As interest rates have risen in 2022 and inflationary pressures have grown, investors have cooled on high-flying aggressive growth stocks. Combining this backdrop with recent equity market volatility, investors have brought dividend equities back into focus. The investing landscape is always changing but investing in periods of inflation will involve more diligence and selection than in years past. As a category, dividend growth has demonstrated resilience, and the utility to a portfolio allocation could be growing in value.

To illustrate this further, we have compared the total return of the Russell 1000 Growth (R1000G) vs. the Russell 1000 Dividend Growth (R1000DG). While the two indices might share some companies in common, the dividend growth index only focuses on dividend payers and requires a demonstrated and consistent dividend growth annually over a minimum ten-year period. To help capture sentiment, we utilized Google Trends² which displays the keyword search activity frequency in Google’s search engine. Taking these all together, we overlaid the period where “inflation” searches became more prevalent.

Interestingly, Federal Reserve Chairman Jerome Powell had a press conference on April 28, 2021. The transcript of the meeting mentioned “inflation” seventy-one times during his meeting¹. Below is one excerpt from his transcript.

 

“Readings on inflation have increased and are likely to rise somewhat further before moderating. In the near term, 12-month measures of PCE inflation are expected to move above 2 percent as the very low readings from early in the pandemic fall out of the calculation and past increases in oil prices pass through to consumer energy prices. Beyond these effects, we are also likely to see upward pressure on prices from the rebound in spending as the economy continues to reopen, particularly if supply bottlenecks limit how quickly production can respond in the near term. However, these one-time increases in prices are likely to have only transitory effects on inflation.”

 

While several factors might be at play, the press conference preceded the 1^st spike in google trends search data shown below. Using a timeframe starting on April 30^th, 2021 we compared performance in Chart 1 of the two Russell 1000 indices through May 31^st 2022.

During this timeframe, the dividend-growth segment not only outperformed the growth segment, but also demonstrated substantially greater consistency and resilience. The resilience is especially evidenced as the frequency of “inflation searches” became more common starting in February 2022 until early May 2022. This segment has been shaded to highlight the corresponding timeline. As shown by the R1000DG total return, investors who favored companies with demonstrated dividend growth would have experienced the desired defensive characteristics when they were needed most.

Ultimately the total return of the R1000DG began and ended the shaded timeframe essentially unchanged and with significantly lower volatility.

 

Chart 1. Russell 1000 Dividend Growth vs. Russell 1000 Growth Total Return Indices. Incorporating Google Trends data searching for “Inflation”

(April 30, 2021 – May 31, 2022)

 

Cashflow is King

Changing inflation expectations created some uncertainty and volatility as investors recalibrated portfolios, rerated valuations, and reassessed their views. While not all growth companies can be judged by the same yardstick, generally the growth segment been impacted by the fact that investor preference has shifted towards cashflow today vs. cashflow in the future. This importance will only grow if inflation is viewed as a growing threat since a dollar today is worth more than a dollar tomorrow.

Bond investors call this very same concept “duration”.  In duration terms, aggressive growth companies act like very long maturity zero-coupon bonds (most interest rate sensitive), where the final payment (earnings) are far off in the future.  During times of uncertainty, investors generally favor cash-flowing businesses as those are the companies that not only survive during tougher times but ultimately thrive during periods of economic recovery.

 

Opportunities in today’s environment

 

The last several years have allowed investors to broadly allocate and index their holdings. However, as the investing landscape changes, company selection will matter even more, especially when it comes to operating within an inflationary environment. The Consumer Discretionary sector has recently seen several large retailers warn of margin compression due to rising transportation costs. Additionally, the defensive Consumer Staples sector has also seen some company’s guiding for lower margins due to risings costs of inputs. While both sectors still have favorable attributes, attractive yield and dividend growth, security selection is key. 

We seek out companies that have pricing power due to maintaining a dominant market position, or they reside in an industry with limited competition, or they possess unique products/services that cannot be substituted. Therefore, we seek out companies in a position to be “price makers” while equally attempting to avoid “price takers”, companies lack pricing power. With security selection criteria constantly in mind, the Financials sector may offer the potential for investors to see rising dividends and lessen impact from rising rates. 

Financials: Rising interest rates should favorably impact the rate-sensitive banks in the U.S. Ultimately rising interest rates will expand their net interest margins (NIM), a key factor for future growth of bank profits. As NIM grows, both earnings and future dividend growth potential will grow. It’s also important to note that most financials are now well-capitalized and undergone regulatory stress tests. 

Ultimately, when constructing a portfolio and selecting companies, the driving factor and emphasis should be on assessing the steps each company is taking to maintain their respective operating margins. Brentview has been paying particular attention as we select businesses in each sector of our portfolio. The attractiveness of each company is ever changing due to competition, consumer behavior, and knock-on effects from the supply chain. While our portfolio requires representation in all S&P 500 sectors, fundamental research and security selection should be key considerations in today’s investment environment.