Will Dividend Stocks Become the Inflation Trade?

Investors were taken by surprise last week when the US consumer price index rose 5.4% year-over-year in June, the fastest pace seen since August 2008. On a monthly basis, it rose 0.9%. Excluding the volatile food and energy prices, while the Core Consumer Price Index rose 4.5% in June, this was the fastest pace since 1991.

Source: YCharts

There is an argument that the recent rise in inflation is temporary. One prime reason is attributed to the supply constraints due to the pandemic. The sudden rise in used cars and trucks accounted for a major portion of the inflation number, and this was mainly due to the global chip shortage, which reduced the supply of new cars. Used cars and trucks rose 10.5% in June from the previous month, when you compare on a yearly basis, prices rose about 45%.

Last week, we discussed in detail technical signals that suggest the market is not currently concerned with inflation. We see this in the new uptrend in bonds and the collapse of certain economically sensitive commodities. The market is shrugging off inflation fears, for now.

You can read our Portfolio Manager’s July Market Update that discusses this in detail here.

We are prepared to shift our investing thesis if the narrative changes. If inflation is not transitory, this reality will show up in price relations first. For example, if bonds continue down while commodities continue up, this could lead to the FED increasing the Fed Fund rate sooner than expected.

Historically, the rise in interest rates has been negative for equities, which ultimately stops the bull market. Some of the possible reasons are when the discount rate increases the present value of future cash flows will be lower. Another reason is that debt servicing costs for companies with high debt will be higher. The exception will be banking stocks which benefit from rising interest rates.

Even if this happens, history tells us that the time to worry is not when the first rate hike happens, but up to 18 months on average after the yield curve inverts. So, even if rates increase ahead of schedule, history tells us that we still have time for the bull market to run.

It’s important to remember that what causes the cascade of events that leads to a bear market, is the FED reacting to rising inflation. So, the sky-high data regarding inflation is nothing to shrug off completely. If inflation numbers do not subside, the FED will have no choice but to raise rates, and we could be looking to invest in an inflationary environment.

Stocks can make solid investments precisely because they beat inflation in the long-term. On a more granular level, the more traditional thinking here is that dividend stocks are ideal during periods of inflation because of the periodic dividend payouts. Dividends also help to fund your increased expenses due to inflation. While growth appreciation stocks are good in the long term, many institutions will see dividend stocks that have reasonable growth as an important hedge. They will also typically view low debt companies with low debt servicing costs as favorable.

Please note: the I/O Fund is a tech growth portfolio that places an emphasis on growth over profits, and for this reason, the I/O Fund does not currently hold stocks for their dividends. Below, we discuss what inflation trades can look like for a more forward-looking discussion.

Dividend Stocks that Institutions Could Favor for an Inflation Trade

Broadcom Inc. (NASDAQ: AVGO) shares rose 50% in the past year. The company’s revenue growth has been strong as it grew at a compound annual growth rate (CAGR) of 16% in the past five years. It also has a very good profit margin which also plays an important role in the long-term stability of dividend payouts.

The company has a dividend yield of 3.00%. It is comfortably above the US 10-year treasury rate of 1.19%. The company has steadily increased its dividends. The free cash flow from which the dividends are paid is also increasing. In the recent earnings call, the company’s CFO, Kirsten Spears mentioned “Relative to capital allocation, first and foremost, we're dedicated to paying 50% of our free cash flows to our shareholders.” In the recent quarter, it had a free cash flow of $3.4 billion and dividends paid were $1.6 billion.

Intel Corp (NASDAQ: INTC) has a dividend yield of 2.45%. The company raised its dividend in January this year. They increased their quarterly dividend by 5.3% to $0.3475/share. The company had a free cash flow of $1.6 billion in the first quarter of the fiscal year 2022. It also had repurchased $2.4 billion of shares and completed the $20 billion repurchase plan announced in October 2019. The management also assured that they are committed to growing its dividend.

Source: YCharts

Will the rise in interest rates be a concern for the ad-tech industry?

Ad-tech stocks typically have low or no debt. One exception is Magnite, which has a debt-to-equity ratio of 1.13. Magnite accumulated debt when it acquired companies in the past year. More recently it acquired SpotX, a deal that will help to double its CTV business. In the words of Michael Barrett, President and Chief Executive Officer, “We believe the combination is transformative because it immediately gives us critical mass and scale in CTV and more than doubles the size of our CTV business”.

Roku has a debt-to-equity ratio of 0.36. The company’s debt is small and it’s coming down. Interest costs were only $742,000 in the recent quarter when compared to $863,000 in the same period last year. Roku’s revenue in the first quarter grew by 79% year-on-year to $574.2 million. It also added 2.4 million incremental active accounts in the quarter to reach 53.6 million. The company had a net profit of $76.3 million when compared to a net loss of $54.6 million in the same period last year.

Source: YCharts

Looking into the stock returns of the ad tech industry, Roku has been outperforming other companies in the past six months. Recently listed companies like PubMatic and Viant Technology had successful initial trading gains but they have not sustained in the recent months.

Secondary Offerings to Raise Cash

After tech’s historic run last year, many companies have benefited from rising stock prices by tapping secondary offerings. Zoom raised $1.75 billion in January this year by pricing 5.15 million shares at $340 per share. It was able to benefit from the strong share price gains due to the remote working boom. The recent offering was about 10 times its IPO price. Previously the company had issued its shares in the IPO at $36 per share in April 2019. Zoom is a debt-free company.

Shopify raised $1.5 billion by offering 1.18 million shares at $1,315 per share in February this year. The company’s share price grew about 175% during the one-year period before the secondary offering. It had benefitted from the shift to online business during the pandemic.

MongoDB recently raised about $889 million by offering 2.5 million shares at $365 per share. The company has a negative debt-to-equity ratio. Its interest expenses are also high, at $3.7 million in the quarter ending April 30 although down from $13.8 million in the previous year. The stock has a three-year return of 510%. 

Source: Ycharts

Conclusion

Many tech companies have low debt right now with many sitting on decent amounts of cash due to raising cash from secondary offerings. The I/O Fund doesn’t own dividend paying stocks as a strategy, per se, yet it’s good to know what kinds of stocks could be favored by institutions should we see inflation haunt the market and consumer spending environment. Specifically, semiconductor companies like Broadcom which continue to have excellent growth and a dividend yield of 3.00% stand out from the list.

Last week, the Portfolio Manager from the I/O Fund spelled out his thoughts regarding inflation fears. In summary, the market’s quiet rotation back into growth stocks and bonds, coupled with the new downtrend in commodities and defensive names, seems to suggest that the market isn’t as concerned with inflation as retail is. You can read this article here.