Investors love dividends. There’s something special about receiving cold hard cash into your brokerage account every quarter, which you can use to pay for expenses or reinvest and buy more stock. Over time, reinvesting dividends can compound your returns.

But how do dividend-paying stocks compare against other segments of the market? Have they been impacted by the tricky macro of the past year? Are dividends more attractive in rising-rate environments? And what factors should investors consider before buying dividend stocks?

To answer those questions, we’ve brought in an expert. James Early is the Chief Investment Officer of BBAE, and formerly the Advisor of Motley Fool’s Income Investor. 7investing CEO Simon Erickson recently spoke with James about dividends and dividend-paying stocks.

In the first part of the conversation, James describes what got him into dividend investing and the “3M” factors — “management, moat, and money situation management” — that investors should look for. He describes how dividends are a good way to keep management teams responsible in their capital allocation decisions. He also describes how dividend-paying stocks perform through different market environments.

James goes on to discuss how dividends can be a long-term relationship between companies and their investors. Consistent dividend payments that rise over time can attract long-term investors. Conversely, dividend cuts — especially when they come by surprise — can damage a company’s reputation with investors.

Simon then asks James to describe the tradeoff between dividend yield and dividend growth. Is it more advantageous for investors to look for higher yields upfront? Or should we patiently wait for dividends to grow over time? James also explains several unique business structures that can have tax-advantages from paying dividends, including Real Estate Investment Trusts, Master Limited Partnerships, or Business Development Companies.

In the final segment, James describes two of his favorite dividend-paying companies: Diageo (NYSE: DEO) and Unilever (NYSE: UL).

Publicly-traded companies mentioned in this podcast include Amazon, Diageo, Unilever, and WalMart. 7investing’s advisors and/or its guests may have positions in the companies that are mentioned.

Don’t miss out on future conversations like this! 7investing will be publishing upcoming interviews with the CEOs of PubMatic, Rocket Lab, and more. Join 7investing’s free email list to get our podcasts and investing insights delivered directly to your Inbox.

Transcript

Simon Erickson  00:00

Hello everyone and welcome to this edition of our 7investing podcast where it’s our mission to empower you to invest in your future. You can learn more about our long term investing approach at 7investing.com/subscribe. My name is Simon Erickson. Today we’re going to be talking about dividends. You’ve got to love dividends. There’s some feeling of safety you get from having a quarterly check deposited directly into your brokerage account and who better to talk to you about dividends and the Grand Poobah of income investing himself James Early. James is the Chief Investment Officer at BBAE. He’s also formerly the CEO of Stansbury China and also advisor of Motley Fool’s Income Investor Service. James is also a close friend of mine for about 15 years or so now. It’s so exciting for me to have you on the 7investing podcast today.

James Early  00:43

Simon I’m just as excited. Yeah, it’s been a while since we chatted, it’s a very flattering intro happy to chat about dividends that have good aspects, bad aspects. I was lucky to to run a dividend newsletter service for 10 years and lucky enough to beat the market during those 10 years but people say what’s my secret I really don’t have anything it’s just dividends are statistically likely to beat the market. So if you’re going to be picking any kind of stocks blindly I’d say let those stocks be dividend stocks.

Simon Erickson  01:07

Can you can you walk us through the background James what got you into income investing what got you interested in dividends in the first place?

James Early  01:13

You know, it was kind of random they needed to guide or run a different service and so there was not you know, there’s not a dramatic backstory but I am a data guy so I mean I look at the numbers I’m not so much an emotional investor which is probably good investing it’s bad and the rest of my life because I’m this like, you know unemotional automaton sometimes but but with investing, it’s useful. And there’s so much data supporting dividend stocks supporting the outperformance of dividend stocks that I took to it like a fish to water, you know, over and over and over again studies show dividend stocks outperform not all the time I want to be clear there are definitely periods of time, including right now. So I’m including right now we’re dividend stocks don’t outperform I just looking moments before we speak we spoke and the s&p 500 is up 9.4% year to date. The dvy which is the iShares select dividend index, something like that as an ETF is down at 9.2-9.4%. So almost literally exactly. 100% inversely correlated for the moment not always so. So it is not it has has not been a good time so far this year for dividend stocks. But but that may change Simon.

Simon Erickson  02:20

So let’s do a quick refresher for a lot of people that are listening to the program or listen to our podcast, this might already be familiar to them. But for someone’s that might not you know, dividends is a capital allocation decision that companies can pursue, right? They have money that’s available, that they want to share with their investors and their shareholders. They pay out a cash dividend, that it’s up to the investor what they want to do with it and take it out as cash and reinvest it to buy more shares other things like this. But in in looking at dividend paying companies, James, if you’re looking at kind of the bigger picture of how they’re structured, or how they’re paying things out, what are a couple of factors that investors should be looking at before they take the you know, the leap of faith and actually invest money in a dividend paying company?

James Early  02:57

Well, great question. Let me just back up there, we just said so there’s a paper and I’m forgetting the exact name, but it’s put by Rob Arnott and Cliff Asness have something called like, surprise, higher, higher dividends equals higher earnings growth. And it basically mean there’s a stereotype with dividend paying stocks that by the time a company gets so old and gray and expanded all its growth opportunities, that finally starts paying a dividend. And that’s sometimes true, but there is massive, massive waste in US corporate America, the corporate world, and dividends can enforce a certain discipline that companies say okay, well, should I should I expand in this kind of a continuous new area that I’m not so good at? Or should I just pay a dividend.  And so dividends have a way of enforcing companies to have a good capital allocation policy. And it’s a way of sort of self selecting responsible company. So that’s an argument for this paper that I just mentioned about why higher paying stocks often have higher earnings growth and often do better is it’s not the fact that they’re giving away money so much as that it signals a sort of a corporate responsibility.  So management is is you want people with tenure in the business, ideally, with with skin in the game if especially as a small company, if it’s a big huge company that’s been around forever, you’re not going to have management that owns like a huge percent usually, but you want them to have some meaningful percent of the equity. You know, I typically Google their backgrounds. Look at the proxy statement, see how they’re paid. Are they paid by stock price gains, which is kind of unknown. Or are they paid by growing return on invested capital, which is sort of like the Genesis, kind of like the I shouldn’t call it kind of the key point of a business basically is to earn more on his capital than his capital providers are expecting. So management is key.  So back to your question, what factors do I look for? I look for what I call the three M’s: management, moat, and money situation management. And by the way, this is my these are my dividend factors. If you said what are your biotech factors, your AI stock factors, I might have different factors but for dividend stocks, these are my factors.  Moat is where you would compare ROIC to, let’s say weighted average cost of capital. In other words, if I borrow money from a bank at 8%, and I go invest that money in the stock market, I’d better earn at least 8%. Right? A business works kind of the same way. But they’re doing more than just borrow money. They’re also taking on money from equity providers and investing it and they’d better earn at least that expected return, which is called the weighted average cost of capital. If you’re debt investors expect 8%. And your equity investors expect 9% and you’re 50-50 debt equity, roughly speaking, your weighted average cost of capital is 8.5%. So companies have a moat, a sustainable, enduring business advantage, whether that’s a brand, whether it’s a regulatory moat, like a pipeline, you can just build a pipeline right next to another pipeline unless you really, really, really demonstrated an economic need companies that have that moat have an advantage. You know, in general, when we model companies, we tend to assume a reversion to the mean, because that’s what happens with most companies. It started out, it’s a great flash in the pan, and after five years, 10 years, 15 years, you know, the competition has eroded at edge. But there are some companies Simon like maybe Walmart, or like Amazon or Disney, that just kind of keep going along and keep earning above average returns just perpetually, they have a moat.  And finally, money situation is what it sounds like it is just can the company pay its dividend? In my early risky dumb years, you know, I once or twice I fell for companies that were paying dividends, by virtue of taking on debt paying dividends, they couldn’t really afford to pay because they wanted to be in the check the box category of dividend stocks because at the time, dividend stocks were sexy, don’t don’t do that. Don’t be you know, young James Early, you want to be mature about this, make sure their coverage is okay. They can pay the dividend, the cash flows are healthy. I don’t really worry about bankruptcy so much with most dividend stocks. I mean, it’s more like can they pay their dividend? If I’m looking at startup company, then you know, bankruptcy may be more of an issue, but it’s just more can they comfortably pay the dividend?  So that’s a very long answer to a very short question. But management, moat, and money situation.

Simon Erickson  06:57

So those are perfectly James. I love the three Ms, that’s a perfect description of what to look for.  Maybe we tie them all together, and we kind of double click in this relationship that the dividend ties a company’s management to the investors themselves, right? If you’re initiating a dividend a long time, a lot of times it’s a long term commitment. Right? Like you said, you have to have a responsibility to kind of pay that out. You might have institutions that have got, you know, retirement funds counting on that dividend. How do you think about dividends and you shouldn’t, should a dividend be something that is just continually paid and then increased 10% every year? Or we certainly some sometimes see companies do variable dividends?  Or is this just something that’s company specific? How do you think about the nature of of a dividend? You know, continuing over time and sustainability of that dividend?

James Early  07:41

It is a deeply philosophical question, Simon. Actually, I’m glad you asked it. You know, originally, dividends were like ultra fixed and they still mostly are in the US. It’s a terrible signal to cut one’s dividend unless everybody else is cutting it, then it’s like, okay, but But generally, you don’t want to cut it because dividends, I mean, stocks originally, were essentially competing with bonds. And so the dividend was sort of like the bond ish aspect of a stock and they wanted to never cut it like a bond. You know, bonds are legally required to pay a certain coupon payment right. Now, in Europe and some parts of Asia, dividends tend to be more flexible, they’re paid out as a percentage of earnings.  Now, when I was a pure idealogue, I love the fixed dividend because it was disciplined. It’s with dividend stocks should do. And I’m probably gonna offend some people who are pure ideologues who just really want that fixed payment. But I would argue, I would argue that it is actually much healthier for a company to have a flexible dividend payout, payout ratio or payment, because they could they could adjust it if they’re making a lot of money, they pay more. If not, they don’t, I mean, from time to time companies pay a special dividend. Yes, but that’s like super rare. It’s just typically a one time windfall. It’s not not like a big thing in the US.  So I’m in favor, I’m in favor of a flexible adjusting dividend policy that scales up and down with company health. And that does not signal the end of the world if a dividend is lowered. I think that would be healthier. For companies, you wouldn’t see people struggling and companies struggling and borrowing money sometimes to pay their dividend, in this case, not to look like a sexy dividend payer, but just because they’re so scared of what happens if they cut their dividend. So so I’m in favor of flexible policy.

Simon Erickson  09:21

James, can we talk about that though? The dividend cut? That’s the worst case scenario, right? Nobody wants to be in the headline that you cut the dividend, but sometimes we see it. We saw Intel just earlier this year Intel’s paid dividends for so many years, and finally said, you know, we really need to put our capital elsewhere, we’re going to cut the dividend. A lot of people of course, certainly hate to see the dividend cut. What is your take on is that responsible management or is that something that just a huge red flag for you as an investor?

James Early  09:45

No, I mean, look, it’s obviously bad and a lot of the people who who bought the stock for the dividend are going to bail, okay, and it’s going to be a negative catalyst for the stock price. In the case of an Intel I mean, that’s probably in the better end of the dividend cut spectrum. You know, a lot of times you’ll have companies paying, by the way, a huge, huge yield is usually a warning sign if you’re just coming in dividends, and you say, Hey, I’m gonna search and you know, Yahoo or finviz or some screener, I just buy the highest dividend yielding stock, that’s great. This one’s paying 16% yield, just right off the bat, I get 16%. So any any capital appreciation is gravy, don’t think like that. Okay. Usually, usually that very high dividend yield is a sign that’s looking backwards is saying last year’s dividend compared to today’s stock price equates to a 16% yield, it does not mean it’s almost it’s very unlikely that you’re gonna get 16% yield going forward. So really high yields are red flags for a cut.  Those are stocks best to avoid if it’s a really good, honest, legitimate company that you’d like to prospects, and they’re just having a difficult financial time for a year or a few years, they have to cut the dividend. That’s it’s healthy, you know, that’s a sign of, you know, just like, it’s good to be able to admit your weaknesses, right, and talk through this as a human. Same thing for a company. So I would welcome that as a sign of financial maturity. I mean, obviously, it’s not good. But you know, if, if you’re relying on the dividend cut to signal financial trouble, like you’re not doing your homework, you know, those those signs should be portrayed or shown across a number of different aspects of a company’s finances. So it should not be a big surprise, if you’d like the company for the long run, continue to hold.

Simon Erickson  11:22

And where is the sweet spot for dividend investing? James, you know, you were talking about kind of using the screener where you might go out and you might look for the highest yield upfront, right, you’re getting the most cash today, but then there’s also risks of in cutting or reducing that later on, versus another company that might have a lower yield a lower upfront payment, that they’re increasing steadily over time. Is there a certain dividend yield? You’re looking forward to at least put some money in your bank every quarter, but then also a growth metric associated with that, too?

James Early  11:47

Yeah, that’s a great question. So I’ll split it into two parts. When I was running Motley Fool income investor, I generally look for that a two and a half 3% minimum yield, because it has to be enough of a dividend for someone buying a dividend product to actually get a dividend. You know, 0.5% yield is just not a meaningful dividend, even if it’s technically deviled dividend. Now, what should people do, pretending you know, that’s not a constraint and pretending you don’t want 16% yield, I’m going to turn to a graphic from the Financial Times.  The data is from Ned Davis research and I believe Hartford funds, starting with $100 in 1973, which is not long after the US abandoned the gold standard until the end of 2021 $100. Put into dividend just plain old dividend payers gross to $8,842, which is wonderfully nice, quite a bit higher than just a plain old s&p 500. But put into companies that are raising or initiating dividend payments, it grows to $14,405. So unless you absolutely like need that high payout, I would say go for the dividend raisers and growers and initiators versus just just a plain high yield because you’re gonna get more in the capital gains side.

Simon Erickson  12:59

And one other question related to this changes, we’ve seen some some kind of unique business models arise to take advantage of higher dividend payouts, right? Some of these are natural as part of the industry they serve. Some are just gonna be a little more creative. One of the more natural fits for the industry is things like pipelines, right? We see midstream pipelines, these kind of massive, limited partnerships are paying every higher dividends. They’re also tax advantaged companies, things like REITs, Real Estate Investment Trusts that often pay very, very high dividends, because they’re required to buy the way that a company is formed. Then we’ve also seen some capital management companies, some of the creative formations that businesses because they want to pay at as high of a yield as possible. Any thoughts on those kinds of unique structures? James, are those good for investors to consider a little bit too sexy and creative and not really good?

James Early  13:42

It depends on the investor. Yeah, and I certainly recommended some of them in my newsletter, you know, business development companies, REITs, and LPs, these are basically all using structures bus by Congress, because they thought the US needed more of something. In the case of business development companies, BDC was more middle market lending, you know, their company, a lot of companies were a little bit too big to go to the local bank, but a little bit too small to go to capital markets to raise financing. So there’s kind of this underserved middle markets, they said, Okay, it’s a pass through thing, you don’t pay tax on the entity level, you pay out huge yields. And supposedly everybody wins.  Similar with REITs. Similar with master limited partnerships, you know, we didn’t have enough in the US. We didn’t have enough midstream energy, infrastructure, we need more pipelines. So Congress essentially blessed this act, which which allowed MLPs and it was abused for a while then they kind of pulled it back to, to just pipelines. I mean, we had you know, Cedar Fair amusement park getting in and as MLP, which is kind of not really the spirit of the law. But, you know, there’s nothing inherently wrong with them. They come and go, I mean, there are fads like everything else, where suddenly you know, BDCs are all the rage suddenly REITs are all the rage, your MLPs are all the rage, and then they’re not and they can be vulnerable to sudden even tiny changes in the law, and they definitely have tax consequences and In terms of should you hold them in an IRA or not? And sometimes these are debated. So, you know, yes, I would, you know, I would not shy away from them, but but they tend to be a little better for probably the higher net worth investors who have their own tax advisor who’s okay to help them, you know, work through some of the stuff, I wouldn’t come in as a brand new investor. And get into that just because a lot, probably a little bit more homework than you want at that stage.

Simon Erickson  15:25

Perfect. So let’s frame all these last 20 minutes or so James of context, and let’s bring it to today where we stand right as investors, because at seven investing, you know, we kind of offer the full buffet of options every month, we offer some high risk, kind of riskier, you know, higher return higher risk, high reward companies, and they also have some lower risk companies on the scorecard as well. I’m getting a lot of questions from our members lately about income producing companies, you know, they don’t like the volatility didn’t like 2022. And like the ups and downs in the market, and they say, you know, what are some of your lower risk, income paying ideas? And I would like to ask that question to you to James is like, you know, in the market that we’re in right now rates are going up, it’s getting more expensive for companies to borrow? Where do dividend paying companies stand? Is this a more attractive time to invest in dividend companies? Or is it was should you go for, you know, a higher risk company now that the market is kind of lower?

James Early  16:13

You know, it’s a great question. If I completely knew the answer, I would be on some beach somewhere. So I’m in but I think right now, you know, it’s easy to tempting to look backwards as an investor, but we need to be looking forwards, we’ve come from a rising, the fastest rising rate environment we’ve ever had literally in the US, right, if I’m not mistaken, was just brutal to you know, Silicon Valley Bank and other other companies taking interest rate risk. And that’s been been brutal to dividend stocks to a lot of different companies. However, we’re nearing probably at a rate plateau environment right now. And probably by the end of the year, maybe early next year, something like that, we may well have a declining rate environment. And that’s important to consider because we invest not for the past, but for the future. So in other words, dividend stocks have taken a beating. I think the DVAYyields, recently, like for four and a half percent. I mean, it’s come on that’s amazing, right. So it was was a horrible time to buy dividend stocks recently. But I think personally, just my own personal view is it’s getting to be a lot better time to look at dividend stocks, as those interest rates start to plateau and possibly go down.

Simon Erickson  17:17

And before we talk about some of the individual companies that I know that you’d like change, are there certain sectors that you really like to invest in for dividend paying companies, banks, pay dividends, some tech companies pay them as retailers, back to the thing that you mentioned about management and kind of a moat that companies have? Are there certain sectors of the market that are more able to afford to continue to pay dividends over time?

James Early  17:39

Yeah, you know, MLPs, we mentioned? I mean, they were complicated, but they do have they have probably the best moats in terms of protective business positions. I mean, banks, banks traditionally had been good dividend payers, you know, that there’s up and down with banks, and there’s their, you know, got interest rate risk.  And so maybe I’m, I might be bottom fishing on some small mid sized banks now, but it wouldn’t be for dividend reasons. In other words, if I’m buying a bank now, I would not be for a dividend reason. Pharma is, is a perennial dividend payer, I love to hate pharma for the longest time as an investment because I was so worried that you know, the chemical based kind of small molecule drug discovery process had really hit diminishing returns. But there’s still a lot coming up from biotech and a lot of biotechs are really for sale on the cheap now. So it may be, you know, and pharma had kind of a save the world boom during COVID. And now let’s come back down to earth a little bit. So, pharma to me is looking a little bit more attractive.  And then just general, I mean, tech companies check hated dividend stocks for the longest time, because if you were a tech company, and you started paying a dividend, it was like checking into the retirement or the hospice even like you, your your days were your best days were behind you. That stigma is now long gone, you know, probably 10 years at a date now. So we’ve got a lot of mature tech companies that have strong business models that have strong gross margins, and are starting to pay dividends. So you know, that’s probably another sector I take a look at.

Simon Erickson  18:57

How about two to three companies, James, that, you know, with all the years of dividend investing that you’ve done, what are two or three companies that you like, you really like to invest in dividend payers?

James Early  19:04

Well, Simon, your your readers seem to be wanting kind of lower risk dividend stocks. And that’s where I’ll go with with these two companies. In fact, I’ll go to the UK. I mean, they trade in the US, but they’re headquartered in the UK. Because UK has had a rough time lately, but these are I think that’s making the prices of tractor for these otherwise good companies. One is Diageo has got a 2% yield. D O is the ticker here. And by the way, this is a company that I like, I’m not telling anyone to buy it or not buy it. It’s not a formal recommendation one way or another just I like it. It’s a no thesis company. No thesis stocks are my favorite dividend stocks. It means nothing particular has to happen for this company to do well. It just has to keep doing what it’s always been doing. There’s no like, you know, regulatory approval. No, you know, phase three trial results. There’s no like particular catalyst. This company makes brand and stuff and it charges a lot of money for it. The alcohol sales worldwide are growing faster than GDP, the hard liquor, a lot of times takes 15 years to age. So you know, Simon and James can’t just start up Simon and James distillery and immediately compete with Diageo. Right. We’re 15 years behind. So it takes a long time to compete with this company, humans will always want to signal status. The Ico is super premium stuff. Their segment is, I want to say growing more than 25% a year in terms of revenue growth phenomenal ROIC is in the mid teens and operating profits are supposed to grow 6% to 9% per year through 2025. So nothing fancy or flashy about Biagio. But I think it is on the right side of a global growth trend. That is number one. Diageo.  Number two is Unilever. Even more boring. This is a boring fast moving consumer products company. They make Vaseline, Dove soap, Q tips, Helmsman…I never like mayonnaise, I don’t know why the Helmsman. Axe body spray. And I’m presuming you’re not a heavy user of Axe Body Spray Simon because I’m about to insult the business you get on the subway with these teams you know this just douse themselves so anyway, I don’t like the product but but I love the company love the company. These guys have over 400 brands, they’re in 190 of the 195 company countries worldwide. That’s that’s a lot 58% of sales are to emerging markets where brands matter and often people pay a little bit more, you know, to get the real brand versus kind of the local brand they might not trust as much beauty 42% of revenues. I’m thinking the food is 38% and then home care just cleaning stuff is 20% the catalyst here you think what the stocks kind of treading water forever. Activist investor named Nelson Peltz joined the board and the CEO is going to be a former CEO as of the end of this year, they tried to acquire GSK as a consumer products division that didn’t go well. He’s gonna quit we’ll have new blood. Procter and Gamble was in a similar situation some years ago. And with new management, they really took off so this could be this this this time right now. 2023 could be Unilever’s Procter and Gamble moment.

Simon Erickson  22:04

Great, great ideas there. James Diageo is do about a 2% dividend yield today. Unilever’s UL three and a half percent dividend yield? Do you collect the dividends and take them all as cash and then reinvest them into one company that you really like? You just let them compound over years and years? What’s What’s the idea for dividends over a long term?

James Early  22:22

Yeah, it’s a great super good question. It depends on the account you’re holding them in. Yeah, you can, you can just automatically reinvest them. In the companies that paid them. You can just take the cash and spend it or you can take them and then put them into whatever is most deserving. And that’s that’s usually what I do. Now. Sometimes I get lazy about it. But but but it’s usually best to take him in and reallocate, especially if that’s a tax advantaged, or I do in a tax advantaged account. So but but you got those choices and you know, maybe when I’m 65, then I’ll switch to just taking that money and spending it.

Simon Erickson  22:53

Yeah, fantastic, James. And just one thing is we’re closing on your BBAE as a brokerage account right here. Can you tell us a little bit about this and where we can learn more about BBAE?

James Early  23:00

Yeah, easy to get bbe.com just BBAE.com. Very easy. As a discount broker. You can use your app, no commission, we have stocks, we have options. We have research, you know we’ve set it up so you can tailor your use depending on how much how much guidance or how much control you want. If you want to just buy stocks with some supporting research, you can do that. If you want to look some investing themes, get some some more robust ideas or clusters of ideas. We can do that or if you just want something that’s managed we can also do that.

Simon Erickson  23:29

Well, thanks very much. Once again, James really the chief investment officer of BBAE. Also a wealth of knowledge about dividend investing. James really appreciate you being on the show today.

James Early  23:36

It’s my pleasure, Simon.

Simon Erickson  23:39

As always, thanks everybody for tuning in to this edition of our 7investing podcast. We are here to empower you to invest in your future. We are 7investing!