LIN - 5 Dividend Gems To Make Your Portfolio Inflation-Resistant

2023-03-07 08:00:00 ET

Summary

• In this article, we start by discussing the impact of inflation on stocks and bonds, as well as ways that tend to protect investors against inflation.
• While commodity futures tend to be the best tools for the job, I present five dividend stocks that benefit from rising inflation.
• The stock selection has a track record of protecting portfolios against inflation while improving the long-term risk/reward as well.

Introduction

Throughout this year, we've explored various portfolio strategies and model portfolios that cater to long-term dividend investors looking to grow their wealth while minimizing risks. In our previous discussion , we explored two dividend strategies and techniques for mitigating risks. However, in this article, our focus will be on inflation. Given that we're currently in a prolonged inflation period, it can be challenging to invest, particularly when high inflation is coupled with economic growth slowing.

In this article, we'll start with a theoretical discussion of high inflation and its impact on both stocks and bonds. Next, I'll present five of my favorite stocks to safeguard dividend (growth) portfolios against inflation. These picks not only offer inflation protection, but they also provide decent yields and have A-rated balance sheets. We want to avoid adding risks when purchasing commodity plays and, instead, opt for high-quality income plays that can add value through dividends, even when inflation is slowing.

So, without further delay, let's dive in!

Inflation Is Tricky - What To Do?

What works, what doesn't, and what to be aware of.

Stocks help you protect your capital against inflation. That is a correct statement. However, it's only true on a long-term basis.

The chart below shows that stocks (in general) have beaten inflation by a massive margin over the past 33 years. That gap widens if we go further back.

Unfortunately, on a shorter-term basis, the case cannot be made that stocks (again, in general) protect investors against high inflation. The impact is even worse when managing a traditional 60/40 portfolio (60% stocks, 40% bonds).

In 2022, the 60/40 portfolio had its worst year in modern history. 2022 was the year the Fed started to become aggressive as inflation became a major issue - both in the US and overseas.

The correlation between bonds and stocks had been (mostly) negative for over two decades, writes Credit Suisse . That ended in 2021 when inflation started to heat up.

Looking at the chart below, we see that periods of high inflation always pressure both stocks and bonds. Bonds usually suffer more than stocks.

Note that the chart above also incorporates economic growth. In times of slow economic growth and high inflation, stocks are unlikely to rise. We saw this play out since the acceleration of inflation in 2021. In times of slower inflation and high economic growth, stocks and bonds tend to fly.

So, what does work?

The answer is commodities. In times of high inflation, gold, commodity futures, and spot commodity prices tend to do well.

According to Credit Suisse, commodity futures are the best way to play inflation, thanks to a negative correlation with bonds, a low correlation with equities, and the fact that they are also a statistical hedge against inflation itself.

According to the bank:

Historically, commodities have had a low correlation with equities and a negative correlation with bonds, making them effective diversifiers. They have also provided a hedge against inflation. Indeed, commodities are unique in this respect, compared with the other major asset classes. However, their inflation-hedging properties also mean that, in extended periods of disinflation, they tend to underperform.

While gold has the highest correlation to inflation, Credit Suisse makes the case that a mix of commodity futures is the way to go. After all, if investors only buy energy futures, they may only benefit if inflation is energy-driven. Industrial metals perform best during demand-pull inflation, and precious metals perform well when central bank credibility is questioned.

Right now, inflation is everywhere. However, I think we can all agree that the bank is right when it comes to diversification.

That said, as we already briefly discussed, commodities are not a hedge against a recession. Especially in the early stages of a recession, commodities tend to perform poorly. They perform best in times when inflation is above treasury bill rates and above average (these two conditions are not mutually exclusive).

So, to summarize the pro-commodities thesis (so far), let me use Bloomberg's Isabelle Lee's words.

Where does this all leave us? Commodity futures don’t offer the totally free lunch many believed before the 2008 implosion. They do, however, offer a uniquely good hedge against inflation. The last decade has shown bad things can happen to returns when inflation is low — but if you’re concerned that inflation will not go without a fight, the case for commodity futures in a portfolio looks very strong.

With all of this in mind, I'm doing things a bit differently in the second part of this article. I will not advise commodity futures to anyone. Financial derivatives are tricky and not what I'm looking for in my dividend portfolio.

However, we're still going to implement the most important takeaways.

• Both bonds and equities have historically been negatively impacted by inflation, although equities tend to be hurt less than bonds.
• To preserve wealth and minimize the risk of inflation eating away at it, investors may want to consider commodities as a diversifier in portfolios.
• Commodities are negatively correlated with bonds, lowly correlated with equities, and statistically, a hedge against inflation itself.
• Energy futures perform well during energy-driven cost-push inflation, industrial metals during demand-pull inflation, and precious metals, especially gold, perform well when central bank credibility is questioned.
• While commodity futures' long-term returns have been healthy, they are not a hedge against recession.

Hence, instead of going with commodity futures, I incorporated a number of commodity-related stocks that are - when combined - highly diversified, benefiting from inflation, and value-adding when added to a well-diversified (dividend) portfolio.

So, let's dive into the picks and the portfolio.

The Right Stocks To Get The Job Done

As usual, multiple paths lead to Rome, meaning there are a lot of other stocks that may also get the job done.

In this article, I present some of my own holdings and stocks that, I believe, will allow investors to be better protected against inflation.

In addition, since we are analyzing only five stocks, I will give a brief overview of each company and the rationale behind their selection. For those interested in further information, I will include relevant links.

Please note that I incorporated our theoretical framework in the stock selection. We're dealing with high diversification in the commodity space, top-tier balance sheets, and consistent dividends, even if one company in the selection has a highly volatile common dividend.

With that said, here are my five picks:

• Average dividend yield: 3.5%
• Average weighted dividend growth rate: 15.9% (skewed by RIO)

Here's the overview of the individual stocks:

Caterpillar - Diversified Machinery

Caterpillar was one of the first holdings of my dividend growth portfolio. Located in Texas, Caterpillar is one of the most diversified ways to gain access to global mining and construction. As I wrote in my most recent Caterpillar article , the company is highly correlated to metals (like copper and gold) yet outperforming commodities on a long-term basis. After all, CAT is a dividend aristocrat and capable of long-term buybacks and margin enhancements. It's one of the reasons why I wanted to hold CAT in my long-term portfolio, despite the fact that it will underperform in times of slow inflation and weakening economic growth. Currently, CAT is performing well due to high commodity prices and solid demand for metals, especially in light of the ongoing energy transition (as explained in my aforementioned article).

The company has an A-rated balance sheet.

Stock number two is similar, yet in a different stage of the value chain.

Rio Tinto - High-Yield, Diversified Operations

Rio Tinto is an Anglo-Australian multinational and the world's second-largest metals and mining corporation. Founded in 1873, the company has well-diversified mining exposure and the goal to distribute between 40% and 60% of its earnings through dividends.

In 2022, the company generated sales in the following segments:

• Iron ore: 56% of total sales.
• Aluminum: 25%
• Minerals: 12%
• Copper: 12%

Please note that the numbers above total 105%. The difference of 5% is reconciliation and inter-segment sales.

The company is not a consistent dividend grower. With RIO, the situation is clear. Higher commodity prices translate to higher dividends. Lower commodity prices lead to a lower dividend. Hence, I would only buy RIO on weakness.

Just like Caterpillar, Rio has an A-rated balance sheet.

Chevron - Reliable Oil Income

Chevron is one of the best ways to get exposure to oil and gas without taking big risks. This California-based oil major is one of the companies that is now spending more on shareholder distributions than capital expenditures.

Last month, the company explained that it is targeting 3% annual oil production growth through 2027. The company expects annual free cash flow to be greater than 10% at $60 brent and raised its buyback guidance range from $10 billion to $20 billion annually! In other words, the company is set to buy back more than 6% of its shares per year - even at subdued oil prices.

Its dividend is consistently growing. Chevron is a dividend aristocrat with a decent yield and a credit rating of AA-. While I could have gone with plenty of other energy stocks, Chevron stands for reliability and consistent income for investors.

Linde - Diversified Chemicals & High Growth

Founded in Germany in 1879, Linde has become the world's largest industrial gas company by market share and revenue. 86% of its revenue is generated from industrial gases. 8% of sales are generated in engineering.

Only 32% of total sales are generated in the United States, as the company has a big footprint in fast-growing markets where demand for chemicals is rapidly growing. This includes hydrogen applications, healthcare, food and beverages, electronics, metals and mining, and so much more.

While the company is not a typical commodity stock, it has several benefits that protect investors against inflation.

• Pricing power : Linde operates in the industrial gases sector, which is a relatively stable industry with high barriers to entry. The company has significant pricing power because of the essential nature of its products.

• Long-term contracts : Linde typically enters into long-term contracts with its customers, which helps to provide a predictable revenue stream.

• Diversification : The aforementioned revenue breakdown per product category and region helps Linde to mitigate the impact of any downturns in a particular industry or region.

• Growth potential : Linde has a strong track record of growth through both organic investments and acquisitions. This can help to drive earnings growth and provide a hedge against inflation.

Linde is also a dividend aristocrat with an A-rated balance sheet.

Deere - Outperforming Agriculture Growth

Deere is one of my all-time favorite commodity-related stocks. I would even make the case that it's one of my all-time favorite dividend growth stocks. This Illinois-based machinery producer has a number of tailwinds, as I wrote in a recent article (one of many).

• The company benefits from high agriculture crop prices.
• Agriculture supply is expected to underperform demand on a long-term basis, creating a rising supply gap, which is putting a floor under prices.
• Higher prices allow farmers to replace old equipment.
• Moreover, because of tight supply, new technologies are needed to maximize yields.
• Deere is the leader in next-gen agriculture technology, with machinery allowing farmers to cut costs and boost output when it matters most.

The company is gaining market share in key segments like large agriculture and benefiting from tremendous pricing power fueled by higher spending power from farmers, good machinery, and the ability to mitigate rising production costs.

While DE has a low yield, it has high historical dividend growth, an A-rated balance sheet, and stock price outperformance in times of agriculture bull markets.

Deere is not a dividend aristocrat, as it tends to keep its dividend unchanged in times of subdued machinery demand.

These Stocks Do The Trick

While commodity-related stocks increase volatility, these five stocks improve the risk/reward, average yield, and total return.

When put together, we have a mix of stocks that cover energy, agriculture, metals, and chemicals. We also have Caterpillar, which is connected to most of these industries.

With that said, I would not sleep well if these stocks were the only holdings in a portfolio. After all, we're dealing with inflation stocks. Also, that wasn't the point of this article.

The point was to improve the "average" portfolio by adding dividend stocks that add value when inflation rises.

In the overview below, we compare two portfolios.

• 100% S&P 500 ETF ( SPY ) . I'm using this portfolio as a benchmark.
• 70% S&P 500, 30% inflation protection . In this portfolio, we give each of our inflation stocks a 6% weighting.

Going back to 1994, the S&P 500 has returned 9.6%, which is more than decent. The standard deviation during this period was 15.2%. However, when adding the aforementioned five inflation stocks, the annual return rises to 11.7%. Moreover, while the standard deviation also rises, the Sharpe Ratio (volatility-adjusted return) improves. So, while we add more volatility, we improve the overall portfolio performance.

This is the performance breakdown per portfolio holding:

With that said, the overview below shows that in times of high inflation, the inflation-protected portfolio does much better. Especially in the early 2000s, the portfolio consistently outperformed the market. In 2009 and 2010, it outperformed again. The same happened in 2016 and 2017. In 2022 the portfolio outperformed by a wide margin. However, it was still down, as 30% inflation protection was not enough to offset the entire S&P 500 decline.

Moreover, the lower part of the overview above shows that the inflation-protected portfolio outperformed the market in every time interval. Volatility was barely higher.

That said, our theoretical framework fits perfectly. The inflation-protected portfolio did not outperform during recessions. During the Great Financial Crisis, it sold off close to 50%. In 2016, it sold off more than the market due to a recession in manufacturing and commodities. In 2020, it also sold off as much as the market.

In other words, we have a portfolio that - historically speaking - is able to outperform the market throughout cycles, thanks to better performance during years with high inflation. It's the opposite of low-volatility portfolios that tend to outperform because of downside protection.

In addition, it is crucial to note that this strategy enables investors to avoid active market trading. It is a low-maintenance, long-term approach that is perfect for mitigating inflation risk. It is the ideal buy-and-hold method for investors looking for a hassle-free investment option.

A Few Words Of Caution

Let me reiterate some key points that have already been highlighted. To begin with, there is no assurance that these five picks will shield your portfolio from inflation. Nevertheless, based on their fundamental data and historical analysis, the likelihood of these stocks being effective inflation protectors is very high. Additionally, there are other stocks that are equally suitable for hedging against inflation, which we will explore in future articles.

It's important to note that this is not a recommendation to purchase all of these stocks. The aim of this article is to provide food for thought. Every portfolio is unique, and my objective was to demonstrate that it's feasible to incorporate inflation protection without resorting to complex derivatives. These five stocks offer a reasonable average yield, strong balance sheets, and traits that can enhance the risk/reward of conventional diversified portfolios.

Takeaway

This article explored methods for minimizing the impact of inflation on investment portfolios, beginning with a theoretical framework suggesting that a diverse collection of commodity futures is the best approach. From there, we discussed five companies that are linked to commodities, offering high-quality balance sheets, strong competitive advantages, attractive dividend yields, and the potential to protect portfolios against inflation while enhancing risk/reward for diversified portfolios.

I can attest that three of the five stocks discussed have been extremely valuable additions to my own portfolio over the past year, reinforcing the study's findings. Moving forward, we will continue to examine methods for mitigating inflation risks and strategies for portfolio management.

Moreover, it's important to keep in mind the cautionary notes above.

In the comment section, please share your thoughts on how you are addressing inflation concerns in your own investments. Are these picks appealing to you, or would you take a different approach?

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