Hedging against inflation with dividend-paying stocks

A little context: Investors may not realize it, but dividend stocks already generate more than half their returns, as the majority of companies listed on market indexes pay dividends. In the past, it was largely utilities, telecom companies and banks that issued dividends. Now, tech stocks, retail stocks—all types of companies—issue dividends, so long as they are in a position to do so. This is another reason dividend-paying stocks are attractive: They inspire confidence that a company has a healthy cash flow, revenues and profits. 

My approach to investing in dividend-paying stocks is to focus on the stock’s growth potential versus just buying stocks that pay the highest dividends. I do this for two key reasons:

1. I’m focused on long-term growth.

2. The way I see it, investing in dividend-paying stocks allows me to get paid while I wait for my investments to grow in value: a great recipe for success.

Here’s what you should know about dividend-paying stocks:

What is a dividend-paying stock?

A dividend-paying stock is a company that pays a portion of its earnings to shareholders on a regular basis. Usually, companies pay dividends each quarter. Dividends are not mandatory. They are not guaranteed and can be increased, decreased or eliminated at the discretion of the company issuing the dividend.

Even though they’re not obligated to pay dividends, companies that do will avoid lowering or eliminating their dividends because this could signal to the market that there is a problem, which could cause the share price to plunge. In fact, some companies increase dividends over time. This has certainly been the case for dividend-paying companies in Canada’s finance sector. Canadian banks, for example, tend to increase their dividends twice a year.

What you earn with a dividend-paying stock

There are two parts to your total return on dividend stocks: the regular dividend payment and the appreciation of the underlying stock. Even if the share price dips, you will still collect the dividend.

Seven benefits of dividend-paying stocks

1. You get paid to wait for your investment to grow.
2. Consistent payments can help your portfolio grow more quickly. Not only do you achieve growth as the stock’s value grows, but you also get regular injections of income that you can reinvest in your portfolio, increasing your compound rate of return.
3. Your portfolio gets a liquidity boost. Those regular payments mean you don’t have to sell stocks to access cash.
4. Dividend-paying companies tend to increase their dividends over time.
5. Canadian dividends are taxed at a lower rate than interest income and earned income.
6. Dividends reduce the overall risk and volatility of a portfolio because dividend payments can offset potential losses.
7. Dividend-paying stocks tend to outperform non-dividend-paying stocks. According to New York Life Investments, dividend-paying companies outperformed the S&P 500 in 12 of the 20 years from 2000 to 2019. This includes the five years during this time frame that the S&P 500 ended down for the year. However, during the COVID-19 pandemic, dividend-paying stocks have underperformed.

Dividend-paying stocks as a hedge against inflation

Inflation is now running at nearly 6% in Canada—the highest rate in three decades—eating into purchasing power and making it hard for investors to realize net gains. Dividend-paying stocks with high yields can help offset the impact of inflation on investment returns, but you have to be careful and make sure the stocks you invest in reflect your risk profile and investment objectives.

I would go one step further. If you are going to buy investments primarily for the dividends, choose companies that have good growth potential, too. Otherwise, it won’t be long before inflation cuts into dividend earnings. This is why I advise my clients to stay away from stagnant, low-growth dividend payers and focus on stocks with good growth potential that also pay dividends. (Read MoneySense’s list of the best dividend stocks for this year.)

Final thoughts

As with any investment, do your homework. Look for good-value, quality investments that are positioned for growth. Talk to your investment advisor about the role dividend-paying stocks can play in your portfolio. They can help you weather all the uncertainty and stay invested: the key to growing your wealth long-term.

Allan Small is the Senior Investment Advisor at the Allan Small Financial Group with iA Private Wealth (allansmall.com) and the author of How To Profit When Investors are Scared. He can be reached at [email protected].

Read more from Allan Small:

• The meaning of market swings—and why you should care
• A contrarian approach to inflation, interest rates and the markets
• What we learned about investing during a pandemic

About Allan Small, FMA, FCSI

Allan Small is the Senior Investment Advisor at the Allan Small Financial Group with iA Private Wealth and host of The Allan Small Financial Show. He is also the author of How To Profit When Investors Are Scared. He can be reached at [email protected].

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