The massive risk hiding inside your S&P 500 index fund

Welcome to Trader Talk. I am Kenny Pulcurry, your host, and today, I am pleased to announce we got David Bonson here who's the head of the CIO of the Bonson Group, and we got Drew Pettitte from Roundhill Investments. He's a chief investment strategist. The last time I talked to Drew, he was at Citibank. So welcome, and I'm, and I'm, uh, anxious to hear about your new role. All right, so David, here we go. I'm gonna hold this up. This is David's latest book. It's called Profit.From the profit, the past, present, and future of dividend growth investing, which is one of David's, uh, themes. Actually, I think that is your theme, right? One way or the other, I want you to sign this book for me before you leave, so it's actually worth something for me, but let's talk about it. So let's talk about dividend growth investing versus pure speculation because I know that's right up your alley.

Yeah, so look, we're a multi-asset firm. We, we invest across all asset classes, but our US equity.Equity exposures over half of, uh, about $11 billion we manage, about $6 billion of it's in dividend growth equity. And we, uh, I developed a conviction for dividend growth post dot com blowup pre-financial crisis. So this has been over 20 years now of what we've built our business around. I believe in it with every ounce of breath in my body. I wrote a book about it in 2018.And I made the case for dividend growth investing, and I felt that it needed to be updated. It's not just a kind of updated version of the same book, it's a new book. But if you think about the last 7 years, COVID hadn't happened, the whole AI moment hadn't happened. There's this kind of ongoing issues as markets just continue doing what they do. I think dividend growth needs to continue to have its case made.

I agree with you100%. Tell me, what was the name of the other book?

TheCase for dividend Growth Investing, investing in a post-crisis world.And so we're still in a post-crisis world. The principles are all still the same, but the charts, the data, the arguments, and the other thing I got to do, Kenny, is I got to respond to some of the critics of Different growth investing, where, uh, the first book, I was unaware that people felt so strongly about some of their silly arguments. Now I got to counter them in this book, you

know, I think what's interesting, and, and Drew, feel free to jump in here, I think what's interesting is this appeals. Look, when I was 30 years old, dividend growth investing.In in my wheelhouse, right? I was further undersca, which I think makes sense. But as I've moved on in years, suddenly dividend growth investing makes much more sense, not only in terms of stability offers a portfolio, but the way itworks,

you know, 11 of the things I do understand is that, uh, look, the way I found dividend growth investing was as a withdrawal strategy. And so there is a sense in which the mechanical benefits I argue for for people withdrawing from the portfolio.Uh, I believe in them very strongly, but that isn't where I stayed. I came for the withdrawal strategy. I stayed for the accumulation strategy, and so I do believe that 25-year-olds, 30-year-olds, higher risk tolerance, there's a lot to be made for that, but I understand that, those withdrawing.From the portfolio consistently, periodically, I think dividend growth has a very obvious advantage. See,

and Ithink we exist because of course strategies like this. So at Round Hill, we're thematic. And look, this is, this is what I did when I was at Citi. I kind of staked my career on it. Look, sectors, companies evolve faster than how we think about sectors and classifications and so on. Thematic investing is real.We see big institutions do it. We see retail investors do it, but that's something that's done as a satellite around a core allocation. So we exist because people look at strategies like this as they're buy and hold. They're not fun, not play money, and then they tilt to different types of risk for a company like us.

Typically dividend growers, dividend, you know.Names in here that you're talking about are typically more large cap that, you know, some people might describe them as boring. They're not sexy. It's not tech, it's not growing at 300% a year and all that stuff. But what it is doing is it's being very consistent. And I'm assuming, I haven't read the book yet, but I'm assuming in your strategy.Or maybe not if people are withdrawing that you're reinvesting in it because all my stuff I, I'm not drawing withdrawing yet, so I'm just reinvesting my dividends to build upthe position.

That's right. So that's not an investment issue. That's a, a, a, a financial objective issue for people like myself. Sounds like you're in the same boat. I'm not touching the portfolio. It's all reinvestment at our firm, it's about 55% of clients are reinvesting, about 45% that have some periodic withdrawal.Um, but that again, the investment strategy is the same. The mechanic changes either withdrawal or reinvestment based on the cash flow need.

Yeah, but were you, were you gonna say something? No,

it's just like, look, there are many roads to roam here, but you can tilt a lot to dividends, or again, you wanna match the core, not necessarily to an index, but what you need as an investor. So this makes a lot of sense to me. Is DRAM a round hill

ETF? Yes, it is. I have to tell you, I, I, when it came out because I was looking for for memory exposure.And, uh, so I bought the D-rim. It's funny. I've had the D-rim now. It's, it's kind of volatile, but because the names are volatile, right? I mean, the names in it are volatile. So, so that's what it is. But I actually found it a great way to kind of give me some exposure to space without just betting on one name. Yeah,

that's how we think about thematics. Look, they are gonna have volatility.We try to be more pure to the theme, but that's the difference. You're, we're gonna give you beta and volatility, but it's how you size it in a portfolio that matters, right?

Yeah. And right now it's the right size, so it's, it works fine for me. But it was funny when you said it. I go, jeez, I think DRM is a round deal, a round deal. How many tips do you guyshave?

Uh, we're over 50 now, and look, we were, we're punching above 30 billion in assets. We were close to 40 billion before the pullback in AI.

OK, so not such a small firm.No,

but,you know,

are these actively managed within ETF or is it set to a certain bench,

not indexed. We actively managed to try to get the thematic exposure. The reason we're active is because these themes evolve. The companies come.In and out of them like even DRAM CXMT, Chinese competitor launches because we're active, we can put that in the basket because if you want memory exposure, you're gonna want to be global

so it's low activity but active yep,

exactly. CXMT is what.

Chinese, uh, memory manufacturer, newer on the block. That's where we saw some news over the weekend, or not this weekend, past weekend before we saw some volatility in memory. So what do

you think? Let's talk about memory just one minute because, um, ASML came out last week with their earnings and they crushed it, right? They did a great job, but they talked about not, not being able to, to, to satisfy demand and memory going out to 2028.MU says the same thing, right? That there's just so much demand that Elon Musk said they'd, he'd buy all the memory chips he could if he could buy them all.

Yeah, this is interesting because that's what companies are talking about, but the market narratives transitioned. Everyone was talking about that.Yeah, growth in the next year or two years. Now they're thinking about through cycle profitability. What's this looking like in 56 years from now. Markets, and I think we can probably all agree on this, don't like when the thesis changes. So that's why we're in that volatile phase right now. Look, tactical bounce this morning because it looks technically oversold, but for the memory trade, and I probably shouldn't say this if I was just hawking our, our products.You need a really significant catalyst to kick this thing back in, and that's gonna come in commentary probably, maybe not even this quarter, but maybe that January reporting season.

Yeah, I think, uh, uh, what do you expect this, this season, 3rd quarter? What do you expect from tech? OK, let's, let's, so, so far we've got ASML. We've got Taiwan semi. Both have killed it,

but the stocks didn't.

No, the stocks didn't because they were, in my mind, they were priced to perfection. And so investors are going, OK, what's next? How could it get any better from here? So they.It's,

look, the old running joke coming from, you know, my old sell side training is every company always be turning, so we get this. When you have everything priced in like this, you need a catalyst to say demand is going to be really strong beyond just the next quarter or so. But you know where the street's really, really good, and this is surprising, gross margins.The street almost always nails gross margins. So the only companies that are getting bid up when stuff looks perfect is the ones that can actually surprise on gross or operating margins. That's tougher,

right.OK, uh, that's great. Thank you. I appreciate that. So let's talk about, uh, I think, I don't know if it's part of the book or not, but you talk about, uh, uh, high flying momentum stocks versus passive investing, passive index funds. Talk about how investors, either one of you, talk about how investors need to, need to think about, you know, only wanting the high flyers versus having some of the passive stuff,

right? Well, but let's also point out that because we're not a high flyer momentum, uh, money manager, and we're not passive index investors.But let's point out how the two have conflated quite a bit. There's a convergence. If you just own the S&P 500, 30 years ago, you were not participating in the high-flying momentum to the same degree you are now, because communication services and technology were one sector then. The two put, it's not exactly apples to apples, but the two put together have.Doubled from where they were in 1999.

It's like 47% of the of the

index, and that if you look at just 10 companies or 7 or 5 or 3, it's the highest ratings by far top-heavy concentration than it ever has been.So to the extent that it's very unlikely an S&P 500, I think we may end up talking about energy in a bit. It's 2.9, 3.3% of the sector of the index. Energy can go up 25% this year like it has. It's not helping anybody in the S&P 500. You're basically leveraged doing video, Microsoft, and Google, right?

So what do you, how do you, what do you say to an investor when they say, I'm just in the S&P.

Well, I say that that has been an incredible place to be, uh, with a decent amount of volatility, not extra historical volatility, but decent amount of all and a wonderful premium return since March 6, 2009. I believe that starting in November 2021 and in 2020202, the S&P did have its only down year since the financial crisis, 2018.Count, it was 4% as child's play. Only year of real downside. 2022 is down to 19%. At one point it drew down over 25%. The other drawdowns we've had over the years, COVID, it lasted a month, uh, Liberation Day lasted 5 days. OK.Look, was it even 5 days? I think it was 4 days, but 5000 points. I think in the Dow, I think you're going to see a range bound market, big moves up, big moves down. When all's said and done, I think very subpar returns across the S&P going forward. So you can't start at 22 times and get the same return as when you started at 13 times. It's math.

No, right, of coursenot. But so can people play that with the equal weight S.Does that change thenarrative?

I would, if someone put a gun to my head and said you have to have one of the two indexes right now at this point, I would buy equal weight. It's very hard to do because the outperformance of the cap weight to equal weight is dramatic. So people have a hard time buying something that seems so historically unlikely to play. But I think that that does make more sense. But for us, I would look back to what happened after the tech boom.And say, by the way, NASDAQ, it dropped 70%. The Dow was up double digits. It was a big growth value shift. It was a wonderful decade for a lot of things that have been out of favor. When we talk about this 22 times in the S&P, almost all of the S&P is trading at 15 to 18 times. It's this top of the, the, the cap weight stuff that's holding up that valuation.

But there's a but to me.I don't want to buy 15 times if it has no growth and has no risk. So it's funny, I actually, when I say risk, like if it has

no growth, it has a lot of risk.

That's the kicker. I want that fundamental upside. So we talk about momentum investing, and is that scary for investors? Yes, if there's no earnings momentum, if there's no fundament fundamental momentum. I think that the issue is.There's expensive for a reason, and there's cheap for a reason. I don't really necessarily need somebody to tell me 5 times as cheap. I need someone to tell me when 5 times is cheap and that's gonna change. And when 40 times is expensive, but going to stay expensive.To us, I kind of like barbelling around a core, and it's really interesting. I always talk about risk, but different types of risk. Why is the S&P actually hung in lately when it's been messy? There's still enough different types of risk that when something comes down, something else is popping. So like Messi last week, it was actually down 2%. That felt like 10% for people.

Well, because individual names, if they're in individual names, they, they're,

you don't own different types of risk. So to us, we like this idea of buying price momentum if it has earnings momentum.Again, when I, a lot of how I do this is like reverse DCF math. If I see good growth, good numbers, back that out, I, I can be comfortable if I think companies are gonna grow. And then give me that cyclical cheap risk that's actually gonna have some tailwinds and some growth.

I think that my point on dividend growth investing is it eliminates this tension in the sense that there is no dividend growing if the earnings aren't growing. It's a byproduct.of growth of free cash flow, and so you get management voting with their checkbook. Like we believe the company's moving along, that's why we're growing the dividend. You go, oh boy, Pepsi's earnings growth has stalled a bit. Well, they keep growing the dividend. We've seen it with Chevron and Exxon so many times over the years, you've seen it with Procter and Gamble, McDonald's. These are returns that blow everything out of the water over time. I think that one of the things you bring up is a very good point.In these little cycles, so we saw it now recently with these things selling off. They'd had a huge run in September. They got pummeled in July, early August. There was a big rotation into things earlier in the year. It's gone up and down, up and down. Then when Nvidia is a great month, people go, Oh, it's up 22%. They don't realize a year ago, it's the same place it is now.You're, I believe that's what happens to an S&P cap-weighted investor in 357 years. I think they're gonna wake up. They might be up. They might be up 3% a year. They're not buying the S&P to be up 3 to 6% a year. And I think that the range bound up and downness of what you're referring to around some of the cyclicality, I think when you get into, you cannot get the earnings growth, margin expansion, and multiple expansion that led.The 16% Keger from 2009 to 2021, you can't get it for the next decade.

You're not, you're definitely not gonna get it from multiple expansion. If you're buying high multiple stocks, they better have really strong and compounding earnings off thoselevels.

And we're talking about within the S&P. The problem is that what giveth taketh away. I think that, uh, let's use it, see, Nvidia hasn't broken yet. Apple hasn't broken yet. Netflix.And, and, and Netflix and Netflix broke. So let's use Netflix as an example. 2012 to 2020, 1 of the Fang darlings, I think it was up 10x. It gave back seven years of returns in about nine months. That happens all the time in

you know what happenedfundamentally in thatstory?

They grew their earnings more when the stock broke than before, but at a lower rate. But

your gross margins as that, as that transition.From a, a growth stock again, transition, the story transitioning is the issue that was treated like a growth stock. Your margin profile dips, you know, even though you're earning more

EBITD as growth, I'm from a free cash flow standpoint, it was never there, and that's where the dividend story allows you to kind of not have to worry about some of those things. The streaming deal, like, you know who looks like the biggest genius on Earth right now is Rupert Murdoch.Because he got out of the streaming thing, sold the Fox assets to Disney at the highest price imaginable, and said, I don't need to worry about this for news and sports. Kept that, and then let Disney and Netflix go fight over streaming along with these others. Look at those stocks since he did that deal to his.

Let, let me ask a question, just real, go back to your dividend investing. Are you?Specifically targeting the, the like the noble, like the aristocrats, the ones that grow their dividends year in and year out for 25+ years.

Yeah, I know what the question is. So are we looking for a high yield? Are we looking for dividend growth? And the answer is yes. Accidental high yielders, no. If a stock's $100 paying a $4 dividend, now it goes to $50 my yield went to 8%. Isn't that wonderful? No, we don't want accidental high yielders because the stock price is going backwards. But nor do we want a company that grows the dividend every year and it has a.Current yield of 0.8%. So to enter, we want to have a yield about double the S&P, about 2.5% at the point of purchase, and then we want the ongoing dividend growth year over year. That's sort of our metrics. We run pretty concentrated, about 30 stocks,

35 stocks, 30,and they're all, they're all large capmega cap named.

They're

not

all. We can do small and mid. It's just that there aren't as many that have the maturity to be there. But I'll give you an example of a company, Molis is an investment bank, no debt on the balance.Sheet 100% of free cash flow is paid out to investors, but it's pure sell side M&A advisory. They don't do capital markets. They don't need a balance sheet. And yeah, that's a, when we bought it, it was a $1.5 billion dollar company. It's now 4 or $5 billion market cap. So, but that's still small to mid-cap range. Yeah.

We got the Fed meeting, which is just days away now. It's the end of the month, right? Uh, I guess it's next week already.

Uh, look, I'll, I'll say you're asking me to predict what they're gonna do, not what I think they should do. There could be two different things there.First of all, it's very clear they're not going to hike in October. Why do I say that? They put out 4 Fed governors to say they're not going to, as Marsh was saying, we're not gonna go cheat anymore and give a, give forward guidance. And so between Williams and some of the others, they've all teased it up. And at this point, with the hot PCE last week, with the hot PPI, all of these things, they are at 15% Fed futures that they're gonna hike next week. So the odds, the futures are telling you they're not going to.At the same time, they're at 90%, that there will be a hike by December. So that, that's, as far as predictably, it seems very clear they're not gonna hike a few days for the midterms, and they will end up hiking in December. Um, as far as what I think they ought to do, the tension here is very clear. I believe Marsh 100%, I've known Kevin a long time, I think very highly of him. I do believe that if you're saying the Fed funds policy rate and where the headline inflation stands, there has to be some sort of relationship there, and because the inflation rate is still running.Hot, they need to go hike. I get it all logically. The problem is, I think it is abundantly clear that this is inflation coming from supply shock causation. Whether it's the energy side, whether it's the impact of tariffs, goods inflation was at 0%, it went up to almost 2%. That's a smaller contributor to the total, but those are things outside the purview of monetary policy. I would like to see Warsh focus on getting the QE thing done and off the table, let his task force come out and say what aStupid idea that is to continue. And in the meantime, the policy rates less important to me. The 10 year and 30 year are not going up only it's because of the underlying base rate. The term premium moved up. Now the whole curve is flattened a bit, but at the end of the day, I think the issue is the AI issuance is massive. And look at the spread, not just from 2 to 10, from 10 to 30 is another 40, 50 basis points right now. That is because you have, by the way,Some companies with higher credit ratings than the United States government, but certainly equal to, right, putting hundreds of billions of dollars of issuance. So tons of more supply, equal level of demand, it pushes prices lower, yields up. That's the story on the long end of the curve. If people think that our country was not worried about $39 trillion of debt, and then it hit $39.1 trillion all of a sudden the bond market, it's the dumbest thing I've ever heard. The issue is related toCompetition at the wrong end of the curve with new debt issuance.

I'm gonna, I don't care if they hike in, in October or December. But what's really interesting to me, what I think changed a little bit last week, it wasn't what they thought, like what the market thought, because no one actually cares what I think the feds are gonna do, um.They are pricing in a pivot.When you look past a year.So all these hikes, whether it's in a month or two, whatever, they, they think the Fed is going to hike, and they think the Fed is gonna control inflation, and then the market is starting to price in the pivot on the other side. When I think about stocks, cause that's really what we're talking about here, the concern is when the market thinks the Fed is going the wrong direction. Right now, they're comfortable because they think the Fed should be managing inflation. If they do that, market's OK.But longer term, they think the Fed's gonna pivot. That's where I think we'll actually have to care about

the Fed. But have they lost control?Of inflation,

I think certain parts of it, yes, I actually, I take that back. They haven't lost control of it. They never had it. OK,

that's the difference.That's why this conversation's hard, Kenny, because people had their diagnosis wrong 345 years ago so much. Uh, money supply was growing huge, people were talking about the, the spending binge out of COVID, uh, we were talking about Fed policy, they held it down at the zero bound too long, but, but look, they also held at the zero bound from 2009 to 2020, right? And then we didn't see that level of inflation.This is, it's a multi-causal situation and everybody wants a single cause explanation. It's more nuanced than that,

andthere's so many things that happened in those time frames that have longer lasting impacts. We gave companies free billions of dollars. I'm not even talking about checks. I'm talking about they were earning more on their cash than they're paying out on their termed out debt.

But I think that the Fed right now is, uh, focused on getting the headline.That inflation's under control. And even if some of that is outside of their purview, I think that from a credibility standpoint, Warsh has to go back they gotta own

that narrative.

Yeah, so, because we got, we got, I gotta, uh, close this up that we've got about a minute left. Tell me where you think the S&P ends the year and where, what you think of 2027 just broadly in terms of where you think the, you think it's a, you think we're still gonna be a strong economy. Do you think we're gonna?Start to slow. Tell me

what you think. Kenny and I do a lot of TV together. He already knows I'm not gonna answer that question. I would be lying. I don't have any idea. And if anyone tells you they know the answer, they don't know either, right?

Well, OK, put it this way. Do you have a sense that we're gonna, that the, that the economy is gonna start, I

think that right now PEs and E, the multiple and the underlying earnings are not the issue. It's the sentiment, and I would not be relying on sentiment to continue to expand.

I think volatility is going up. Yeah, that's, that's the kicker to me. I think a lot of growth is priced in, even if the PE keeps trending down. I hate, I hate PE as my valuation indicator. Do

you think yields go? Do you think because yields have come down last, last week we saw suddenly they, they went into the bond market.

They came down to where they were 7 weeks ago,

correct? Correct. Do you think they go back up, or do you think they kind ofhang right in

here? I think the long end is gonna start to come down, come down.

I do. Wow.

I don't, I think the language, I do not think you have enough nominal.GDP growth to support a 30-year, 5. You know what's funny,

I don't know if it comes down, but I think the volatility of the 10-year comes down. And I think even if rates go up but at a slower pace, I think that feels a lot better for

stocks. Listen, he's gonna bring, he, meaning Kevin Warsh, has to a ton, a ton of issuance of the market. All right, gentlemen, listen, we've run out of time. I really enjoyed this conversation. I want you both to come back and we'll try this again 4 or 5 months from now just to see where we're at and how it all turned out. Until the next time, take good care.