Mr. Bailer, US equity markets remain close to record levels. Are stocks simply too expensive?

No. That's one of the misconceptions about the US market. When people say the S&P 500 looks expensive, what they usually mean is that the most expensive stocks in the US look expensive.

If you divide the S&P 500 into valuation quintiles, you see that the most expensive 20 percent have become significantly more expensive. We saw something similar during the technology bubble in the late 1990s, and over the past few years we have seen tremendous excitement around artificial intelligence.

«Dividend growth is one of the best leading indicators of free cash flow.»

But the cheapest 20 percent of the market still trade at relatively normal valuations. So not all US stocks are expensive. There are still plenty of interesting opportunities in the cheaper areas of the market.

Where are you finding those opportunities?

We like companies that pay dividends and can grow those dividends over time. We also like what you might call boring companies, businesses that can compound value over long periods of time.

That is very different from what parts of the market are rewarding today. But over the long term, we believe that type of company can deliver attractive returns.

Why are dividends so important to you?

Dividend growth is one of the best leading indicators of free cash flow. If management recommends increasing the dividend and the board approves it, that tells you something important: management and the board believe cash flows are stable and potentially growing.

Boards tend to be conservative when making those decisions. Of course, management teams can be wrong, just like all of us. But a rising dividend gives us additional confirmation that the underlying cash flows are moving in the right direction.

So this is not a traditional deep-value strategy?

No. We use what I call a “three-circle approach”. We look for stocks that are out of favor, but we also want to see improving business momentum or a catalyst that could drive that improvement. That helps us avoid value traps.

«Financials are our largest sector weighting, and regional banks are particularly interesting.»

And we want quality. We are humble enough to recognize that we don't know whether there will be a recession over the next couple of years. So we want companies with strong balance sheets and stable cash flows.

If you had simply been a deep-value investor, you would have struggled for much of the past 16 years. Combining valuation, business momentum and quality gives us a more balanced approach.

Which part of the US market looks particularly attractive to you right now?

Financials are our largest sector weighting, and regional banks are particularly interesting.

«I believe there is a manufacturing renaissance taking place in the United States.»

One example is Fifth Third Bancorp. It acquired Comerica, which has significant exposure to Michigan and Texas. We believe the timing of that transaction was attractive, and Fifth Third has an opportunity to generate synergies and expand its position in Texas.

More broadly, I believe there is a manufacturing renaissance taking place in the United States. Tax policy is encouraging companies to manufacture more domestically, while tariffs are another incentive to shift production to the US. Texas is benefiting significantly from these developments.

Why should regional banks benefit from that?

Regional banks have significant exposure to commercial and industrial lending. If manufacturing activity increases, they can be direct beneficiaries.

We believe regional banks could see some of the most interesting earnings developments over the next several quarters. They are an area where we still see attractive valuations and improving fundamentals.

Artificial intelligence has been one of the dominant forces in the equity market. Is the enthusiasm justified?

Artificial intelligence is a huge game changer. There is no question about that.

What concerns me is that investors may be paying too much for some of the companies benefiting from the infrastructure build-out. Markets move in cycles. When an area has very attractive growth prospects, enormous amounts of capital flow into it. Companies raise equity, borrow money and invest heavily. That is what we are seeing with data centers and AI infrastructure.

The infrastructure beneficiaries are the obvious trade today. Everybody is focused on them.

Where should investors be looking instead?

At what comes next.

The next stage will be enterprises upgrading their systems so they can actually use artificial intelligence. After that, the really interesting question is which companies can translate AI into higher productivity.

Banks could be major productivity beneficiaries. Insurance companies could also benefit substantially. We see opportunities in healthcare as well.

«I worry that Europe is not being aggressive enough.»

At the moment, I think investors are overpaying for parts of that first group – the infrastructure beneficiaries – while some of the future productivity winners remain underappreciated.

Which financial institution could benefit most from AI?

J.P. Morgan could potentially be one of the biggest beneficiaries from an AI perspective. But from a valuation and earnings perspective, we currently find regional banks particularly interesting.

Europe is investing less aggressively in AI infrastructure than the United States. Does that concern you?

Yes. I worry that Europe is not being aggressive enough.

There are going to be competitive advantages for companies and economies that embrace this technology and ensure their systems are ready to take advantage of it.

The US also has greater flexibility in its labor market. Companies can reorganize and move people around more easily. AI should allow companies to generate significant productivity improvements, and I wonder whether Europe, with somewhat more rigid structures, will be able to capture the same benefits.

Where do you currently see the biggest risk to dividends?

One area we are cautious about is parts of the food sector, particularly snack foods.

GLP-1 drugs are changing consumer behavior from a health perspective, and in the US we are seeing changes in eating habits. Some food companies have high dividend yields and high payout ratios, while volumes have been under pressure. That raises questions about dividend sustainability for certain companies.

Have you recently changed your view on any sector?

We have become somewhat less bullish on refiners than we were at the beginning of the year.

«I am surprised the market and the economy have been this resilient.»

Refining margins have been very strong, partly because of disruptions to Russian refining capacity. These companies are generating significant cash flow, but we think they may currently be overearning. If crack spreads normalize, the stocks could come under pressure. We have therefore reduced our exposure since the beginning of the year.

The US economy has remained remarkably resilient despite high interest rates. Has that surprised you?

Yes. I am surprised the market and the economy have been this resilient. With the US 10-year Treasury yield approaching 5 percent, I would have expected the economy to slow somewhat.

But we are simply not seeing the cracks. Credit spreads remain tight. Banks are not reporting significant credit problems, and non-performing loans look fine.

And the latest earnings season was extraordinary. I have been doing this for more than 20 years, and I haven't seen many earnings seasons this strong. Normally you see something like this immediately after a recession. This time, we didn't even have a recession.

How much of that strength is attributable to AI?

A significant amount.

The aggressive AI build-out in the US is helping corporate earnings. And it goes beyond the direct beneficiaries. Excitement around new AI-oriented companies supports capital-market activity, which in turn benefits financial institutions.

«I strongly believe in cycles.»

AI is already having an impact on earnings, economic activity and employment.

So the AI party isn't over yet?

It's difficult to see what would cause the party to end at this point.

Eventually it will end. I strongly believe in cycles. But right now it is difficult to identify the catalyst that would bring it to an end.

That doesn't mean investors should simply chase the most expensive AI stocks. Our approach is different. We provide diversification from the growth exposure investors already have through the S&P 500. The index itself already contains a very large technology and growth component.

What ultimately differentiates your investment approach?

Experience and research depth are important. Brian Ferguson and I have been doing this for more than 20 years, and we have a well-resourced team. Being part of BNY gives us access not only to fundamental analysts but also to quantitative specialists, responsible-investment experts, fixed-income expertise and investigative research.

But ultimately it comes back to discipline. We want value, improving business momentum and quality fundamentals. And we have institutionalized risk controls to ensure that we deliver the value and income exposure we promise our clients.

It is designed to be what you might call a «sleep well at night» approach.

The US midterm elections are approaching. Could the elections put pressure on equity markets?

I'm not particularly concerned. Studies have shown that markets have historically performed well even under divided government. When power is split between the parties, it becomes more difficult to implement major policy changes.

For the companies we follow, I don't expect the midterms to have a significant impact. I know other investors are concerned about the elections, but I'm not.

John Bailer is the lead portfolio manager for dividend-focused Large Cap Value strategies at BNY Investments. He’s responsible for creating the Income Stock strategy to meet demand from clients seeking attractively valued higher dividend income while not sacrificing dividend growth. 

He is also the lead portfolio manager for the Equity Income strategy, which emphasizes dividend growth stocks, and a senior research analyst on the Dynamic Large Cap Value strategy.