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Each month, we get more news about how rising prices are eating into our wallets, whether it’s October’s 6.9% inflation rate in Canada or the 7.7% rate in the U.S. But inflation is also detrimental to investors, their portfolios, and their plans for retirement. So, what can they do to combat it?
The threat of rising inflation and resulting interest rate hikes has sent markets spiraling into bear market territory. Though we’re of the view that core inflation should taper off for the remainder of the year, investors are likely facing a new inflation reality in the long run – one that’s a few notches above the 2% or so we’ve seen over the last decades. If this is the case, investors should be asking how they can protect their portfolio. Our answer to this challenge starts with equity duration.
As bond investors should know, duration is a measure of the weighted average of each cash flow that’s due to be received over the life of the bond. The lower the duration, the sooner the investor is theoretically repaid on an investment. It’s also a measure of the sensitivity of the bond’s price to changes in interest rates: The higher the duration, the more the bond price changes as rates change.
This same concept can be extended to equities. Equity duration can be thought of as a measure of how long an investor must receive dividends in order to be repaid the purchase price of the stock. Since cash flows are weighted by their present value, equity duration – like bond duration – can also be a measure of how sensitive the stock price is to changes in interest rates.1 Equity duration is key to understanding how to invest for inflationary times.
Why is equity duration management important in the context of an inflationary environment? First, moving into stocks with lower durations could be part of a strategy to lower overall portfolio volatility, as research suggests that lower-duration stocks tend to be less volatile than higher-duration ones. Moreover, with inflation on the rise, interest rates are rising as well. In a persistently rising rate environment, low-duration stocks would, by definition, outperform high-duration stocks (all other things being equal).
With the information that low duration can be key to fighting inflationary and rising rate environments, what characteristics should you look for if seeking low-duration equities? We believe that inflation-fighting equities come with three key characteristics.
1. High and growing dividends
One way to lower equity duration and, thereby, fight inflation is to target dividend payers. Part of the reason is the simple argument that a bird the hand is worth two in the bush. In a world where purchasing power is decreasing rapidly, having dividends in one’s portfolio removes the uncertainty associated with waiting for dividends in the far-dated future. Dividends are also a major source of total returns – going back over a century, they’ve provided nearly half of the total return of the S&P 500 Index.
But finding quality dividend-paying companies that can help lower your duration profile goes beyond just looking at a dividend yield figure. It’s critical to dig deeper to find companies that are generating strong cash flow – as opposed to looking only at profits or at earnings before interest, taxes, depreciation, and amortization (EBITDA) measures – which can be manipulated.
Only companies that are generating real-world cash flows can be counted on to distribute those flows in the form of dividends. Also bear in mind that there’s a difference between high cash flows and dividends, and growing cash flows and dividends. Certainly it’s nice to have a high dividend, but for long-term investors, we prefer an approach that focuses on companies that are growing their cash flows and dividends; the ability to consistently grow cash flows and distribute them in the form of dividends over long periods is a testament to these companies’ ability to withstand rocky economic times and deliver value to investors. Indeed, it’s no surprise that during inflationary periods, the S&P 500 Dividend Aristocrats Index has outperformed the broader S&P 500.
2. Return on equity
Second, return on equity (ROE) can be a great tool to qualify a low-duration company. ROE is an excellent gauge of the money-making power of a business. By comparing the three pillars of corporate management – profitability, asset management, and financial leverage (debt) – ROE tells an investor a lot about the effectiveness of a company’s executive team and the overall strength of its business.
A high return on equity Is a great indicator of a company that’s efficiently using the capital of its shareholders, making it high quality and likely able to continue generating cash flows. This is important since it’s a sign that the company is self-funding, meaning it’s less likely to have to go to market to raise debt or equity – something that’s particularly costly in an environment of rising rates and bear equity markets.
In short, a company that can efficiently turn its capital into revenues and profits is one that’s likely to have a better profitability profile, higher cash flows, and overall lower duration.
3. Low price-earnings multiples
Finally, price-earnings (P/E) multiples are a key fundamental to watch in times like this. With both the Bank of Canada and the U.S. Federal Reserve (not to mention other central banks around the world) raising rates to combat inflation – in additional to other measures – financial conditions are tightening. This doesn’t bode well for stocks with high P/E multiples.
Why so? From a logical perspective, stocks with high P/Es (that is, growth-oriented stocks) are generally less profitable and cash-flow positive than stocks with lower P/Es (value-oriented stocks). In other words, cash flows, and thus dividends, are more likely to flow to investors further into the future than for stocks with low P/Es, thereby increasing equity duration. Furthermore, growth names also rely more on debt financing, and with rates on the rise, it’s going to become more expensive for these companies to borrow.
The relationship between P/E and rising rates can be seen historically as well. The last few decades suggest that when financial conditions tighten (for example, when interest rates are rising), P/E multiples contract – particularly when conditions tighten quickly, as we’ve seen in the last few months.
The Chicago Fed’s National Financial Conditions Index bounced off its June 2021 low, rising to -0.15 in July 2022, indicating that financial conditions have been tightening.2 In that same timeframe, S&P 500 forward P/E multiples have contracted to 15.8 from 21.4. If history is any indication and if rates continue to rise as the market is expecting, equities with high P/E multiples could be in for a rough ride.
Fighting the devastating effects that inflation can have on portfolios is no easy task, and certainly there’s no one solution. But by targeting companies that are paying and growing dividends, are using their capital efficiently, and have lower price-earnings multiples, we’re confident that investors can build portfolios capable of withstanding rocky markets and inflationary times.
Notes
1. Although there’s no generally accepted formula for equity duration as there is for bond duration, the concept for both is similar, with the caveat that dividend payments aren’t nearly as certain as a bond’s coupon payments are, hence the lack of consensus on how to calculate equity duration.
2. For the National Financial Conditions Index, values below 0 indicate looser-than-average financial conditions, while values above 0 indicate tighter-than-average, so a rising number indicates tightening financial conditions.
Robert Wernic is Director of ETFs for Eastern Canada in Quebec at Manulife Investment Management. This article previously appeared in the Fall 2022 issue of Your Guide to ETF Investing, published by BrightsRoberts Inc. Used with permission.
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