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Deep Dive: These quality dividend stocks have a built-in advantage that can keep you ahead of inflation in 2022

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Investors keep hearing about rising labor costs and supply shortages that have helped feed inflation. It’s a time for long-term thinking about how to stay ahead — that is, how to avoid losing buying power.

Bill McMahon, managing director and chief investment officer for active strategies at Schwab Asset Management, favors companies that pay dividends and have strong cash flows. In the current inflationary environment, he suggests investors consider companies with very strong brands, such as those in the photo above.

A screen of stocks is below, highlighting several of these companies.

Inflation accelerated to a 5.4% annual pace in September from 5.3% in the previous month, the government reported Wednesday. That’s a 30-year high. Indexes for food and energy rose the most.

“You are seeing pricing pressures across the spectrum — labor shortages and supply shortages,” McMahon said during an interview Tuesday. “We put  lot of that into our own thinking as we position our portfolios.”

With oil and natural gas costs continuing to rise, and supply and labor shortages in various industries, McMahon said that during third-quarter earnings season that begins this week, rising costs will “creep into income statements.”

For some companies, year-over-year earnings comparisons will be disappointing to investors. He said the period of high inflation “may last longer than many people expect,” especially because or the energy supply shortage.

McMahon pointed to consumer staples, which includes some companies that have the strong brands and pricing power he favors right now. This has been the second-worst performing sector of the S&P 500 Index
SPX
so far in 2021:

S&P 500 sector Total return – 2021 Total return – 2020 Total return – 3 years Total return – 5 years Total return – 10 years
Energy 54.7% -34% -9% 0% 22%
Financials 32.5% -2% 56% 119% 357%
Real Estate 26.7% -2% 63% 73% 232%
Communications Services 20.7% 0% 81% 83% 214%
Information Technology 16.1% 44% 121% 253% 646%
Industrials 13.8% 11% 43% 88% 279%
Materials 13.6% 21% 61% 94% 207%
Consumer Discretionary 12.2% 33% 73% 145% 455%
Health Care 11.8% 13% 46% 97% 363%
Consumer Staples 6.5% 11% 47% 56% 204%
Utilities 4.9% 0% 34% 61% 175%
S&P 500 Index 17.1% 18% 66% 123% 341%
Source: FactSet

These returns show how long economic cycles can take to play out. The energy sector has been this year’s strongest performer, as a combination of rising global demand, supply shortages in Western Europe brought about in part by policies emphasizing alternate fuels while millions of homes are still being heated by natural gas, along with supply disruptions and bottlenecks. But the energy sector has also been the worst performer for the 10-year period.

Dividend-paying stocks

McMahon suggested a broad screen for stocks that produced a list that included several companies with brand loyalty and pricing power.

The screen began with the S&P 500, which was narrowed to companies that pay dividends and appear likely to have sufficient cash flow to raise their payouts to investors.

One way to measure a company’s dividend-paying ability is to compare its free cash flow yield with its current dividend yield. Free cash flow is the remaining cash flow after planned capital expenditures. It is money that can be used to do various things that might be good for shareholders, including buying back stock (which lowers the share count and increases earnings and cash flow per share), raising dividends or business expansion.

If we take a company’s estimated free cash flow per share for 2022 and divide it by the current share price, we have its estimated free cash flow yield. If that yield is higher than the current yield, the company appears to have “headroom” to raise its dividend payout.

Note that in this stock screen, we excluded real estate investment trusts (REITs) and financial companies.

Among the remaining stocks in the S&P 500, consensus free cash flow estimates for 22 among analysts polled by FactSet are available for 360 companies. Of those, 265 pay dividends.

McMahon suggested removing the top quintile of those stocks, by dividend yield, to “probably eliminate some troubled companies.” This also removes some slower-growing companies and possibly some that might be more likely to cut their payouts.

“Sometimes really high yields can be somewhat illusory,” McMahon said.

If investors shy away from a dividend stock, its yield will go up. A very high yield may even signal a dividend cut. Here are three stocks with higher yields that were removed from the list:

  • AT&T Inc.
    T
    has a dividend yield of 8.18%. The company hasn’t cut its dividend yet, but said in May it would “resize” the dividend as part of its its divestiture of Time Warner.
  • Lumen Technologies Inc. LUMN (which was known as CenturyLink until a name change in September 2020) has a dividend yield of 8.18% that appears very well supported by an estimated free cash flow yield of 12.26% for 2022. But the company cut its dividend by more than 50% in early 2019. Among the 14 analysts polled by FactSet that cover Lumen, seven have “sell” or equivalent ratings on the stock. Among sell-side analysts — that is, the ones who work for brokerage firms — negative ratings aren’t very common. In fact, among the S&P 500, there are no companies with majority “sell” ratings and only one other (Consolidated Edison Inc. ED) with 50% “sell” ratings.
  • Kinder Morgan Inc. KMI has a dividend yield of 6.02% with an estimated 2022 FCF yield of 9.24%. The company cut its payout by 75% in December 2015.

After removing the top 20% of our list by yield, we were left with 212 companies. We then narrowed it further to the remaining 210 with estimated free cash flow “headroom” for 2022.

Here are the 25 remaining stocks with the highest dividend yields:

Company Dividend yield Estimated 2022 FCF yield Estimated 2022 “headroom”
Clorox Co.
CLX
2.85% 3.04% 0.20%
Invesco Ltd.
IVZ
2.81% 17.33% 14.53%
Whirlpool Corp.
WHR
2.80% 10.37% 7.57%
Baker Hughes Co. Class A
BKR
2.80% 6.85% 4.06%
PepsiCo Inc.
PEP
2.74% 3.82% 1.08%
Cisco Systems Inc.
CSCO
2.73% 6.53% 3.80%
VF Corp.
VFC
2.71% 3.99% 1.28%
Johnson & Johnson
JNJ
2.69% 6.65% 3.96%
Intel Corp.
INTC
2.66% 5.97% 3.31%
Eastman Chemical Co.
EMN
2.65% 8.69% 6.04%
Corning Inc.
GLW
2.64% 6.92% 4.28%
Tapestry Inc.
TPR
2.61% 8.91% 6.31%
Genuine Parts Co.
GPC
2.61% 4.95% 2.34%
Best Buy Co. Inc.
BBY
2.56% 9.44% 6.88%
Cummins Inc.
CMI
2.52% 6.66% 4.14%
ConocoPhillips
COP
2.51% 12.63% 10.13%
ViacomCBS Inc. Class B
VIAC
2.45% 6.05% 3.60%
Procter & Gamble Co.
PG
2.45% 3.75% 1.30%
Ralph Lauren Corp. Class A
RL
2.39% 6.08% 3.69%
CVS Health Corp.
CVS
2.39% 9.99% 7.60%
Colgate-Palmolive Co.
CL
2.38% 4.96% 2.58%
Mondelez International Inc. Class A
MDLZ
2.35% 4.68% 2.33%
General Dynamics Corp.
GD
2.34% 6.37% 4.03%
Caterpillar Inc.
CAT
2.34% 5.70% 3.36%
Archer-Daniels-Midland Co.
ADM
2.33% 5.76% 3.42%
Source: FactSet

Click on the tickers for more about each company. Click here for Tomi Kilgore’s detailed guide to the wealth of information available for free on MarketWatch’s quote page.

If you see any stocks of interest in this article, or anywhere else for that matter, it is important for you to do your own research and form your own opinion before making a purchase.

Even though this screen wasn’t specifically limited to consumer discretionary stocks, many with beloved brands made the list:

  • Clorox Co.
    CLX
    has the highest dividend yield on the list, but the lowest estimated free cash flow “headroom” for 2022.
  • PepsiCo Inc.
    PEP
    made the list, with the Frito-Lay family of snack products in its portfolio, along with its iconic beverage brands. Larger rival Coca-Cola Inc. didn’t make the list, as its higher dividend yield of 3.10% took it out of the screen.
  • Johnson & Johnson
    JNJ
    has a slew of brands consumers are loyal to, including Band-Aids.
  • Procter & Gamble Co.
    PG
    is another consumer staples giant with popular brands, including Tide (whose pods show the appeal of innovation).
  • Colgate-Palmolive Co.
    CL
    — no explanation is needed for toothpaste brand loyalty.
  • Mondelez International Inc.’s
    MDLZ
    snack brands favored by ravenous consumers include Oreo cookies, as well as Cadbury and Toblerone chocolate.

Leaving the list in the same order, here’s a summary analysts’ opinion about the stocks:

Company Share “buy” ratings Share neutral ratings Share “sell” ratings Closing price – Oct. 12 Cons. price target  Implied 12-month upside potential
Clorox Co.
CLX
16% 53% 31% $162.96 $161.47 -1%
Invesco Ltd.
IVZ
43% 50% 7% $24.23 $30.09 24%
Whirlpool Corp.
WHR
50% 50% 0% $199.68 $270.80 36%
Baker Hughes Co. Class A
BKR
87% 13% 0% $25.75 $28.48 11%
PepsiCo Inc.
PEP
52% 44% 4% $156.93 $166.68 6%
Cisco Systems Inc.
CSCO
57% 43% 0% $54.28 $62.85 16%
VF Corp.
VFC
63% 29% 8% $72.30 $93.57 29%
Johnson & Johnson
JNJ
58% 37% 5% $157.69 $186.44 18%
Intel Corp.
INTC
37% 39% 24% $52.17 $61.83 19%
Eastman Chemical Co.
EMN
73% 27% 0% $104.15 $136.15 31%
Corning Inc.
GLW
69% 31% 0% $36.42 $48.23 32%
Tapestry Inc.
TPR
64% 36% 0% $38.38 $53.77 40%
Genuine Parts Co.
GPC
14% 79% 7% $125.14 $130.88 5%
Best Buy Co. Inc.
BBY
43% 47% 10% $109.32 $130.19 19%
Cummins Inc.
CMI
44% 56% 0% $230.14 $280.39 22%
ConocoPhillips
COP
90% 10% 0% $73.41 $79.23 8%
ViacomCBS Inc. Class B
VIAC
48% 37% 15% $39.15 $52.60 34%
Procter & Gamble Co.
PG
52% 44% 4% $142.11 $155.20 9%
Ralph Lauren Corp. Class A
RL
50% 50% 0% $115.06 $142.94 24%
CVS Health Corp.
CVS
77% 23% 0% $83.79 $96.15 15%
Colgate-Palmolive Co.
CL
36% 50% 14% $75.67 $87.11 15%
Mondelez International Inc. Class A
MDLZ
83% 17% 0% $59.67 $71.01 19%
General Dynamics Corp.
GD
63% 26% 11% $203.55 $222.31 9%
Caterpillar Inc.
CAT
42% 50% 8% $189.92 $230.90 22%
Archer-Daniels-Midland Co.
ADM
63% 31% 6% $63.39 $67.77 7%
Source: FactSet

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