Broker Check

The Great Inflation Hedge

| May 03, 2021
Share |

All good things must come to an end. In this case, we're talking about low inflation.

While we think the odds of hyperinflation are fairly low, a return to normalized inflation rates definitely seems to be on the horizon. This is thanks to massive stimulus, a rebound from the depths of the pandemic, and a return to global growth, all of which started to push measures of inflation higher. For instance, according to the Labor Department, the Consumer Price Index (CPI) jumped 0.6% month-over-month in March. Year-over-year, the metric surged 2.6%, which is the fastest rate since 2018.

We've talked about inflation risk in the past and now we want to address a tried-and-true hedge when it comes to income inflation – dividend stocks, specifically dividend growth stocks. By that we mean dividend-paying equity holdings with the potential for price growth, as well as consistently strong dividend payout growth.

See, the current inflationary environment could feed dividend growth stocks. For example, we’re seeing consumer goods companies pass along raw material inflation. Kimberly Clark announced price increases to cover higher feedstocks. Similarly, the heating, ventilation, and air conditioning company Trane is passing along stock-induced price increases to consumers. And even the great Procter & Gamble announced price increases across all product categories due to higher material and shipping costs.

In our opinion, this is the time for dividends to come to the rescue. Dividend growth stocks have proven themselves as a great way for portfolios to battle rising prices and keep gains and income ahead of the CPI. Part of the reason comes down to what Kimberly Clark, Trane, and P&G are doing. Corporations can pass on cost increases to consumers, which keeps profits humming in periods of inflation. In general, dividend stocks continue to reward their shareholders during this time.

Historically, the rate at which stocks in the S&P 500 have increased their dividends per years has been just under 6%. That rate is more than double the long-term average for inflation. The following chart from Alpha Architect highlights how dividend growth has managed to outperform inflation over a 25-year rolling period:

As you can see, dividend growth (the darker blue line) has managed to beat inflation even when there are spikes in the CPI, with only a few minor exceptions. Additionally, total returns for dividend growth stocks have been robust during periods of inflation. As shares raised payouts, investors have historically flocked to these stocks to take advantage of the higher income, thus increasing the market value of the stocks as well.

The key for the strategy though is not to focus on seeking extremely high headline yields, it’s to focus on dividend growth. Typically, we target dividend growth stocks yielding within a range of 1.5% up to 4%, and we like to focus on a higher rate of payout growth rather than initial yield. Stocks like Starbucks or Home Depot fit the bill, considering their strong pace of payout increases.

This is why we at Cornerstone are bullish on our dividend growth model as a hedge against rising prices. We expect our large-cap U.S. dividend growth strategy to be a core part of our customized portfolio options entering this new inflationary era.

Negative News Can Be Costly

As our readers know, we think news has become more “infotainment” than information. Headlines are emotionally charged and meant to attract eyeballs. And we don't blame new organizations for this because they need views to make money selling ads.

But when it comes to investing, this headline grabbing talk can be astronomically expensive – here's why. The following chart includes some “crises” since 2010. And please understand, these events were serious. They include international debt issues, global political affairs, and pandemics. We call out their validity as crises only from an investment perspective because, for most of the events, investors dealt with tension, fear, and anxiety in these scenarios, much of it media driven.

Though as you can see in the chart below, overall stocks didn’t care in most cases. If they did, it was mostly short-lived, even if it lasted a few weeks or months. Long-term, stocks really don't care about the latest crisis headlines.

Looking at the chart, do you see anything? Here's what we see. If you got spooked out of your stocks by listening to news headlines, it would have cost you dearly.

Today, the latest fear-grabbing headlines are about tax policy. While we’ve admitted that this is something we have to keep an eye on, many of the talking heads are trying to get investors riled up again.

We're actually seeing this line up perfectly with recent institutional investor, or “big money,” movements. Looking at last week's buying data, we see real estate being gobbled up by institutional investors:

But why?

If taxes, more specifically capital gains rates, are raised, rates on dividends could (theoretically) rise too if some of the leaks out of the White House are to be believed. Real Estate Investment Trusts (REITs) don’t mind though because a majority of REIT revenue is taxed as ordinary income. So, those funds will escape a potential tax liability (mind you one that hasn’t even been voted on yet). The sudden boost in appetite for real estate stocks has propelled it to the strongest sector in our data as well:

We’re not saying the logic in buying REITs isn't sound. Remember, real estate stocks organized as REITs are required to pay out a minimum of 90% of taxable earnings, and typically their yields are very enticing. Add that to how the U.S. is vaccinating quickly with a full economic reopen just around the bend, and it appears REITs should benefit, especially those that were beaten to near death levels last year. If you add in the tailwind from being a potential tax even, it’s a nice set up.

But that does not mean that there are no other opportunities. There are, including large-cap U.S. dividend growth stocks. Just remember that talk can be expensive. Don't let it make you stray from your long-term investment objectives.

New Growth Areas to Consider

We receive a lot of questions about new high growth areas, so we wanted to include some ideas of ways to make money as more passive investors. The best comparison we can use is how during the California Gold Rush the folks who sold pickaxes, shovels, and jeans to aspiring miners made much more money than most of the gold miners.

So, here are ideas to invest in the “stores” feeding some of the newer high growth investment areas. Please understand, these are not specific stock recommendations to buy. These are examples of macro-level themes on long-term, passive equity investing in growth opportunities.

Cryptocurrency

Nowadays the subject of cryptocurrency can’t be escaped, especially in the wake of the Coinbase initial public offering. In our opinion, one of the best ways to participate without owning cryptocurrencies directly (or via some Tesla crypto side door) is PayPal. Remember PayPal? In essence, it takes a significant transaction fee of 1.8% to 2.3% off the top of all cryptocurrency transactions.

Cannabis

There has always been major volatility in cannabis stocks. And recently, news across Canada and the U.S. brought concerns of an oversupply of cannabis. Therefore, maybe a safer way to participate in the growth (no pun intended) is to invest in a company like Grow Generation, which is essentially a Home Depot-like store for cannabis growers.

Artificial Intelligence

Rather than focus on a particular AI firm or use, we suggest focusing on the parts that run AI, no matter the use. And even with seemingly sky-high prices, we think the real leadership in AI (and a great way to profit from the trend) is with the chipmakers, specifically NVIDIA, which dominates AI chipmaking.

5G

As we replace broadband networks, there are several companies working to either make networks faster for many different uses or sell devices for this new three-channel standard, again for many different uses. In the spirit of looking to the “store” and not any particular product, Aviat Networks makes networks faster, while Wi-Fi device seller Netgear is a good example of 5G device adoption.

microLED

This is an emerging flat panel display technology. LG dominates the current LED technology television production; however, Samsung is expected to rival this dominance with its new microLED televisions. Sticking to our theme of “stores” getting rich, Kulicke & Soffa recently acquired a firm to commercialize an LED dye transfer technology in the making of microLED. As such, it could be a pipeline to the next generation of television manufacturing.

Remember, we’re not specifically recommending anything with the commentary above. These are examples of “stores” in growth areas that investors may have interest in examining. They’re very much akin to the suppliers who profited off the gold mining bonanza many years ago. Considering the “Wild West” nature of the aforementioned growth areas, the connection seems valid, and perhaps profitable.

*Cornerstone Financial Services, LLC does not own any of these holdings directly in managed accounts but may indirectly through ETF investments.  Daniel Milan owns PayPal personally.

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unaffiliated entities.

Share |