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. This was pointed out on the investing blog, SentimenTrader, as well as in Barron’s.

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 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.

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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.

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 for free. 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. The snapshot below shows that based on a value composite the portfolio is under the 50% percentile in terms of cheapness.

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.

As you’ll see in the table 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, the average dividend yield is 2.5%, and the shareholder yield is 3.6%.

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. 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.

Dividend Kings

Ticker	Name	Value/Quality Relative Rank	# Of Gurus > 80%	Price	Mkt Cap	PE	PS	PCF	Dividend Yield	Shareholder Yield
AFL	AFLAC INCORPORATED	1	6	$55.4	$37.6B	7.1	1.7	6.4	2.4%	2.7%
IBM	INTERNATIONAL BUSINESS MACHINES CORP.	2	2	$149.36	$133B	25.5	1.8	11.1	4.4%	6.8%
TGT	TARGET CORPORATION	3	4	$232.57	$115B	19	1.2	13.2	1.6%	3.1%
BEN	FRANKLIN RESOURCES, INC.	4	3	$34.28	$17B	16	2.5	11.4	3.3%	6.7%
TROW	T ROWE PRICE GROUP INC	6	7	$195.25	$44B	16.6	6.7	13.4	2.2%	4.0%
LOW	LOWE`S COMPANIES INC	7	5	$187.88	$132B	20.5	1.4	15.7	1.7%	4.0%
ADM	ARCHER-DANIELS-MIDLAND CO	8	2	$64.64	$36B	17.6	0.5	11.8	2.3%	0.1%
WMT	WALMART INC	9	3	$140	$392B	32.5	0.7	16.7	1.6%	4.9%
PEP	PEPSICO, INC.	11	2	$148.58	$205B	27.6	2.9	20.3	2.9%	3.7%
CINF	CINCINNATI FINANCIAL CORPORATION	12	4	$121.7	$19B	6.4	2	6.2	2.1%	2.5%
JNJ	JOHNSON & JOHNSON	13	2	$164.49	$433B	29.1	5.1	19.3	2.6%	1.5%
						19.8	2.41	13.23	2.5%	3.6%

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Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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