As the stock markets continue to recover (assuming it has not done yet), the talk of inflation is coming back in the news. Our government has pumped in so much of printed money in the system that there is a concern that US economy will experience inflationary times. There is no denying that inflation will take away chunk of our real returns from overall investing returns.

Many of the well known economists and investors (including Warren Buffett) have expressed concerns about inflation. Among all the experts and pundits, I believe, David Swensen gave a very pragmatic and down to earth response to this question in an interview on WealthTrack. According to Swensen, he does not know what will happen. He cannot predict it. There will be inflation if the recent pumping of money supports the economy and growth returns to US economy. If there is no growth, then there will be deflation of dollar value. His message was to address these issues with proper diversification and asset allocation. As individual investors what can we do to (or rather how can we) blunt the effect of inflation or deflation. Following are five aspects one can look into to manage their asset diversification.

• First, include Treasury Inflation Protected Securities (TIPS) in your portfolio. As an example, one can consider simple US Treasury based bond fund like iShares Barclays TIPs (TIP) to offset this risk. It also has low operating expenses of 0.2%.
• Second, include gold commodity as an asset in your portfolio. I believe one should hold physical gold in some form (like coins, bars, jeweler, etc). There is no point in holding those gold derivatives which can easily be manipulated. Furthermore, most of the world currencies are now completely detached from gold standard. So I would really question the notion that gold remains an inflation hedge. I tend to believe gold is an excellent hedge against any short to intermediate term crisis like currency issues, sovereignty issues, etc. It is important not to go crazy and binge on gold, but maintain an asset allocation that you are comfortable with.
• Third, include dividend paying stocks in your portfolio for companies that are doing business in commodities. These companies are able to increase prices of their products as price of raw commodities increase. Examples of such companies are ADM, EEP, KMP, BP, XOM, CLX, MCD, utilities, etc. These types of companies are less susceptible to inflationary environment.
• Fourth, include dividend paying stocks of US based or developed country multinational companies that derive significant chunk of their earnings from emerging markets. As inflation erodes dollar value, currencies from other countries can provide the fill up to their earnings.
• Fifth, include emerging market ETFs (stocks or bonds) in your portfolio. It is important to look for ETFs that are based on individual markets, denominated in local currency, and essentially captures a wider market base. The simple way to start your allocation using VWO or EEM, which are broad based. After that look for individual country ETFs. In my opinion, all those ETFs and funds that hold dollar denominated ADR and ADS does not provide hedge against the dollar inflation/deflation.

The message here is that maintaining a diversified asset allocation should be simple and easy to understand. What’s the point in investing in those confusing derivatives and linked to futures (commodity or currency) which are difficult to understand.

What is approach to this issue? How do you plan to address it in your portfolio?

This article was first published at The DIV-Net on October 1, 2009.

This article originally appeared on The DIV Net, on July 9, 2009.

Archer Daniels Midland (ADM) is one of the world’s leading agribusiness companies, with significant market presence in agriculture processing and merchandising. ADM has approximately 230 plants location worldwide. It is one of the world’s largest processors of agricultural commodities, such as oilseeds, corn, wheat, protein meal, corn sweeteners, flour, biodiesel, ethanol, and other food and feed ingredients.

ADM is a dividend aristocrat and has been raising its dividends for last 34 years. The most dividend increase was in February 2009. I view ADM in dividend portfolio as a proxy for commodity asset class. Considering the recent turmoil in commodities sectors, my objective here is to analyze if ADM still continues to be a good dividend growth stock and how does it rate on my scale of risk-to-dividends.

Trend Analysis
Here I am looking at trends for past 8 years of corporation’s revenue and profitability. These parameters should show consistently growth trends. The trend charts and data summary are shown in images below.

• Revenue: In general, a growing trend since 2001. The average revenue growth for last 9 years is 21%.
• Cash Flows: Very erratic operating cash flow with significant reductions since 2005. Negative in 2007 and 2008. Same trends fro free cash flow. Not a good observation.
• EPS from continuing operation: In general, increased trend, with exponential growth between 2004 and 2007.
• Dividends per share: Consistently growing dividends since 2000 (and before than since last 34 years).

ADM: Trend Analysis

ADM: Data Summary

Risk Parameter Calculation
Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 2.14. This is a medium risk category as per my 3-point risk scale. The reduced gross margin and negative EPS growth rate in 2008 makes it a medium risk to dividends.

Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past five years.

• Dividend growth rate: The average dividend growth of 17.2% (stdev. 8.7%) is less than average EPS growth rate of 28.6% (stdev. 39.1%). Dividends have grown slower than earnings per share.
• Duration of dividend growth: 34 years.
• 4 year rolling dividend growth rate for past ten years: More than 10% for past 8 years. 14% for last five years.
• Payout factor: In the past 8 years, it has always been less than 35%. Presently it is at 18%.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 2.1%; and (b) MMA yield is 3.4%. Last 8 years average dividend growth rate has been 17.2%, however, my expected dividend growth rate is 8.5%. With my projected dividend growth of 8.5%, the dividend cash flow is equal to MMA income in 10 years time period.

Fair Value Calculation
This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 15 year DCF: $15.5
• Average high yield price calculated based on past 10 years: $20.5
• Pricing based on past 10 year relative price-to-earnings ratio. $43.1
• Pricing based on price-to-earnings ratio of 12: $33.2
• Graham number: $35.4

The range of fair value is calculated as $23.9 to $29.6. This is determined by taking average (for high value) of above five parameters and then subtracting it with half the standard deviation (for low value).

Qualitative Analysis
ADM’s history can be traced back to 1902. It has survived all the significant ups and downs in the economic growth of United States. This demonstrates that it keeps adapting to changes in the market place.

• ADM is continues to maintain its leadership position in agriculture business, with its unparalleled global asset base, flexible processing capabilities, and financial strength. Unlike its business competitors, ADM focuses on long term profitability.
• It is operates in a cyclical commodity industry. While current recession seems to have had an impact on its year-over-year financial results, it continues its asset expansion through acquisitions and capacity expansion. To me any corporations that still can go down that path in recession is something that shows positivity and management’s confidence.
• It’s year-over-year may show cash flow concern or reduced EPS. However, I believe those are due to capacity expansions and acquisitions.
• In addition, a lot has been said about ADM’s push into ethanol business and its long term viability and sustainability. I believe ADM has positioned itself (and still continues to do so) as an undisputed leader of ethanol producer. The market for alternative fuel is bound to grow in future.
• One thing that came as a surprise to me was the gross margins and operating margins are in single digits. Perhaps, it is the operational capability that allows it to maintain continued profitability at such low margins. At such low margins, there is no room for error.

Conclusion
I like ADM’s global asset base, focus on long term profitability, and diversified product strategy. I also like ADM as a proxy for agriculture commodity asset class. It has been raising dividends for last 34 years. The stock’s current risk-to-dividend rating is 2.14 (medium risk). As long as my allocation allows, I would take a long term position ADM for (1) agriculture commodity exposure; (2) slow dividend growth company with potential capital appreciation; and (3) low volatile stock in my portfolio.

Full Disclosure: No position at the time of writing. I may initiate a starter position in near future.

TIP Guy at TIPBlog.in presented his thoughts on how dividends are perceived at least in India’s corporate world. I am reproducing certain snippets (with author’s permission).

The lack of consistent dividend growth companies in emerging markets can be interpreted in different ways

1. Emerging economies need very dollar to invest back in their businesses. The cost of external capital is typically higher, and hence it is advisable to use internal resources. Shareholders can get their return by capital appreciation on their share values.
2. The managements are not mature enough to understand the importance of common shareholders, or sharing a piece of profits with shareholders, and/or prudent cash management over longer term.
3. The taxation policies which do not favor dividend distributions.

I believe most of the corporations in emerging markets are personality driven, and lack any institutional management philosophy. The corporations are primarily driven by personal aspirations (both, good and bad), and as a result the shareholders have miniscule holdings (and contributions). I cannot recall any instance where majority shareholders (other than family and friends) or banking institutions that have been able to make any change. And hence, this has a part in driving the dividend strategies. Common shareholders have such a small percentage holdings that they always remain in back burner.

There are approximately 400 companies in India that have at least paid dividends for last 10 years. However, they have not been growing consistently. Furthermore, the dividend strategies also hinge upon governments taxation policy and cost of available capital. I believe as that as Indian economy grows and competition increases, the cost of capital will come down, and taxation policy will evolve slowly towards friendlier dividends. As of today, at least the dividends are tax free for individuals.

Certainly, there are issues about Indian corporate’s dividend friendliness. However, there are 400 companies that still pay dividends. If we look back 30 or 40 years, I tend to believe that’s how US companies and corporate may have viewed the dividends. As US economy matured, few selected companies continued to follow their strategy resulting in Aristocrats’ and Achievers. While I tend to agree that, over time, Indian corporate may evolve towards dividend friendliness, I do not think it is at a point where they can be attractive on its own. There is promise, but not yet.

Until then I believe using US-based multinationals that generate revenue from emerging markets are best proxy for investing in emerging markets. Some examples are:

• QCOM (my analysis)
• BDK (my analysis)
• CBY (my analysis)
• INTC (my analysis)
• ADM (my analysis)
• PG
• UL/UN
• Nestle

What investment vehicles do you use for investing in emerging markets?