Dividend investing: four tips to beat rising inflation

In this third of our mini series on dividend investing, Alice Guy looks at how to use dividends to combat rising inflation and examines the history of dividend stocks.

When the going gets tough, it’s time for investors to get back to basics. And the recent resurgence in popularity of income funds is a case in point: many investors turning away from glamorous “Ferrari” growth stocks towards reliable “Ford Focus” steady income-generating stocks.

Seeking out stalwart dividend payers is a well-trodden strategy in times of economic uncertainty. But, with many of us relying on dividends to see us through these difficult investing times, it pays to look back at the history of dividends to see how they have responded in previous periods of high inflation. Are dividends a good hedge against inflation, and how can you use dividend income to protect your wealth and maintain a steady income?

Inflation is normal

It’s important to remember that the last 10 years of ultra-low inflation have been the exception, rather than the rule. In fact, over a longer period of the last 50 years, inflation has actually averaged above 5%, well over the Bank of England’s current target of 2%.

For businesses and the government, a low level of inflation can actually be a good thing. The opposite, deflation, encourages consumers to delay purchases as they wait for prices to fall, and it can be a sign of economic stagnation. But very high levels of inflation are also bad for business as rising wages and costs make it difficult for businesses to plan and make a profit.

The ideal, and the Bank of England’s long-term aim, is a steady level of low inflation that can keep the economy ticking along but avoid any enormous spikes.

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Dividends normally beat inflation

So, how do dividends usually respond to inflation? Research from Invesco shows that dividends beat inflation most of the time.

From December 1971 to April 2022, UK dividend income grew in excess of inflation for 63% of the time. That means dividend investing was generally an inflation-beating strategy and banking those dividends would have bolstered your wealth and helped you prepare for times when income dipped.

The remaining 37% of the time, when dividends stagnated or fell, it usually followed a period of economic recession. For individual companies, other specific factors also came into play: some businesses, such as Rio Tinto (LSE:RIO), cut dividends during the pandemic in line with their rules on paying a percentage of their earnings as dividends.

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What happens to dividends when inflation is high?

But what happens to dividend income during times of ultra-high inflation?

Thankfully, periods of long-term high inflation are fairly rare. In fact, there were only three times during the 20th century when inflation hit double digits for three consecutive years.

During the two years up to mid-1975, when inflation hit an eye-watering 27%, dividends fell by around 20%, but then stabilised and gradually recovered. Dividends then delivered above inflation growth over the following four decades.

Four strategies to protect dividend income

Given the potentially volatile nature of dividend income, here are four strategies to maximise your dividends and protect your wealth in times of high inflation.

1) Focus on value, not growth stocks

Growth stocks tend to perform better in times when the economy is booming. Because most of their value is based on future predicted profits, they often have a higher share price when consumer confidence is running high, and the future looks rosy. But the opposite is true in difficult economic times. The past six months is an illustration of this: the share price of many growth companies has nose-dived as future revenues look increasingly optimistic. And to add insult to injury, growth companies with unpredictable revenues also pay out lower dividend payments, especially when the economy contracts.

In contrast, established “value” dividend-paying companies tend to have a higher dividend yield and prioritise dividend payments, even in tough economic times. Value companies also usually have a lower price/earnings ratio because their price is largely based on current rather than future revenues.

An easy way to invest in value stocks is through an income fund or a UK-based tracker fund. The value-heavy FTSE 100 index is full of blue-chip high dividend payers, boasting an average dividend yield of around 4% per year, compared with the 1.5% yield of the US-based S&P 500 index.

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2) Look at dividend cover as well as dividend yield

Remember that dividend yield can be deceptive, especially in a falling market. That’s because it’s based on dividend payments per share, divided by the share price to give a yield, or return on investment. The problem is that a falling share price actually leads to an increase in dividend yield, meaning that a generous yield could mask a company in trouble.

Instead, of purely focusing on dividend yield, look at a range of investment data, including price/earnings ratio and dividend cover to give a better picture of the overall financial health of a company.

Dividend cover is a measure of how easy a company will find it to maintain its current dividend payout at the same level. It’s worked out by dividing a company’s earnings per share by the dividends paid to shareholders. 

A low dividend cover means a company might struggle to continue paying the same level of dividends in the future. Cover of less than 1.5 suggests the dividend might be at risk, while less than 1 indicates that the company is not making enough money to pay the dividend out of new profits. Safety-conscious investors prefer dividend cover of 2 or more.

3) Diversify your investments

Remaining diversified is important for all investors, including dividend investors. An easy way to achieve this is through an index tracker or an income fund, and ii’s handpicked Super 60 list of investments includes several options for dividend investors.

Possible funds to consider include the Fidelity Global Dividend fund, which invests in global stocks with predictable and resilient return profiles and currently returns a dividend yield of around 3%. Or, if you prefer a UK-based fund, you could look at the Vanguard FTSE UK Equity Income Index , a passive income-focused fund, which has a current dividend yield of around 3.8%.

If you want to invest in individual shares, then make sure you have a well-balanced selection from across a variety of sectors and geographies, and don’t put all your eggs in one basket.

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4) Invest for the long term

It’s long-term investing where dividends really come into their own. That’s due to the compounding effect of reinvesting your dividend income leading to snowballing wealth over time.

Our research shows that someone who invested £10,000 in the FTSE All-Share in 1986 and spent their dividends, would now have an investment pot of £57,734. But, if instead they reinvested dividend income, that initial £10,000 would have grown to an eye-watering £219,581 by June 2022.

The long-term impact of dividend reinvesting means that income investors also don’t need to be overly concerned by stock market volatility. That volatility is only an issue if you sell your shares in a dip, thereby crystallising your loss. But, if instead you’re focused on the long-term goal of growing your wealth, then you can keep calm and carry on investing.

Building wealth is a marathon, not a sprint. And in uncertain times, the dividend-focused tortoise rather than the growth-hungry hare is likely to lead the investing race for some time to come.

Read the second and third articles in this series here: Dividend investing: three tips for a comfortable retirement incomeand Dividend yield: three tips to help build your investment wealth