Many investors want to create an income from their investments, perhaps to meet the expenses of everyday life, pay for a child’s education, or meet mortgage payments without reducing capital. Other investors look for capital growth, but want to achieve this with a cautious outlook.
Often, fixed income investments are recommended to these investors. Cash bonds and treasury securities, for example, give a steady and known return with safety of capital.
But the level of income won’t increase from a fixed income security, and the rate at which the capital grows when interest is reinvested is unlikely to make one rich in any length of time. This creates problems for both income and growth seekers.
Inflation will take its toll
It may be comforting to have a known and steady stream of income from a fixed income investment, but when it comes to inflation then an investor needs to take into account the decreasing purchasing power of his fixed rate income over time.
For example, a fixed income investment of $50,000 that pays interest of 2.5% per year will yield $1250 each year that it remains invested. In 10 years, the annual income will still be $1250. Perhaps an investor who bought such an investment ten years ago did so in order to pay his electricity bill. But with inflation running at an average of 2.5% per year, the investor’s electricity bill will be $1600 now.
The $50,000 bond investment no longer pays enough income to satisfy the investor’s electricity bill.
Rising dividends combat inflation
Now consider the investor who invested his money in ‘ABC’, a business that generates and sells electricity and paid shareholders a dividend of $1.35 (a yield of 4.5%) ten years ago. He invested enough money to generate $1250 in income to pay his electricity bill, also. His total investment was $27,750.
In fact, it turns out that ABC has increased its dividend for 10 consecutive years, and by an average of 4%. The dividend he was receiving on each share is now $1.95. At the time he made the investment, his dividends paid his electricity bill. Now they give him an income of $1850. Perhaps even better, the investment he made into an electricity company is paying his electricity bill, and more besides!
What about the capital value of the shares?
It’s true that share prices can fall as well as rise, so the value of the shares of a dividend stock could indeed have fallen over the duration of the investment. But dividend stocks that raise their dividend year on year tend to rise in price, for the reason explained below.
The first point to note, however, is if the investor were investing for income there is an argument that says the value of the investment is a secondary consideration: dividends are paid per share, not per dollar as interest is. If dividends are rising, and income level following suit, does the value of the investment matter?
Second, however, is this: the stock has been bought in the first place because of its yield: if the dividend keeps rising, then it is likely that the stock will continue to be bought for the yield. This will create buyers that will support the share price.
Consider the stock ABC in the example above. The yield had remained unchanged throughout the term, but the dividend had increased from $1.35 to $1.96. So the share price now is $43.55. The investor’s original investment has increased in value, as has his dividends. It is the increase in dividends that has driven the increase in the value of the shareholder’s investment.
Look for stocks with rising dividends
To protect against the effects of inflation, and give a rising income when it’s needed, an investor could invest in rising dividend stocks. But the rising dividend and high yield are not enough to make the stock a buy.
An investor should also look at the rate of growth of the dividend and the history of that growth. Companies that have a history of raising the dividend year on year are more likely to continue doing so.
On top of this, of course, the business itself should be on a firm footing. Is the dividend cover sufficient for dividends to continue to be paid? Does the company have a good cash flow? Are there legislative or competitive issues that may hamper earnings growth in years to come? What is its debt position? All these questions and more should be addressed before committing to an investment.
A good place to start the search for potential dividend candidates is to google for dividend aristocrats (those stocks that have a 25 year history of raising dividends) and dividend achievers (which have a 10 year history of consecutively rising dividends).
A company that raises its dividend is not only rewarding its shareholders but also indicating its confidence in the future, and its potential for on-going profitability. But before making an investment, you should conduct a level of research that produces reasons for owning the shares other than a good dividend paying policy.
Not all those companies that have a history of increasing dividends will continue to do so. Some investors will argue that a dividend stock should never be sold. But, perhaps, when a company that has raised its dividend for 20 years or more suddenly does not do so, or even cuts the amount, it is a sign of changing fortunes that should not be ignored.
As with any portfolio, although a dividend stock portfolio creates a passive income that can be reinvested easily, it should be managed and monitored on a regular basis. Keeping on top of individual constituents, and maintaining proper diversification, will help to ensure those dividends keep on rising and your income beats inflation.