LMT - Surviving Inflation: 5 Perfect Dividend Stocks To Get The Job Done

2023-04-03 07:30:00 ET

Summary

• In this article, we start with a discussion of the importance of inflation protection (in light of current developments) and things to consider before researching individual stocks.
• I then present five dividend stocks with stellar balance sheets, wide-moat business models, consistent and high dividend growth, and the unique ability to offset high inflation.
• Historically speaking, these stocks have outperformed the market on a long-term basis and done very well in times of accelerating inflation. I expect that to continue.

Introduction

In this article, I want to do a number of things. First of all, I want to discuss inflation. The market is now betting on an end to the Fed's hiking cycle, as market participants believe it is unlikely that the Fed can keep hiking in the current situation of weakening economic growth and stress on the financial sector. Unfortunately, it looks like inflation will remain sticky, causing policymakers in both the US and EU to prepare the market for more hikes. Second, in light of these developments, I want to highlight five dividend stocks that can help you protect your portfolio against uncertainty and high inflation. The stocks have top-rated balance sheets, wide moats, decent yields, consistent dividend growth, and the ability to outperform the market on a long-term basis and especially in times of elevated inflation.

So, let's get to it!

Inflation: Too High And Very Persistent

We're past peak inflation. Inflation peaked slightly below 9% in June 2022. Unfortunately, inflation hasn't come down as quickly as some might have hoped.

There is immense pressure on the Federal Reserve to take swift action against inflation. This is because maintaining elevated interest rates over a long period of time can create a significant strain on discretionary spending and the financial system, which has become accustomed to low-cost financing. This is also contributing to the current weakness observed in the financial sector.

Hence, Federal Reserve Governor Philip Jefferson made the case that the Fed isn't at its goal, meaning there's room for more hikes.

The current inflation rate is too high. It is the goal of the Federal Open Market Committee to get it back down to 2%, in a way that is sooner as opposed to later," he told an audience Monday at Washington and Lee University in Lexington, Virginia. "It is going to take some time because there are components of inflation that have turned out to be quite persistent - for example, services excluding housing.

ECB President Christine Lagarde made a similar case. In the Euro Area, inflation has come down while core inflation keeps making new highs, showing that inflation has worked its way through the system.

The ECB still has "ground to cover" to bring inflation back to 2% over the medium term, Lagarde told students in Florence, Italy, on Friday. Nevertheless, the 350 basis points of interest-rate increases since last July "is beginning to work," she said.

Lagarde reiterated that the recent financial-market stress won't interfere with the fight against elevated prices, and said Deutsche Bank shouldn't be compared to the downfall of Credit Suisse Group AG.

Based on this context, investors are now betting on the return of inflation in a scenario where the Fed is forced to pause due to banking woes and economic weakness.

Essentially, major investors are now pushing for inflation-protected bonds.

BlackRock Investment Institute strategists, including Wei Li, have written that inflation is likely to remain stubbornly high, even if the Fed expects it to be transitory (unless there is a deep recession). As a result, the investment implication is to be overweight inflation-linked bonds on a tactical and strategic horizon.

Moreover, according to Roger Hallam, Global Head of Rates at Vanguard Asset Management, the Fed faces the challenging task of bringing inflation back to its 2% target.

My personal opinion is that inflation will remain elevated on a long-term basis. Key aspects of my research are food inflation, supply chain issues, and shifting energy fundamentals. I believe in multiple waves of inflation, dependent on the hiking/easing cycle of the Fed and global economic demand.

Hence, when I started to put (almost) all of my money in dividend growth stocks in 2020, I mainly focused on value stocks that would get me the outperformance I needed in such a situation.

Now, let me share five fantastic dividend growth stocks with you. I own some of them and believe they are tremendous additions to any dividend (growth) portfolio, regardless of your age or financial goals.

What Are We Looking For?

Overall, stocks can be an effective hedge against inflation to safeguard your wealth. However, this may not hold true in every scenario. During the previous year, as inflation began to surge, only a few stocks outperformed. Those stocks that carried duration risk showed poor performance, such as growth stocks, which became less attractive due to higher inflation and rates. When inflation is expected to stay high, investors tend to choose stocks that produce immediate value rather than waiting for future growth. Growth stocks become more attractive when investors can incorporate lower rates into their valuations.

Hence, for the first time since the early 2000s, value stocks started to outperform growth stocks with a wide margin in 2021.

With that said, investors need to incorporate a number of factors in their research when looking for suitable investments.

• Look for companies with pricing power : Companies that are able to pass on price increases to consumers are better equipped to navigate an inflationary environment. Look for companies that have a strong brand, a loyal customer base, and a competitive advantage in their industry. This especially applies to consumer stocks, as consumers tend to go with cheaper brands in times of high inflation.

• Consider companies in sectors that are less affected by inflation : Some sectors, such as healthcare and utilities, are less impacted by inflation because they provide essential goods and services that people need regardless of the economic environment.

• Avoid companies with high debt levels : Companies with high levels of debt may struggle to maintain dividend payments during periods of high inflation. Look for companies with strong balance sheets and manageable debt levels. Even if some companies with high leverage ratios have hedged most of their variable rates and have no imminent maturities, investors might still punish these companies, as risks of prolonged high inflation are still an issue.

• Consider dividend growth stocks : Companies that have a history of increasing their dividends over time may be better positioned to maintain their dividend payments during periods of high inflation. Also, consistently high dividend growth protects your dividends against inflation.

With that in mind, here are the five stocks that I admire and trust to get the job done.

The 5 Dividend Stocks To Get It Done

In almost every article that includes multiple stocks, I mention that multiple roads lead to Rome. Below, I listed just five stocks. While I believe that these stocks are great examples, the list could have been much longer.

• Average portfolio dividend yield: 2.9%
• Average weighted portfolio dividend growth: 8.6%

Also, all stocks in this article meet a number of requirements. You can check this yourself using a stock screener (like Yahoo Finance).

• A net debt ratio of less than 2.5x EBITDA.
• At least 15 years of consecutive annual dividend growth.
• A forward dividend yield of at least 2.5%
• Being headquartered in the US.

Chevron

As you can see, I picked just one commodity stock. Chevron, one of the world's largest oil and gas companies, has a dividend yield of 3.7% and 5.8% average annual dividend growth over the past five years.

As I discussed in a similar article last month, the best place to be during times of inflation is the commodity space. Historically speaking, commodities are the place to be when prices heat up. That makes sense, as commodity players have tremendous pricing power.

Chevron isn't different.

The company experienced a significant increase in oil and gas prices in 2022, resulting in buybacks and dividends totaling almost $20 billion. In the United States, all major players in the industry distributed more cash than they invested in CapEx last year.

Chevron, with an AA- balance sheet, plans to maintain an annual CapEx of $13 to $15 billion through 2027 and increase oil and gas production by 3% per year. At $60 Brent, the company anticipates generating enough free cash flow to repurchase shares worth up to $20 billion per year. This is expected to come with improving dividend growth.

Due to its sound balance sheet, high dividend yield, consistent dividend growth (even during recessions), and smart management focused on future energies rather than low-margin projects like wind and solar power, I have included the stock in my dividend growth portfolio.

The reason why I didn't go with more commodity stocks is that I wanted to go with stocks that also perform well in times of falling inflation. I wanted to create a mini stock selection that protects investors against inflation, yet it doesn't mean investors depend on high inflation to make money. That is absolutely crucial in long-term investing.

Lockheed Martin

Lockheed Martin wasn't an obvious pick for one major reason: fixed-price contracts. For example, in 2022, the company had net sales worth $66 billion. $41 billion was provided by fixed-price contracts. As the name already suggests, prices are fixed. Only $25 billion worth of sales came from cost-reimbursable contracts.

This is what the company said about high inflation in its latest 10-K:

If inflation remains at current levels for an extended period, or increases, and we are unable to successfully mitigate the impact, our costs are likely to increase, resulting in pressure on our profits, margins and cash flows, particularly for existing fixed-price contracts. For new contract proposals, we are factoring into our pricing heightened levels of inflation based on accepted DoD escalation indices and other assumptions, and in some cases seeking the inclusion of economic price adjustment (EPA) clauses, which would permit, subject to the particular contractual terms, cost adjustments in fixed-price contracts for unexpected inflation.

The company is making the case that high inflation is an issue. That is correct. However, and this is why I included LMT in this article, the company has the option to get cost adjustments in fixed-price contracts for unexpected inflation.

After all, Lockheed is more than just a defense company. It is also the backbone of NATO defense forces and the head of a supply chain that involves thousands of companies and millions of employees (indirectly related to the supply chain). Hence, it is beneficial to the US government that Lockheed doesn't suffer from high inflation as it works its way through the entire supply chain.

Hence, the 2023 defense budget was all about including the impact of inflation. The same goes for 2024, as discussed in the National Defense Magazine .

During the previous budget cycles, Congress has criticized the president's requests for being inadequate to address modernization needs for a peer-adversary fight and to cover inflation. Congress added $46 billion to the president's 2023 defense budget request.

With that said, another benefit that comes with owning Lockheed is buying an anti-cyclical business model that is unlikely to suffer from lower orders during economic turmoil. If anything, higher orders are likely, as governments can use defense spending to support manufacturing during recessions (again, because of the supply chain behind LMT).

Thanks to these benefits, LMT has consistent dividend growth, a decent yield, and a low-volatility profile, as we'll discuss in the next part of this article.

The company also enjoys an A- balance sheet.

Johnson & Johnson

Johnson & Johnson is extremely boring. However, when it comes to investing, that's a good thing. The company has a fortress balance sheet, enjoying an AAA rating.

Thanks to its healthcare operations, the company has pricing power and anti-cyclical demand. In addition to growth factors like an increasing global population and higher spending on premium brands (especially in emerging markets), Johnson & Johnson has the ability to use pricing to offset high inflation.

Over the past five years, operating margins have remained consistent, hovering between 24.0% and 26.0%.

This is what Seeking Alpha contributor Jonathan Weber wrote last month:

This resilient business model was showcased again and again in the past, including during the Great Recession. Between 2007 and 2010, Johnson & Johnson did not have a single year of negative earnings per share growth. Instead, earnings per share rose every year in that time frame, by 5% per year on average. That was a very strong showing, considering many other companies ran into major trouble during that especially harsh economic downturn. Of course, since JNJ's earnings per share kept rising, the company did not have any problem covering its dividend and could keep its dividend growth track record in place.

Moreover, the company has consistent and sustainable dividend growth.

On top of that, shares are attractively valued. Shares are close to their 52-week low, trading at just 12.3x NMT EBITDA.

The next stock is similar. It may not be a healthcare stock, but its business is almost equally anti-cyclical.

PepsiCo

PepsiCo was one of the first holdings of my dividend growth portfolio in 2020. It didn't take me long to decide which defensive stock I wanted to add. The company competes with companies like Coca-Cola (KO) in the soda business and dominates the snack aisle thanks to successful products like Cheetos, Doritos, and others.

Thanks to the anti-cyclical nature of its business and loyal customers, the company has used pricing to offset volume weakness. In 4Q22, for example, the company saw a 1% decline in volumes. However, organic revenue growth was 15%. This was the result of a 12% growth rate in price/mix, which reached almost 30% in LATAM.

In addition to an A+ balance sheet, a 2.5% dividend yield, and a sustainable payout ratio, the company has consistent dividend growth, protecting investors (the dividend and capital gains) against inflation.

The next stock is a tech company.

Texas Instruments

Headquartered in Dallas, Texas, Texas Instruments has turned into a semiconductor giant with a market cap of more than $170 billion.

Founded in 1930, the company designs and manufactures a range of semiconductor products, including analog and digital signal processing chips, microcontrollers, and sensors, that are used in a variety of industries, such as automotive, communications, computing, and industrial equipment. Texas Instruments is also known for its graphing calculators, which are popular among students (including myself) and professionals.

Texas instruments is a technology stock, which adds a unique twist to this tiny 5-stock portfolio. However, it's also a dividend growth stock with 17 consecutive years of dividend growth, a dividend yield close to 3%, and a payout ratio of less than 50%. Five-year average annual dividend growth is at 16%.

What makes TXN so powerful in times of high inflation is a mix of factors. One of them is the fact that Texas Instruments is not a typical growth stock. While it benefits tremendously from growing technology adoption in industrial, automotive, and personal use end-markets, it is already profitable, which sets it apart from a wide range of startups and growth stocks that aren't able to offset costs. This is great for times of rising rates and higher inflation.

The other reason is the quality of the company's products. As discussed in its most recent earnings call, the company's customers do not pick Texas Instruments because of its prices. Some companies are able to boost prices as customers value the products and services it brings to the table.

And so pricing just to comment on that, I'd say that there's nothing unusual going on with pricing. As you know, pricing doesn't move quickly in our markets, our practices and pricing though I know that they've changed with many of our peers, our practices have not changed. We just continue to price aggressively in the marketplace, but pricing isn't the reason why customers choose our product. There's usually not the top few reasons why they choose our product. So really no changes on that front. So thank you for those questions, and we'll go to the next caller.

- Dave Pahl (TXN Head of Investor Relations)

Some Historical Proof

Ok, this is the part where we incorporate the survivor bias. Backtesting these stocks comes with a survivor basis, as we know that these companies have performed well in the past. However, I believe that they will continue to perform well based on their business models and ability to do well when inflation is high and/or accelerating.

With that said, going back to 1986, this (equal weight) portfolio has returned 15.2% per year (including dividends). This is well above the 10.6% annual return of the S&P 500. The standard deviation was 16.0%, which is slightly above the market's standard deviation of 15.4%. I'm not surprised by that, as a fifth of this portfolio consists of oil (Chevron). Yet, the risk-adjusted return is still much higher, as shown by a 0.78 Sharpe Ratio.

On top of that, the max drawdown of this portfolio is 37%. The worst year is -25%. This is pretty good and confirmation that these stocks do well, in general. As I mentioned in this article, this was very important to me, as I don't want to build a portfolio that turns into dead money the moment inflation peaks.

As we can see above, in 2022, this 5-stock portfolio beat the market by a wide margin. The same happened prior to the Great Financial Crisis when inflation ran hot (2004-2007) and in both 2016 and 2017 when inflation accelerated again.

To put it differently, although inflation hasn't been a significant concern since the 1980s, there have been instances of rapid inflation in the market since then. Whenever this occurred, the mentioned portfolio safeguarded its investors against the negative impact of inflation.

Takeaway

In this article, we started by discussing why the market is preparing for a rebound in inflation and an overall prolonged period of above-average inflation. Based on that background, I covered a number of things investors need to be aware of before picking stocks for the fight against inflation. This includes being careful and not going overweight in commodity stocks. After all, the goal is to hold stocks for multiple decades.

Based on that context, I presented five dividend stocks with the ability to beat inflation when it matters most. All of these stocks have great wide-moat business models, healthy balance sheets, and a few aspects that allow them to do well, even when inflation is high.

Data/backtesting shows that these stocks got the job done in the past, and I have little doubt that they will continue to get the job done in the future, which is why I wrote this article.

While there is no need to copy this mini portfolio, I believe that investors benefit by holding one or multiple stocks from this selection.

Let me know what you think of my thesis on inflation and my stock picks. I look forward to your opinion.

For further details see:

Surviving Inflation: 5 Perfect Dividend Stocks To Get The Job Done