Mitigating the Hidden Tax and the Pursuit of Growing Income
Inflation is one of the most hazardous taxes imposed upon the individual investor and consumer. A decline in purchasing power and the increase in the cost of staple goods combines to create a potentially disastrous environment for a long-term investor concerned about inflationary risk as he or she approaches retirement - especially for those that seek an income stream that continues to increase and does not jeopardize their principal through the risk of permanent capital loss.
In his last testament titled "Financial Chaos" written in 2005, one of the most well known and respected investors in recent history - Sir John Templeton, discussed the risks facing individuals at the dawn of the 21st century and revealed a way to seek protection:
"Not yet have I found any better method to prosper during the future financial chaos, which is likely to last many years, than to keep your net worth in shares of those corporations that have proven to have the widest profit margins and the most rapidly increasing profits. Earning power is likely to continue to be valuable, especially if diversified among many nations."
-Sir John Templeton, 2005
Which Corporations are These?
Let's break this paragraph down. The first part is simple, "shares" meaning common stocks - an equity participation in the future growth of an enterprises profitability. In environments where interest rates have the potential to rise, conventional bond investment (excluding special situations, which are typically not accessible to a majority of individual investors due to both time constraints for analysis and the capital required) is a dangerous proposition unless they are being held to maturity - even then a bondholder faces the erosion of purchasing power through inflation. Seeking to purchase common stocks of quality companies with a focus towards a margin of safety and a long term orientation can provide investors with much needed protection through income and both capital preservation and appreciation during long periods of tumult.
The second piece of Templetons writing, "widest profit margins and the most rapidly increasing profits," can be read several different ways, it could either signify corporations that are demonstrated leaders in their sector, or perhaps companies which are able to consistently generate strong profits and revenues with minimal capital investments or it could be those which retain the greatest freedom to adjust their pricing power, develop new products and to increase their dividends to mitigate inflationary pressures on shareholders.
Though there are companies that are able to retain their earnings and compound them internally at a favorable rate, I will not be focusing on them in this article, instead I will be focusing on three sectors containing large quality companies that pay dividends which have grown over time: Consumables, Utilities and Large Healthcare and Pharmaceutical companies. I will only name a few in each sector - there are many more which can be uncovered with only the slightest research as they are often very familiar.
Consumable Essentials: The Right Place - but the Right Time?
Many companies in the consumable sector are favored by dividend growth investors by virtue of their increasing dividends and long history of dividend payments. Names such as Johnson & Johnson (JNJ), Kimberly Clark (KMB), Colgate-Palmolive (CL) Proctor and Gamble (PG), Coca-Cola (KO), General Mills (GIS), Kellogg (K) and Kraft (KRFT) have found their way into many an investor's long-term holdings for good reason.
I believe that all of these companies are excellent, safe and well run. The rationale behind purchasing shares in these corporations is also extremely simple: as long as growth occurs in the world and the population increases, more people will be brushing their teeth, using Kleenex, drinking carbonated beverages, taking a Tylenol for a headache and eating basic types of food. Though this growth might be slow, it is steady and that often wins the race.
Despite how I may feel about the sustainability and utility of these companies - I think that it is difficult to purchase shares to establish an initial position during a prolonged bull market because of the risk of overpaying. Ideally I would be purchasing shares in these companies during a bear market and dollar cost averaging over a longer period. Another big problem currently is flight to yield caused by a low interest rate environment which increases the risk of paying an excessive premium for name brand companies.
As more money moves off the sidelines, demand for the most popular names is sure to rise and for good reason. In my personal investment portfolio - I aim to capture a yield of no less than 4% annually. Kraft comes the closest currently - offering a yield at around 3.97% - attractive for a large company in the food area relative to 2.85% from General Mills and 2.82% from Kellogg.
Utilities - Do They Pass the Test?
Utilities including electric, water and telecommunications are another compelling sector that deserves mention for an investor seeking income at pace with inflation and safe harbor in times of economic turbulence. Anything that provides an essential service is going to be the last thing to go during times of economic hardship - furthermore, natural growth in demographics will produce slow, albeit dependent and organic growth over the long haul.
1. Stable, Dividend-Paying Telecommunications Companies:
Telecom companies including AT&T (T), Verizon (VZ), NTT DoCoMo (DCM) and Nippon Telegraph and Telephone (NTT) provide a growing income stream and yield over 4% currently. Share appreciation for the latter two companies has been stagnant for a long time and is subject to yen-related currency risk while I believe that shares of AT&T and Verizon are both vulnerable to an influx of sideline money, exposing careful investors to the risk of overpaying.
As an investor looks outside of American and Japanese telecoms, several other names become apparent including France Telecom (FTE) offering an enormous yield of 9.32% annually and Telecom Argentina S.A (TEO) with a 6.1% yield. Though these yields are enticing, there are significant risks in both of these companies to investors either through dividend cuts or governmental intervention - and I would caution prospective buyers to be extremely careful with their research, future yield assumption and purchase of these securities. When in doubt about the presence of a margin of safety, I elect to move on.
2. Power, Water and Gas
Power and water suppliers, including the Southern Company (SO), California Water Services (CWT), Public Service Enterprise Group (PEG) and Exelon (EXC) also furnish attractive and increasing yields between 3% and 4%, with some outliers in the sector including Exelon offering over 6%. However the risks in this area are considerable - as seen with the recent precipitous drop in the share price of Exelon and the fear of unsustainable yields. In addition, the risk of price inflation caused by a flight to yield situation also exists - raising the risk of individuals paying an unwarranted premium.
Logically an index option for this sector of utilities is attractive to me for several reasons, as I believe that many individual investors can mitigate the risk of a single utility company encountering difficulties through the purchase of the Utilities SPDR (XLU) - which currently furnishes a yield of 3.46% and has a P/E ratio of 8.17, a low expense ratio and furnishes an investor with comprehensive geographic coverage.
In contrast to consumable products, regulation plays a significant role in this sector and the rate of annual price increase is often capped by government legislation, translating to a slower albeit predictable increase in the profits of these enterprises and, correspondingly, increases in dividends. Utilities are also a capital intensive business, raising the risk of a single company reducing its dividend payments in favor of capital expenditures. While this does not happen often, it is a possibility that must be accounted for by investors selecting individual utilities.
Large-Cap Pharmaceuticals and Healthcare
The rationale behind the staying power of healthcare companies, though morbid, is a simple one: people continue to get sick. In addition, examination of the adaptive behavior of viruses and bacteria indicates that nature contributes to the growth of the healthcare industry through evolutionary fiat. As pathogens mutate and develop resistances to current products and treatments, new antidotes and cures must be developed to fight them. This process occurs constantly.
Despite the simple bullish case driving perpetual healthcare growth there are also certain risks and drawbacks. Many healthcare companies are dependent upon new "blockbuster" drugs to generate outsized profits. Since drug production is an incredibly lengthy and capital intensive process there are definite risks in development and investor pessimism surrounding the inevitable expiry of a patent. Many investors are forward looking and often form strong opinions about the future drug pipeline in major companies. When a much touted drug fails to obtain FDA approval or is clinically ineffective, the price of the company can fall considerably.
With smaller companies, a failure of a drug or molecule can mean bankruptcy, yet with larger companies that have multiple lines of dependable revenue, a buying opportunity can present itself. In a similar vein, litigation over unanticipated side effects can also create opportunities if an investor is able to see value in the product lines and generics, which are responsible for steady revenue streams.
Though I have already briefly discussed Johnson and Johnson as a potentially attractive option in the consumable section, the company is also a dominant entity in the field of healthcare and biotechnology, with a robust drug pipeline and prosthesis division that is almost certain to grow as demographics shift over the next several decades and a larger portion of the worlds population is able to access quality healthcare. I think that there is currently a risk of overpaying for shares relative to the current dividend yield - however as with any large company I would watch for a spin-off in the near future, as recently occurred with Abbott Laboratories (ABT) and Pfizer (PFE). A spinoff could unlock significant value for shareholders - or provide investors with a potential entry point into a specific sector of Johnson & Johnson's business, which they deem especially attractive.
Other names in the healthcare space that I am following include AstraZeneca (AZN), Merck (MRK), Amgen (AMGN), Sanofi (SNY), GlaxoSmitheKline (GSK) and Eli Lilly (LLY). Despite the fact that I believe all of these companies have room to grow, I think that there could be significant obstacles facing interested investors in the near future related to unwarranted flight to yield premiums as well as the regulatory issues surrounding the implementation of new healthcare legislation in the United States. Nevertheless, the increasing dividends furnished by these companies provide an attractive venue for income oriented investors to further explore.
I was motivated to write this article because of the prescience in John Templeton's writing and his incredible track record as an investor. I feel that more investors deserve the opportunity to see his writing and heed his warnings. I am very sure that other individual investors will interpret his writing differently and seek value in many other places. I view these three sectors as being attractive to defensively oriented investors that seek dividend growth, enterprise stability and a margin of safety. I must also caution against overpaying for quality companies - as it is a considerable risk when establishing a position in a zero-interest rate environment as demand for yield could artificially inflate prices of quality companies.