What’s the best protection against inflation?
If you answered “gold”, you are (surprisingly) far from the truth.
After a complete decade of growth and low-interest rates, the spectrum of rising inflation hit the market for the past few weeks. The latest stats promise us a hot summer with inflation numbers we forgot it could even exist. The last inflation push before April happened back in September… of 2012.
Many experts predict several months of high inflation with the rising cost of commodities and consumers with plenty of money in their pockets. While the FED continues to believe it’s a temporary phenomenon, the stock market is cooling off rapidly as investors cash their profit in fear of reduced margin caused by inflation.
Now, selling your stocks to hide with bonds isn’t exactly helping to protect your capital against inflation. In fact, with such low-interest rates, you are eating your returns alive if you go for security. Hence the question:
What’s the best protection against inflation?
I always thought that gold was the answer to this question. I’m not a big fan of the yellow metal (I prefer buying productive assets). However, I must admit that for how long as we can trace it back, an ounce of gold has shown a consistent purchase power. In other words, what you could buy with an ounce of gold 2,000 years ago is pretty much the same today.
This belief is reinforced by the impressive return obtained by investors during stagflation in the 70’s. However, the read of this article from Morningstar shows that gold has been a mediocre store of value during the latest two high inflation periods.
If gold’s return was negative during the 80’s and early 90’s, what can protect your portfolio against inflation?
Three other types of assets:
- Real Estate Income Trusts (REITs)
Let’s take a look at each of them and how you can use them in your portfolio.
Commodities are the best shield against inflation
Looking at commodities to know if they can shelter your portfolio against inflation is like looking at the classic “the chicken or the egg?” causality dilemma. When demand for the commodity rises, the price will follow. Later on, higher commodity prices will also push the higher price for goods sold. We only have to think about how fuel prices dictate transportation costs, especially in the food industry.
Therefore, if you want to protect your buying power, having commodities in your portfolio will exactly do that. However, you must be prepared for a wild ride on this horse:
You can imagine that as a dividend growth investor, investing in commodities would not be my first choice. For example, Oil & gas stocks will raise passions and attract many investors during bull markets. As the economy grows, demand for such products increases accordingly. Commodity prices go up, profits are skyrocketing, and dividends are generous. The problem is that it rarely stays that way.
The energy sector is the most cyclical of all. If you are courageous enough to ride the roller coaster, you can grab shares at highly depreciated prices every few years. If you would rather stay focused on a dividend growth investing strategy as we do here at DSR, you must be incredibly picky before investing a penny in this sector.
I prefer pipelines (midstream industry) as the most exciting opportunities in the energy sector. Pipelines are capital intensive and exposed to regulators and potential oil spills, but they also act as toll roads. The world needs energy, and pipelines are the ones providing it.
Now let’s look at how REITs could protect your hard-earned money.
Landlords can pass the inflation to their tenants
REITs are not only popular because they distribute generous dividends but also because they are easy to understand. Investors can picture an apartment building or an office tower and see how tenants pay their rent monthly. They are willing to purchase units of those businesses in exchange for income and peace of mind.
The concept of being a landlord and having tenants is comparatively simple to understand. If the landlord faces high property maintenance costs, he can easily pass the increase to his tenants through a rate increase. Typically, REITs will have escalator contracts where rent gradually increases. This is the definition itself of inflation.
If you are looking for a good income source and solid protection against inflation, investing a portion of your capital into REITs could be a great solution. A company like Realty Income (O) offers a ~4% yield with a 3-4% dividend increase each year.
Realty Income Corporation is the largest triple net lease REIT in the U.S. It is highly diversified and enjoys a regular stream of cash flow from investment-grade tenants. As most of its leases are for 15 years, O enjoys a predictable recurring income year after year. Realty Income deserves to stay in a dividend income investor’s portfolio because it has paid dividends for almost five decades. It shows a steady cash flow stream from diversified properties and quality tenants, maintaining high occupancy levels that have never dropped below 96% (97.9% at the end of 2020). While most of its tenants are in the retail industry, they are primarily in defensive sectors. This is how O managed to collect 93.6% of its rent in Q4 2020 including 89.9% of its top 20 clients, amid the pandemic.
Another interesting pick with a lower dividend growth rate but strong growth perspective is Stag Industrial (STAG), with a 4% dividend yield and a ~1% dividend growth rate. AS you can see on the graph, the lack of dividend growth is compensated by the stock price appreciation:
While the growth of e-tenants’ credit profile is important, the need for warehouse space keeps growing. STAG is one of the largest players in that field and uses its size and strong balance sheet to acquire more real estate in this market. The REIT shows 43% of its clients handling e-commerce activity. We appreciate STAG’s highly diversified tenant base offering warehouses to multiple industries. Roughly 55% of their tenants’ credit profiles are publicly rated and 30% of all tenants show to be investment-grade companies. STAG focuses on smaller and individual properties. This enables the REIT to face less competition and improve its diversification.
Can you protect your portfolio against inflation with equities only?
I’m a big believer that offense is the best defense. Morningstar’s chart shows that equities could be a good ally in your quest to defeat inflation, but not necessarily the best one. This is especially true if you consider all stocks.
However, when you narrow down your research using the dividend triangle and focus on dividend growers, you can find many great candidates for your portfolio that will perform well. You can see how the S&P 500 Dividend Aristocrats have done well for the past 10 years.
Before the major stock rebound of 2020, the Dividend Aristocrats (25+ years of consecutive dividend growth), have systematically beat the S&P 500. When you can count on companies that are well established in their market, showing robust growth vectors and increasing their dividend year after year, you don’t have to fear much about inflation.
Dividend growers will provide you with a double protection
What I like most about dividend growers is that they provide me with two types of protection. First, their dividend increases year after year. Therefore, your portfolio income is virtually sheltered from inflation. My dividend income has grown by 33% (2018 dividend income vs. last twelve months) in the past three years. These calculations come from an account where I can’t add new capital (it’s coming from my former employer’s pension plan). I use this portfolio as a real case study to track my investing journey.
Second, since dividend growers also tend to outperform the market, capital appreciation is a nice bonus. Over the long haul, the combination of dividend yield + capital appreciation has a pretty good chance of increasing my buying power!
Finally, during challenging times, my portfolio value will decrease like any other, but the dividend payment will likely increase. Therefore, it will act as a good reminder that patience is vital!
Mike Heroux, Passionate Investor & founder of Dividend Stocks Rock
P.S. On a side note, I’ll be hosting a free webinar about retirement and the withdrawal mechanics on Thursday May 20th. If you miss the live even, you can still watch the free replay here.
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