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Using equity income to power your portfolio and beat inflation

Using equity income to power your portfolio and beat inflation

  •  
By Karyn West
  •  
4 minute read

With interest rates at record lows, investors are turning to equities for yield and taking on more risk in their portfolios. But investors should only target companies that are financially sound and capable of growing their dividends over time, which will help to counter the effects of inflation on investments.

 

Dividend investing has a long tradition. Economists Benjamin Graham and David Dodd famously wrote in their book Security Analysis (1934): “The prime purpose of a business corporation is to pay dividends to its owners. A successful company is one that can pay dividends regularly and presumably increase the rate as time goes on.”

Several studies show that dividend yields have been strong indicators of earnings growth. Dividend stocks too have historically outperformed the market with lower volatility.

Importantly, dividend growth drives the long-term total return from share investments. According to index provider MSCI, dividend increases have been viewed as a sign of future profitability. In a 2016 paper, MSCI analysed the historical performance of global equities into three components: dividend yield, dividend growth and changes in valuation. Over the long run, dividend growth easily accounted for the greatest proportion of the total return on equities. Over 20 years, dividend yield and dividend growth contributed 93 per cent of the total return, compared with roughly 7 per cent for changes in valuation or price over 20 years.

Looking ahead, dividend growth will help protect investors’ portfolios against inflation, which is likely to climb over the coming months, especially as supply shortages and bottlenecks continue to push up global commodity prices and consumer prices. This year, inflation in developed economies has witnessed a sharp increase. In the US, the consumer price index hit 5.4 per cent in June compared to 12 months previously. That was the fastest rise since 2008. Inflation also overshot forecasts in the UK in June 2021 and we can expect to see this more of this in coming months in other developed economies, where spending has been boosted by quantitative easing and huge levels of fiscal stimulus.

Of all the measures that investors can take to protect their portfolios against inflation, investing in companies with good dividend growth is one of the most powerful. There are many companies with strongly growing businesses that are capable of sustained, real dividend growth of 5 per cent per annum and more over the long-term, well-above prevailing inflation rates in developed economies.

Essential to this investment strategy is investing in financially sound companies with strong business performance, good corporate governance and a high level of profitability, which may stem from a company’s pricing power and ongoing cash generation. That provides a company with the funds necessary for investment to drive future growth. Financial discipline, low leverage and risk control are important too. By keeping payouts relatively low and retaining profits for investment, future growth is more likely and therefore, so is sustainable dividend growth.

Also important is investing in companies with high growth potential. We can find many of these companies in the technology and healthcare sectors, which we believe offer the best prospects of capitalising on the growth in the global economy and in turn, providing shareholders with sustainable dividend growth. Over time, these industries have shown to have more resilient businesses, providing defensive growth.

Investing in companies that can maintain dividend payouts provides good downside cushioning that we have observed during the COVID-19 pandemic. During 2020, the three sectors of technology, healthcare and consumer staples provided the bulk of growing dividends across global equities. The biggest cutters were financials, consumer discretionary and energy companies, that is, lower growth sectors.

Compared to interest rates of just 1 per cent per annum or less on term deposits, there are plenty of companies globally whose businesses are surging forward and capable of rewarding shareholders with sustained, real dividend growth of 5 per cent per annum or more. As always, diversification by strategy, including a sustainable dividend strategy and superior stock picking will deliver the best returns over time.

Finding businesses that have good return on equity, good margins and pricing power will be important in the post-COVID environment. At the same time, it is crucial to avoid companies whose dividend payout is extremely high or negative, putting future dividend payments in doubt. Higher yielding stocks are often in lower growth industries and investing primarily for higher income can be done at the detriment of capital growth and future income. If dividends do not rise at the pace of inflation, income is falling each year in real terms.

Karyn West, managing director, Apostle Funds Management