The Dividend Mailbox

Do Dividends Care About Recessions?

January 20, 2023 Greg Denewiler Season 1 Episode 19
The Dividend Mailbox
Do Dividends Care About Recessions?
Show Notes Transcript

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Heading into 2023, it seems as though the word recession is on the tip of everyone's tongue. At first thought, a recession might make you grimace, but what do they actually mean in real terms for an investor? Truth be told, you never know you're in a recession until after the fact, but it is essential to understand how they affect the economy. If you're a long-time investor, 2008 and 2001 were painful examples of just how fast your portfolio's value can change. So we know recessions are bad for the stock market... are they that bad for dividends?

Good news for the dividend growth investor — dividends are resilient through even the worst of downturns.

In this month's episode, Greg takes a page out of the market history book to dive into just how recessions affect GDP, earnings, the stock market, and especially dividends. He makes the case that dividends are a much more stable, if not the most predictable, factor to focus on when things get rough. Later he examines UPS as a potential dividend growth candidate. 

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Greg 0:11  

This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks, and make each year's check larger than the last.


Greg  0:40  

Welcome to the 19th episode of The Dividend Mailbox, and in this episode, we're going to look at recessions. Most people are concerned, are we going to go into a recession? Are we in one, have we been in one? And the obvious question is how does that impact equity markets? Well, I think by the end of this episode, one takeaway is that from a dividend perspective, recessions really don't have much of an impact. We'll start out just looking at how the market has responded to recessions in the past. And then one of the things that we're going to do is look at an individual company, UPS, and how its dividend has been impacted. But before we get started in the actual meat of the podcast, our goal is to try to give you relevant information that will help educate you as far as the attractiveness of dividend investing and what the potential is, and really the wealth creation that you can get from investing in dividends. We do want to try to keep this as relevant as possible because one of the problems sometimes you run into is what is important to me, may not be as important to you, or something that you may have a concern for is just something that's not on our radar currently.  

So if you submit a question, and we use it in one of our future episodes, we're going to send you a Dividend Mailbox Yeti tumbler, it's 10 ounces, and it has the dividend mailbox logo on it. We'd love to hear from you. Send us a question, topics, or even potential stock questions. Feel free to email us. So with that, we will now move into recessions. Let's look at how they have impacted the markets in the past and how much should we really worry about a recession in the coming year.


Greg  2:50  

Over time, recessions are unavoidable to some degree, any investable asset out there has a cycle, and the economy is no different. So one of the things that you really need to know as an investor is: “okay, how bad are they? How big is the effect of a recession? And what does it actually mean in real terms?” Probably the first thing to do — the best thing to do is: “okay, what is the definition of a recession?” Of course, the saying goes, if your neighbor loses their job, it's a recession, if you lose your job, it's depression. In the old days, a recession used to be defined as two-quarters of no or negative GDP growth. Well, one of the things you have to do is define the difference between what actual GDP growth is, and there is nominal and then there's real. One thing that gets a little confusing possibly — last year, we did have two declining quarters of GDP, it was the first and second quarters of last year. But you have to realize that was real GDP not nominal. And the difference is nominal GDP includes inflation. So if the economy grows by 3%, and then also there's 3% of price hikes in there, the economy ends up growing by a total of 6%. But that's nominal. When you look at real GDP, it adjusts for inflation, and that is where you're looking at whether the economy is actually just growing organically or not. And if that number declines, then we have a recession. But one of the things that has made it more challenging this time around — about 9.9 times out of 10 you always have higher unemployment associated with recessions. That has not occurred, and if anything, we're still getting employment gains. You can see some headlines right now of big tech companies are laying off numbers like 10,000, 18,000, from Amazon, and it may lead you to believe that the economy is definitely slowing down. It may be, but those are headline numbers. The overall economy has been growing by 250,000 plus jobs, and it's still too early to tell you whether we have a real change in the unemployment rate or not. The question on everybody's mind is — at least on investor’s minds — are we in a recession currently? Are we going to have one this year? The problem with recessions is you virtually never know until after the fact, because the data, it lags a little bit. We don't even know when they start or stop, really until after they're over. From that standpoint, you're not going to know now anyway. Everybody's looking for the absolute numbers and the sign that yes, here we are, well, the markets ahead of that game. Historically, the market predicts recessions, and it's really on both sides of the fence. The market starts to sell off before we even know we're in a recession. And this is the really more important thing, as headlines are coming out stressing that the economy is weak, the market tends to bottom six to 12 months before the recession actually bottoms. And that's why it's really risky to try to get out and wait for signs to get better before you turn around and get back in the market, and why it's so hard to time it. If you're sitting here waiting, and you're listening to The Dividend Mailbox podcast trying to figure out are we in a recession or not? It doesn't even really matter, because the markets going to price it in before it happens. One of the big problems when you get into an economy that is not performing very well is everybody wants to predict what's going to happen next, or really almost worse, everybody wants to convince you that it is going to get worse. Because the more you become fearful of what is about to happen in your near future, the more you're going to look for answers, and the more you're going to pay attention to the media in whatever form that is. It's just sort of human nature to look for answers. The problem is nobody has them. And one great illustration of that, you almost sort of have to laugh about this, but it's not really funny. If the Fed knew what was going to happen, we wouldn't even have this problem. Because they would either be putting money into the system or taking money out, they would be proactive, and the economy would just continue on, and life would be great. Well, of course, the Fed has no idea either. And if you want any proof of that just go back 13 months, and the Fed thought inflation was transitory, and it wasn't even going to be a problem. Well, guess what? Wrong on that one. If you go back to 2008, which we're going to we're going to hit this in just a second, you look at the Fed, and Bernanke back in 2007, first part of 2008 was basically predicting that the housing market is okay, and things aren't going to get that bad. The subprime mortgages, they're not that big of a factor in the economy. And guess what? They were wrong. And then everybody was predicting the new normal coming out of 2008, because it was a huge impact on the economy. Basically, the definition of the new normal was, we were going to have slow growth, we had too much debt, companies were recovering from crisis in the financial markets, and the stock market would probably not come anywhere close to growing and its long term rate of 10%. Well, guess what happened on that one, pretty much dead wrong. It was one of the best-performing decades for the stock market ever. So there you are back to predictions, they're really hard to do. And it's kind of amazing of how the market can move two or 3%, just on a statement from the Fed, when they have no idea what's going to happen next. I may be sounding a little harsh on that, but that's always the way it is and it's partly why the economy cycles. You have excess that gets built up into the system. And especially here just recently, when you had zero interest rates and everybody borrowed money, it caused inflation in asset prices, and it caused them to move higher than what they probably should have been. Well, you get a reaction back down to more of a normal valuation and things never go back to normal. They usually either get too high or they get too low, temporarily. In the end, and nobody really knows. But one of the things that you do need to know is how have recessions impacted GDP, the stock market and earnings in the past. And of course, the big thing is dividends. Probably the best one to just look at to keep this from getting too deep into the woods is go to 2008, because that was considered to be the worst recession since the Depression back in the 30s. I mean, it was rough. Now, there is a difference between the financial economy and the actual GDP. And what I mean by that is, GDP peaked in April of 2008, and it was not quite $15.8 trillion. The bottom came in April of 2009, so that was about a year and a half later, GDP dipped down to $15.1 trillion. That's only a decline of 4%. That really is not much. But if you remember living through 2008, one definition was It was bad. It was bad to the point that there was a space there of a week or two, where for all intents and purposes if you knew anything about the financial system, it had shut down. That was one of the few cases where I think actually, the media probably did us all a favor, because they weren't really telling you at that point how bad it was, because it got extremely scary. The Fed and the Treasury basically started to guarantee almost everything, and even GE which had commercial paper rated at triple A, in a space of a few months, bond prices really started to fall, basically, the entire debt market started to get into distress. And the Treasury actually had to come in and guarantee General Electric's commercial paper, because they couldn't sell anymore in the market, really, at any price, nobody would buy it. But GDP only declined by a total of 4%. So when you have an economy that seems to be under significant stress, the first thing you got to start thinking about is well: “Okay, how do you reconcile those two things?” Part of it is you have about 30% of the economy, that's government spending. So that doesn't change. If anything, it just continues to go higher over time, because the government continues to spend more money. So that is a little bit of a stabilizer right there. The other thing you have to remember about GDP is a lot of the leverage that gets shaken out when the economy slows down, these companies that are higher leveraged, or more dependent on financing, those markets can change fast. You may remember the CEO at the time of Citigroup, who was Charles Prince, made a famous statement or somewhat famous, “we'll keep dancing as long as the music keeps playing.” Well, his point was, is we're going to aggressively be loaning out money until we see signs that things are slowing down, and then we'll change our tune. When the music stops, things can change extremely fast. And what ended up happening was Citibank had to be bailed out, and it's because they were just too leveraged. They had too big of a loan portfolio for the size of their assets. So one of the things you got to keep in mind, GDP doesn't change by that much. But when you have leverage, sometimes it can only just take growth to slow down or stop, we don't even have to decline, if there's too much leverage, it changes everything. Everybody thinks that they're going to be the first one to leave the party when it starts to slow down. Well, never seems to work that way. But the broader economy: people are still going to work, they go out to lunch, you still buy groceries, you still need basic things to live. Cars are still driving, things are still functioning, but it just doesn't feel like that. So when you look at the economy, it really doesn't move that much. And then the average recession is less than a year, actually a little less is the average. 2008. it was 18 months, that was actually one of the longer ones since the depression. So just from that same point, they're really not that bad. Pretty much going back to 1950, the average decline of GDP, it declines by about one and a half percent on average. The impact is not as great as what it may feel like. But of course the stock market is a whole different animal. 


One of the famous sayings is: in the short term, it's a voting machine, but in the long term, it's a weighing machine. And what that means is that you make your vote a lot of times it's just purely on emotion. But when you weigh something, you're looking at what the actual substance is, and that just doesn't change that fast. Now, from quarter to quarter, there can be abrupt changes, but companies tend to revert back to the mean, and the core business over time tends to not change that fast. Well, why does the stock market decline 50% when GDP only declines 4%? Because that's what happened in 2008. And that's what happened in the recession of 2002. While the pretty simple answer is earnings are much more volatile than GDP. Long term, they both grow by roughly 6%, and the problem is quarter to quarter or year to year, they can deviate by a fair amount because earnings have leverage in them. Company earnings declined by 91%, in 2008, and in 2001, they declined by 55%. But they revert back to the mean, they do recover quickly, which the market always seems to forget. As you look at 2008, and 2001, and the difference in the economy, in 2008, basically, everything correlated to one meaning that there were really virtually no places to hide. And in 2001, there were value stocks that actually did fairly well, most, a lot of the hit just came in high tech and growth. So again, earnings can be volatile. And in both those periods, the S&P declined by roughly 50 and 55%. Really, this whole thing is driven by perception. Because if you're looking at it, just from a standpoint of a long-term investor, if historically, it only takes a few years to get your money back, why would you even sell? It's a game of perception, and you can't predict it from day to day to week to week, except that long term, we magically seem to come back to that 6% number. So just to review, on average, since 1950, looking at all recessions, company earnings declined by about 26%. And the stock market declines by about 30%. Slightly more, because as we've mentioned, it's a game of perception, but the two are pretty interrelated, and it makes sense that they would follow each other. The only difference is, is that earnings typically recover faster than the stock market. On average, earnings recover in about a year and a half, while the stock market, on average takes about two years to recover.


Greg  17:56  

So the great thing about dividend investing is that dividends are much less volatile. On average, looking at all the recessions going back to 1950, dividends only declined by about four to 5%. And the biggest reason why it's even that bad is because 2008 was really a worst case scenario. The dividend of the S&P 500 peaked in September of 2008 at $28.85. It reached a low, the March quarter of 2010 of $21.90. The dividend declined by about 25% there, but one thing you have to know, as is almost always the case, you have to know what's behind these numbers, and what's sort of driving the bus. And in this case, the major banks were all forced to cut their dividends. JP Morgan actually was relatively healthy considering the environment. They didn't want to cut their dividend, but the treasury secretary at that point said we're not going to have the perception that one major bank is stronger than another — last thing we want is a run on one of the major banks and having to bail them out. So even though Citigroup and Wells Fargo were not financially doing very well, they forced all of them to cut dividends, including JP Morgan. Well, they're big dividend payers, so that was a big piece of why the dividend in 2008 dropped. But by July of 2012, the dividend was back to $29 and started to move higher again. So the recovery was fairly quick about not quite two years later. Guess what? “Okay, that was a decade ago, what's the dividend of the S&P 500 now? It's almost $67. That is up three times from 2010. So the risk is, if you're waiting for clarity, the market quite likely has already moved a substantial amount by the time you start to feel more comfortable with getting back in. And if you miss part of that move from around $28 to let's just say 40, or $50 in a dividend, that's pretty substantial. So where does the fact that dividends are less volatile come in here? Let's look at some of the other recessions to try to put it into perspective. In 2020, when they actually shut the economy down, (and talk about an impact, that was really the worst in history period, two months where the economy basically 30% of it disappeared), the dividend going into it was a little over $59. It hit a low of $57.60. You know, that's only off about 3%, and by November of 2021, we were right back to $60. And then, as I just mentioned a few minutes ago, just a year and a half later, we're now back up over $67. You go back to 2001, dividends went from $16.76 to $15.69, and they were back within about a year and a half after that into a new high. You go into 1991, September of 1992, the dividend was $12.40, just a quarter later, we had hit the bottom, and it was $12.38, we lost two cents. You know, within the next year, we were back making new highs, you go back to 1981-82, which was a relatively severe recession — well, we basically had a double dip, we pulled out of it in ‘81 but then went right back into one in ‘82. Over that period, there was no decline in the dividend of the S&P 500. ’75— ‘73 to 75 — that was the big oil shock. What happened to dividends? They went from $3.71 to $3.68, they dropped three cents, that's 1%. And then we went back to a new high just in the next year. Every recession has a different cause, and when you look back in history, they were all usually something that nobody really had any idea was coming. So it's extremely hard to predict them, and GDP usually takes a mild hit nothing severe, and it's typically a lot less than what people think. Earnings are where all the volatility is, they too are extremely hard to predict. The stock market from day to day is really just reacting to news headlines, but dividends just don't move that much. And part of that whole concept is they're tied to GDP, they tend to track GDP, and they just don't move near as much as earnings, or the price of stocks, for sure. Sometimes they don't even decline at all in a recession. And they rebound faster. Over time, they're much more predictable. That's one point that you really need to understand about recessions. Dividends are a great way to manage your emotions through difficult times. Even recessions hardly affect them. Really, what you should be looking for is: “bring on the recession,” because that's going to allow me to reinvest my income, and to really bump up my potential dividend growth down the road, because I'm able to buy some assets at a much cheaper price. That's when you get a chance to really add to your return. So, you really should be looking forward to it, not worry about what it may do to you. And what I really want to stress here is if we do go into recession, if you have a company that has a predictable dividend, has a good strong cash flow, has manageable debt, has had discipline allocating their capital, that's exactly what you want to own. And if we ended up not going through a recession, then you still want a predictable cash flow because that's what you reinvest, and that's how you continue to build wealth.


Greg  24:26  

So we've been talking about a recession or the possibility of a recession. Now let's look at a company that we've owned for quite a while. When you first hear the name you might think, “well, this company is definitely going to be impacted if we go into a recession,” but I think it's something a little different than that. What we're going to cover right now is UPS. We started buying it several years ago when the price was considerably lower. When we did originally buy it the dividend was a little more attractive and the stock was a little cheaper than FedEx. It's a company that I call a GDP plus company, which means — at least my definition of that is: you're going to get the growth rate of whatever GDP grows by. If it's 5%, including inflation, then UPS should grow by six or 7%. It'll be slightly better than what the economy grows over time. That is all you need to get 6% plus dividend growth. Well, one thing you might be thinking about is okay, we are getting ready to potentially go into a recession, or maybe we're in one. Now, the great thing about being a GDP company is that yeah, a recession can impact it. But instead of having earnings that maybe get hit 50-75 %, if GDP declines by 5%, UPS is probably only going to decline by at most 10%. Those trucks keep going through the neighborhoods, pretty much whether there's a recession or not, and there are still a lot of goods that are moving that are not cyclical. It's a pretty consistent, predictable company, and that's what makes this a great dividend growth story. And I'm going to give you just a little background on UPS. Basically, there are three competitors out there. The post office, they're a competitor, but not really. The biggest company that competes against them is Federal Express, and even that is a little segmented. FedEx does more overnight stuff, UPS tends to be a little bit more ground focused, but they also do overnight. The post office is just something that's been out there. But both FedEx and UPS have done very well, even with the post office being a traditional player in that space. Now, a couple of years ago, you had a great opportunity to buy UPS, because the stock was hit fairly hard. We did add more to it, and the catalyst was when Amazon came into the market. They announced they were going to start their own distribution. And initially, the market became extremely nervous over that move, because Amazon in the past, when they announced major market moves, they tended to be a category killer. So, the fear was that Amazon was going to come in and really take market share away from FedEx and UPS. In the end, it actually became a positive, because UPS does not want to deliver one small little box to your doorstep. They just don't make much money on it, or they actually lose a little bit. They want more business-to-business or the larger-size packages. Since then, Amazon has built their own network, and FedEx and UPS continue to do quite well, even with that competition out into the marketplace. So, you had Amazon show up a few years ago. Well, revenue of UPS has still grown by 64% in the last five years, and the last 10 years, it's grown by 90%. So that is slightly better than the economy, which is one of the reasons why I call it a GDP-plus company. So, let's look at the dividend. Okay, right now they're paying $6.08, which is about 3.4% with the stock at $180. Here's another great thing to look at and to always consider with these dividend growth stories, because they're not just straight lines. 10 years ago, the dividend was $2.08. Five years ago, the dividend was $3.12. So, it grew over a five-year period by about 50%. And then just last year, the dividend was $4.08. So it was somewhat of a slow grower in the last few years. But there's a great catalyst on this thing that happened a few years ago. And one of the things that UPS did in order to remain competitive was they started to ramp up their CAPEX. Going back to 2000, they spent about 2.5 billion. They went from CAPEX in 2015, it was around 5 billion, and went up into the mid-sixes in 2019. They started to ramp up CAPEX, they really started to focus on: “We need to limit the touches of our packages to as few as possible.” So, they started to spend a lot of money updating their Memphis distribution center, really trying to make the company much more efficient. And 2020 started to decline a little bit in 2021 back down to 4 billion. So now we're back on the downside of CAPEX and now they're reaping the benefits of it. So, the great thing about a company like UPS, where they've spent the money on CAPEX, they don't have to continue to do it every year, because the automation is now in place. And they can continue to live off of that for years to come. Looking at return on invested capital, they've seen the benefits of their CAPEX because right now it's around 20%. In the past, it was in the mid-teens. They reinvested their capital into making the business more efficient, and they got the payoff from it, because earnings have grown in the last five years by 230%. A few years ago, the dividend, as I mentioned, was $4.08. Just in the last 12 months, they bumped the dividend by 50%, so now you're up to $6.08 — you've had a dramatic increase. Well, first thing I got to tell you, is if you think you're going to get those numbers for the next decade, I would say it's not going to happen. If it does, that would be a great surprise. But again, right now all we need is 6-7% earnings growth, and we're going to get to dividend growth, and that's what this thing is set up to do. They've got the ability to maintain that dividend and continue to grow it because in the past, the dividend payout ratio has averaged between 40 and 70%. That's an indicator where their company potentially is going to struggle going forward. Well, the great news about UPS is that earnings have really done well recently, right now, their payout ratio is around 40%. It's really going to be relatively easy for them to continue to grow the dividend. Just 6% growth should translate into a 6% dividend growth. On another front, you look at shares outstanding, also been somewhat disciplined there. In the last 20 years, shares have declined by 30%. last 10 years, they've declined by 10%. So that helps to ensure that they continue to grow that dividend. Because even if their net income is the same, and they've reduced shares by 10%, well, that right there means that dividend can go up by 10% – just with the same earnings without any growth at all. And one of the ways you may remember that we look at a company and just do a quick kind of back-of-the-envelope to get a good feel of — “Can we actually achieve our 6% dividend growth over the next 10 years?” — is our simple little 10-year model. We take the current dividend, $6.08, we grow it by 6%, and if you go out 10 years, that would imply that in 2032, the dividend would be a little more than $10 a share. Is that attainable? Well, the simple answer is if they're earning a little over $12 now, without any earnings growth at all, they could pay that dividend out right now. But they're not going to pay that much of their earnings out. The point is, that with very little earnings growth, you've got the ability for this company to grow its dividend. And if the dividend is 3.4% 10 years from now, and they've grown it to slightly more than $10, that's going to give you a total return of 110%. And that doesn't even include the compounding of the dividends that you receive. So, the stock price of UPS will increase because you've got a much higher dividend, but we're using the same yield of 3.4%. You've got an implied stock price that's much higher, and in this case for UPS, it's $300 a share. Even if the dividend goes up to 3.6% in 10 years, that's still a 100% total return. And if the dividend drops to 3% 10 years from now, you've got 135% in your total return. So that's a little bit of a margin of safety for you. 

So, another great point to make is that sometimes and we've talked about a few of our positions recently, that they're not getting to dividend growth currently, but UPS is a great example where they were not growing the dividend by very much a few years ago, but then they play catch up and part of that is because they're reinvesting in the business. It's not a stock that's got a lot of sex appeal to it. But from a standpoint of looking at dividend growth, and compounding your income over time, it's a pretty simple story that is easy to connect the dots that “yes, the economy will probably be bigger than it is 10 years from now.” And right now there's a lot of fear that a recession is out there. I think if UPS sells off at all because of worries about the economy, it's going to be a great time to accumulate it. It's attractive currently, but any downside from a lower market and fears of recession is a great time to add UPS. You have to own a portfolio of these things and UPS was just one example. So please keep that in mind and do not take this as, “this should be your all in that bet to get dividend growth.” 


So to sum up here, “okay, so what happens if we actually have a recession?” I hope you realize, really by focusing on dividend growth, you're taking a lot of the volatility of the market out. Where when you look at whether we've been in a recession or not, the dividend just doesn't change by that much. And if you look at 2020, when we had GDP declines that were 30% in a matter of one quarter, UPS continued to grow their dividend, and then they substantially bumped it and it was by 50% in the last year. But again, even though we get recessions, and we get corrections in the stock market — as far as: “should you worry?” What you really should probably be looking for is if we do get a recession, and we get a market that corrects further from where we've been in the last quarter or two, use it as an opportunity to continue to acquire these great long term dividend payers because the cheaper you can buy them, you're just going to ramp up your six or 7% to eight, nine or 10.