By Philip van Doorn
Investors keep hearing about rising labor costs and supply shortages that have helped feed inflation. It’s a time for long-term thinking about how to stay ahead — that is, how to avoid losing buying power.
Bill McMahon, managing director and chief investment officer for active strategies at Schwab Asset Management, favors companies that pay dividends and have strong cash flows. In the current inflationary environment, he suggests investors consider companies with very strong brands, such as those in the photo above.
A screen of stocks is below, highlighting several of these companies.
Inflation accelerated to a 5.4% annual pace in September from 5.3% in the previous month, the government reported Wednesday. That’s a 30-year high. Indexes for food and energy rose the most.
“You are seeing pricing pressures across the spectrum — labor shortages and supply shortages,” McMahon said during an interview Tuesday. “We put lot of that into our own thinking as we position our portfolios.”
With oil and natural gas costs continuing to rise, and supply and labor shortages in various industries, McMahon said that during third-quarter earnings season that begins this week, rising costs will “creep into income statements.”
For some companies, year-over-year earnings comparisons will be disappointing to investors. He said the period of high inflation “may last longer than many people expect,” especially because or the energy supply shortage.
McMahon pointed to consumer staples, which includes some companies that have the strong brands and pricing power he favors right now. This has been the second-worst performing sector of the S&P 500 Index /zigman2/quotes/210599714/realtime SPX +1.32% so far in 2021:
|S&P 500 sector||Total return – 2021||Total return – 2020||Total return – 3 years||Total return – 5 years||Total return – 10 years|
|S&P 500 Index||17.1%||18%||66%||123%||341%|
These returns show how long economic cycles can take to play out. The energy sector has been this year’s strongest performer, as a combination of rising global demand, supply shortages in Western Europe brought about in part by policies emphasizing alternate fuels while millions of homes are still being heated by natural gas, along with supply disruptions and bottlenecks. But the energy sector has also been the worst performer for the 10-year period.
McMahon suggested a broad screen for stocks that produced a list that included several companies with brand loyalty and pricing power.
The screen began with the S&P 500, which was narrowed to companies that pay dividends and appear likely to have sufficient cash flow to raise their payouts to investors.
One way to measure a company’s dividend-paying ability is to compare its free cash flow yield with its current dividend yield. Free cash flow is the remaining cash flow after planned capital expenditures. It is money that can be used to do various things that might be good for shareholders, including buying back stock (which lowers the share count and increases earnings and cash flow per share), raising dividends or business expansion.
If we take a company’s estimated free cash flow per share for 2022 and divide it by the current share price, we have its estimated free cash flow yield. If that yield is higher than the current yield, the company appears to have “headroom” to raise its dividend payout.
Note that in this stock screen, we excluded real estate investment trusts (REITs) and financial companies.
Among the remaining stocks in the S&P 500, consensus free cash flow estimates for 22 among analysts polled by FactSet are available for 360 companies. Of those, 265 pay dividends.