividends in 1602, which seems to be the first public company that has paid dividends. But we've seen dividends with long-standing track records. In fact, the most consecutive increases here in the States is a company that's been paying since 1816. And in fact, sort of a hybrid security—we'll get into a little bit on the div yields versus fixed income yields—but the British Empire actually issued British consul bonds, which were first brought about in 1754. They finally retired those in 2014. So, a unique characteristic of having some growth, like a dividend income, but also a perpetuity, which is unlike fixed income. So, yeah, dividends have a very long, rich history throughout the globe in many different eras.

Paige: Bryant, did you have any other things you wanted to add about dividends?

Bryant: Yeah, dividends prior to 1958, to your point, oftentimes had yields above that of the bond market, but largely because equities were considered to be incredibly risky back then. We didn't have the same governance standards we have today. We didn't have the same regulatory framework. And so, investors really demanded that income back as a security blanket for owning the riskier part of the capital structure. But as the regulatory framework changed and as the SEC started to put guide rails around buybacks for stocks, we started to see corporates decide to change and shift the way they use their capital and investors embraced that, especially after the 1980s. And so, that history is long and rich. Dividends are important to an extent, but the menu of options is increasing for investors. And that's where our team really begins to dissect what we want companies to do with their capital. And dividends remain today as a very viable and sometimes very important option as to how a company should use their capital. But we also see a lot of other ways companies can use their capital, including making acquisitions, including organic investments in things like CapEx (capital expenditure) to build more factories or research and development to get ahead on innovation technology standpoint, maybe even vertically integrating. The supply chain today is an incredibly chaotic environment. We want companies to think about vertically integrating. And then, of course, there are buybacks and dividends. So, the menu is wide, and we want our companies to think about what's the highest and best use for their capital and make sure they have the freedom to make those choices. So, dividends are a piece of it—an important piece at times—but not the only piece. And that's why I think the debate begins to kind of unfold.

Paige: I think as we get into this debate, part of the heart of it is the issue of capital deployment. And we could break those into four categories: the internal use of CapEx, like you said; or mergers and acquisitions; and then, the returning value to shareholders, which is the dividends; and the share repurchase. And I think as you look across the landscape, different industries have different histories and different industries have different capital needs. I think we all agree on that. Let's take a moment and share with everybody how our philosophies relate to dividends. Do you want to kick it off, Bryant?

Bryant: Yeah, sure, I can start. So, we believe companies create value based on how they use their capital. Every quarter, every year, ideally, they create free cash flow. That free cash flow flows into the balance sheet. And now, the CEO, CFO, and board director says, what do I do with that capital? They all have the same menu. And again, what we want them to do is to look at the landscape and say, hey, today, the proper thing for us to do, given where we are as a company competitively, given where we are in our life cycle, is maybe make an acquisition to expand our total addressable market. Or maybe we've got really great assets competitively, but we can create higher efficiency by investing internally to create higher margins. And we want our companies to think about all those options. What's really important during times of, I'll call it turmoil, where we have now a lot of volatility is freedom. We don't want them handcuffed. And when I think about this menu of capital allocation options, the only thing you can't send back to the kitchen, so to speak, is a dividend. Once you start paying that dividend, the world believes that is sacrosanct. If you decide to cut that dividend, your stock gets punished in a meaningful way because it sends a negative signal to the market. Now, you could always pursue an acquisition and then say, no, I don't want to do it. You can always start buybacks and pull back if your stock price moves higher. You can always pull back on your CapEx, but you can almost never cut that dividend without a negative ramification. And so, at a time like this, where we are today in a market environment, what we really treasure is freedom. It’s flexibility. And we worry today that the dividend is a handcuff on that flexibility.

Jim: Yeah, I think there are some things in there that I definitely agree with and I think there are some things that right now we would probably push back a little bit from our perspective. I mean, first, in the menu of choices, I agree that there's a lot more that we can look at in these times of uncertainty. I certainly would agree, too, if you end up with a dividend payout that is too high, that that becomes a meaningful handcuff, right? What we're going to look for and what I like what you said about these uncertain times, I think that's where an active manager has to really do the due diligence because there is a broad menu. If you are choosing to return capital and at a growing rate in the dividend, which a lot of end investors do favor, then you need to be very careful about the other options that you're taking. Where I would probably push back a little bit is we don't feel our companies are handcuffed if we're doing the analysis and the due diligence because, as Bryant mentioned, the share repurchase, which generally takes up a higher percentage than the dividend, that's sort of the spring that they can bring up and down, and they can do that easily and adjust that, and we've seen that through the pandemic, through the rise of interest rates, different market times. So, we think that gives that freedom while there's still the consistency and capital discipline.

Bryant: Let me jump in on that. So, that's a common phrase we hear—it’s that dividends instill discipline. And I see that, but that's also our job as active managers to do the due diligence on the front end to make sure that we have trust and confidence in the CEO, CFO, and board. And so, we like to use things like the cash flow statement to analyze a history of discipline and capital allocation. If they like to make acquisitions and they're telling us they're going to make more, is there a good history behind that? Do they make smart ones with the right prices? If they are buying back stock, are they historically doing it at the right prices at the right times? And so, I think there is absolutely a way to verify a company's integrity with capital discipline and deployment and not really require the handcuff just to ensure it. And that's our view on it. We try to do that diligence upfront.

Paige: I think my perspective may be a little broader because we manage U.S. and international. And international’s a little different. In Europe, I think it's more a function of earnings and almost a payout ratio. In Japan, it's even more that way. So, if you're having a bad year, if you're having a tough year because your environment's difficult, then you could pay out less and it doesn't really hurt you that much. We actually, in 2020, went through a true dividend crisis in Europe because the government and the regulators told companies they had to pull back on dividends they'd already declared because the way European companies work with employees is a little more like our unemployment insurance. So, companies eliminated dividends or they cut them. And then the next year, they came back right at the same level. One thing I think has happened as our resident historian, 20 years ago, you would find trust documents that said you can only own stocks that pay dividends and you can only own bonds that are AAA-rated. Well, the world's changed and trust documents have changed. And if you said you could only own bonds that are AAA-rated, you might have a problem now because the U.S. isn't AAA-rated. So, I think that, yes, companies may take a hit when their dividend is cut. A lot of times, though, if the dividend is cut but not eliminated, there may be even a relief rally because it's the company acknowledging what investors have seen coming. And we've seen that in some cases with our stocks. But I think it is important, there is a distinction between dividends and fixed income in that dividends are assumed and expected to be continuous, but legally, they can cut dividends, whereas it's much worse if you don't make your bond payments.

Bryant: Those trust documents, I think, were very relevant in those times where, again, the regulatory backdrop was very different, but it kind of points towards another handcuff, which is if an active manager is required to own companies that pay dividends, it begins to reduce the flexibility in terms of all the options they have. And so, again, I think that a lot of terms and conditions have changed. But again, equity income investing is all about providing a material dividend of some size that matters. And that gets harder to do when the risk-free rate is now pushing well above 4% after this period of ZIRP (zero interest-rate policy). And so, when I think about handcuffs, as a portfolio manager, what I really want, again, is flexibility. I want a lot of tools in my toolkit to express my views. Let's take the Russell 1000 benchmark, for example. It's a large-cap index, very broad index used across value, growth, and core. And if you look at, for example, there's 125 technology stocks, give or take, in that index. Only 25, give or take, actually pay a dividend above 2%. That's a really small, narrow set of companies to choose from. Of the 150+ industrial companies, only 50 or so pay a dividend of 2%. And so, not only is the corporate handcuff in terms of the freedom to how to deploy capital, a fear for me, for an investor is that your active manager is also handcuffed a little bit and it pushes you into a narrower set of companies. And that's another fear I have. When people think about equity income investing, they see the carrot of the dividend, which is nice, but they forget about the stick that it puts on the active manager as well.

Jim: I think you bring up some really good points, maybe one way—and then, Paige, I'll have you jump in—would be, again, what are the objectives? What are the goals? Who's the end investor, right? So, we look at that end client. They treasure, they do want to get that dividend. Is there a potential trade-off or a crossover point? Absolutely right. But we look at it as that, again, instills that discipline that the client then can choose how they're going to reallocate their dollars. Do they reinvest within the strategy or within the company that's paying the dividend or do they deploy it elsewhere? I think your points are well taken on certain areas of the market are more difficult, quite frankly, to be able to find that depth—technology being one. What I would say is if we were looking at 2023 or 2024, I would probably agree with you or be forced to agree with you. But in 2025, looking out, I think we start to see some of that change—that some of the large-cap tech names are now beginning to pay and grow a dividend. We're still waiting on a few more. But we're starting to see those choices broaden out. So, with us, I think we can either do one of two things. You can be patient and you can wait and there are still good days ahead for those companies. You can try to find exposures to tech or tech-like in other areas. Are there shallow ends of the pool that we have to do some extra work to work around? Absolutely. But I think we're able to do that. And I think in 2025, we think that most of those shallow pools are starting to get a little bit deeper.

Paige: As an equity income portfolio manager, I'm trying to deliver a solution to a set of clients who have a specific set of needs. And I would think that the perfect allocation for the retiring person—which may be different than your end client that is looking for maybe a more aggressive or an institutional pension or whatever, something that has more predictability—that you would own a combination of fixed income for the stability, growthier unconstrained portfolio that maybe has more beta that outperforms in up markets, but you also want to have something that outperforms in down markets. Because what differentiates you in a retirement phase is that you're taking money out instead of putting money in. And I think that's where equity income shows its value to that particular group of people.

Bryant: I love where you took that because I think it is all about outcomes for investors, right? And one of the things that we hear a lot, especially in the media or just from investors in general, is that we love our dividends because they provide protection—this downside protection mantra. And I'd love to hear your views on that. My particular views on it are that that dividends as a defensive characteristic is a big red herring. The dividend itself is actually cyclical. To your point, earlier you said as earnings fell—I think it was a European crisis, if I recall—as earnings fell, they had to cut their dividends. Dividends are actually cyclical around the change of earnings. I think the idea of dividend-paying stocks outperforming the broader market and market drawdowns comes down to the characteristics of the business itself. Typically, dividend-paying stocks have pretty stable cash flows. They have to in order to pay a dividend and be predictive. And so, you have this lean towards consumer staples companies, healthcare companies, utilities, REITs (real estate investment trust). And so, my view is that it's not the dividend that provides protection. It's the stability of cash flow that characterizes protection. And it just so happens that a lot of dividend-paying stocks have those. And so, I'm curious if you guys think about dividends as protective mechanisms in a different way than I do, which is really more cash-focused than dividend-focused.

Paige: Well, I think we have a lot of overlap in the way we look at stocks and the kind of companies that we own. And I certainly hope that the great dividend-paying stocks, the ones in the 1% to 3% yield range, continue to pay their dividends. But yeah, maybe there is something to be said about those companies themselves, but also, if you think about stocks like bonds, you've got your dividend and the value at the end. If interest rates go up—it's not just interest rates—if your discount rate goes up, then the higher coupon bond goes down less. And so, in times of great distress and markets pull in their duration and when we're very frightened like in 2020, instead of looking out five years, all we can do is look out a quarter. Then, that dividend as a percent of the value of the stock is worth more. And I think that's why in downdrafts, which are becoming deeper but quicker, I think there is value to the dividend. To me, the greatest risk for the individual is the sequencing risk—that they get frightened, they get shaken out of the market at a bad time. And so, with equity, I'm trying to drive equity and income. And to me, the dividend isn't a handcuff. It's a benefit. And I think that if you look at the index returns in those downdrafts, whether it's 2022 or the fourth quarter of 2019, you do see that they are defensive, but you're just kind of trimming the peak off of the cycle, which some people might be happy giving up a little bit of the upside in the up market to avoid the fear in the down market.

Bryant: I think that's a great point. I think the value in a company, which is what comes down to how much it moves down in a down market comes down, in large part, to the duration of the cash flow you're going to receive and shortening the duration makes a ton of sense. And that does provide protection as well. And I think as long as a company still maintains the flexibility to do other things in that moment, that's the exact moment you want them playing offense. The best way to create value, in my mind, is to play offense while others are playing defense. And as long as the payout ratios—I think, to your earlier point—aren't so high where they lose that freedom, not only do you shorten the duration with your dividend, to your point, but you can then start to buy back stock. And that's what puts a floor on a stock price. When stocks are falling, a company that can go in there and say, this is a really attractive price long term for my equity investors and I'm going to buy it back, that even shortens the duration further. And so, as long as they have the freedom, I think it's a really valid argument that the duration of the cash flow streams pulled in and that helps provide protection.

Paige: What's interesting, if you look at the U.S. and Europe, I saw a study that showed that European companies have actually increased their share repurchase, but they maintain their dividends. And one of the reasons why in Europe you have a higher yield is mainly because the multiple is lower. And I do think that as we talk about where we are with dividends and what is the next step with dividends—maybe that's our next subject—dividend yield is a valuation metric and it can vary because of what percent of the market doesn't pay a dividend or how much companies are paying out as a percent of their earnings. So, it's not quite as direct as P/E (price-to-earnings) multiples, but dividend yields in the U.S are approaching levels we haven't seen since 1999, which may be some commentary on where we are in the market. As an equity income investor, where I'm a little more conservative, I'm concerned about people's ability to weather the storm. Now would be time when I might be taking a little risk off the table because I think the market's kind of full. But maybe that means you peel back on growth and add more to value.

Jim: Yeah, I would add, I guess, the two pillars I'm hearing on both sides, I do think that you have to do the work upfront. It is a cash flow story that it's going to pay the dividend, right? But on Paige’s side, I would echo that a lot of our clients really appreciate when in those downtimes, they're going to get that rising stream of income, so that it's not in a down market in 2022, fourth quarter of 2018, they're going to see 6% to 7% increase in what they're getting from those dividends. And that sort of does two things. One, it obviously keeps the average person into the market. And I think the average investor gets 50% of the return of the S&P 500, call it 5% versus 10% long term. Why? Because they tend to make the wrong decision at the wrong time. They don't play offense like companies do because they're going to go and play extra defense at a time when they shouldn't be doing that. So, we think the dividend prevents that or enables them to stay in the market. And that's a key point for most of our investors.

Paige: Well, maybe we say it a different way. I mean, we all like cash flow. We want our companies to have cash flow. I just want my clients to have the cash flow.

Bryant: It's a fair point.

Jim: The risk I was going to say about the dividend cuts because you bring up a great point, right? Like, if the dividend is cut, we look at this like we're 60 Minutes. We're too late to help you if we sell the stock generally after the dividend cut. So, there are obviously a lot of signs before then—that payout ratio is getting too high, cash flow is going down, that costs are going up—I mean, there's a host of different things that we all know that would tip your hand that goes from a green to a yellow to a flashing red—that we have sort of a problem within an individual stock. So, one of the things we do monitor quite closely is we don't want to be, generally speaking, in those highest-yielding bond proxies because then you're sliding over, then it is a pseudo fixed income-type investment, but it has the risk of an equity investment. So, you're getting less upside and more downside. Versus in that dividend sweet spot, we kind of think that you're getting a good trade-off where you're able to still have the company getting the growth, but also they're not going to be as handcuffed as some of those higher yielders would be.

Bryant: Maybe all of this speaks to no matter where you are in equity income, in unconstrained equities, it really comes down to having a very clear insight as to how a company is going to create value and what that means for your future return profile as an investor. And that really comes back to, again, active managers doing their job. We all know there's 100 ways to do what we do, and there's no right or wrong way to do it. It's just a matter of preference. And so, our team's preference—we still have companies with dividends. Don't get me wrong. But we still want more freedom, more flexibility, especially during times when rates are rising and volatility is up. We think that freedom, that option on that freedom is increased in value. But at the end of the day, the investor needs the outcome pattern.

Paige: I think what this discussion has said is that even if you are conservative, if you want to be more value than growth, you can still have diversification just from the differences in the positioning. So, we talk about stocks when we're diversifying, but it's important to think about the subtleties around your different equity solutions and more diversification within limits. You don't want to own like 30 different strategies. But it's kind of like, am I going to wear black shoes today or brown shoes today? There's a reason why you need to have a choice.

Jim: I kind of like the word you used—the volatility of today—because Bryant, I've heard you also talk about some of the macro backdrop, which we haven't really talked about. And you've said that the Fed (Federal Reserve)—if we're going to talk handcuffs—the Fed is sort of really in a tight bind right now. We have still two hot wars going on across the globe. We've moved from ZIRP to, we'll call it, a higher or more normalized rate environment. And the economy and fiscal policy—well, we just had the passing of the Big Beautiful Bill. It's beautiful or big. I guess it's all big. Depending on whatever side you're on, how beautiful it is, it might be open for debate. But I like because, I think to your point, it really opens up—there's probably a menu of outcomes that were bigger than there were two or three years ago—some outcomes good for the economy and good for stocks, some less so. But that again, that due diligence, that focus back in where we need to go and look at what companies do we think are driving the free cash flow and it comes down to that durable asset base, free cash flow generation, and how efficient they are at the capital allocation. Now we may favor, maybe you would call it, more conservative capital allocation, paying out some back to the end shareholders, but still efficient or justifiable that they can still grow the business as well.

Paige: All right. Well, great. This was so much fun. And I think what we've discovered is that we each come at this from a different perspective. My perspective is towards meeting the needs of a particular subset of clients who enjoy having the dividend. I also agree that there could be an opportunity to raise your long-term return by focusing on companies that are more aggressive in how they use their capital and maybe not in direct cash flow internally rather than externally. As long as we all can find our universe of names, I think that we can continue to serve our clients. And I think it's important that in this world of turmoil that we reexamine our previously conceived notions and always be looking for the fresh perspective. So, Bryant, Jim, thank you.

Jim: Glad to be here.

Bryant: It was a pleasure.

Paige: And thank you for joining us for this edition of SpringTalk.