2017 looks set to be a challenging year for investors due to the risks posed by a Trump Presidency and higher inflation. New policies pursued by Trump could lead to greater uncertainty. Higher than expected US interest rates may be a consequence of rising inflation resulting from the US running a larger budget deficit. Similarly, uncertainty in the outlook for world trade could lead to damaged confidence across the global economy.
Brexit is already forecast to spur inflation to around 2.7% this year. This could leave a number of high profile income stocks unable to offer real terms rises in dividends. Therefore, the world of income investing could be turned on its head, with a high yield no longer deemed sufficient unless it comes with inflation beating income growth.
Against this backdrop, companies that are able to register consistent and stable returns while also raising dividends at an above average rate could prove popular. In my view, Compass Group (LON:CPG) ticks these boxes, while also offering an appealing valuation and long term growth potential.
President Trump
The Presidency of Donald Trump is perhaps the greatest known unknown of recent years. It is still highly unclear exactly how he will govern, although it seems likely that a looser fiscal policy will be undertaken. This will include significant tax cuts and higher spending on infrastructure in order to boost the US economy and create jobs.
This may sound like a good plan in theory, but it is not difficult to see how inflation could be the end result. The Federal Reserve may believe they can stay ahead of the curve, but if Trump spends big in a short space of time and time lags are factored in, inflation could become a runaway problem. This would be likely to cause uncertainty not just in the US, but across the global economy.
Further, Trump’s attitudes towards tariffs and world trade are arguably the most protectionist of any modern US President. This week, for example, he stated that German cars may have a 35% import tariff imposed on them if they are assembled in Mexico and exported to the US.
While it is unlikely to be put in place, it provides an example of how volatility is likely to increase while he is President. This could mean investors price in greater risk when valuing assets.
Inflation prospects
The UK’s pending inflation rise is a separate issue to the Trump presidency. Rather, it has been caused by weaker sterling resulting from uncertainties regarding Brexit.
The Bank of England believes inflation will reach 2.7%, while other forecasters believe 4% is within reach this year. Talks between the UK and EU have not started yet, but it is difficult to see how they will progress in a smooth and orderly fashion.
…companies which are unable to raise dividends by 3%, 4% or even 5% plus per annum may fall out of favour with investors.
Both sides have red lines on freedom of movement, so access to the single market is unlikely in my view. Therefore, I believe the reduced appetite for sterling will continue and the inflation problems experienced in the coming months will worsen over the course of 2018.
In such a situation, companies which are unable to raise dividends by 3%, 4% or even 5% plus per annum may fall out of favour with investors. This may lead to a readjustment in what constitutes an appealing income stock, with dividend growth rather than dividend yield likely to take precedence in my opinion.
Dividend growth
Given the potential for higher volatility and inflation this year, I believe Compass Group is a highly appealing stock to own. Between 2012 and 2016, its dividends per share have risen by 48.8%, which works out as an annualised rate of 10.5%. Due to high profit growth in that period, its dividend payout ratio is 51.9% and therefore has room to rise.
Dividend growth in financial years 2017 and 2018 is expected to be 9.2% and 7.8% respectively, which should be well ahead of inflation. This could convince income investors of its long term dividend appeal within what may prove to be a lengthy period of higher inflation.
It may only yield 2.6% even using 2018’s forecast dividend figure, but in my view the potential for a dividend which may be consistently twice (or more) the rate of a high inflation figure could be enough to convince many income investors to buy it.
The right type of business
Compass Group’s business model is highly resilient in my view. It is geographically well diversified and its focus on food services means that its core operation is defensive by nature. It has growth opportunities within a growing or contracting global economy. Specifically, in the latter scenario budget pressures could lead more organisations to turn to outsourcing.
Although its net debt to equity ratio of 121% is relatively high, strong free cash flow and a stable business model mean that acquisition opportunities are likely to be fulfilled without significantly increasing the company’s risk profile.
…within the realm of defensive businesses, few are able to offer the dividend growth potential of Compass Group.
Given the uncertainty which has the potential to build throughout the year, I feel defensive shares could become more popular. However, within the realm of defensive businesses, few are able to offer the dividend growth potential of Compass Group.
Therefore, I believe it has a degree of scarcity value. Its P/E ratio of 24 and EPS growth forecast of 17% this year mean it is fair value in my opinion. That’s particularly so given its relatively low risk business model.
Total return potential
In my view, Compass Group will perform relatively well this year in what could be a difficult year for equities. I think its popularity will rise as President Trump’s policies begin to take effect, with the potential for an increasingly risk off attitude among investors likely to take hold. This could be due to higher inflation in the US or even increasingly protectionist policies which end up being pursued by the new President.
Alongside this risk, UK investors must cope with the likelihood of a higher inflation rate. It would not surprise me if inflation moved past 3% this year, since I believe a ‘hard’ Brexit will become increasingly likely as a stalemate ensues from negotiations. In such a scenario, companies which can pay inflation beating dividends could see their ratings rise on a relative basis.
Given this outlook, I believe Compass Group is an appealing buy. Its business model has proven to be highly defensive and its core business is relatively resilient even in difficult economic circumstances. Its dividend growth prospects are bright and its valuation is fair given its growth outlook. Therefore, while not the most exciting of companies, Compass Group could be the perfect stock to own for 2017.