Wednesday, July 29, 2015

Dividend Growth Stocks Protect Investors from Inflation

One of the biggest risks that investors in retirement face is inflation. There is a general trend of rising prices over time, which decreases the purchasing power of cash today, as prices on many items slowly increase. A dollar today is going to have a higher purchasing power than a dollar received in 2025.

Dividend growth stocks are the ideal venue for investors in retirement. This is because the dividend income usually rises faster than the rate of inflation, in diversified portfolios of dividend paying securities. For example, historically prices have risen by an average of 3.90% per year between 1960 and 2014. However, annual dividends on the S&P 500 index have increased by 5.60%/year between 1960 and 2014. I have taken the S&P 500 as a proxy for overall dividend growth that could be expected from a diversified portfolio of US stocks.

Based on this exercise, it seems that over time, the growth in dividend payments has exceeded inflation by over 1.70% per year. While this does not seem like a lot, if this tiny amount is compounded over long periods of time, it could turn to a pretty sizeable pile of extra inflation proof cash. A dollar that compounds by 5.60%/year would grow over 19 times in 54 years. In comparison, a dollar that grows by 3.90%/year only grows almost eight times over the same time period.

The other risk that investors face is longevity risk. However, once you have assembled a diversified portfolio of dividend growth stocks, which delivers sufficient retirement income that grows above the rate of inflation, you have essentially killed two birds with one stone. As a rule, investors should plan for at least a 30 year retirement. This means that whether you retire at 40 , 50 or 60 years of age, you should follow a similar investment strategy that focuses on a sustainable and growing distribution income, that maintains purchasing power over time by the very least.

Therefore, if your portfolio generates the income you need on day one of retirement, and it can be reasonably expected that this income will grow over time, then you should be pretty set for retirement. The other defense mechanisms to ensure that dividend income grows over time is by focusing your attention only on the companies that can grow earnings over time, have sustainable distributions and are acquired at reasonable prices. If you also add in the additional layer of protection that diversification provides, by acquiring stakes in at least 30 – 40 individual securities from several sectors, you would have increased your odds of staying retired forever.

For example, at the end of 1994 Exxon (XOM) was selling for a split-adjusted $15.1875/share, and paid a quarterly dividend of 18.75 cents/share. This translated into an annualized dividend of 75 cents/share for an effective yield of 4.90%. Ten years later, Exxon had already merged with Mobil to create ExxonMobil and was paying an quarterly dividend of 27 cents/share. This corresponded to an annual dividend of $1.08/share, for an effective yield on cost of 7.10%. If we go forward by another decade to early 2015, we have ExxonMobil paying a quarterly dividend of 73 cents/share, or $2.92/share annualized. This translates into an yield on cost of 19.20%. To put it in dollar terms, if a retiree had put $10,000 in ExxonMobil stock in 1994, they would have received $490 in annual dividend income from the position. If they kept spending all the dividend income for over 20 years and never reinvested another dime into the position, they would be earning more than $1920 in annual dividend income by 2014. At the same time, the retiree would need less than $900 in 2015 to have the same purchasing power as the $490 they earned in 1995. This means that the growth in dividends outpaced inflation in a way that the retiree had the options to either succumb to lifestyle inflation or invest any extra income into other income producing assets. They could have picked companies like Coca-Cola (KO), Kellogg (K), General Mills (GIS) along the way, and further turbo-charged their dividend compounding process. Investing trough a tax-deferred account such as a Roth IRA would have also resulted in minimization of taxes over time.

Chances are that over the next 30 years the composition of your dividend portfolio will be different, as many companies merge, spin-off subsidiaries, get acquired. A few might end up cutting distributions, before failing outright. The beauty of the strategy is that on average, the winners will be able to grow your dividend income enough to compensate for those who eventually cut or freeze distributions. In my case, my organic dividend growth has always outpaced inflation since I started my journey.

Full Disclosure: Long XOM, KO, K, GIS

Relevant Articles:

Investors Should Look for Organic Dividend Growth
The Pareto Principle in dividend investing
Dividend Stocks for Inflation Adjusted Income Streeams
Dividend income is more stable than capital gains
The Four Percent Rule is Dependent on Dividend Yields

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