Looking For Current Income With An Inflation Buffer?

By Sandy Pomeroy

Equities with dividends >2.5% appear to trade close to their greatest relative discount since the unwind of the tech boom of the late 1990s.

In the first six months of 2022, the typical 60/40 portfolio declined by double digits, marking the worst performance for this asset allocation mix since 1932. The main culprit was inflation. Higher interest rates have hurt fixed income markets, and higher discount rates have weighed on equity markets, especially those stocks with high valuations. In the current financial market turmoil, where can investors look to help offset the pressures of inflation? Based on my experience, high-quality dividend-paying stocks could provide a natural inflationary hedge into the next leg of the economic cycle.

Companies paying dividends generally require high levels of cash generation. More importantly, their management teams are typically forced to be disciplined in their capital allocation decisions. As the cost of capital rises with higher levels of interest rates, wider spreads and lower equity valuations (higher cost of equity capital), I believe managements with experience in this discipline should benefit. In June, inflation as measured by the Consumer Price Index (CPI) was running at a 9.1% annualized rate, which represents a 40-year high. Given this backdrop, the subset of dividend payers that can actually grow their distributions to shareholders is critical to offset price pressures. In this environment, those stocks with over a 2.5% dividend yield have grown their earnings per share (EPS) by over 20% annualized over the past five years. They have grown their dividends by an average of 7.7% over that period, and over 16% in the last 12 months, far outpacing the annualized inflation rate of 4.5% over the last five years. At the same time, payouts ratios have declined as earnings have grown faster than dividends, giving these companies more room to reinvest or continue growing dividends, even during economic slowdowns.

Despite these positive dynamics, as of June 30, the data suggests that stocks with yields over 2.5% appear to trade close to their greatest relative discount to the broad market since the tech boom of the late 1990s. In fact, this group currently trades at a one-standard-deviation discount to the market, down from a three-standard-deviation differential back in January. From a historical standpoint, the last time this occurred, many investors eventually benefitted from a significant valuation rebound-making these companies worth a look for those focused on current and growing income streams to help offset inflationary headwinds.

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