Inflation Worries? Fight Back with Dividend Stocks

Budget proposal could change how inflation is calculated
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Inflation is back in the news these days, thanks to President Obama's new budget proposal. That proposal adjusts the way inflation gets calculated in an attempt to raise tax revenue and stem the rise of Social Security spending by slowing the rise in the Consumer Price Index.

No matter how it gets officially calculated, inflation is a real threat to your long-run ability to make ends meet. You need an effective way to fight that threat, especially now that potential changes to the official calculations are likely to slow the automatic benefits you're used to getting from the old method.

Pick your Risk

In this era of abysmally low interest rates, there are no safe and surefire ways to protect yourself from the ravages of inflation. Even recent issues of TIPS bonds -- the U.S. government's Treasury Inflation Protected Securities, which are designed to help investors fight inflation -- currently carry negative interest rates. That means investors will still lose money in real terms after those bonds adjust for inflation.

The real question these days isn't whether you take risks with your money to try to keep pace with inflation -- it's what risks you take just to keep treading water in real terms.

In that light, owning the stocks of companies that pay dividends, have regularly increased their dividend payments, and look capable of continuing to raise their dividend payments just might be the best inflation fighter available to your arsenal.

Why Dividends May Be Your Best Bet

There are three key reasons to believe that successful companies can continue to raise their dividends at least as fast as inflation: accounting, real growth, and cost-cutting.

Accounting: Consider a company that likes to pay a dividend equal to 50 percent of its after-tax earnings to its shareholders as a reward for the risks of owning its stock. If its costs rise in line with inflation and it can pass a similar increase down the line to its customers (whose costs would also be rising in line with inflation), then it has an automatic gain in profits and dividends, in line with that inflation. The table below shows how it works:
First YearSecond Year, After 3% Inflation
Pre-Tax Profits$100,000$103,000
Tax (35%)$35,000$36,050
Profit After Tax$65,000$66,950
Dividend (50%)$32,500$33,475
Dividend Increase3%
Data from author's calculations.

In reality, not all costs or prices rise exactly in line with inflation, but the general concept still holds.

Real growth: Of course, most companies wouldn't be satisfied to just keep pace with inflation; they're trying to grow their businesses in real terms, as well. Assume that, in addition to the 3 percent inflation, they manage to eke out 1 percent growth in both revenues and costs, from really building their business through introducing new products or gaining new customers. The adjusted table would look like this:
First YearSecond Year, After 3% Inflation and 1% Real Growth
Pre-Tax Profits$100,000$104,000
Tax (35%)$35,000$36,400
Profit After Tax$65,000$67,600
Dividend (50%)$32,500$33,800
Dividend Increase4%
Data from author's calculations.

Cost-cutting: Additionally, just like you and I try to look for ways to cut costs in order to keep our own personal inflation rates down, so do companies. They use tactics like "leveraging their scale" to try to get better prices on their larger purchases, not replacing people who leave (or even downright firing folks), and redesigning their products and processes to cost them less.

Assume that same company facing 3 percent inflation and the costs of 1 percent real growth successfully cuts down its baseline costs by 1 percent. Its adjusted table would look like this:
First YearSecond Year, After 3% Inflation, 1% Real Growth, and 1% Cost-Cutting
Pre-Tax Profits$100,000$114,400
Tax (35%)$35,000$40,040
Profit After Tax$65,000$74,360
Dividend (50%)$32,500$37,180
Dividend Increase14.4%
Data from author's calculations.

Those three factors, working together, are what allow many companies to consistently raise their dividends and what enable those dividends to often increase at least as fast as inflation.

Who's Done It?

These sorts of things actually happen in the real world. Several companies have been increasing their dividends for decades, and a few have actually reached the half-century mark of not only paying dividends, but regularly increasing them as well.

The table below calls out a handful of the ones that have been most successful at pulling off that string of longevity:
CompanyIndustryYears of Consecutive IncreasesDate of Last IncreaseAmount of Last IncreasePayout Ratio
American States Water (AWR)Water utilities58July 31, 201227%45%
Genuine Parts (GPC)Auto parts wholesale57Feb. 19, 20139%48%
3M (MMM)Conglomerate55Feb. 5, 20138%37%
Coca-Cola (KO)Beverages-soft drinks51Feb. 21, 201310%52%
Johnson & Johnson (JNJ)Drug manufacturers -- major50April 26, 20127%62%
Data from company press releases and DailyFinance, as of April 10, 2013.

Dividends aren't guaranteed, of course. But given the choice between an absolute guarantee that your buying power will lose ground to inflation over time and a fighting chance to keep pace that's backed up by decades of evidence, wouldn't you want to at least consider giving growing dividends a try?

For More on Dependable Dividends

If you're on the lookout for stocks with strong track records of paying you well for owning them, The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks."

Motley Fool contributor Chuck Saletta owns shares of Genuine Parts Company. The Motley Fool recommends 3M, Coca-Cola, and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson.
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