Dividends to fight inflation: income investing can relieve hard-pressed investors

Dividends are an important element of long-term equity returns, forming about one third of returns since 1940. This becomes even more important when capital returns are more muted. We expect dividends to be a greater proportion of total returns in the current environment than they were through the past decade, when capital returns dominated.

Importantly, dividends have a good track record of keeping pace with inflation. In the US, companies that pay dividends tend to outperform those that don’t in times of high inflation and rising rates. They also tend to be more defensive options, meaning they tend to fall less than the market in down periods. This is important in the current, volatile conditions.

Dividend strategies, by nature, invest in more established companies that generate lots of free cash flow and tend to fare better in a slowing growth or recessionary environment than more growth-focused companies that need to invest for that growth.

Quality means companies that generate good, consistent returns on equity (ROE) and have strong balance sheets which in practice means relatively low levels of net debt. The trick is to find companies that can pay dividends above the market, are well covered by earnings and likely to grow over time.

Consistency is very important in income investing too - these metrics should be steady over time, rather than fluctuating wildly from year to year. Taken together, these factors are a powerful mix. Companies with high levels of debt and excessively high dividend pay-out ratios are much more vulnerable to high inflation, rate rises and slowing economic activity. Dividend cuts are often the result.

Healthcare, consumer staples and utilities tend to be relatively immune to the economic cycle. There are several ‘dividend kings’ in the financials and industrials too, showing there are also opportunities in more cyclical areas. Dividend kings are those with a 50-year record of annual dividend increases and these tend to come from the US - there are actually none from continental Europe.

Increased pay outs are typically a sign of confidence in the future of the business and are met with a corresponding positive share price reaction. Perhaps these companies are in newer industries like semiconductors that don’t have the track record of 50 or 60 years, but they can be just as effective to own in a dividend-focused portfolio.

Johnson & Johnson is a global healthcare giant, which owns a number of pharmaceutical, MedTech and consumer brands. Demand for healthcare is highly inelastic which has underpinned 60 years of consecutive dividend increases for the firm.

Cincinnati Financial is a US property and casualty insurer. Insurance is a more cyclical market than healthcare, so the fact it has been able to increase its dividend for 61 consecutive years is perhaps even more impressive and testament to how well the business has been run.

Two other stocks with at least 50 years of dividend increases are PepsiCo and Nucor. Pepsi will be familiar to most people but Nucor is perhaps a less well-known name. It is a US steelmaker with a 50-year track record of consecutive dividend increases. Given how cyclical the steel industry is, this is a remarkable achievement.

Nucor also has a strong focus on sustainability – it is the largest recycler of scrap metal in the US and due to the efficiency of its operations, its carbon intensity is less than one third of the world average for steel mills. This will hopefully help it to grow the dividend for another 50 years.