Something happened recently that has never happened before in the market. If you take the current rate of inflation and compare it to the S&P 500’s earnings and dividend yield, you get a number that is basically close to zero, explains Justin Carbonneau, editor at Validea.

This means that total implied expected return of the S&P 500, which includes capital gains and dividends, is below the current inflation rate. On a real basis you could be losing purchasing power as prices rise and stocks fail to meet a return higher than the possible inflation rate. (This was pointed out on the investing blog, SentimenTrader, as well as in Barron’s.)

More from Justin Carbonneau: Dividend Aristocrats: Value and Yield in Inflationary Times

This is not a great situation for investors who are buying the S&P 500 and counting on returns, especially those counting on income and growth, if we find ourselves in a persistent inflationary environment.

But not all hope is lost. To understand why, hang with me for a second.

One potential solution involves searching for long-term consistent, higher than average dividend payers and combining that search with quality and value in and effort to produce returns above what the broader market may give you.

Quality Value During Inflationary Times

In a recent piece from GMO, the investment firm made the case for quality and quality value, especially during periods of higher inflation.

Specifically, they note:

  • “High-quality stocks beat the S&P 500 in six of the eight inflationary periods.”

  • “Cheaper high-quality stocks beat the S&P 500 in seven of the eight inflationary periods.”

  • This would make sense since many high-quality companies are more profitable entities. As inflation eats away at profits, quality firms can better absorb the cost increases.

    When you add in value, you most likely get a bump in returns due to increased expectations in interest rates, which make value stocks, which are valued more on near term cash flow (vs. growth stocks and long duration cash flow streams), more valuable based on their earnings stream.

    Story continues

    Importance of Dividends

    What if we married our high-quality value idea with high dividend paying stocks?

    This is where the dividend aristocrats come into play, but with a twist.

    On Validea, we run a pre-defined screen that identifies the dividend aristocrats. The aristocrats are companies that have paid and increased their dividends for 25 consecutive years – no small feat!

    Of course, for many investors keeping it ultra-simple, buying the ProShares S&P 500 Dividend Aristocrats (NOBL) is a fantastic option, but as we can see in our ETF Factor Report on Validea, many of the holdings aren’t that cheap based on traditional value metrics.

    From Dividend Aristocrats to Dividend Kings

    Using our factor scores and guru models, I wanted to see if I could better represent high quality and value in looking across the Dividend Aristocrats and pinpoint names that might be give us a better opportunity in inflationary times (playing off the research from GMO that shows quality value outperforming).

    Using the Dividend Aristocrats as a starting point, I pulled in both our value and quality composite scores, which rate all companies through sub factors such as return on equity, gross and net margins, sales and EPS consistency for quality and valuation metrics like the P/E, P/B, P/S, P/CF and EV/EBITDA for value.

    I then combined the value and quality composite together in a combined ranking. From there, I looked for names that have strong interest from at least two of our guru-based models, which gives me some degree of confidence that the stocks are exhibiting a fundamental attractiveness based on investment strategies that have been tested and work over time.

    See also: Biodesix: 5 Reasons to Bet on Data-Driven Diagnostics

    As you’ll see in the list below, it’s an eclectic mix of stocks from a host of different sectors in the market. The average P/E of the 11 stocks is just shy of 20, which is reasonable and the average dividend yield is 2.5%:

    Aflac (AFL) — yielding 2.4%

    IBM (IBM) — yielding 4.4%

    Target (TGT) — yielding 3.1%

    Franklin Resources (BEN) — yielding 3.3%

    T. Rowe Price Group (TROW) — yielding 2.2%

    Lowe's Companies (LOW) — yielding 1.7%

    Archer-Daniels-Midland (ADM) — yielding 2.3%

    Walmart (WMT) — yielding 1.5%

    PepsiCo (PEP) — yielding 2.9%

    Cincinnati Financial (CINF) — yielding 2.1%

    Johnson & Johnson (JNJ) — yielding 2.6%

    Furthermore, if we get inflation, having a quality value tilt will likely be important as highlighted by the GMO research. Moving up the dividend aristocratic hierarchy doesn’t require too much work if you know what to look for.

    Investors looking for quality, value and growing and consistent dividends can use the Dividend Aristocrats as a starting point and then incorporate other variables like I did to key in on those stocks that may possess attractive investment qualities and characteristics.

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