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2 inflation-busting stocks to stop returns going up in smoke

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This week the Chief Economist at the Bank of England suggested that UK inflation could be heading toward 4% this year.  That is bad news for savers, who – with an annual average interest rate of 0.64% – could see the value of their savings inflated away by 3.36% each year in real terms.  It is also a challenge for UK stock market investors, who now need to recoup an annual yield or appreciation of at least 4% just to protect the principal value of their investment holdings in real terms.

Some might look to the soaring valuations of big tech stocks as a hedge against this inflation.  But as satisfying as it can be to catch a tech bull run that sees investment values grow quickly, sometimes it can be more prudent to avoid dabbling in volatility and simply go long on quality stocks with good dividend yields. Here, I identify two quality stocks that offer a little of both worlds – a good and reliable dividend yield, but also with the opportunity for the ‘bonus’ of some share price growth.

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And there’s no easy way to say this – we’re talking tobacco.  Investors are free to build their portfolio as they wish, and a portion of investors will avoid tobacco investments for reasons that are well documented elsewhere.  But my concern here is simply finding high-yield stocks whose quality is empirically supported by a good Piotroski F-Score, and in these terms, it’s two tobacco stocks that come out on top.

Imperial Brands

With a dividend yield of 8.86%, a £1,000 investment in Imperial Brands (LSE: IMB) today offers an inflation-busting 4.86% annual yield in real terms.  Reinvesting dividends back into the stock over a period of 10 years would result in a future investment value of £2,417, or 141%.  And with a £14 billion market cap, Imperial Brands is a relatively low risk investment. 

Imperial is the fourth largest tobacco company in the world and has been around since 1901.  It passes 8 of the 9 financial tests in the Piotroski F-Score.  Put simply, it’s a high-quality stock with a good dividend yield, in an established and diversified global business, which is perhaps a little under-regarded by investors due to its focus on tobacco. 

But as UK inflation rises, I expect to see more investors move out of low-yield stocks and into Imperial to hedge against 4% inflation by recouping the 8.86% dividend yield.  This renewed interest may also drive the stock price up by 8% to reach its 52-week high.  In that scenario, if I bought at the current price, I could recoup a blended overall return of 16.86% this year for what I would suggest is a very low risk investment.

British American Tobacco

With a dividend yield of 7.61%, a £1,000 investment in British American Tobacco (LSE: BATS) today offers an inflation-busting 3.61% annual yield in real terms.  Reinvesting dividends back into the stock over a period of 10 years would result in a future investment value of £2,135, or 113%.  Much like Imperial Brands, BAT has a safe ‘blue chip’ market cap of £64 billion.

The company’s pre-close trading update for the first half of 2021 disclosed cash conversion of over 90%, which leaves plenty of headroom to sustain the dividend; plus 5% revenue growth is more than respectable in the most challenging trading year in memory. BAT also expects its non-combustible portfolio to double its current £16 billion in revenues within five years, further diversifying the business and continuing to secure its future.

Today BAT is trading at 2,830 with 13% upside to reach its 52-week high of 3,175.  I expect it will reach this higher level within 12 months as investors rotate out of low-yield growth stocks and into inflation-hedge stocks.  This would offer me a blended one-year return of 20.61% for low-risk high-quality stock with a Piotroski F-Score of a respectable 7 out of 9. 

Imperial offers the more attractive yield whilst BAT offers slightly more upside in terms of price growth if we set the price target as the 52-week high of either stock.  BAT offers a slightly better one-year blended return.  One potential route for me would be to hedge these stocks against each other by giving them equal weight in a portfolio and reinvesting their dividends.

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Tej Kohli owns shars in British American Tobacco. The Motley Fool UK has recommended British American Tobacco and Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Tej Kohli is a deep tech and real estate investor at Kohli Ventures.  He is best known for his mission to end poverty driven blindness at the Tej Kohli FoundationTej Kohli regularly shares his thoughts and wisdom on Twitter as #TejTalks.

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