November 2022 Client Letter
A year ago, when cryptocurrencies were trading at their all-time highs, I was interviewed by CNBC. According to CNBC, financial advisors like me were divided on whether it was too soon or too risky to put clients’ money into cryptos. The article looked to establish whether to invest or not.
I explained to the interviewer that I had struggled to develop an investment thesis to justify any meaningful purchase of cryptos other than speculation. The commonly cited benefits of cryptos include an alternate form of money, a store of value, a hedge against inflation, and benefiting from a limited supply.
I take issue with all these points. I view money as something that is stable. To my mind, cryptos fail in the stability category. One hundred dollars worth of crypto today might be worth a whole lot less in the future. Perhaps a few cryptos will someday be viewed as stores of value, but that time is not here. Gold has been around for a millennium and is probably the better asset if stored value is the goal. Where is the proof that cryptocurrencies can keep pace with inflation? I view stocks as the better inflation hedge. And limited supply? Not quite. There are thousands of cryptocurrencies. Anyone can create a virtual currency and market it to investors. As I noted to CNBC, “Regulation is not yet here with these cryptos.”
When it comes to allocating your hard-earned savings, Richard C. Young & Co., Ltd believes an emphasis on investment versus speculation puts the odds of future success in your favor.
We have felt this way for decades and have developed much of our investment philosophy based on the work of the father of value investing, Ben Graham, and that of Vanguard founder Jack Bogle. In his book, Bogle On Mutual Funds, Bogle wrote about the risks of investing:
Manage your affairs with prudence, intelligence, and discretion. Do not speculate. Consider probable income as well as probable safety of capital. Recognize that there is no avoiding risk of one kind or another. For instance, holding cash—or hiding it in the proverbial mattress—at best assures no earnings on your capital and, at worst exposes it to erosion by inflation. So the question is: What kinds of risks are you prepared to take?
I can’t speak for all my clients, but I gather many of you, like Bogle suggests, treat income, safety of capital, and protection against inflation as investment priorities.
Stocks can be an attractive asset for generating income and protecting against long-run inflation risk, but many stocks may not be appropriate to meet these goals. High growth or aggressive growth strategies tend to favor shares that pay low or no dividends. And some firms that operate in these high-growth areas are more susceptible to deflationary forces within their industries.
Investing in dividend-paying stocks is how one generates income from an equities portfolio. Dividend stocks also tend to hold up better than high-growth (valued highly) and non-dividend-paying stocks in an inflationary environment that leads to higher interest rates.
Lawrence Strauss recently highlighted some of the benefits of investing in dividend payers in the current environment. He wrote in Barron’s:
Dividend stocks have been relative winners in this year’s market selloff. Dividend-paying shares in the S&P 500 Index are down 11%, including dividend income, compared with declines of 19% in the S&P 500 and 23% for non-dividend stocks. Bonds aren’t doing much better. The Bloomberg U.S. Aggregate Bond Index is off 16%, its worst performance on record going back to 1988.
Dividend stocks’ relative strength reflects a few factors. Payouts cushion against sliding share prices. And the dividend payers congregate in value sectors, such as financials, energy, and utilities, which have outpaced growth sectors, such as tech, where dividends aren’t as generous or widespread.
At Richard C. Young & Co., Ltd, we craft stock portfolios for clients that are invested exclusively in dividend payers. We favor higher yields, as most would, but yield is not our only criterion, and it is not the most important variable. In fact, investing only in the highest-yielding stocks can lead to inferior results. Ultra-high yields are often a signal from the market that a firm’s dividend is at risk.
In addition to yield, we evaluate firms’ dividend consistency, records of making regular annual dividend increases, prospects for future dividend growth, and dividend safety. Not every stock we purchase is strong in every category. Some firms pay high yields but have low dividend growth prospects, while others have strong dividend growth prospects but low yields. Then there are some firms that have moderate yields and moderate growth prospects but multi-decade records of paying and increasing dividends.
Blue Chip Dividend Stocks
This latter group tends to be more blue-chip in nature. Examples of some of the firms I would put in this category include Air Products & Chemicals, Procter & Gamble, and Johnson & Johnson.
Air Products and Chemicals
Air Products and Chemicals, Inc. (APD) produces industrial atmospheric and specialty gases and performance materials and equipment. The company’s products include oxygen, nitrogen, argon, helium, polyurethane, epoxy curatives, and resins. APD’s products are used in the beverage, health, and semiconductor fields. Selling industrial gas is an attractive business. There is nothing proprietary about the gases and chemicals Air Products sells, but they are essential inputs of the manufacturing processes of many firms. For many customers, industrial gases are also a low-cost input, which makes buyers less interested in price shopping and more interested in the reliability of supply. Air Products has paid a dividend every year since 1954, and it has increased the dividend for the last 40 consecutive years. Its shares yield 2.2% today. Twenty years ago, the shares also offered a yield of about 2.2%. Since then, the dividend has compounded at 10.8%. Not surprisingly, if you add the starting yield of 2.2% to the 10.8% dividend growth rate, you get a figure of 13%, which almost exactly matches the two-decade total return of 13.1% in the stock.
Procter & Gamble
Procter & Gamble produces products that are a part of most consumers’ everyday lives. Crest toothpaste, Tide detergent, Pampers diapers, Gilette razors, and Bounty paper towels are just a few of the firm’s 60+ brands. P&G also has one of the most impressive dividend records of any stock. P&G has paid a dividend every year since 1891, and it boasts a 69-year record of making annual dividend increases. P&G shares yield 2.6% today.
Johnson & Johnson
Johnson & Johnson is a diversified healthcare firm. The company has large businesses in pharmaceuticals, medical devices, and consumer health products. The healthcare industry benefits from favorable demographics (an aging population), strong pricing power, and recession resistance. JNJ’s diversified business mix and the recession-resistant nature of healthcare have made it one of the more stable and reliable blue-chips an investor can purchase. JNJ is the least volatile stock in the S&P 500 (as measured by monthly 10-year standard deviation). It also has one of the highest financial strength ratings among companies in America. JNJ is one of only two companies that are still rated AAA by S&P. In the early 1980s, there were 60. JNJ has paid a dividend every year since 1944 and has raised the dividend for the last 58 consecutive years. The shares yield 2.6% today.
Some of the firms we own that have strong prior and prospective dividend growth are Home Depot and Texas Instruments.
Home Depot is the world’s largest home improvement retailer. Home Depot’s scale gives it negotiating power with suppliers and a logistical advantage when delivering to its pro businesses. Home improvement retail has also been relatively insulated from e-commerce competitors. Over the last decade, Home Depot’s dividend growth has averaged 20%. Over the next couple of years, with headwinds expected for the housing and remodeling markets, we expect dividend growth will average 8–10%—still an impressive growth rate for one of America’s largest retailers.
Texas Instruments is a leader in analog chips, which convert real-world signals into digital signals. The analog chips business has attractive economics. Like the industrial gases sold by Air Products, analog chips are a lower-cost input. Unlike industrial gases, which are commodities, analog chip designs often have proprietary designs, and customers build those specially designed chips into the products they are making. The hassle of changing analog chip makers to save a couple of bucks isn’t worth it for most firms. This allows Texas Instruments to earn high returns on the money it invests in its business. Texas Instrument’s five-year average return on capital ranks among the best in the S&P 500. High and reliable returns on capital have allowed TXN to increase its dividend at a 22% annual rate over the last decade and a 17% annual rate over the last five years. Today, the shares yield 2.8%.
High Dividend Yield Stocks
Some of the high-yielding stocks that we own in common stock portfolios include Verizon, Avista, and Kinder Morgan.
Verizon is about as boring a business as one can invest in. The industry is mature, growth prospects are modest, and international expansion is unlikely. That doesn’t make Verizon a bad investment. Verizon generates loads of cash flow that it returns to shareholders in the form of dividends. The dividend yield on the shares is an impressive 6.8%. The dividend doesn’t increase much every year, but it should keep pace with inflation over time. What is there to hate about a 6.8% yield and 2–3% dividend growth in a known commodity like Verizon?
Avista is a regulated utility in the Pacific Northwest involved in the production, distribution, and transmission of electricity and natural gas. Avista has operations in Washington, Oregon, Idaho, and Alaska. The company has over 400,000 electricity customers and almost 370,000 natural gas customers. Almost 50% of Avista’s electricity generation comes from hydroelectric power, with 60% of the firm’s total electricity production coming from renewable sources. Avista shares yield 4.6% today, and the company has increased its dividend every year for the last 20 consecutive years.
Kinder Morgan is one of the largest energy infrastructure companies in North America. Kinder Morgan owns an interest in or operates 83,000 miles of pipelines, 141 storage terminals, and 700 billion cubic feet of natural gas storage. Oil and gas pipelines and storage facilities are some of the most attractive energy stocks to own for dividend investors. Most energy firms are capital intensive, and the same is true of pipelines and terminals, but unlike oil and gas producers, which must reinvest most of their profits back into the business to maintain their asset bases, pipeline firms have low ongoing capital maintenance requirements. Once the large initial cash outlays are made to lay pipe or build a terminal, most of the cash flows those assets generate can be paid out to shareholders in the form of dividends. Kinder Morgan shares yield 5.95%. Over the last five years, Kinder Morgan’s dividend has compounded at an annual rate of 17%.
Investing is a Process
At the bottom of our letterhead is our tagline, which reads, “diversification and patience built on a foundation of value and compound interest.” The “patience” part of this phrase equates to time. Time can be an overlooked ally of successful investors. It’s difficult to outsmart the markets, especially during shorter periods. The markets can go up when there are bad headlines and go down when there are good headlines. Kneejerk reactions and selling during these periods can lead investors to outfox themselves and then miss out on potential gains or realize unneeded losses.
The WSJ recently profiled various Americans who are planning their retirements, noting the difficulties they have faced this year.
The WSJ article mentions that “Susan Hodges, 66, and her wife decided to pull all their money out of the markets in May. ’We can only take so much anxiety,’ she said.”
There are all sorts of things wrong with Susan Hodges’s situation. Why on earth would Hodges and her wife pull all their money out of the markets? Few professionals would recommend such a strategy. You do not want to be in a position where volatility makes you so uncomfortable that you get out. Perhaps she is not receiving thoughtful investment counsel on how to craft a portfolio calibrated to match her ability and willingness to take risks. I tell clients all the time that it’s fairly easy to stay the course when you have J&J, P&G, Visa, and U.S. Treasuries on the books. Hodges and her wife may also have been drawing too much from their portfolio annually, which can really accelerate declines in value during years like 2022. Once again, she was maybe not getting good advice on annual withdrawal amounts, tracking or adjusting annual expenses, life expectancy, etc.
The article notes that Hodges now has 10% of her portfolio in the stock market, but it doesn’t say when she got back in. It is entirely possible she lost money with the 10% she reentered with. She is not giving time a chance to do the heavy lifting. Stocks are cyclical, and they can be volatile in the short run, but the historical record (1927–2001) shows that over periods of 15 years or more, investors have never experienced a negative return.
Stocks Have Entered the Best Year of the Election Cycle
This year, Election Day arrived in the midst of global economic and geopolitical uncertainty, including a war over the horizon, inflation, rising interest rates, and the tail end of economy-shattering pandemic lockdown measures. The results of the election were mixed, with the GOP taking control of the House of Representatives and the Democrats holding the Senate. As we wrote to you in September, such a divided government has traditionally coincided with stronger stock markets.
But it isn’t just who controls the branches of government that correlates with positive investment outcomes, it’s also the timing of the election cycle. According to a study by US Bank, after every midterm election since 1939, America has seen its stock market rise in value. That’s an impressive 83-year record. The phenomenon is called the “midterm effect,” and it is heavily studied because of its persistence in delivering above-average returns. It hasn’t seemed to matter which party won or which was in power. The study also found that since 1962, the S&P 500 has returned an average of 15% in the first six months following the midterm elections. Average returns in the first six months of years without midterm elections have only been 4%.
In 2018, a second study by researchers from Australia and the United States found that “US equity premiums over the last 145 years average 15.41% annualized in months following midterm elections, yet only 2.98% in other months. The 12.43% annualized premium difference is both statistically and economically significant.” Their research suggests the midterm effect is considered a major public announcement, and may therefore have an effect on markets similar to that of other public announcements such as payroll numbers, GDP, and industrial production.
A third study of the midterm effect published by researchers from New Zealand’s University of Canterbury suggests the effect of the midterm elections on stock prices is so strong it “tops any effect associated with the election of a president and indeed any other calendar- and politically-related pattern.” The study also suggests that the benefits of the midterm effect are shared across industries. After studying 49 industry portfolios, the researchers found “higher excess returns around midterm elections for most industry portfolios.”
The exact cause of the midterm effect is still uncertain, but there’s no debate about its existence.
Have a good month. As always, please call us at (800) 843-7273 if your financial situation has changed or if you have questions about your investment portfolio.
Matthew A. Young
President and Chief Executive Officer
P.S. Details of the collapse of cryptocurrency exchange FTX are still unfolding, but early reports suggest at least $1 billion in client funds may have disappeared. Former Treasury Secretary Larry Summers said FTX’s collapse is similar to other major bankruptcies in recent decades.
“A lot of people have compared this to Lehman. I would compare it to Enron,” Summers told Bloomberg’s Wall Street Week. Summers described some aspects of FTX’s downfall that reminded him of Enron: “The smartest guys in the room. Not just financial error but, certainly from the reports, whiffs of fraud. Stadium namings very early in a company’s history. Vast explosion of wealth that nobody quite understands where it comes from.”
P.P.S. Investors can benefit from some early takeaways from FTX’s demise. For starters, those depositing their assets into FTX were doing so in a firm that was not a brokerage firm or bank registered and regulated in America. Accordingly, these investors forfeited protections that could have reduced financial loss, including regulatory oversight, and federal insurance through the Securities Investor Protection Corporation or FDIC deposit insurance. Additionally, because FTX was not an American regulated financial firm or publicly traded company, it was not required to publish financial documents investors typically use to evaluate a business and conduct due diligence. As noted earlier in this letter, you want to manage your financial affairs with prudence, intelligence, and discretion. If Jack Bogle were alive today, I’m quite sure he would have thought FTX did not pass the smell test.
P.P.P.S. Consumer staples shares have long been one of our favored groups. Why? For starters, the dampened cyclicality of the sector provides a greater degree of confidence in the long-term prospects of firms in the space. Many companies in the staples sector are durable businesses with long operating histories and formidable brand portfolios. Consumer staples stocks, and reliable dividend payers in general, rarely receive media hype compared to the newest technology firms in the NASDAQ; but when you are in the business of long-term compounding, boring, routine, and dull stocks are desirable.
P.P.P.P.S. In the fourth annual CNBC FA 100 ranking (2022), Richard C. Young & Co., Ltd. was again recognized as an advisory firm that helps clients successfully navigate their financial lives.
* Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized advisor. Rankings are generally limited to participating advisors and should not be construed as a current or past endorsement of Richard C. Young & Co., Ltd. CNBC is a trademark of CNBC LLC. All rights reserved.