FA Center: Dividend stocks are a top inflation-fighting investment you want in your corner now

Investors are too quick to shun dividend-paying stocks when inflation worsens. That’s because they’re focusing on too short of a time horizon. When measured over at least several years, dividends historically have done an admirable job of keeping up with inflation.

To illustrate how the short term can lead you astray here, contrast the Dow Jones Industrial Average’s

real (inflation-adjusted) yield currently with where it stood at the beginning of 2021. At that time, the Dow’s nominal yield was 1.9% versus the U.S. Consumer Price Inflation’s (CPI) 12-month change of 1.2% — for a real yield of 0.7%. Now, in contrast, with inflation running at an 8.5% annualized pace, the Dow’s yield is 2.1%— implying a real yield of minus 6.4%. No wonder short-term investors are unimpressed with dividend-paying stocks.

But consider what happens when you focus on a 10-year period. The accompanying chart plots the trailing 10-year growth rate of the S&P 500

dividends-per-share (DPS) and the CPI. Notice that, to an impressive extent over the past century, the two data series tend to rise and fall together. The correlation coefficient of the two series is a statistically significant 0.61.

This correlation would be even stronger if the past two decades were not included, since DPS growth rates have risen markedly in recent years as inflation receded. Those divergent trends are most likely an exception that proves the rule, since the divergence likely was caused by the growth in share-repurchase activity among dividend-paying companies. Other things being equal, repurchases cause dividends-per-share to rise faster than total dividends.

The strong historical correlation means that DPS tend to grow faster when inflation is higher, and vice versa. That’s precisely what you want in an inflation hedge. You just have to be patient.

The stagflation era

Another example of dividend-paying stocks’ inflation-hedging potential comes from the stagflation era of the 1970s into the early 1980s. That era is often Exhibit A in financial advisers’ argument for why you should look elsewhere than dividend-paying stocks for an inflation hedge.

Consider the nine calendar years from the beginning of 1973 through the end of 1981, during which the CPI rose at an annualized rate of 9.2%. During that period, the 30% of stocks with the highest dividend yields produced an annualized return of 9.9%, according to data from Dartmouth College finance professor Ken French — or 0.7 of an annualized percentage point better than inflation.

The S&P 500’s dividend-adjusted return, in contrast, was 5.2% annualized over this same nine-year period — equivalent to a real yield of minus 4.0% annualized.

The return of this portfolio of high-yielding stocks does not incorporate transaction costs, so on a net basis it would be lower. Yet the return probably wouldn’t be much lower, since the high-dividend-yielding portfolio typically is low-turnover. But it would be impressive if this portfolio even kept pace with the market itself, given the stagflation era’s reputation as being terrible for equities.

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Even if this high-yielding portfolio does not beat the market, it’s telling how much better it did than a second portfolio that included the 30% of stocks with the lowest yields. This low-yield portfolio produced a return of 5.0% annualized over this same period. Given that this second portfolio’s return was calculated in the same way as the high-dividend one, and given that their turnover rates should be similar, the spread between the two — 4.9 percentage points — should be a fair estimate of the advantage dividend-paying stocks had over low- or no-dividend payers during the stagflation era.

Finding dividend winners

If you’re persuaded by these historical reflections to consider dividend-paying stocks now, be careful not to load up your portfolio with the highest-yielding stocks. Such stocks tend to be particularly risky, since their high yields reflect the market’s judgment that their dividends are unstable.

Far better to pick less-risky stocks with strong balance sheets. Only consider companies given high scores for quality and safety by independent rating agencies. Choose companies that have a long history of not only paying a dividend but never cutting their dividends. You won’t necessarily pick the stocks with the highest current yields, but you will find companies whose dividends-per-share are likely to keep pace with inflation.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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