Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How Dividend Investors Are Hedging Inflation Risk
Transcript
- Lucas: If our money conversations have helped you think about a decision differently, or even just made your Tuesday morning commute a little less dull, there is a way to keep that going. Honestly, if today was worth a coffee to you, that is the link — buy me a coffee dot com slash fexingo — that is F. E. X. I. N. G. O. Luna: Yeah, it really does help keep the lights on and the research sharp. Thanks for the support. Lucas: Let’s get into it. We have spent a lot of time lately talking about how rising rates crush high-yield sectors, but today I want to look at something slightly different. We are sitting here on October twenty eighth, two thousand twenty six, with the ten-year Treasury yield holding flat at exactly five percent. It is not moving much, yet the market feels incredibly brittle. So, the question is: how do we actually protect our cash flow when the risk-free rate is this high? Luna: It feels like everyone is still panicking about the spread between short and long bonds, but isn't the bigger issue just the cost of goods sold creeping back up? I saw some early Q three reports where input costs were ticking up again. Lucas: Exactly. And that is why I am looking at the consumer staples sector, specifically the companies that have demonstrated what we call 'pricing power.' Take Coca-Cola. Their stock is down one point six percent over the last five days, which sounds scary until you look at their balance sheet. They have been raising prices on their beverages for three consecutive quarters, and volume has remained surprisingly stable. That is the holy grail of inflation hedging. Luna: But isn't there a limit to how much you can charge before people start switching brands? I feel like soda is a discretionary spend right now. Lucas: That is the key distinction. Discretionary means elastic demand, meaning if the price goes up, you buy less. But for Coca-Cola, the brand loyalty acts as a buffer. They aren't just selling sugar water; they are selling a habit. And when you look at Procter & Gamble, it is similar. Their stock is up two point two percent recently, and they have managed to increase prices across their household care lines without seeing a significant drop in unit sales. This is what we mean by inelastic demand in an inflationary environment. Luna: So you are saying the quality of the dividend matters more than the yield itself? Because a four percent yield on a stock that loses ten percent of its volume isn't really a dividend, it's a liquidation sale. Lucas: Precisely. A liquidation sale. If you are chasing a seven percent yield in a sector like retail or lower-tier tech, you are often getting paid to take on risk that the market hasn't fully priced in yet. But with Procter & Gamble, the payout ratio is sustainable because their operating margin is expanding. They are not just cutting costs; they are passing costs on. Let's look at the numbers. Their earnings per share growth has been driven by price increases, not just cost-cutting. That is structural strength. Luna: I remember when we talked about Verizon last month. Their dividend cut was a wake-up call for the telecom sector. Is that the same kind of warning sign for other industries? Lucas: It is a very similar dynamic, but the cause is different. Verizon had to cut because their capital expenditures were too high relative to their cash flow. Consumer staples don't have that problem. You don't need billions in new factories to sell soap or soda. The asset light model means more free cash flow is available for dividends. However, we have to be careful. Not every staple company has this pricing power. Some are just guessing wrong on price elasticity. Luna: Right, so how do we identify those companies before the market does? Is there a specific metric we should be watching in the quarterly reports? Lucas: Look at the gross margin trend quarter-over-quarter. If a company raises prices and their gross margin expands, they have won. If they raise prices and the margin shrinks, they failed. It is that simple. For example, look at the S&P 500 index. It is down point four percent this week, but the Staples Select Sector SPDR Fund, which tracks these exact companies, has been relatively resilient. The underlying businesses are generating cash flow that is real, not accounting fiction. Luna: So it is about verifying the cash, not just trusting the headline price hikes. Do you think the Fed's current stance affects this? Lucas: The Fed Funds effective rate is at three point seven five percent, and it looks like they are pausing. This stability helps because it removes the uncertainty from the discount rate. When interest rates are volatile, valuations get messy. But when the ten-year Treasury is stuck at five percent, we can actually model these cash flows with some confidence. It forces us to look at the quality of the earnings, not just the multiple. Luna: And that quality is what separates the Kings from the rest. The ones who have raised dividends for fifty years straight. They survived the nineties, the zero, and the twenty twenty crash. Lucas: They did. And part of that survival is discipline. They don't pay out everything they make. They retain enough to invest in efficiency. Take Johnson & Johnson. Their stock is up four point two percent recently. Despite all the legal headwinds they have faced, their pharmaceutical segment continues to generate massive free cash flow. They have the pricing power of patented drugs, which is even stronger than consumer staples. Luna: Patented drugs are basically monopolies. Isn't that a bit risky from a regulatory standpoint? I worry about government intervention on drug prices. Lucas: It is a valid concern, but currently, the political wind is blowing in favor of domestic manufacturing and innovation. The Inflation Reduction Act has passed, and while it caps some insulin prices, it leaves room for most pharma companies to adjust their portfolios. Johnson & Johnson is diversifying away from legacy issues. Their core business is still a cash flow machine. And in a five percent rate environment, that machine is invaluable. Luna: So you are suggesting we overweight the staples and maybe underweight the high-growth tech stocks that rely on future cash flows being discounted at a lower rate? Lucas: I am suggesting we balance them. Tech is still important, but for income investors, the certainty of the staples is providing a floor. Look at the Russell twenty small-cap index. It is up one point four percent, showing some life, but it is still volatile. The S&P 500 is dragging. The safety of the staples is acting as an anchor. We are not trying to beat the market; we are trying to preserve purchasing power. Luna: Preserving purchasing power against inflation. That is the real goal. Because a four percent dividend yield doesn't mean much if inflation is running at five percent. Lucas: Exactly. Real return is all that matters. And companies with pricing power offer the best chance at a positive real return. They are essentially adjusting their revenue streams to match the changing value of the dollar. It is a natural hedge. You don't need complex derivatives or options strategies. You just need to own businesses that can charge more for the same product. Luna: That sounds almost too simple. Why doesn't everyone just do this? Is it really that straightforward? Lucas: It is straightforward, but it is not easy because it requires patience. You have to hold through the dips. Like when Coca-Cola dropped one point six percent this week. Most investors panic and sell. But if you understand the underlying economics, you know that the business is fundamentally unchanged. The price went down, the opportunity went up. That is the counter-intuitive nature of dividend investing. Luna: So the dip is the friend, not the enemy. We use the volatility to buy more shares of these reliable compounds. Lucas: Precisely. And compounding works best when you aren't interrupted. By taking dividends and reinvesting them in quality names during market downturns, you increase your share count. Then, when the market recovers, you have more shares paying higher dividends. It is a flywheel effect. But it only works if the companies survive and thrive. Luna: Do you think there are any sectors we should avoid completely in this environment? Or is it just about picking the winners within each sector? Lucas: I would avoid sectors with high fixed costs and low pricing power. Think about airlines or hotels. They have huge debt loads and cannot easily raise ticket prices without losing customers. Their margins are thin. In a five percent rate environment, their interest expenses are crushing them. They are vulnerable. Stick to the businesses with strong balance sheets and inelastic demand. Luna: So it is really about debt management as much as it is about revenue growth. High debt kills dividends when rates stay high. Lucas: Absolutely. Interest expense is a non-discretionary cost. You have to pay it before you pay your shareholders. Companies with low leverage, like many of the consumer staples giants, have plenty of room to maneuver. They can borrow cheaply if they need to, or they can just use their cash reserves. It gives them optionality. Luna: Optionality is a luxury in uncertain times. It lets you wait for the right moment to act instead of being forced to react. Lucas: That is the mindset shift. From reactive to proactive. We are not guessing where the market is going next week. We are building a portfolio that will perform well regardless of where the market goes, as long as inflation remains persistent. That is the bet we are making. Luna: And betting on the companies that are already doing it, rather than hoping they figure it out later. Lucas: Right. Proof in the pudding. We have seen these companies navigate decades of economic cycles. They know how to adapt. Our job is just to follow their lead and stay invested. It is boring work, but it pays off. Luna: Boring pays the bills. Excitement bankrupts accounts. I think we can agree on that. Lucas: Agreed. So as we wrap up, ask yourself this: does your current portfolio have the pricing power to survive the next five years of inflation? If not, it might be time to rebalance towards the quality names we discussed today. Luna: A good question to sit with over the weekend. Thanks for breaking it down, Lucas. Lucas: Anytime, Luna. Stay sharp.