Are dividends the answer to the inflation problem?

Interest rates may be edging upwards, but the average interest rate on a savings account is still less than 1%, according to MoneySupermarket.com. And with Inflation now approaching 10%, it is eating away at the value of our money.

This was highlighted perfectly in a recent note from the team at Dundas Global Investors. “Inflation is investors’ greatest enemy, a relentless force of immense corrosive power,” it said. “Sustained 2% inflation over 40 years eradicates 55% of the real value of money; replace 2% with 7% and 95% of our spending power is lost.”

The team says that the answer is dividend growth: “There is plenty to worry about. We worry most about the corrosive effect of sustained inflation. Dividend growth is the antidote. Valuation is important, but it doesn’t drive long term total return – where dividends go, share prices will follow!”

The important role of dividends in total returns

The managers of Guinness Global Equity Income agree that dividends are important for total returns. “Taking a step back, we think it is helpful to emphasise once again the importance of dividend investing, particularly in lower- growth environments,” they said.

“We assessed the importance of dividends to the total return an equity investor receives over long periods. Specifically, we see that in the various decades from the 1940s, dividends accounted for on average 48.9% of total returns in the S&P500 index.

“However, in the two lower-growth decades, the 1940s and 1970s, dividends played an even greater role, contributing on average over 75% of total returns. Even in high-growth decades such as the 1990s or 2010s, dividends still accounted for over 25% of the overall total return.

How dividends can maintain income streams

“We also note that over long periods, the growth in dividends matches and often exceeds inflation – suggesting that the income stream from dividend payments can be maintained in real terms,” the Guinness managers continued.

“As such, we believe there is a good argument for dividend investing in the current market environment. We would caution, however, that not all dividends are created equally. We note that ‘high-yield’ stocks and sectors can perform poorly in market sell-offs, and particularly in recessionary environments, as these companies can often be more economically sensitive or more highly regulated.

“In this scenario we believe the case for quality, growing dividends may be more compelling: they are less likely to be cut, they can protect better in a downturn, and often have better prospects for stable and sustainable earnings growth.”

The days of getting rich quick are over

Nick Clay, manager of TM RedWheel Global Equity Income told us more about the importance of dividends in a recent podcast.

“We’ve become very used to getting rich quick in this world dominated by QE [quantitative easing] and zero interest rates and I think people will come to realise that we need to go back to a more achievable way of building our wealth through time, rather than the way we become accustomed to,” he said.

“As we now move away from that environment investors are going to find that the compounding of dividend income is going to be the largest driver of total return going forward and not the capital gain.

“You can increase dividends to compensate you for inflation. Now, obviously you need to be in companies that can raise their prices and increase their dividends and not all of them can do that. But if you can find the right ones, then you are able to compensate yourself for the inflationary backdrop and generate decent real returns.”

You can listen to the podcast interview here:

Consistently growing your dividend

One way of achieving a consistently growing dividend is to invest in investment companies, which can dip into their revenue reserves if dividend payments are cut by underlying holdings.

The Association of Investment Companies (AIC) has recently released a list of the 42 investment companies currently with a yield above 3% and a five-year track record of increasing dividends. Of these 42 investment companies, seven are Elite Rated by FundCalibre.

Annabel Brodie-Smith, communications director at the AIC, said: “With inflation rising and savings rates still low, these 42 investment companies might offer a way for savers to increase their income. The companies come from a range of sectors, from mainstream equities to bonds, infrastructure and even private equity, and all have raised their dividends every year for the past five years.”

Elite Rated investment companies with a yield of 3% or more that have increased dividends annually for at least 5 years.

*Source: AIC/Morningstar, as at 22 July 2022. Includes investment companies that meet both criteria: (a) a yield of at least 3% based on dividends from the last complete financial year divided by the current share price; and (b) a record of increasing their annual dividends for at least five years in a row. Special dividends are excluded. Investment companies that are winding up are also excluded.