Dividends for A Pricey Market

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We do think there's an opportunity for companies outside the Mag Seven, outside of IT. That doesn't mean the IT sector will not do well. We, we think a dividend growth strategy as a core equity exposure makes a lot of sense in a portfolio.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Matt Quinlan. He's a portfolio manager with Franklin Templeton, and in a moment we'll hear from him on dividends, growing ones. He'll share some of his favorite stocks with rising payments. Before that, we'll say a few words about the broad stock market and whether valuations should be making our knees wobble. Is that clear that that's a metaphor for fear or concern, Alexis? I mean, wobbling knees, that's a universally understood, uh, I think so. People aren't going to be thinking like a medical issue or something like that, right? Okay. Listening in is our audio producer Alexis Moore. Hi Alexis. Hey Jack. The stock market hit record highs in August. Now it's September. Now it's serious season. Kids are back to school. We're moving into, you know, cold weather in the Northeast. It's time to get somber and serious about what is next for the stock market and whether it's too pricey. I've got the S&P 500 at just over 24 times this year's projected earnings. And that's high. I would say that's halfway between kind of high and crazy high. We're not at crazy high yet, but we're pushing those levels. And that gets me concerned about whether we're headed for a drop. And it's very difficult to say. I get different perspectives on it every day. Let me share two that came in just in recent days. Deutsche Bank sent over a big scary chart. It's titled S&P 500 CAPE ratio with 10-year total returns, real and nominal, from the high and low valuation points. Quite a title. CAPE stands for cyclically adjusted price earnings ratio. That's a measure made popular by Yale economist Robert Shiller. Basically, if you look at the ratio of companies' prices to earnings, you never quite know whether earnings are normal. Are they normal right now, or are they unusually high or unusually low? That can really affect your P/E ratio. So what you do is you take a longer-term average of earnings. That's what the cyclically adjusted part of the CAPE means. Now, maybe you believe that measure is a good predictor and maybe you don't. On this chart, Deutsche Bank is pointing out that using 150 years of data, when valuations are high, forward returns have been consistently weak. When I say forward returns, I mean returns over the following 10 years. In fact, from the last 3 major valuation peaks, 10-year real total returns have all been negative. By real total returns, I mean total returns after subtracting for inflation. When were those peaks? Well, one was just before the Great Depression, around the end of the 1920s. Another was in the 1960s. There was a belief at the time that this group of big American companies called the Nifty 50 could outgrow all others, that no matter what price you bought these stocks at, you'd do well over the long term. That theory worked until it didn't. And the third big peak, of course, was the dot-com stock bubble that popped in early 2000. If you bought at any one of those three valuation peaks, your 10-year returns after inflation were— let me take them in order— -13% for the first one, -12% for the second. And if you bought at the dot-com bubble peak, you lost 29% after inflation over the following 10 years. So where are we now on that cyclically adjusted P/E ratio? Well, eyeing my big scary Deutsche Bank chart, we're high, higher than we were in 1929 or in that 1960s peak, not quite as high as we were during the dot-com stock bubble. The flip side of this, which this chart also shows, is that when valuations have been low, the subsequent 10-year returns have been extraordinarily high. The average 10-year return after inflation on this 150-year chart has been about 7%. Deutsche Bank writes that this chart illustrates how central artificial intelligence has become to the outlook for US stocks. The bank strategists write, if one believes we're entering a genuine paradigm shift— Alexis, did I tell you that when I got to college, I had only ever read the word paradigm and never heard it before? So in a class, I said paradigem. Out loud. No, that's okay. That happens. Save that story for another day. They write, if one believes we're entering a genuine paradigm shift beyond anything seen in the past century and a half, then the outlook for long-term returns could still be constructive, but you are taking a big position beyond what has already been 150 years of US equity market dominance. They also write, a key distinction versus the 2000 bubble, the is that today's valuation extremes are largely concentrated in the US. Other G7 equity markets sit at more moderate valuation levels. However, they lack the same AI exposure that makes the US narrative so compelling to many. Okay, so that's Deutsche Bank and it makes me a little nervous. Let's move on to something to get us cheerful again, and that comes from Evercore ISI. They sent a report titled Twice in a Lifetime. And in that report, they raised their price target for the S&P 500 to 7,750 by the end of 2026. Where does that take us? Hold on, I have to do some fancy calculating. 7,750 over— how do you factor polynomials again? Wait a second, that shouldn't be part of it. That's a 20% increase, 20% increase between now and the end of 2026. I'd love it. But where does that come from if prices are already riding high? Well, it comes of course from artificial intelligence, which Evercore ISI calls bigger than the internet. They write earnings drives AI and AI drives earnings. Is that what they call a, um, it's a little circular, right? Well, Let me continue. Some of the factors helping, they say, are the OBBB, the one big beautiful bill, beautiful budget bill. Am I missing a B? Anyhow, the budget. Also falling trade uncertainty and a stable economic outlook and the inflection of AI adoption. This causes them to raise their earnings estimates for 2025 and 2026. The level that they're raising earnings estimates to, by the way, is not that high compared with the consensus outlook. The consensus estimates I have imply 11% earnings growth for the S&P 500 this year and 13% growth next year. That's certainly good growth if we get it. Evercore writes overweight portfolios with AI enablers, adopters, and adapters as AI adoption inflects, driving productivity across the U.S. economy. They say that more market scares are inevitable and that investors should use them as buying opportunities. By the way, that view, the 20% increase from here through the end of next year, that's Evercore's base case. Their bull case is S&P 9,000, believe it or not. That's a 40% increase. And their bear case is 5,000. That's a 22% decline. You would think that with a range that wide, they have all their bases covered, although they write that If the S&P falls to 5,000, that suggests a P/E ratio of just under 19 times, 19 times earnings. Is that really a bear case? Is that what we call bearish these days? Maybe I'm more hypothetically bearish than others. My bear case involves actual bears. Watch your back. I know it sounds a little silly. Well, it could go to 9,000, it could go to 5,000. When strategists give these targets, they're giving what their clients want. People want specific answers. Where is the stock market going? Please round to one decimal place. And of course, that's impossible. You can't say in the short term what the market is going to do. I haven't found a way to reliably do that, by the way. I don't think that the constraint is how much you know. I don't think it's based on ratios and the economy and what's coming for legislation or company earnings or so forth. I think over the next year, where the market's headed is totally dependent on human behavior and emotions. And it's really hard to predict that for everyone at the same time. I think you stand a better shot of saying what the market might do over the next decade based on the past relationship between starting valuations and what happens down the road. Even that's not a sure thing. All of this leaves me A, concerned that stock prices look too high and that future returns could be low. I think most investors, if you told them your average returns over the next 10 years are only going to be, you know, a couple of percent after inflation, lower than you're used to, I think they'd be much more comfortable with that than you telling them we could have a 50% drop any day now. There's no way of knowing which we're headed for. All I can tell you is that I'm glad I'm still invested broadly in the U.S. stock market. I'm glad I didn't pull my money out during past points where I thought valuations looked too high. That's why I don't make big rash changes to my asset allocation because I don't really know what's coming next. But I think it makes total sense for investors to be looking for ways to get a little bit safer now, especially if these are investors who are approaching retirement or approaching the point where they're going to need to spend some of the money that they've accumulated. When I look at bond yields, if I look at the Treasury curve, you can get just about as much on short-term Treasuries as on longer-term Treasuries, somewhere around 4.25% right now. I know that the Federal Reserve is expected to reduce interest rates soon. That will lower the rates that you get on those short-term Treasuries or short-term CDs and the like. It's an open question of what it will mean for longer-term rates. There have been periods recently when long-term bond yields have been rising even though the Fed's expected to cut short-term rates. Why would that happen? Investors are concerned about deficits. They're concerned that we might be losing control over them. So they worry that rates on the long end are going to have to be higher going forward, even if short-term rates fall. If you're someone who's in the market for bonds, that means you won't necessarily miss out on good yields on longer bonds. Even if the Fed cuts rates. It's difficult to say. I want to talk more about that in coming weeks, about how to get a little bit safer with bonds. I want to talk more to Deutsche Bank's point about investing overseas in markets that are cheaper than the US. We talked about that, I think, early this year, about how it's kind of like eating your vegetables. Everybody says you have to do it. You have to diversify overseas, but the US market has outperformed for so long. And my takeaway then was I'm still going to do it, you know, not necessarily with a smile on my face. I'm still going to eat my vegetables. And so far this year, overseas markets have outperformed the US broadly. But we'll talk more in weeks to come about whether that's likely to continue and what investors should do about it. I want to hear from someone now about dividends. Dividend stocks have not outperformed on pretty much anyone's timeline, not year-to-date or or over the past 5 years or 10 years or even longer. There have been short periods where they've done relatively well in falling markets. I'm interested in dividends now because the stocks look fairly cheap. There's an ETF called the iShares Core Dividend ETF. The ticker is DIVB, and that trades for around 15.5 times this year's earnings projection. That's a good deal cheaper than the S&P 500. The yield on that fund is around 2.8% recently. That compares with the yield on the S&P 500 of just over 1%. The price has pushed so high on the S&P 500 that it has depressed the dividend yield. What interests me about dividends is that if we reach a period where prices perform poorly, prices fall either suddenly or gradually, what have you, then you look at your account statement and you're bummed by the market value of what you hold. The market value has changed. It has fallen. But what hasn't fallen, hopefully, is the income stream you're receiving from those investments. If you have dividend stocks and they're good quality companies that haven't cut their payments, you can at least comfort yourself by looking at the money you have rolling in. So I wonder if even though dividends don't look attractive based on past performance, and even if these companies are generally not the go-go artificial intelligence names that everyone's talking about now, I wonder if it's a good time to mix more of these types of stocks into a portfolio. There's a classic trade-off, of course. You can find the stocks with big, high, juicy dividend yields, but they tend not to have particularly fast growth. Some of those companies have flaws, sometimes glaring flaws. Or you can find companies whose dividend yields are not remarkably high at all, but they have fast payment growth. I spoke recently with a portfolio manager who looks for both types. He oversees two funds, one with higher yields and a value tilt, and one with fast-growing payments and a growthier tilt. His name's Matt Quinlan at Franklin Templeton, and we will hear from him and some of the stocks he likes right after this quick break.

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Welcome back, Seas. Do we, uh, are we calling it that? We're not saying that. Is that— did we decide whether to make that a new catchphrase? I think we should make it a thing. I don't think so. I got my finger to the wind on that thing and I don't think people will love it. Welcome back. Matt Quinlan is the lead portfolio manager of the Franklin Equity Income Strategy, and he's the co-lead portfolio manager of the Franklin Rising Dividend Strategy. Those have been available as traditional mutual funds. Franklin just launched its Dividend Growth Strategy as an ETF. The ticker there will be FRIZ. F-R-I-Z. I guess the F is for Franklin, the R and I are for rising, but the Z. What, what do you, maybe it's the F is for Franklin and then it's just Riz like the kids say, you know, charisma, right? I didn't know you knew that. Oh, I know. I know all the, I know all the middle school lingo. Come on. I spoke with Matt recently about what he expects for dividend stock performance going forward. And I asked him for a few of his dividend stock picks. Let's hear that conversation. He will go through 3 of his favorite stocks that have fast-growing dividends. And after that, I'll chime back in for just a moment to share with you 3 of his favorite stocks from the other portfolio, the ones with higher dividend yields. Let's hear some of our conversation now. How have dividend stocks in general done versus, let's say, the S&P 500? Have they had a hard time keeping up in recent years just because some of those go-go growth stocks have shot ahead?

They have in recent years. They obviously did quite well in '22. '23 and '24 were tougher years for dividend strategies. Over longer periods of time, you know, I mean decade, two decades, those types of parameters, dividend growth has actually outperformed. So the genesis of the strategy of the dividend growth strategy is that Companies that can increase their dividends over time outperform those companies that don't have a dividend or have a static dividend. So that's really the genesis of a dividend growth strategy. They have struggled more recently, as you mentioned, '23, '24. '25 has been a much better year. Markets where there is broader representation, where sectors like financials, industrials, utilities, those types of things that can do well and it's not being led by a narrow group of stocks are good for dividend growth strategies. But to your point, it has been a tougher period to keep up with the S&P.

I mean, I hear what you're saying and it makes sense, you know, on paper. But when I think dividends, I just think I want to get paid. I want to be paid right now. The whole appeal is like cash coming in, right? If I've got a 3% or 4% or 5% or more yield and let's say the market tanks for a while, well, at least I still have that healthy income stream coming in. But if we're talking about 1% and change, now I'm back to having sort of hope for the future that that income stream is going to be, you know, it's a tougher thing for an investor to get their head around, is it not, that I want to have dividends, but I'm going to sacrifice that current yield now in hopes for a rising income stream going forward. Can't we just get 3% or 4% yields now with growth?

Well, you can certainly get 3% to 4% yield today in, you know, money market accounts or other fixed income instruments. I think what we are trying to achieve and what our strategy is offering is an income stream along with investing in some of the great companies that are innovating across the diversified sector. So capital appreciation and a level of income and a level of resilience. So if the market is more troubled, it's a portfolio that should hold up well. If the market is doing well, it's a portfolio that should see capital appreciation. It might not be the highest performing fund in the portfolio in terms of if it's an up 20% or 30% type year, but it's a portfolio that should participate nicely in that type of environment, better downside, more resilience, and hopefully an attractive through-cycle performance. That's really what the strategy's about. It's not an income strategy. It's a dividend growth strategy that profile market leaders, less levered balance sheets, those attributes that allow the portfolio to hold up quite well.

Talk to me, if you would, about some of your favorite names in the dividend growth portfolio.

So a few of them would be Apollo. So it's an alternative asset manager, about $840 billion or so of assets, largely in credit. They are a leader in private credit, continuously launching new products that are being well received. They utilize two insurance carriers to help fund some originations. We think their fee-related earnings will grow about 20% per year. So we think there's very attractive growth in that space. So Apollo is a name we like quite a bit. They've been a leader in private credit for a number of years. So they were earlier in private credit. It's most of their business. Very good track record in terms of losses, very good track record in terms of returns. The insurance side of the business adds a different element in terms of funding. Very good management team. So we think they're very well positioned and they do compete with the KKR, the Ares, the Blackstones of the world, all good companies. But Apollo is one that we think stands out nicely. We think Apollo will— their dividend will roughly grow in line with their fee-related earnings. So call it high teens, 20%. We think it should be a solidly double-digit dividend grower.

Okay. I guess if you tuck away one of these dividend stocks and it only pays 1.5%, you're not exactly bragging about the yield today, but if you're compounding it at a high teens rate over time, before long, 5, 10 years from now, you might look back and have a pretty robust income stream as a percentage of the price you originally paid.

Yes, that's absolutely right. Any of these that kind of, you could be the same for a Microsoft. We mentioned that name. There's a lot of other names where you've seen solid capital appreciation. The dividend looks small, might be growing 10 to 15% a year. The yield isn't there because the stock has done so well. So that would be a nice situation to have, but that is really the profile We'd like to see the portfolio overall have a dividend growth higher than the market, high single digits, that type of a dynamic. So you should see, to your point, a dividend growth on your cost at that level at an attractive rate, and then hopefully you see some capital appreciation along the way.

[Speaker:TREY_LOCKERBIE] And I guess also, if something happens to the structure of interest rates, something happens in the bond market that's going to slam the stocks that have come to look like bonds. I'm thinking, I'm thinking of a certain telecom company out there that had a 6% yield last I checked. And so people might think, oh, that's, you know, I don't know. I don't want to call it a bond proxy, but maybe the thing starts to trade like bonds do in relation to changes in interest rates. I guess if you've got that 1.5% yield to start, you dodge that problem. You're not going to trade like a, like a bond proxy with a 1.5% yield, you're going to trade more according to the growth of the company. Do I have that right?

I think that's right. The dividend payment is reflective of what they're earning, reinvesting, what they're growing at in terms of their earnings and cash flow. We also want that capital appreciation. Some of those bond proxies might not have the same types of capital appreciation opportunities that we're seeking in our companies, if that's really what they are. But we think a nice mix of a dividend stream that it continues to grow while they're pursuing the capital appreciation is a compelling opportunity.

Okay. Can you tell me about another one?

Sure. Another name would be Marriott. I think we're all familiar with Marriott. They have about 250 million members in their loyalty program. We think there's underappreciated growth in terms of they'll grow their units or their rooms at about 5%. They'll get a few extra points from pricing. So you see a top line of, call it, 7 to 8%. We think they can continue to grow There's a lot of demand for their brands in Asia and in the Middle East, but they're also investing heavily in technology to improve their app, their reservation system, property management. So we think there's margin and cost saving there. So we think it should be another attractive grower, very much a leader in their field, another name that fits our portfolio well.

What is it that's going to give this company— obviously it's a very well-known brand. What's going to give them a competitive edge going forward in a world where I mean, there are plenty of hotel chains and there are also people who are renting out private residences to travelers. And so what's going to keep this company safe over the long term?

I think their loyalty program really is the industry leader. And I think that as they continue to fine-tune that with benefits and more align that with travelers and points and that people get very much aligned with the brands and the brands that they have in their portfolio. So I do think people will stick to that. I know the way I— largely the way I travel, but I do think there's a lot of brand loyalty. There's a lot of scale. Again, getting involved more with technology and improving that side of the business. So they do compete with those Airbnbs and whatnot, but certainly a lot of business travel is more towards the Marriott and the Bonvoy properties. So we think they're very well positioned.

The portfolio is Marriott, Bonvoy, Ritz-Carlton, The W Hotels, um, Strigis, and St. Regis, right? Oh, you know what, Alexis, don't cut that out. I deserve it. There's a typo here. It says Strigis, and I read it as Strigis and didn't, uh, connect that it was St. Regis. Okay, I accept that humiliation. There's something here called addition, so it's a, it's a diverse portfolio, I guess I won't say all income levels, but is it sort of mid to upper income levels of travel? It's a 1% or thereabouts dividend yield on this one. What would make you happy in terms of the rate of growth in the dividend payment over the years to come?

This one will be a little bit lower than Apollo, which we talked about, but it should be aligned with earnings growth, which should be roughly low double digit. So we think that that's the type of increase that we expect there. We don't expect our companies to, you know, when we get involved in a name to see a higher or lower payout ratio, for example. Certainly ask and look at what it is and look what the history has been, but we aren't really betting on or estimating, you know, what a future payout ratio might be. But we do get a sense from the management team that the dividends will roughly grow in line with earnings, and that should be about what we expect from Marriott in terms of earnings.

Okay. Do you have a third? I can't, you know, we can't leave it at just two. We always have to get stocks in threes.

Sure. Parker-Hannifin. Parker-Hannifin, one of our largest industrial holdings, a leader in motion and controls, you know, wide range of end markets in terms of aerospace, you know, implant manufacturing. So think about hydraulics, braking systems, valves, sealants, The algorithm here is more similar to something like a Marriott where you have, call it 4% to 6% organic top line growth. You'll see some margin improvement. So roughly about 10% earnings growth. We would expect the dividend to grow again in line with that type of an earnings profile, but a really good, well-rounded industrial business and one we think is really well positioned in the future.

I have to remind myself about these, the portfolios of the stuff these companies make. It's so diverse. I tend to think of them all as makers of doodads, but what are the end markets that they serve?

Aerospace would be about 35%. That's the biggest segment, but you'll see in-plant manufacturing, which is just really in basic industrial manufacturing. You'll see transportation, another call it 15 or 20%. HVAC would be another smaller segment of theirs. So I really think of them as a general industrial player, a leader in those submarkets, but they're in all forms of industrial manufacturing, really.

Trey Lockerbie: How do you pick this one over— there are a number of these companies that make this wide assortment of goods for different industries. What are the attributes that you look for that point you to Parker-Hannifin specifically versus the others?

Yeah, I would say there's a few. I would say it's end markets, but it's also themes and megatrends. So things like, if you're a believer like we are in airline passenger flying continuing, so aerospace is a market that we like. Digitalization, electrification, those are all themes that we like. Data center, not as much of a story here with this name, but Those types of themes, secular themes, we like quite a bit, and you'll see that throughout the portfolio. You know, good management team, proven track records, compelling algorithm, financial algorithm. This is a little bit more short cycle in terms of Parker-Hannifin, but they've been going through some portfolio changes to improve the quality of the portfolio, both selling and adding segments. So we take all of that into consideration, but it's really about execution and market exposure and, and confidence in the management team to carry out the strategy.

That's about a 1% dividend on that one too. And what are you thinking of in terms of a payment growth rate over time for that one?

Similar to a Marriott. So call it a low double digits. They're gonna grow their, their top line, call it 5, 6%. We expect cost savings and margin improvement, some productivity gains, double-digit earnings growth, and the dividend should grow in line with that.

Okay. Last question. I won't ask you for terrible stocks. We only want the good ones, but I will ask you, if you were sizing up a dividend payer, what are some things that you would see that would raise caution flags or where you would just say, I'm going to pass on this one altogether? I never invest in a company when I see this.

Well, a cut in the dividend would be the most significant. Generally, you know, there's been some erosion along the way. So, I would say before you get to that point would be a slowing of the growth of the dividend. And sometimes it happens for reasons that are natural. A company just matures and they slow down. If you think about some of the consumer staples names, which had higher dividend growth 10 to 15 years ago than they do today, some of that's just a matter of size. But I think in other instances, you see companies slowing the dividend growth. Sometimes they go through acquisitions, which makes sense in terms of adding capabilities or product, and there might be a slowing of the dividend for a period of time, which would be fine. But sometimes it continues on longer than that. So I would say a slowing of the dividend growth is a trend really we're looking for, or if there's been a change in the commitment to the dividend, if there's a new management team, they don't feel as committed to dividend growth.

They never come in and tell you, "Ah, we don't care about that dividend." There must be some coded language that they use.

You're right. You can see it in terms of there are instances where companies were very kind of consistent 5% top line, high single-digit earnings grower, steady business, and then they start to make acquisitions. You might get a new team that does acquisitions. They want to grow. Then instead of growing 5% top line, they want to grow 7%. So they buy things. To your point, exactly. They're not going to cut the dividend, but they're deemphasizing it. They might stall the growth for a while. And in cases like that, obviously you hope the acquisitions work out. And those are things that we're looking for.

Thank you, Matt. I promised everyone some stocks from Matt's other portfolio, the Equity Income Fund. These are ones with higher starting yields, maybe with slower payment growth, but still with some growth in payments. Those names are RTX, Cisco Systems, and Philip Morris. RTX is the defense contractor you might know as Raytheon. It changed its name a couple of years ago. The yield there, this is the lowest of these three. It's 1.7%. Cisco Systems, the internet infrastructure company, the yield there, 2.4%. Philip Morris. This is the company that sells Marlboro cigarettes overseas, not in the US. The one that sells them in the US is called Altria. Philip Morris handles the overseas sales of Marlboro and other brands. I believe we talked about them briefly earlier this year. The company is making a big push into non-tobacco sources of revenue. The yield there on Philip Morris is 3.3%. And that is all the talking I've got for you for now. I'm exhausted. I'm going to, I'm going to book a stay at a Strigis hotel just to, just to rest up. And, you know, I want to think about some of these new paradigms that we've been talking about. If you have a question and you'd like it played and answered on the podcast, you can send it in. It could be on a future episode. Just use a voice memo app. Send it to jack.hough@barons.com. Thank you for listening. Alexis Moore is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. And if you listen on Apple, please write us a review. See you next week.

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