By Charles Farrell and Fred Taylor
For the last five years, investors have been waiting with anticipation for the next outbreak of inflation. Why? Because many investors believe that the Fed’s aggressive action to both lower interest rates and make more money available for consumer and business loans should have led to an inflationary surge in the economy. But, for reasons that aren’t fully understood, the easier access to credit has not translated into significantly higher consumer and business spending, so inflation remains low.
History, however demonstrates that at some time, we are likely to experience another period of higher inflation as a result of the Fed’s policies. It just may take longer than anticipated; and oddly enough, it may follow a period of deflationary pressure. Yet all this money floating around is likely to find its way into the economy and drive up consumer prices at some point.
Since inflation is all about rising costs, to get ahead of the inflation threat, investors need to find an income stream that can rise along with inflation. Historically, one of the best places to find a rising income stream has been in the stock market through dividend payments.
While many investors understand that companies pay dividends, they don’t often understand dividend growth and its ability to help outpace inflation. Since dividends are fundamentally paid from company profits, as the economy and company profits grow, the dividend payments tend to grow. Thus, the dividend offers a good opportunity to receive an income stream that both keeps up with and often outpaces inflation.
For instance, between 1990 and the end of 2013, dividend payments for S&P 500 companies increased a little more than 5 percent annualized, while inflation was only 2.6 percent. That means if you had received $1,000 in dividends from an investment in S&P 500 stocks at the beginning of 1990, those dividend payments would have grown to about $3,300 per year by 2013, while the costs of goods you bought in 1990 for $1,000 would have increased to about $1,850 by 2013. That’s how dividend growth can help investors maintain and even increase purchasing power over the long term.
This concept of dividend growth can be applied to an entire portfolio of dividend-paying companies with the goal of driving up income each year faster than inflation. By starting to compound dividend income now, investors can build up greater cash flow to help offset whatever higher inflation we may experience later. And if inflation stays low, then all the better, because that income would be growing that much faster when compared to inflation.
While dividends and dividend growth are not guaranteed, they have historically proven their ability to keep up with and outpace inflation. That’s why we continue to focus on what we believe are higher-quality, dividend paying companies. We think the potential for growing cash flow today will help investors get well ahead of the negative impacts of inflation down the road.
For those who are still saving for retirement, that growing cash flow can be directed back into the portfolio as new investments. And for others living off their investments, that cash flow can be used to help meet their lifestyle needs. Either way, we think the dividend growth objective can help investors build both asset values and income streams to outpace inflation
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*Source: S&P 500 Index dividend data from S&P Dow Jones Indices, S&P 500 historical quarterly, per share earnings and dividend data. Inflation data from Ibbotson Associates Stocks, Bonds, Bills and Inflation 2014 Classic Yearbook.
Charles Farrell is chief executive officer of Northstar Investment Advisors, LLC in Denver, and the author of “Your Money Ratios: 8 Simple Tools for Financial Security.“
Fredrick B. Taylor is president of Northstar Investment Advisors, a firm he co-founded in July 1995. He began his investment career in 1984 on the municipal bond trading desk at Mabon Nugent in New York City. From 2008-2010, Taylor served as an economic advisor to Colorado Governor Bill Ritter. He is also a member of the Colorado Forum. He serves as treasurer for The Children’s Hospital Colorado Foundation.