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Inflation Concept

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Co-produced with Treading Softly

Inflation is still a hot topic. One point that many seem to be overlooking is that even with declining inflation, prices are still very high. While inflation may go back to levels we’re used to seeing, positive inflation percentages still mean that prices are still rising. “Slowing inflation” does not mean prices will return to what we were seeing in prior years. It only means prices will go up more slowly.

This means that many commodities at higher than historical prices are going to find and set new floors to climb from instead of returning to prior levels. It’s all part of the result of a global monetary policy to jump-start economies. The more money floating in the system, the more dollars it takes to purchase the raw basic ingredients of society.

While the Federal Reserve wages a war again inflation, I am going to buy inflation-benefitting investments and opportunities, knowing that even when inflation gets tamed down the road – these investments will continue to produce higher levels of cash flow and big dividends going forward. Even if inflation comes down to “only 2%”, the price of things like oil, corn, gas, iron, and many other commodities will remain well above historical levels. We are still in the early stages of the commodity supercycle. The companies that provide commodities are positioned to have outsized earnings for several years.

Let’s dive in.

Pick #1: BCX – Yield 6.4%

If you ever need proof of how irrational the market can get, take a look at BlackRock Resources & Commodities Strategy Trust (BCX). We’ve been in an inflationary environment for some time and BCX is invested in the areas that have seen the most inflation: Energy, Mining, and Agriculture.

BlackRock BCX fund

BlackRock

No doubt, the logic of many is that the Fed is drawing the line on inflation, combined with concerns that a recession might lead to a decline in energy demand. Ironically, this recession is supposed to be caused by high inflation.

One thing to understand about inflation is that it measures the change in prices, and is not an actual indication of price. Say inflation stops today, for the next year, everything remains exactly the same price it is today, that is 0% inflation. Oil right now is $107/barrel. So if inflation is 0%, then a barrel of oil will still be $107, and the company that sells it will still receive $107. Remember in March of 2021, there were “fears of dwindling demand” for oil? Those projecting $100+ oil were called “fantasist bulls.” Now, somehow the idea that oil might settle around $100 is somehow bearish for oil companies.

It’s the same story for a lot of other commodities generated by companies in BCX’s portfolio.

Commodities price trend
Data by YCharts

Prices are up a lot, they probably will cool down, and that’s ok. The prices are already at levels that the producers certainly didn’t count on in their business plans. Oil companies don’t need $100 oil to be profitable and farmers don’t need $7+ corn. Even with prices coming down from recent highs, these companies are still receiving much higher prices than they’ve received in the past decade. They will still have one of the best years they’ve had in a very long time.

While we wait for the market to realize that prices are still high, we can pick up more shares of BCX during this dip.

Pick #2: RIO – Yield 14%

Rio Tinto Group (RIO, RTNTF, RTPPF) is one of the major iron ore producers in the world and is often referred to as one of the big three Australian iron ore producers, alongside BHP (BHP) and Fortescue (OTCQX:FSUMF).

RIO, along with BHP, FSUMF, and Vale (VALE), provides China with 76.5% of its iron ore imports. Why is this important? Because China buys 70% of all global seaborne iron ore. If a major company wants to sell iron globally, China is the biggest buyer.

China’s economy has been slowed due to its COVID-19 policies but is already seen as rapidly reopening and getting fired up again. As steel mills and other areas of the economy come back to life, iron ore prices are likely to rise.

Iron ore spot price
Data by YCharts

Iron ore remains elevated from 10-year historical norms due to baked-in inflation on commodity prices, but lagged recently due to China’s lockdowns lowering demand.

RIO has strongly outperformed the market as a whole, year to date.

Rio Tinto return
Data by YCharts

This is primarily driven by its large semi-annual dividend payout offsetting the price declines. RIO attracts many traders between its dividend announcements and sees them depart in the largely quiet spells between them, providing income investors opportunities to buy more shares when the seas are quiet before they’re roiled up again.

RIO has a generous payout policy of paying between 40-60% of its profits as semi-annual dividends to its shareholders, in April & September. Currently, RIO is expected to generate an EPS of over $10 a share. This provides for a $4-$6 dividend payout. RIO has already paid $4.79 a share this year in dividends, but this was tied to 2021 and not 2022s performance. We can readily expect another interim dividend to be declared in July/August and paid in September. If RIO earns on target in 2022, we are likely to get between $2-3 in September and the remainder in 2023.

We continue to see RIO as an excellent route to gain exposure to commodities from a very shareholder-friendly management team. We liked them when we last recommended them in December, and continue to do so.

Dreamstime

Dreamstime

Conclusion

Using BCX and RIO, we can enjoy outsized dividends from commodities. By owning shares of those companies zeroed in on the building blocks of society, we can enjoy inflation’s benefits while the world’s central banks work on offsetting its negative impacts.

For income investors, we look for undervalued opportunities, which reward their shareholders strongly and hold them for years to come. By buying BCX and RIO now, we can enjoy their recent sell-offs while the market focuses on the battle to reduce inflation. Knowing that even as inflation slows, prices will remain at high levels relative to history.

These new baselines mean strong and large dividends for years to come, and likely a higher share price to enjoy as investors buy into these opportunities after we’ve been in place.

Who doesn’t like great dividends and an unrealized gains cushion to ease the mind in times of volatility? I don’t know a single retiree who wouldn’t like that.

That’s the beauty of our Income Method.

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