Grow your divis to beat inflation

Rising dividends are one way to confront the cost of living crisis. Robert Stephens explains how to identify the stocks well placed to pay shareholders more

The highest rate of inflation since 1992 means that many income investors are experiencing a decline in their spending power: the dividends paid by their stock holdings are, in many cases, failing to keep pace with seemingly uncontrollable rises in the cost of living.

As the Bank of England now expects inflation to peak at around 10pc by the end of the year, investors who rely on their portfolio for some or all of their income face a very challenging period.

Owning stocks that can deliver rapid dividend growth is one strategy to counter money’s continuing loss of value. While there is no magic formula for identifying such stocks, investors can increase their chances of success by following a few simple steps.

PRICING POWER

A key consideration when seeking companies that can quickly grow dividends in an inflationary environment is whether they are able to pass higher costs on to customers. Some firms, such as those in the tobacco and utility sectors, should have little difficulty in achieving this goal thanks to the inelastic nature of demand for their services.

Others, though, will need either unique products, strong brands or contractual agreements that allow them to raise prices and hence grow dividends. Company updates, backed by your own observation and common sense, will be useful here.

DIVIDEND POLICY

It’s also worth looking at a firm’s dividend policy. You should be able to find it in investor updates such as the annual report and it will state how the management team plans to use any spare cash in future. Some will seek to reinvest excess capital in growth opportunities such as new products or expansion into new regions or countries. Others will aim to make acquisitions to grow. Others, often those in more mature industries, where growth opportunities are relatively modest, may instead say they will return excess capital to investors in the form of dividends.

While dividend policies can change according to trading conditions, they provide an insight into how dividend payments may evolve over time.

BUSINESS MODEL Unfortunately, many firms currently face an uncertain outlook. Alongside high inflation, the Bank of England expects economic growth to slow in the coming months. Therefore, investors should seek companies that have a resilient business model capable of overcoming tough economic conditions so that they can continue to raise dividends. Factors such as their market position relative to rivals, and the characteristics of the industry in which they operate will influence the reliability of their dividends. Annual reports and investor updates should give you much of the information you’ll need to help you make a judgment.

TRACK RECORD

A firm’s record of dividend payouts during past periods of economic turbulence will often provide insight into its likely future performance. If a company managed to maintain or grow its dividend during the financial crisis or the pandemic it may well be able to do so now. Information on past dividends can usually be found in the “investors” section of a company’s website.

TOO MUCH DEBT?

Rising interest rates threaten companies that have taken advantage of too much cheap borrowing in recent years. If that debt becomes more expensive to service it will reduce the amount of cash available to pay a growing dividend.

You can get a sense of whether a company is overborrowing by comparing total debt to net assets ( both available in annual and interim reports). A ratio of less than 100pc is often considered healthy, although higher levels are acceptable in defensive industries such as utilities and tobacco. Comparisons with similar companies may be useful.

As an alternative yardstick, firms that currently enjoy generous “interest cover”, calculated by dividing operating profits by net interest costs (also available from annual and interim accounts), should be less vulnerable to rising interest rates.

THE ‘PAYOUT RATIO’

There is always a limit to how much any company can afford to pay in dividends over the long run. Although borrowings can be used to temporarily raise shareholder payouts, ultimately firms can only pay shareholders an amount equal to or less than their profits. Otherwise, their payouts will become unsustainable.

Companies that have a modest dividend payout ratio, calculated by dividing dividends paid by net profits, may also be in a stronger position to pay more in future. They may be able to raise dividends at a faster pace than their earnings growth rate with

The cigarette company British American Tobacco is well placed to raise its dividend

out compromising long-term financial health.

BUT NO GUARANTEES Clearly, there is no guarantee that any company will increase dividends at a pace that matches or beats inflation. This is particularly true in the current environment, where raising dividends at a double- digit pace, in line with the Bank of England’s inflation forecast, is a challenging proposition. It is made even more difficult by the worsening economic outlook.

However, investors who depend on their portfolio for an income face the real threat of a significant fall in spending power. Using our simple but structured approach to identify companies that offer a higher chance of raising dividends at a rapid pace could allow such investors to emerge from current economic difficulties in good shape.

Robert Stephens, CFA, is an independent equity analyst