3 High-Conviction Dividend Investments For What's Next

view original post

Introduction

When it comes to investing, I am all about the “big picture.”

As most of my readers know, I care about major trends and developments that can impact our investments and provide us with long-term opportunities to beat the market.

Although all three subjects are correlated, my research framework is based on three areas:

• Macroeconomics. This includes leading economic indicators, unemployment, inflation, and related.
• Supply chains. The pandemic was a prime example of the importance of being on top of supply chain developments. More recently, this includes coverage of economic re-shoring.
• Politics. This includes topics like the General Election in the United States and geopolitical issues like the war in Ukraine and the Middle East.

In this article, we’ll discuss a key issue that is both macroeconomic and political. It also involves the Fed. Based on that discussion, I’ll present a number of dividend (growth) investments that I expect to be perfect for the next decade (and beyond).

So, let’s keep this intro short and get right to it!

It’s Getting Political!

Don’t worry. This isn’t about Trump vs. Harris or any other topic that could cause a very unpleasant discussion in the comment section.

This is about the role of the Fed and the increasing importance of politics.

On August 30, I read a fascinating Bloomberg article from Allison Schrager, a senior fellow at the Manhattan Institute, titled “The Fed Is No Longer The Only Game in Town.”

The article discussed shifting power between the Federal Reserve and the federal government. In fact, it suggests a peak in the Fed’s influence.

As most readers know, the Fed has been (and still is) very powerful, as it has been tasked with keeping inflation at 2% and maintaining maximum employment. In order to get this done, it uses its balance sheet in open market operations and changes short-term interest rates to influence lending.

None of this will change.

However, it has become less powerful. The article makes the point that since the pandemic, fiscal policy (government spending and taxation) has had a major impact on the economy. Using research from New York University, Stanford, and the London Business School, the paper finds the following (emphasis added):

[…] the US is moving from a regime of “monetary dominance” to one of “fiscal dominance.” In the former, the Fed controls inflation by adjusting short-term nominal interest rates. The government supports these efforts by committing to increase future taxes, ensuring that other interest rates don’t change too much and debt doesn’t overwhelm markets. Under a monetary dominance regime, interest rates and inflation are low and relatively stable.

The regime changed during and after the pandemic, when wartime-sized debt was issued with no care of paying it back. As a result, interest rates increased and became much more volatile, the correlations between stocks and bonds flipped, and inflation returned — all hallmarks of a fiscal-dominance regime. – Bloomberg (emphasis added)

As we can see above, elevated rates and sticky inflation, two factors we have discussed since at least 2021, are two of the key characteristics of what could be a new regime.

Although the Fed is still doing what it does best, it is less powerful, as its influence on inflation and unemployment is weaker. One good example is how the U.S. Treasury used its Treasury General Account and Reverse Repo to more than offset the Fed’s quantitative tightening.

In other words, the government offset a lot of tightening. According to my connections in the industry, this is due to a bigger political issue in Washington that I will discuss in the future.

Speaking of Washington, the article (indirectly) makes the case that it may not even matter who wins in November – at least not with regard to the power loss of the Federal Reserve.

• Both Democrats and Republicans want to bring back manufacturing to the United States (re-shoring).
• The use of tariffs is on the table for both – although I believe a Trump administration could use tariffs more aggressively. Tariffs can be inflationary.
• Both parties want to improve the nation’s infrastructure and housing shortages. This, too, impacts inflation and employment, among a wide variety of other factors.

The bad news is that the government is on thin ice. The debt situation has become an issue, a second wave of inflation needs to be avoided, and it cannot become too powerful, as the free market should be the main driver of innovation and demand/supply developments.

Especially the inflation situation worries me, as the Fed is now looking to cut rates before inflation has normalized, as Lawrence McDonald points out in the tweet below:

Although I believe that economic turmoil could temporarily push inflation down, my thesis remains that longer-term inflation will remain above average.

As we just discussed, this makes sense in a fiscal-dominance regime.

This brings me to my three high-conviction ideas. Although I like a wide range of stocks, I want to highlight three dividend investments that make a lot of sense in a fiscal-dominance regime.

While these investments will likely do well regardless of what happens in Washington, they all bring something special to the table that could allow us to generate substantial returns in a fiscal-dominance regime, especially if this comes with a bigger focus on economic re-shoring, infrastructure spending, housing, and other key factors.

So, let’s start with the first pick, an investment that makes a lot of sense in an environment of elevated inflation.

Canadian Natural Resources (CNQ) – Inflation Protection And Energy Tailwinds

When it comes to being protected against inflation, it’s hard to beat the energy sector. Using Hartford data, one could say it’s impossible to beat inflation.

Although equities in general have performed quite poorly in high and rising inflation environments, there are potential areas that have historically performed better at the sector level. The energy sector, which includes oil and gas companies, is one of them. Such firms beat inflation 74% of the time and delivered an annual real return of 12.9% per year on average.

This is a fairly intuitive result. The revenues of energy stocks are naturally tied to energy prices, a key component of inflation indices. So by definition, they generally have performed well when inflation rises. – Hartford Funds (emphasis added)

However, especially in the current environment, oil-focused companies are attractive, as producers are not as aggressively investing in exploration as they used to.

On top of that, the fact that the biggest source of supply growth, the U.S. shale industry, is running out of stream, Exxon Mobil (XOM) sees a scenario of significant supply shortages on the horizon.

This bodes very well for oil prices!

It’s also great news for Canadian Natural, Canada’s largest oil producer and second-largest natural gas producer.

Canadian Natural has it all:

• It has a proven reserve life of more than 30 years (this excludes any new discoveries).
• It has the second-largest reserves among supermajors.
• Close to 60% of its production comes from Canadian oil sand and thermal operations. These have 0% and 13% decline rates, respectively. Although sand and thermal operations have higher upfront costs, they provide significant benefits compared to capital-intensive fracking operations.
• CNQ enjoys very low breakeven prices. Its thermal In Situ operations are breakeven in the low $40 WTI range. Its sand operations are breakeven in the mid-$20 to low-$30 WTI range.

Moreover, going into this year, the company reached its C$10 billion net debt target, which means every penny of free cash flow is distributed to shareholders.

Currently yielding 4.2%, Canadian Natural has hiked its dividend for 24 consecutive years, giving it one of the best dividend growth records in the entire oil and gas industry.

As we can see above, the base dividend comes with buybacks and special dividends, especially after hitting its debt target.

To give you an idea of how high shareholder returns can be, the company made the overview below.

• At $80 WTI, the company estimates roughly C$5 in per-share free cash flow. This translates to a current free cash flow yield of 10.2%!
• At $95 WTI, that number rises to more than 14%.

Although oil is currently in the mid-$70, I expect oil to move significantly higher once global economic growth improves. On top of that, I expect energy to be one of the best sectors to be in light of inflation risks.

Hence, I have been adding gradually to my position on every CNQ dip in recent quarters.

Moreover, although the numbers above already suggest a fair valuation, the data below confirms it. Currently, CNQ trades at a blended P/OCF (operating cash flow) ratio of 7.7x, roughly one point below its long-term average.

Based on current OCF estimates, it has a fair stock price of C$64 in Toronto, 30% above the current price. The same applies to New York-listed shares.

Currently, I am giving CNQ a Strong Buy rating.

The second pick is a company I have covered for more than a decade.

CSX Corp. (CSX) – Dividend Growth, Buybacks, And Re-Shoring

As some readers may know, CSX is one of my all-time favorite dividend growth stocks.

Since 2004, CSX has returned 15.4% per year, supported by consistent dividend growth and aggressive buybacks. Over the past ten years, CSX has returned 288%, beating the tech-heavy S&P 500 by a decent margin.

The only reason I do not own this Class I railroad is that I own three other railroads, including its peer, Norfolk Southern (NSC). I did not sell NSC to buy CSX, as NSC became really cheap because of internal struggles.

However, generally speaking, I think it’s fair to say that CSX is the better railroad of the two companies that dominate railroad transportation in the East (see the chart below).

There are many reasons to like CSX. Although it is cyclical, which is something some investors want to avoid, it has a track record of excellence, as it has always kept its operating ratio subdued, even when post-pandemic supply chain challenges hit.

Currently yielding 1.4%, the company has grown its dividend by 125% over the past ten years. The five-year dividend CAGR is 8.5%. The payout ratio is just 25%, as CSX prefers buybacks to dividend growth.

Hence, since mid-2014, it has bought back 35% of its shares, making it one of the most aggressive repurchasers on the market.

Moreover, while current cyclical headwinds are pressuring the company, it expects low to mid-single-digit total volume and revenue growth in the second half of this year, supported by new opportunities in merchandise, intermodal, and export coal, three areas I’m very bullish on.

The main reasons, however, why CSX is included in this article is its ability to benefit from economic re-shoring and the related push from both Democrats and Republicans to bring back industrial production.

This is what I wrote in a CSX article on June 19:

Essentially, with more than 500 development projects in the pipeline, CSX believes it is in a great spot to leverage new opportunities, mainly in the Southeast and Midwest regions, which are reshoring hotspots, as the 2023 map from The White House shows.

Looking at the map above, CSX could not be in a better spot, as it services the area that benefits from most re-shoring. This also applies to its peer NSC and transportation companies like Old Dominion Freight Line (ODFL), which I own as well.

Moreover, the company, which enjoys a BBB+ credit rating (one step below the A range), has an attractive valuation. Despite very weak consumer and manufacturing sentiment, analysts expect 4% EPS growth in 2024, potentially followed by 11% growth in 2025 and 2026.

As CSX currently trades close to its long-term P/E ratio of 17.4x, this implies a 10-11% annual return.

Although this is subject to change, I’m very upbeat about CSX’s future, expecting it to be a great place to be for the next decade (and beyond).

Needless to say, I’m giving the stock a Buy rating.

Carlisle Companies (CSL) – Dividend Consistency And Building Tailwinds

Both Democrats and Republicans know the U.S. needs to build more homes.

Earlier this year, NPR wrote the U.S. faces a housing shortage of somewhere between 4 million and 7 million units. This is one of the reasons why the Fed is having such a hard time pressuring housing-related inflation, including rent.

On top of that commercial buildings also come with tailwinds:

• Economic re-shoring requires more construction.
• As I wrote in my prior article on CSL, the average commercial building in the United States was 53 years old in 2022. The lifespan of these buildings is usually between 50-60 before it triggers a wave of maintenance requirements.

Although these operations are still cyclical, I consider the building products industry to be one of the best places to be for the next decade.

Carlisle generates roughly 70% of its revenue from construction materials. The remaining 30% are generated by weatherproofing technologies.

More than 60% of its revenue comes from replacement and remodeling demand in the commercial industry. Almost all of its sales are domestic.

Furthermore, the company sees a total addressable market of $70 billion. CSL has just 6% of this market, which opens up a lot of room for organic growth and M&A.

It also has a fantastic dividend – despite the fact that it’s below 1.0%.

Currently yielding 0.9%, the dividend has a payout ratio of just 18% and a five-year CAGR Of 16%. It has hiked its dividend for 46 consecutive years and remains in a great spot to maintain aggressive dividend growth.

It has also bought back 28% of its shares over the past ten years.

This has helped the company to return 13.9% per year since 2004.

Going forward, Carlisle is really upbeat about its opportunities, expecting more than $40 in EPS by 2030. This is based on 5% annual organic revenue growth and a return on invested capital of more than 25%.

If we apply the company’s average P/E ratio of roughly 18x, we get a fair stock price of $720, 70% above its current price.

Although CSL isn’t very undervalued on a shorter-term basis, I am extremely upbeat, expecting CSL to beat the market for many years to come and benefit from strong secular growth, especially if the government puts a bigger emphasis on housing shortages – supported by the need of commercial operators to maintain their buildings.

This warrants a Buy rating.

Takeaway

The landscape of investing is shifting, with political and macroeconomic factors playing an increasingly critical role in shaping market dynamics.

While the Federal Reserve continues its traditional duties, I believe its influence is fading in light of growing fiscal dominance.

This new regime highlights the importance of strategic positioning in sectors that can thrive in an environment of elevated inflation and geopolitical shifts.

My top three picks, Canadian Natural Resources, CSX, and Carlisle Companies, are in a great spot to capitalize on these trends, as they offer impressive dividend growth and potential for significant long-term gains with secular tailwinds.

Hence, these investments not only hedge against current risks but also align with emerging opportunities.

Going forward, I’ll discuss more opportunities, as I have a whole list of attractive investments for “what’s next.”