Morningstar - Q3 2022 - 59

price of buyback was $70 a share. That gets you
scratching your head.
Thomas: Don, to what extent do you engage with
companies about their dividend policy? You've said
that you're not an activist, but you are a " suggestivist. "
What do you mean by that?
Kilbride: My job is to try and produce investment
returns for fund shareholders. It is not to run
big companies. I've never run anything in my life,
not even a lemonade stand, so it doesn't ever
make sense for me to tell highly intelligent, driven,
talented people how to run their companies.
But I sure will offer a suggestion if they want me
to offer a suggestion.
In my view, the most important job any
management team has to its financial shareholders,
not all stakeholders, is to spend
our money well. Job number one is to invest in
your business and make it more valuable over time
and create value and then take that value
and give it back. There are multiple ways to do
that, share repurchase and dividends being the
principal. We prefer dividends, obviously.
Davis: I agree with Don. We don't try to tell
you how to run your company. But we do
think a lot about capital allocation. How are you
going to use that free cash flow that's generated?
Are you using it in a shareholder-friendly
way? You should be able to articulate a dividend
policy. What are you thinking about as far
as payout ratio? How capital-intensive is your
company? How cyclical is your company?
When Amgen AMGN initiated their dividend, I was
out in California with their senior management
and spent a lot of time talking about what [they
were] trying to accomplish with this dividend.
What is the message that you're trying to convey?
We've done it with Lam Research LRCX. It
was fascinating, because they were tired of being
owned only by tech funds and hedge funds.
Every time you got some rumor out of Asia about
chips or something like that, their stock was
up or down. We tend to be long-term shareholders,
and they recognize that. So, they sent their
whole team-CEO, CFO, head of research and
development-and we learned a lot about them.
We had a company called Celgene that visited
us and spent about three hours with us talking
about it. They didn't take our advice. They sold out
to Bristol-Myers BMY. But they did listen.
We walk them through our standpoint. We'd
like to see growth in the dividend in line with the
growth of the free cash flow of the corporation.
We don't want you announcing a 50% increase if
you can't afford it.
Thomas: There have been questions about whether
energy companies allocate capital well. Are you more
comfortable with the energy space now?
Hart: For sure. It was Jim Mulva at Conoco COP
who started the conversation around
focusing on returns to shareholders instead of
solely on increasing production. It maybe
doesn't sound like a seismic shift, but for the
energy companies, it really was. This
was a number of years ago, and more and more
companies have adopted that principle.
They're not going to just keep pumping out barrels
that are not economic. It sounds silly when
you say it out loud. Why would they?
Because for a long time, that's the way they
conducted themselves.
There's a lot more capital discipline within the
energy space. And part of that is companies
initiating dividends. To their credit, some of the
energy companies that are paying dividends
now came into our offices at JPMorgan when they
were thinking about a dividend. And we're
like, OK, but remember, you're connected to a
commodity. You have to have both the intention
and the ability to pay the dividend. It's a
recurring commitment. And I think a lot of these
companies did it the right way, where they
increased the dividend, but they had a variability
element depending on what's going on with
the commodity price and how much extra free
cash flow they do or don't have.
Davis: Just an example of this: We have
EOG Resources EOG in our portfolio.
Hart: We do, too.
Davis: They announced that they're going to
return 60% of their free cash flow to shareholders.
That was so different. It used to be you put
everything back into the ground.
I was having dinner with David O'Reilly, who
was CEO of Chevron CVX, in New York one night,
and I asked him what he thought the price of
a barrel of oil would be. He said, " Scott, between
$35 and $150 a barrel. " When he said that,
with all his geologists and economists, I laughed,
and I realized how volatile that product is.
The cash flows of corporations like EOG are so
dependent on the price of oil. At $95 oil, they can
produce a 14% free cash flow. At $75, it's a
different story. So, the variability of the dividend
makes so much sense.
Factoring in Inflation
Thomas: How are you factoring in inflation and higher
rates as you look at the companies you invest in?
Kilbride: There's two dimensions to the question.
The bigger dimension, which I think is trickier
to talk about, is how do investors perceive
dividend approaches in a world that's changing
insofar as inflation goes?
What I'm more certain about is how we think
inflation's going to impact the companies in
our portfolio. In a world where we're experiencing
inflation for the first time in a long time, you've
got to circle back to your companies and try
to figure out who's got the ability to weather
this. You want companies that you think
can negotiate their way through that-they can
pass it along or they can even price for it.
The list of companies that can do that consistently
really gets narrow. Any company that can price
successfully has got to be doing it from a basis of
innovation or brand or a product that is a
small percentage of their customers' expense, but
very important. We're trying to think about our
companies in those dimensions.
We've got a portfolio of businesses that have
through the years been successful at growing their
dividend at a substantial rate-in many
cases, over 10% [annually]. That doesn't happen
by accident. That happens because they've
got a business model that grows as well. Very
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Morningstar - Q3 2022

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