What NOT to Invest in During High Inflation & Other Topics

There are many factors to blame for the ongoing bear market. While 2022 appears to have never-ending red days, the topic that hits closer to home is red-hot inflation. It may be challenging to invest in an environment like this, but you will undoubtedly lose purchasing power if you don't. It seems investors are between a rock and a hard place.

In this episode, Greg eases the dilemma of choosing where to put your assets during high inflation. It shouldn't come as a surprise that a growing income stream of dividends is an excellent place to start. Later on, he looks at the market's overall valuation and takes a different approach toward speculation (contrary to what Warren Buffet may say). At the end, we introduce our first official segment, "Right, Wrong, or Who Cares?" to ensure we're staying up to date with our investments.

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Transcript

Greg Denewiler  0:11  
This is Greg Denewiler, and you're listening to another episode of The Dividend Mailbox, a podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.

Greg Denewiler  0:39  
Welcome, everyone to the May episode of The Dividend Mailbox. Today, we've got several topics that we're going to cover. First, we're going to explore the world of inflation and why the dividend strategy works well, and also why some of the other areas of the market don't work so well. Then we'll transition into the market, and since we've had the worst start to the year in decades, (as far as market performance), we'll just examine how the market is priced currently. Then we'll look at Berkshire Hathaway and Warren Buffett, and I'm gonna give you a little different spin on the definition of speculation and what it means to us. And we will wrap up with a new segment: "Right? Wrong? or Who Cares?"

Greg Denewiler  1:30  
So let's look at inflation. Yesterday I was filling up the car, I only put a half a tank of gas in and it cost $40. So it's not fun, whether you can afford it or not, but inflation is definitely here. It may be hard to invest in a high inflationary environment, but if you don't, you're definitely going to lose money because you're losing purchasing power. So as we look at how to invest, let's start with what we don't want to own in a high inflationary environment. Well, the first thing is a fixed-rate investment. Fixed income investments that have a low rate of interest, something like a treasury bond, CD, anything that if you own it for one year or five years, 10 years, it's going to pay the same rate over the life of the investment. Because bond prices move in the opposite direction of yields, the last few months have been very difficult for the bond market. Because interest rates have gone up by a couple of percentage points, the value of bonds has dropped fairly extensively. It's been one of the worst bond markets in several decades. If you would have bought a two-year Treasury three months ago, you were lucky to get a half of 1%. Now a two-year Treasury is well over 2%. So looking back, that half percent doesn't feel too good. And in his current environment with rising interest rates subsequently causing yields to increase, that two-year bond you bought has already declined in value. So if you were to look at your account today, it would show a loss from when you bought it. And if inflation continues to stay up at these levels, that is probably only going to get worse. So even today, if you buy a 10-year treasury, you get roughly 3%. And that is not even close to the inflation rate that we currently have, which depending on which measure you use, is up between six and 8%. But at the gas pump, it's even higher than that. So owning bonds in an inflationary environment is not a very appealing choice. The second thing you probably don't want to own is a highly value growth company. And that is a company that is going to generate its cash years out into the future. And what I mean by that is some of the high technology or some version of a startup where you've got earnings that are several years out into the future. You know, and will they ever earn anything? We're not going to go there, but what happens is these things get discounted. So one way I want to try to illustrate this is just take your mortgage. So if you have a million-dollar house, and you're paying 3% on that mortgage, well, if interest rates go up to 5%, your same income affords a smaller house. Really what you've got there is less value, and when you look at these growth stories, it kind of works the same way. If you're going to receive $1 in 10 years, if interest rates go up, then that $1 is just worth a little bit less today, which is why these high-value growth stocks have done so poorly in the last few months. So you want to stay away from investments that don't pay anything right now and it's all based on the future. The third thing you probably don't want to own right now is lower-quality companies. One of the reasons why the Fed raises interest rates is to get inflation back down and the Fed's target is 2%. What potentially happens is and what the market seems to be afraid of currently, if we go into a recession, because of higher interest rates, you don't want lower-quality investments. At least in my definition, they could have higher debt levels, they could have a very cyclical or unpredictable earnings stream, or they could just be in an industry that is extremely competitive and they have a hard time earning at least their cost of capital. So if we do end up going into a recession, these are the companies that are more likely to become in some form of a distressed situation. When you have a higher dividend, a company that let's say it pays 5%, or 6% 8%, dividend, and it's really not growing, frequently, those investments are a little lower quality. So in a quick summary, what you don't want is a fixed payment, especially a low fixed payment. You don't want low quality, and you probably don't want cash flows that are way out into the future. So one of the things that investors think about is, well, what's the best way to participate in higher inflation? What do you want? It would be commodity prices. But the problem there is when you look at wheat, you look at oil, you look at Gold- there, you're just speculating on what somebody may pay in the future. If you look at Gold, just in the last month- which in the past is usually considered to be a great inflationary hedge- well, just a month ago, it was $1,950 an ounce, and now it's at 1860. At least currently, that's not a very good inflation hedge. Who knows what it'll be in the future, but that's what we try to stay away from, is the who knows. So what do you want? You want a growing income stream. You want quality, consistency, and predictability. And really, that comes with a growing dividend. Because if you have a 3% dividend this year, and that dividend grows to 3.2%, next year 4%, let's say five years out- what's that doing?- it's giving a higher payment. This gives you a better chance of keeping up with inflation. It potentially even can outpace it over the long term because your income stream also has inflation built into it. So investing in a dividend growth strategy is really just another form of investing in inflation. These companies have to be mature, at least on some level. They don't have as much debt. They just tend to be higher quality. 

Greg Denewiler  7:52  
So of course, the problem is, even dividend growers and quality companies can not do well when the broad market is declining. Let's just take a quick look at the overall market and just try to get some feel, is it really still overvalued? Reasonably priced? Or just a feel of kind of where it's at. You know, the S&P 500 since the first of the year is down 16%. Well, that kind of leads you to think or wonder maybe, should I be really worried? And maybe I shouldn't even be in the market right now? Of course, I have to throw out, the only way you can grow your income is you have to own something. So you have to stay invested to have a growing dividend. But then the question becomes, well, do you want to get out and try and get back again? First of all, the S&P 500 right now is around 4000, and earnings for 2021 were a little over $200- $208 a share. So that means the P E of the market right now is 19. The estimate for this year for 2022 is $225. At 4000, that's a P E of 18. And if you look at next year's estimates, they're $248, and that's a P E of 16. Here's the good news. So you're going out 18 months roughly, then you get to a P E of 18, (based on current projections), That's where we've been for the last several decades. And 16, it's the long-term average of the market. And there we're talking 50 years plus. So from this standpoint, we're fairly valued. And I can tell you one thing if you look at interest rates in the last 50 years, they haven't been at 3%, they've been higher. We actually have room for interest rates to go up, and you could say with some reasonable assurance that the market is reasonably valued right now. So overall, a lower PE is better because it just means you're paying less for $1 of earnings. It's human nature to be nervous. I mean the reality is, with few exceptions, probably everybody's nervous. But here's one of the things you have to remember: as the market sells off, that just means you're able to buy that future income stream at a cheaper price. Your future returns are going to be higher. You're investing for a long period of time, we're looking at a 10-year plus time horizon, and that's how we get the value of compounding and creating long-term wealth. The market never stops at reasonable. It either goes above reasonable or it goes below reasonable. So maybe we're gonna go below it for a while. But if you're getting a 3% plus growing dividend stream, that's going to carry you through. And that's part of what you really have to anchor yourself to. 

Greg Denewiler  10:46  
So along the lines of a growing income, and investors who follow that strategy, a big part of Warren Buffett's portfolio generates an income. So it's pretty easy to draw the comparison that he also does the dividend growth strategy. Well, Berkshire Hathaway had their annual meeting a few weeks ago, and this year, Warren Buffett and Charlie Munger got on a rant about speculation. And one of the targets they had was the Robinhood investors and basically referenced them as treating the market as a big casino. What I find really fascinating, if you look at the annual report from last year- 12/31/2021, you know, that a piece of Berkshire Hathaway's portfolio is public companies. It comes in at over $300 billion. But about 45% of it is Apple, and it's by far their largest position. Well, speculation has different meanings to it. Pretty much any financial planner or any advisor would tell you, that it is completely inappropriate to have 45% of your portfolio in one stock. So they bash speculation, but in the last quarter, they put another 600 million into Apple. That in itself is really just another form of speculation. To Warren Buffett and Berkshire Hathaway, he happens to feel comfortable enough with Apple that he's got that much of a concentrated position. The other piece is he's got several private companies that even if Apple dropped 50%, which I'm in no way implying it will, even if it does, he's got other assets to help offset that. Personally, it's just something we can't do. We can't do it as a fiduciary for our clients. And I wouldn't do it with my own money because being in this business long enough, sooner or later, you're going to make a mistake. Keep in mind, if you had a cell phone when they first came out, there was this company called Motorola. They completely dominated the industry, and we all know that Motorola basically, it still exists, but nothing in the form that it used to be. And I could go on and on. That's not the point. What we're trying to do is build discipline. We're trying to build a multitude of companies that grow their dividends over time, to have a diversified portfolio, and we try to minimize the risk. But look, the reality is life is speculation when you wake up in the morning, but you want to try to get as much predictability as you can. You know, the Robinhood crowd, let them do whatever they're going to do. Sure, it can potentially create a little bit more volatility. But you can also look at that as a big positive, because it may give you a chance to buy something cheaper that you didn't have before. And in the end, whatever happens to them happens to them. And as you've seen here in the last few months, that hasn't affected the dividend story much at all, because it is performing much better than what a lot of those speculative names have done. So one thing I do have to agree on, kind of on the lines of Buffett, one of the things you notice is he kind of says the same thing over and over and puts a little different tilt to it sometimes. But in the end, it's sort of the same message, and it's compounding cash flow over a long period of time. When you look at great coaches, one of the things that come up is they will tell you got to do the fundamentals. That's a piece of what this podcast is doing. You know, when you look at Michael Jordan's story, what did he do? He went out and shot like 500 Free throws a day. It's get really good at just the basic fundamentals. 

Greg Denewiler  14:51  
As you all know, one of our goals is to stay accountable and continue to track the companies that we invest in or mention. So now let's turn to our new segment: "Right? Wrong? or Who Cares?" Some of you may be even tired of hearing the name, but we've been talking about Clorox for a while now. We think it's extremely important to stay on top of our investments and to look at how our strategy is unfolding over time. Besides Clorox reported earnings a few weeks ago and the story is developing how we had hoped it would. We started buying in around $160, then a few months ago, as we really got into the story, it had declined down into the 140s, and it ended up going as low as 127. And as it declined, we continued to accumulate. So we have an average cost now that's well below $160. I think there's an interesting perspective right now. Back in the middle of April, Clorox was $146 a share and now it's up to $158. It's actually up. It has done much better than the market has done this year. And you're probably thinking: "I need more Dividend Mailbox Podcasts because this is how you make money- market is going down, these picks are going up." I hate to bring the bad news to you, but if you buy something for long-term compounding, you buy it for long-term dividend growth. And if the stock goes down 10 or 20%. It really almost is a "so what." We didn't own it just to make 10 or 20%- Or if it goes down, our story must be wrong. We bought it because we thought there was a good story there. Our story was simply they had several decades of consistent margins, their margins had really gotten hit due to the last few years, and we were looking for the margins to recover. And again, go back and listen to some of the previous podcasts to go over that. But Clorox is a story of transition. One of the reasons the stock has moved up is they just reported some improvements in their last earnings call. Their gross profit margins, they're up about 8% from where they were at the end of December. If you look at cost of goods sold, they're down 4%, so their costs are declining. And then you look at SG&A expenses, they've declined by 3%, so they are cutting costs. And that's exactly what we wanted to see. As that unfolds, what you've got is a story that at the moment is showing signs that it may work, so the stock has done well. But the price of the stock at the moment really doesn't matter, and fortunately, it's come up. And even there, I have to say, if you're looking for long-term growth and trying to create wealth, we don't really want to start going up right now, we want to be able to acquire more of it at a lower price. Because in the end price will reflect a higher dividend and higher earnings. But it's better if you're going to be in it for several years that, that comes later on instead of on the front end of when you buy it. That's just the reality of how compounding really works to your favor. So, you know, Clorox has rebounded back up to $158, and in our mind, that really doesn't mean anything. We bought it for the story and the long-term value of its growing dividend, not a short-term price increase. On the other side, we mentioned Whirlpool. We specifically said we're not buying it, but Whirlpool has also gone up in the last month. From a price standpoint, it's gone from the $170s up to $183. It's roughly the same percentage as what Clorox has done. And you would say: "hmm, should have owned that one, too." The story is much better for Whirlpool right now, but I don't have the confidence that it's going to hold. But it's more of an issue that we just didn't really know the story well enough that we were willing to buy it. So, therefore, whether the stock goes up or down, doesn't even matter, because we're after long-term wealth creation and what we feel comfortable in. You know, we don't chase stories, we try to look at long-term predictability. So for the first official segment: "Right? Wrong? or Who Cares?" With Clorox, at the moment we're right. But it's not because the stock has gone up, it's because the story, so far at least, is working out. With Whirlpool- Who cares?  You know, this is all about discipline. We have no regret that we didn't buy it because it just doesn't fit what we do, or we don't know it well enough to feel comfortable holding it.

Greg Denewiler  19:50  
And finally, if you've been following these podcasts for the last several months, and you've been looking at the market and how it's performed, a lot of the big growth story names like the Amazons, Microsoft, Apple, Netflix, they've sold off quite a bit. I hate to bring up Cathie Wood's ETF ARKK (the symbol ARKK), which holds a portfolio of disruptive tech companies, which for the most part are extremely speculative. That might do really well over the next decade or two. But it is down right now about 60 to 70% from its high. But the dividend story is actually working extremely well right now. Basically, it's flat for the year. So it's nice when things go well, but we're not in this to try to figure out what asset group is going to do the best over the next quarter or six months or a year. It's great that the dividend story is holding up better right now. But really every strategy will cycle. Actually, last year, the dividend story lagged the S&P a little bit. Well, depending on what you were in, basically our portfolio lagged by about 10%. The point is, it's a strategy that we feel comfortable with, it's got the benefit of it gives a little bit more predictability in a down market. But we're not chasing returns. You kind of pick and choose your battle, but don't switch horses, that's the biggest advice that we can give.

Greg Denewiler  21:34  
If you enjoyed today's podcast, please leave us a review and follow us on LinkedIn, Instagram, and Facebook. If you would like more information regarding dividend growth or just our style of investing, go to growmydollar.com. There you will find some of our previous podcasts and also our monthly newsletter. If you have any questions or anything to add regarding today's podcast, email ethan@growmydollar.com. Past performance does not guarantee future results. Each investor should consider whether a strategy is right for them and all the risk involved. Dividend Stocks are volatile and can lose money.