Markets are in turmoil. Volatility is high and the Fed is in a tough spot.
In addition to discussing macroeconomic developments, I explain my strategy and thought process when it comes to buying quality dividend growth stocks.
I highlight five dividend growth companies that I believe offer a great risk/reward and terrific long-term value.
Introduction
Last week, I started to invest some of the cash I had been saving since the start of 4Q22. As most readers know by now, I had, and still have, a somewhat bearish view of the market, as I believe we're dealing with a very tricky situation caused by persistently high inflation and weakening economic growth. As markets have been in turmoil lately, I decided to pull the trigger on a number of investments I had on my list. I somewhat aggressively added to five of my favorite holdings, which I believe will be key drivers of potential outperformance in my portfolio.
In this article, I will walk you through my thought process and explain which stocks I bought and why I bought them.
So, without further ado, let's dive straight in!
Macroeconomic Turmoil & Risk/Reward
I started investing in 2011. So, when I say this is the most challenging market environment I have ever witnessed, it needs to be taken with a grain of salt.
Earlier this month, I wrote an article focused on the tricky economic situation we're currently in, including the role of the Federal Reserve, which is dangerously close to making a major policy error. Or, as some call it, breaking something.
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The market is in an incredibly tough spot.
On the one hand, we have declining economic indicators pointing to a recession. One of them is the yield curve, which indicates a high probability that the United States will enter a recession in the next 12 months.
Societe Generale (Via Twitter @DisruptorStocks)
We also have regional manufacturing surveys that hint at the steepest decline in output since the 2015 manufacturing recession (ignoring forced lockdowns in 2020).
Bloomberg
On the other hand, we have sticky inflation.
In February, core prices increased by 0.5% versus January. Core prices were up 5.5% versus February 2022. Not only did core prices come in higher than expected, they even accelerated over the past three months.
“February’s CPI report shows that inflation is not vanishing quickly, and there remains a compelling need for the Fed to continue raising rates. A 25-bp move would be appropriate at the March FOMC meeting, followed by a couple more until the Fed reaches a terminal rate of 5.25%.”
Based on these developments, my thesis has been that markets underestimate how hawkish the Fed needs to become to fight inflation. When adding declining economic growth, I expected the stock market to hover between the low-3,000 and mid-4,000 range for an extended period of time. After all, the better market sentiment would lead to easing financial conditions and higher inflation expectations. That would eventually reduce sentiment. At low prices, the opposite would occur. Tight financial conditions reduce inflation expectations, hence the hope that the Fed might be done hiking. That creates new buying opportunities.
With that said, the market has gone sideways since the summer of 2022, falling as low as 3,600 and recovering as far as 4,300. Earlier this year, it looked like my thesis was wrong, purely based on sentiment and the belief that inflation was quickly abating.
StockCharts
Unfortunately (for the market), that was not the case. The Fed remained hawkish while higher rates started to pressure the financial system. Now, we're back at 3,900.
Based on this context, I haven't invested any major cash since the October lows of 2022. While I have reinvested dividends and made some minor changes, I increased my cash position to roughly 15% of my total net worth. That was not based on selling, only on increasing my savings rate. I was not a net seller of stocks.
Now, that number is back below 10%.
So, why did I buy with stocks well above the lower bound of my expected trading range?
As you will find out, I bought stocks that underperformed the market due to cyclical risks and/or developments tied to interest rates.
While I still believe that the market is in for more weakness, I liked the long-term risk/reward of these investments. After all, as I invest in long-term dividend growth stocks, I am more afraid of missing out on upside potential than 15-20% more downside in a worst-case scenario. Let's assume I'm wrong and markets bottom at current prices. I'm left with a bunch of cash while watching my favorite stocks take off. Again, I don't believe that this will happen, but it's a risk I'm not willing to take - at least not with all of my cash.
Moreover, I did wait for a better entry. Everything I bought was trading at attractive prices. This doesn't guarantee that the bottom is in, but it does sweeten the deal (risk/reward)
This was the main rationale behind my decision to start buying. If stocks continue to fall, I will deploy the remainder of my cash and increasingly hunt for stocks that I love to buy on severe weakness (as discussed in this article ).
So, now let's discuss my investments.
Buying More Rails
I added to Union Pacific ( UNP ) and Norfolk Southern ( NSC ).
File this under promises made, promises kept, as I said that I would buy both UNP and NSC close to their October lows, which is what I did.
I now have 16% railroad exposure, which makes it the second-largest industry in my portfolio. Two of them are American Class I railroads UNP and NSC. UNP has a duopoly in the West with its Buffett-owned peer BNSF, the other has a duopoly in the East with its peer CSX Corp. ( CSX ).
On top of cyclical headwinds, both are struggling. As I discussed in a recent article , UNP is under fire from activist investors as it has become one of the worst-run railroads in the US, lacking safety, operating efficiencies, and volume growth. Norfolk Southern is also struggling. It's behind the East-Palestine train derailment, and it's under pressure from terrible consumer sentiment, pressuring intermodal freight. I discussed these developments in this article .
While none of this sounds promising, there is good news. Both railroads have terrific track records when it comes to shareholder returns. Moreover, none of them deal with issues that cannot be solved. If anything, they offer us terrific buying opportunities.
While EBITDA estimates are subject to change, UNP is trading at 12.0x NMT EBITDA. NSC shares are trading at just 10.3x NMT EBITDA. None of these valuations are deep value, but both offer a decent risk/reward.
TIKR.com
Moreover, as the chart below shows, NSC has priced in a lot of economic weakness. The same goes for UNP. However, adding another chart would have made the overview too messy.
The lower part of the chart below shows the ISM manufacturing index (the black line) and the total stock price decline from its all-time high. While there's room to the downside if we enter a full-blown recession, the risk/reward is becoming quite good at these prices.
TradingView
Furthermore, both UNP and NSC have terrific dividend scorecards, scoring high on safety, growth, yield, and consistency.
Seeking Alpha
UNP has hiked its dividend for 16 consecutive years. It yields 2.7%. The payout ratio is below 50%. The average annual dividend growth rate of the past five years is close to 15%.
NSC has hiked its dividend for 6 consecutive years. It yields 2.7%. The payout ratio is below 40%. The average annual dividend growth rate of the past five years is close to 15%.
So, while I do not know for sure if NSC and UNP have bottomed, I like the risk/reward. A lot of weakness has priced in, and potential business improvements (forced by activist investors?) could add significant growth potential.
On top of that, both benefit from supply chain re-shoring, labor shortages in trucking, and the fact that rail transportation is climate-friendly compared to long-haul trucking.
Buying Consumer Exposure
I added to Home Depot ( HD ), despite severe consumer weakness.
This is what consumer confidence looks like:
University of Michigan
This is what growth (contraction) in building permits looks like:
Federal Reserve Bank of St. Louis
While we are seeing some improvements, the two pillars that drove Home Depot's rapid growth in the past decade are gone. High rates and related economic uncertainty have undermined consumer confidence and weakened one of the strongest sectors to be prior to 2020: consumer discretionaries.
Given my view on the economy, these things can get worse. However, they also provide us with great buying opportunities.
HD shares are trading more than 30% below their all-time high. This is the worst sell-off since the Great Financial Crisis.
Some readers may recall that I sometimes write that I am extremely picky when it comes to buying consumer stocks. A lot of consumer stocks are dependent on consumer trends. As I'm not in the business of predicting what consumers might fancy a few months/years from now, I stick with companies that don't necessarily deal with these issues.
Home Depot has a major footprint in the do-it-yourself space, it has perfected its supply chain operations, and its business model comes with great pricing benefits.
That said, the aforementioned economic challenges and the fact that a lot of consumers improved their homes during the pandemic have caused a scenario of flat EBITDA on a prolonged basis.
TIKR.com
The good news is that HD's attractive valuation makes up for these issues.
HD shares are trading at 12.9x NMT EBITDA, which is a good price.
According to the Yardi Matrix February self-storage report , self-storage rates in the United States are starting to go back to normal after reaching record highs during the summer of 2022. However, this is a typical seasonal slowdown that the industry isn't worried about because there has been a consistent increase in demand over the past few years.
In fact, the report found that more households are using self-storage than ever before, with approximately 14.5 million households using self-storage in 2022. This is up by around 970,000 since 2020. The Self Storage Association conducted the latest demand study and found that the percentage of households using self-storage increased to 11.1% in 2022, up from 10.6% in 2020 and 8.95% in 2005.
Overall, the self-storage industry appears to be in good shape and well-positioned to handle any potential economic issues in 2023 due to the record demand for their services.
EXR currently yields 4.1% after hiking its dividend by 8% last month. Over the past five years, the average annual dividend growth rate was 14.4%. The company has 12 consecutive years of hikes after cutting its dividend during the Great Financial Crisis. The adjusted funds from operations payout ratio is 77%, in line with the sector median.
On top of managing a very healthy balance sheet with 65% fixed-rate debt and an average weighted interest rate of just 4.1% with 5.1 years to maturity, the company is trading at 19x full-year core FFO, which is attractive.
An Honorable Mention
I added to Danaher ( DHR ), but not as much as I would have liked.
In this article, I mentioned another article that contained a number of stocks I wanted to buy on more severe weakness. One of the stocks mentioned in that article is Danaher, a fast-growing healthcare supplier with an ultra-wide moat, strong pricing power, and fast dividend growth (yet a low dividend yield).
Danaher Corporation
In this case, it's just an honorable mention, as I only reinvested some dividends. The other stocks mentioned in this article were bought way more aggressively.
However, I still wanted to update readers on this move and, once again, highlight the company's ability to generate outperforming returns with subdued volatility.
The good news is that Danaher continued to be a terrific source of wealth. When looking at the numbers below (January 1988 - February 2023), we see that DHR has returned 20.3% per year. This performance has remained consistent. Over the past ten years, the stock has returned 20.3% per year. Over the past three and five years, the return has remained close to 20%.
Portfolio Visualizer
Moreover, the company has done this with subdued volatility. Over the past five years, the annualized standard deviation was 23.8%. That's slightly more than 500 basis points above the market's standard deviation. That might sound lit a lot. However, that's not the case. We're comparing a single company to a well-diversified basket of 500 stocks.
Takeaway
Bear markets aren't fun. They test how much we trust our investment process and often cause our portfolio value to decline. However, as I trust my process and my 21 dividend growth stocks, I haven't had a bad night of sleep in a very long time. At least not related to the market, that is.
If anything, investors need to embrace weakness, as it's the only way we get to buy great companies at great prices.
In this article, I highlighted five investments in the dividend growth space that I bought last week. I bought them quite aggressively, as I spent more than half of my available cash on them.
While I'm far from sure that I bought the bottom, I do like the risk/reward and will continue to use this strategy.
Going forward, we'll continue to discuss other attractive picks and a variety of investment strategies. So don't hold back in the comment section and let me/us hear your thoughts!
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