Dividend growth and inflation

The problem with inflation is that everything costs more. While this is common knowledge, the solutions for protecting yourself from inflation are less well known.

There is solid rationale that short-term inflationary risks are currently limited. However, few argue against that idea that longer-term risks are significant. The dramatic increase in money supply in the U.S. and around the globe has many investors, strategists, and economists quite worried about the prospects of inflation.

Advice on protecting against the possibilities of latent inflation might lead to a discussion on U.S. Treasury Inflation- Protected Securities, commodities, or foreign investments. TIPs and commodities have proven to be effective inflation fighting instruments. Arguments in favor of foreign investments tend to be based on the idea that the U.S. is in greater trouble than other parts of the world; that inflation overseas will be relatively less and therefore equities will fare better as will foreign currencies.

These approaches, while all valid, tend to remain in the fringes of most investors' comfort zones due to either difficultly in understanding these approaches, the low yields provided by TIPs, or the volatile nature of commodities and foreign investments.

There is another approach that is seldom mentioned. Namely, investment in dividend-paying stocks. Most investors do not consider that the inflation protection from dividend-paying stocks as dividend growth because it may not necessarily appreciation in the price of the stock. Specifically, companies that declare dividends tend to increase the dividend over time and avoid cutting their dividend. This story plays out consistently across companies and throughout history.

Interestingly, dividends tend to grow faster than inflation. The S&P 500 stocks have seen 3.5 percent annual dividend growth versus 2.2 percent annual inflation over the past 139 years. Further, when inflation "heats up," so does dividend growth.

Take for example, the 1970s: inflation and dividend growth both averaged 7 percent. To better envision the effects of inflation consider that in 1970, $100 spent at the grocery store, would have escalated to $200 by 1980; the exact same goods doubled in cost over a 10-year period. However, in early 1970, the average S&P 500 company had a dividend yield of 3.4 percent. An investment of $2,950 in common stocks with a dividend yield of 3.4 percent would have provided enough dividend income to cover your $100 tab in 1970. Dividends were raised concurrent with inflation and by 1980 the same common stocks provided $200 income of dividend income — covering your inflated grocery tab in 1980.

Note that this does not take into account the price change in the common stocks during that time; $2,950 appreciated to $5,715. In the 1980s, inflation cooled off (averaging 5 percent) while dividends kept growing at 7 percent. In fact, dividend growth matched or outstripped every major inflationary or deflationary period in history since 1872 (the first year that market data is readily available) — with the exception of 1900-to-1920 when inflation averaged 5 percent and dividend growth averaged at 2.5 percent.

Over the last six months, many companies have reduced dividends — particularly within the financial sector. This highlights the point that companies do in fact cut dividends occasionally and the companies that offer dividends are not without risk. Despite these dividend cuts, companies in the S&P 500 currently provide a dividend yield of 3.5 percent on average, the rate in 1970 prior to inflation.

It is reasonable to assume that companies will raise their dividends as corporate earnings recover. It is also reasonable to assume that, should we find ourselves in a higher inflationary environment, overall dividend growth will once again outflank inflation While resurgence of inflation is not known with certainty, what is known is that historically dividend paying stocks have provided a very good source of protection.

— Jack Brown is f ounder of Laur eola Asset Management Company. His primary responsibilities include port folio manag ement and in vestment r esearch. H e has been a chart ered f inancial anal yst sinc e 2003 and is the vic e-president of the CF A Society of Naples.