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Buy Alert: 2 High Dividend Growth Stocks To Combat Rampant Inflation – Seeking Alpha

Fortune"s Most Powerful Women Summit - Day 2

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Paul Morigi/Getty Images Entertainment
Inflation is a gigantic corporate tapeworm. -Warren Buffett
Written by Sam Kovacs
I remember being told once, that you don’t need to run faster than the tiger, you just need to run faster than your brother.
The tiger will eat your brother and you’ll be safe. Unfortunately, with inflation that doesn’t work.
Inflation isn’t a tiger. Inflation is more of a tapeworm, to paraphrase Buffett.
If your business grows at a faster rate than your peers, but you don’t keep up with inflation, then in real terms, your business is declining.
Inflation cleans the plate.
Consumers all over are feeling the pinch of inflation. Whether it’s when filling up the tank or the pantry, prices are going up.
I was particularly amused this morning when I saw on Seeking Alpha’s trending news that, Cathie Wood believes we don’t have an inflation problem.
Then again, I still remember when she said that oil was in a secular decline and heading for $12, so maybe I will not put too much emphasis on her analysis.

Cathie Wood Tweet

Twitter

Twitter
There has been a lot of Cathie Wood bashing this year. And all of it has been justified.
I’ll explain why with a quote which has been one of the cornerstone frameworks of how I approach everything in life.
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. – (probably not) Mark Twain
Whether Twain actually wrote or said this is irrelevant.
Being certain and convinced of anything while only having partial information is a surefire way to lose money in investing.
If you want to lose your own money while investing in your business, no worries, go ahead. But when you have 1.3m followers, maybe you want to be a little more open minded.
The goal isn’t to try and massage the narrative, because you can’t will markets into doing what you want them to do.
Powell tried to visualize inflation away by making “transitory” his mantra for 2021. It didn’t work.
Our approach has been to consider what we do know, and find options where “heads we win, tails we win more”.
For instance, back in August, when a member of the DFT asked if we should be concerned with the summer decline in oil prices we said:

Preferences aren’t as important as constraints in assessing outcomes.
The constraint is that the world needs oil. The preference is that it wants clean energy.
The outcome is that the world will use oil.
And if the firms which generate profits from oil, trade at a discount because they’re a “bad bad company” then dividend investors reap the profits by getting outsized yields relative to their dividend growth potential.
Did I know that oil was going to $90? No of course not. I don’t have a crystal ball, and I’m not smarter than the next guy or gal.
With inflation it was the same. Were we convinced that inflation wasn’t as transitory as Powell believed? Yes, but we weren’t certain.
When market participants are overly certain about something, you want to identify opportunities which stand to benefit from their misplaced certainty.
By the time this article hits, inflation data is expected to hit. It is expected that inflation will be the highest recorded in the past 40 years.
Whether 7% inflation and higher sustains for longer or not is yet to be seen. However being convinced that inflation is only due to supply side factors (which would in theory be transitory) and not demand led (by say all the extra money pumped into the economy and -7% real Fed rates) is crazy.
Maybe it’s time you picked stocks which will do well in inflationary environments, and won’t miss out on anything if inflation doesn’t manifest?
If inflation does sustain, and does persist, there is a simple formula on the business end to beat inflation: pass the buck to the consumer.
If you can’t pass the buck, you need to grow faster than inflation.
So we’re looking for businesses with pricing power and growth.
On the stock side, we need to anticipate that sustained higher inflation would lead to higher rates.
This changes discount rates. Higher discount rates reduce exponentially the value of future cashflows. Companies which have low profits today and high profits later will get killed.
Don’t believe that rates will go up again and again?
Just look at the two charts below which show 60 years of 10 year treasury yields and inflation data.

10y Treasury Yield

MacroTrends: 10y Treasury Yield

MacroTrends: 10y Treasury Yield

Inflation chart

MacroTrends: Inflation

MacroTrends: Inflation
Now the Fed is only pricing 4 to 5 interest rate hikes this year, which should leave Fed rates about 1.6% by the end of the year.
Even if inflation subsides to 5%, that would still leave us at negative 3.4% real rates, which lets me believe that it is very likely we see rates increase continually for multiple years, as the Feds tepid response will have virtually no impact on a market flush with cash.
The best place to turn to then, would be the financial sector.
Since I asked the question to our members in March 2021 “Do you own enough banks?” the Financial Select Sector SPDR Fund (XLF) has outperformed the S&P 500 (SPY).
This was tarnished by two periods of Delta and Omicron.

Dividend Freedom Tribe Price Chart of SPY and XLF

Dividend Freedom Tribe

Dividend Freedom Tribe
As we move towards the spring, I expect to see financials have another burst up.
The divergence between the index and the financial sector which started in 2018 is set for a reversal.

Dividend Freedom Tribe 10Y Price Chart of SPY and XLF

Dividend Freedom Tribe

Dividend Freedom Tribe
So that sort of sets the scene:
Find me two high growth, high pricing power financial stocks which are trading at attractive valuations.
At this point you’ve already read an article’s worth. But as Lincoln would say:
If I only had an hour to chop down a tree, I would spend the first 45 minutes sharpening my axe.
Our axe is super sharp now.
Morgan Stanley (MS) arguably has the best CEO among Wall Street financial companies (sorry Jamie).
When James Gorman took the helm of the company in 2010, MS managed to get 7% ROTCE at best.
James Gorman set his eyes on improving this metric. As John Mason points out in his recent article:
Mr. Gorman set very aggressive goals, wanting the bank, after years of shortfalls, to get its ROTCE up to 10 percent, then 12 percent, then to 15 percent.
In 2021, that went up to 20% on the back of excessive money in M&A markets and elevated trading.
His vision of elevating MS to being the ultimate wealth management powerhouse was brilliant and continues to be.
When the stock increased its dividend by 100% last year, following the Fed lifting its ban on dividend hikes, I knew it was time to get into the stock.
So much so that it was one of the two stocks I bought for my Birthday.
Let’s zoom into what this does to the valuation from the standpoint of a dividend investor, with the MAD Chart below, which shows valuations relative to historical dividend yields.
Below I got a 5 year chart, which is more representative than a 10 year chart because MS started increasing its dividend again in 2014, which skews the 10 year chart.

MS MAD CHart

Dividend Freedom Tribe

Dividend Freedom Tribe
What this chart shows is that in the past 5 years, MS has yielded between 1.45% (when the price hit the top of the red band) and 5% (when the price hit the bottom of the blue band).
It currently yields 2.63% which is just above the 5 year median yield of 2.57%.
There is no reason that a company like MS should yield this much.
At most, a fair yield would be 1.75% to 2%.
Why? In one word growth.
MS has made 30% dividend growth per annum a habit, and given that it pays out only 30% of its earnings, they still have room to grow.
Do I expect 30% growth for a decade? No maybe not, but neither do I need to.
We have a proprietary method to calculate “required dividend growth” for dividend stocks. MS has a required dividend growth rate of 9.5% to 12%, which means that as long as the dividend grows by that amount or more, it will be a brilliant investment for the dividend investor.
The brilliant management team, large moat as its position as the “white shoe” WM firm, and sector headwinds make MS an easy investment. I wouldn’t be surprised to see MS go up to $130 in the next year, and anywhere between $150 and $180 in the next 3 years.
Below $110 it is a strong conviction buy.
This idea was first shared with the members of the Dividend Freedom Tribe over a month ago, and was generated by a member of our community which asked us to cover it.
Ally Financial (ALLY) is not your usual bank. It is the largest digital only bank in the US and it has been growing aggressively.
Over the past 5 years, Revenues have grown at 8% per year. Net income has grown at a 28% CAGR.

Ally Investor Presentation

Investor Presentation

Investor Presentation
All digital banks are an interesting business. I believe most people use them in conjunction with a traditional brick and mortar bank. I started that way. I am a bit of a financial services and products geek, so I’ve opened accounts at pretty much all of the best options available to Europeans (Wise, N26, Revolut, etc).And while at first I was using these as secondary banks, or segregated accounts, they now occupy a core place in my banking flow.
The data suggests that increasingly, people are using digital only banks as their first source of banking.
The data with ALI doesn’t lie. Customers have grown at a 19% CAGR, but its lending products have really taken off in the past few years, as demonstrated by the Ally Home and Ally Lending charts above.
This creates an interesting opportunity, where we will have an increasing number of people continue to sign up for a digital bank as a back-up, and then eventually convert to credit cards, debt products, etc.
This should provide a clear pipeline of growth in upcoming years.
Furthermore, Ally can acquire firms which are not as digitally integrated, and expand its digital offering through them, creating instant synergies.
An example of this is when they acquired Fair Square, to integrate their credit card offerings into ALLY. Just like management comments at the end of the last earning call:
” we’re really pleased this year to see every one of our businesses scaling up ahead of expectations and a really bright future ahead “
What is interesting, is that ALLY is a dynamic online bank, but with the traditional shareholder friendly approach that banks were loved for pre 2009.
Before we touch on the dividend, ALLY has a buyback yield of 4% during the TTM, which is in line with its 5 year 5% average yearly buyback.
This is a great way to deploy excess cash, crowd out excess shareholders, and liberate cashflows for the remaining shareholders.

Ally Investor Presentation

Investor Presentation

Investor Presentation
The next point is of course the dividend, which has been growing at a fantastic rate.
During the past 5 years, the dividend has grown at a 25% CAGR, and it has grown twice in the past year, to make up for the 6 quarters at which the dividend was held constant in 2019-2020.
This is exceptional, as with the current yield of 2.44%, Ally needs to grow between 10% and 13.4% per annum to be a great investment.
I seriously doubt we’ll see anything less than 15% growth for the next few years, and as such believe it is attractively priced relative to future potential.
Finally, looking at the MAD Chart, Ally is currently trading below its 6 year median yield of 2.06%.

ALLY MAD Chart

Dividend Freedom Tribe

Dividend Freedom Tribe
This period was marked by the 2020 year which was awful for financials, and skews the ranges downwards. I expect the ranges to gravitate upwards over upcoming years as investors favor financials, favor those with the growth needed to outpace inflation, and recognize ALLY’s explosive growth.
Ally is a great buy all the way up to $57, and could easily be worth $90 to $100 in 3 years or so.
If inflation subsides and rates don’t go up by as much as it’s possible, MS and ALLY will still do well thanks to their positioning, management and great runway of growth, and attractive valuations.
If these two things do manifest, these stocks are extremely undervalued.
Heads you win. Tails you win more.
2021 was a difficult year to navigate with wild swings both ways. It’s only getting tougher in 2022.
Our flagship Low Yield / High Growth portfolio is beating the S&P 500 as well as other indices like QQQ and DVY, all while offering meaningful income.

Members of the Dividend Freedom Tribe get 3 model All Weather portfolios and weekly Buy/Watch/Sell Lists to help them navigate any market conditions.
We give you everything you need to bulletproof your portfolio.
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This article was written by
Hi there! We’re Robert & Sam, a dad & son team of dividend investors.
If you’re looking for regular analysis of some of the best dividend opportunities, you’re in the right place!
We regularly publish articles highlighting high quality companies, with superior management and dividend policies, which are trading at great prices.
Whether you’re retired or still accumulating, we offer a path towards reducing risk while achieving strong returns.
We eat, breathe and sleeep dividend investing. We’ve poured thousands of hours of our lives into researching, creating original strategies, and developing tech solutions which make investing a breeze.
If you want to benefit from all of this, you should seriously consider trying “The Dividend Freedom Tribe”, which includes a training course, three model portfolios, weekly in depth analysis, our buy/watch/sell lists, access to MAD Dividends Plus for free, as well as a community of lively dividend investors.

Disclosure: I/we have a beneficial long position in the shares of MS, ALLY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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