Inflation is man made; perhaps it can be man-mastered. The threat which alarms us may also alarm legislators and other powerful groups, prompting some appropriate response. - Warren Buffett
Written by Sam Kovacs
Introduction
Back in the 80s, Buffett made the above statement concerning inflation. If you had read this statement two years ago, you'd likely come to the conclusion that inflation has become man-mastered.
But to me the threat which alarms investors no longer alarms legislators. Ask anything to Fed Chairman Jerome Powell, and the answer will be the same.
What about this afternoon's rain? Transitory. I'm feeling bloated, what's your take, Jerome? Transitory. And what about this bout of inflation? Transitory.
A word that was only used on occasion is now becoming overused. Mr. Powell is probably singlehandedly behind the increase in google searches with the word "transitory".
Source: Google Trends.
It sounds like he is trying very hard to keep to his script. And to be fair, I do understand that he is between a rock and a hard place. Deflationary pressure of technological advances and an aging population need to be offset. But press on the pedal too much, and you risk the rampage of runaway inflation.
Now I don't doubt that part of the current inflation is indeed transitory. The question is whether all inflation above 2% is transitory.
The answer is probably no.
Which stocks will do well?
If the baseline for expected inflation changes from 2% to 4%, then discount rates investors will use goes up as well. A 2 point change in discount rate puts significant downward pressure on the value of future cash flows.
Stocks that trade at high multiples of current cash flows, earnings, dividends, on the basis that the future will be a lot brighter, will get hit because the future will have to be a lot brighter just to catch up with inflation.
So this favors stocks that are trading at cheaper valuations. The "value" stock, if you will. But not any low multiple stock.
To fight off inflation, companies need to be able to either increase volume, or prices, just to break even.
Companies with strong pricing power, which can pass off the costs of inflation to consumers, and which can continue growing their business, will come out on top.
This is no small feat. Capital discipline must be observed. New investments and acquisitions must be considered with a higher hurdle. If no such investments exist, the companies will be better off returning cash to shareholders through dividends and buybacks, rather than keep excessive amounts of a depreciating asset --cash-- on their books.
So with this in mind, we must look for:
- Very high quality companies.
- With strong growth prospects.
- With good pricing power.
- Trading at bargain prices.
- Which are shareholder friendly
Looking through the 45 high quality dividend stocks on our Buy List, there were many candidates.
But after eliminating stocks, one after the next, I came up with 3 stocks I believe nearly all dividend investors should own in their portfolios.
Morgan Stanley (MS)
The first stock is one of the latest additions to our Dividend Freedom Tribe portfolios.
A week before the Fed released stress test data, we were telling our members to get ready for the big dividend hikes.
We were expecting the banks to come out of the gates with massive dividend hikes. The sort of dividend hikes that say "How dare you ban me from raising my dividend? I've got so much excess capital and I'll show it".
For the most part, we didn't quite get the impact we were hoping for.
JPMorgan (JPM) increased its quarterly dividend from $0.9 to $1. An 11% increase. At face value it's an interesting increase, but when we consider that this increase should account for 2 years of dividend increases, it amounts to only a 5.4% CAGR.
This is half the increase we were expecting.
Accounting for the dividend increase, JPM moves from somewhat overvalued to slightly overvalued.
Source: Dividend Freedom Tribe.
So we weren't quite satisfied with it.
Bank of America (BAC) increased its dividend by 17%. This amounts to an 8% CAGR over the past 2 years.
Somewhat better than JPM, but still quite disappointing when all things are considered.
Some smaller banks like Huntington Bancshares (HBAN) and Regions Financial (RF) are expected to announce their dividend within the next two weeks. If any executive from these or any other bank is here reading this, rally your trips and increase the dividend by a large amount.
The only bank which wanted to make a strong statement was Morgan Stanley.
The company nonchalantly doubled its dividend. As it stands, the dividend has grown at a 30% CAGR over the past decade.
CEO James Gordon said:
Morgan Stanley has accumulated significant excess capital over the past several years and now has one of the largest capital buffers in the industry.
With one wave of the corporate wand, MS' dividend yield doubled from 1.5% to 3%.
Just look at the value this adds from a dividend investors' perspective.
Source: Dividend Freedom Tribe.
You can see that the huge dividend increase results in a corresponding increase in value, if you follow our thesis that dividend stock prices follow their dividend over time.
This creates a fabulous opportunity. Over 80% of the time in the past decade, MS has yielded less than it currently does.
If you missed buying JPM when it yielded 3%, why not get in with one of the nation's best banks.
It is one of our highest conviction ideas today.
You can read Logan Kane's article here, where he makes a bold comparison to Apple (AAPL):
This said Morgan Stanley's business plan isn't super different from Apple's back in the day. The principles in my mind for growing the share price of a mature company are pretty simple.
- Find cheap sources of financing
- Generate recurring revenue
- Return capital to shareholders via dividends and aggressive buybacks
To understand how great a dividend opportunity MS is. Let's simulate income from the position over 10 years, assuming 12% dividend growth, which is reasonable for MS given the track record and moat.
$10K invested today would provide $1,247 in year 10, assuming dividend reinvestments. This is 12.47% of the original investment, way above our 10% threshold to consider a dividend stock a "great" income opportunity
Source: Dividend Freedom Tribe
MS is the best bank money can buy today.
Suncor (SU)
Energy stocks have been a great investment so far in 2021. In January, in an article titled "", I warned that "owning only 2.28% (the sector weight of the index) of your portfolio in Energy stocks might be the biggest mistake of 2021".
The big leg up in Energy stocks has been a boon for our portfolios. But in the last two months, some new risks have stalled the advance in energy stocks, namely: The delta variant, lifting of Iran sanctions, and the political rift between Saudi Arabia and the UAE.
Nonetheless, the sector has been underinvested in, and you would likely still do well by throwing darts at a list of Energy stocks and picking them.
But our approach as always is rather to identify which stocks are the most mispriced and buy those.
Of course, you could probably do alright by buying majors like Exxon (XOM), although we set a cap on buying when the stock yielded 6%+. Ditto for Chevron (CVX), which still offers a good margin of safety at current prices.
But neither of these offers the growth prospects I talked about in the introduction.
Of the 13 Energy stocks that we cover, 9 of them are currently on our buy list.
Interestingly enough, it is the Canadian stocks (which are also listed on the NYSE) which we really like today.
Among them, Enbridge (ENB) has been a recurring idea for investors seeking a high yield and reasonable growth. But once again it's not high growth.
High growth names like EOG Resources (EOG) and Cimarex (XEC) now trade at valuations that don't provide investors with large margins of safety.
But there are some assets that are just purely mispriced.
And today's suggestion could be considered somewhat controversial by dividend investors.
After all, just last year, Suncor cut its dividend by more than 50%.
We're usually quite reticent to invest in companies that just cut their dividend, as it usually is an indication that dividends won't come flowing back.
The destruction of value caused by a dividend cut is apparent on our MAD Chart below:
Source: Dividend Freedom Tribe.
This chart shows that despite the stock trading 40% lower than its 10-year high, it is trading at its 10-year median dividend yield (marked by the line between the pink and light blue areas).
But just as dividend cuts destroy value, dividend hikes create value.
And within the next 4-5 years, the dividend should climb back up to its pre-cut level.
I'm a generalist investor, who supplements my research with what specialists have to say. We're lucky on Seeking Alpha to have some great Energy specialists.
I'll quote research from a couple of them here.
First, Michael Boyd did a great review of Suncor's analyst day presentation.
In it he says:
No question that the cut to the dividend last year upset a lot of investors, though it appeared necessary at the time given the duress Canadian producers, in particular, were under. Luckily, future Suncor upside in free cash flow is largely expected to flow through to shareholders, with 100% of the first $1,000mm going to shareholders and 50% of the remainder. So, for income investors that are a bit cautious on whether management can hit these targets, there is some solace in the fact that dividend bumps are front end loaded. With the current dividend payment costing Suncor about $1,300mm per annum, even just the first tranche has the potential to nearly double the payment. Framed another way, if management hits their targets to the tee, investors can expect to see the dividend increased by 25% per annum through 2025.
Management's target of 25% CAGR is feasible assuming $55 WTI, which is 25% below the current WTI price.
Why is 25% CAGR on SU so great? Well, let's simulate income for your position.
Assuming you invest $10K in SU and reinvest dividends at the current yield while the dividend grows at 25% per annum.
In year 5, you would expect to receive $988 in income, of which $99 comes from dividend reinvestment.
In other words in 5 years, you would get a 9.88% yield on your initial investment.
Source: Dividend Freedom Tribe.
Consider the fact that we consider a 10% yield on original investment in 10 years to be a "great" income opportunity. Here you will likely get that much in just 5 years.
If you have trouble understanding why Seeking Alpha's HFIR says that Suncor is "one of the most mispriced large-cap energy names in the market today", then the income projection above will likely clear things up for you.
I expect SU's price to double in the next 5 years, maybe sooner. HFIR's thesis in his excellent article is summed up by his following words:
In order for energy companies to become very insulated from the high fluctuations of oil prices, you need a few things:
- Resilient balance sheet
- Integrated business structure (produce oil, transport, and refine)
- High barriers to entry
In the case of Suncor, it effectively operates in an oligopoly structure in Canada with high levels of crude inventory, refineries, and a downstream network of gas stations making them #1 in Canada.
Suncor is a screaming buy.
Kroger (KR)
How do you top off a list on value stocks after mentioning a financial and an energy stock? You go with a consumer staple stock.
With a shift in consumer habits led by Covid-19, many of these have done very well.
But very few have the ability to grow their dividend at a fast rate. A few do, and of these, my favorite is Kroger.
To drive home the point of high growth, let's compare an investment in KR to other consumer staple stocks which we track.
If we invest $10,000 in Kroger, reinvest dividends at the current yield of 2.2%, and that they continue to grow the dividend at 12% per annum for the next 10 years, then you could expect to receive $846 in year 10, or 8.46% of your initial investment, enough to qualify as a "good" income opportunity.
Source: Dividend Freedom Tribe (KR simulation)
On the other hand, if you invest the same amount in Clorox (CLX), which yields 2.5%, and the dividend continues to grow at the historic rate of 7%, then in year 10, you'd expect to receive $618 in year 10.
Source: Dividend Freedom Tribe (CLX simulation).
Finally, if we simulate the income from an identical investment in Coca-Cola (KO), which yields 3.1% and we project dividend growth at 3% per annum, then in year 10 you'd only expect $548 in income.
Source: Dividend Freedom Tribe (KO simulation)
What this shows you, is that if your goal is to live off of dividends forever, you cannot only consider dividend yield. You need to consider it in conjunction with likely dividend growth.
The rest of the article is information that has already been shared with our Dividend Freedom Tribe members, which makes the case for KR.
Source: Dividend Freedom Tribe
In the past 10 years, KR has spent less than 25% of the time with a yield this high.
I think it is a brilliant opportunity to increase the size of a position in KR, as I expect it to trend up to $45-$50 in the next few quarters.
Nearly all of Kroger's consumers (over 90%) use a Kroger's loyalty card which gives the company fantastic data on over 60 million households.
The company's investments in digital sales have paid off, with triple digit growth in online sales since early 2019. But this is only the tip of the iceberg.
This snippet from the latest earnings call gives a good idea of the edge the company gets from all this data.
New trends are emerging as well as customers settle into new routines. In a recent survey of our customers, a remarkable 92% of the people say they enjoy cooking the same or more than they did pre-COVID. And as people's busy social lives pick up, more customers are looking for convenience in cooking options. We continue to utilize our data to understand those behaviors that are more permanent in nature. Whether customer habits are returning, hardening, or emerging, we will continue to meet the customer where they are and use our data science expertise to be where they are going.
This level of insight allows the company to adapt its offering in real time. While it is still a reactionary rather than anticipatory process, being data rich is a lot better than the alternative.
Continued sales growth, margin expansion, and a buyback rate of 3% should allow KR to grow the dividend at least by 12%, which would be enough for it to yield 8.45% on cost in 10 years, assuming you reinvest dividends.
Conclusion
No matter what happens, these stocks have strongholds in their respective businesses, what Buffett would call moats. They are extremely shareholder-friendly and able to pass on the costs of inflation on to consumers. Whatever happens from now, these 3 stocks will do great for dividend investors like us.
Want our list of 45 undervalued "Buys"?
We presented 3 ideas here, which will likely give a nice boost to your portfolio. But if you want to focus on value stocks, in a framework which also leads to a dividend rich retirement, you'll need more.
Members of the Dividend Freedom Tribe get our daily updated Buy/Watch/Sell lists.
There are currently 45 stocks on our Buy list, more than enough to build a portfolio.
Plus we're offering 35% lifetime discounts. Click here to get yours.
