Mark Lister: Good growth the way to conquer inflation

Nothing stands still in this world, especially the cost of living. Investment portfolios can't stand still either. They must generate an income that, over time, grows at a rate that at least matches inflation.

This week saw the release of inflation for the third quarter. At 1.1 per cent it was only a shade over the Reserve Bank's forecast of 0.9 per cent. This takes the annual inflation rate to a relatively modest 1.5 per cent, well within the Reserve Bank's 1 to 3 per cent target range.

This is something of a false dawn, however, as the inflation rate is expected to spike to more than 4 per cent as the increase in GST works its way into consumer prices, althoughit should settle back to around 2.5 per cent by this time next year.

But an inflation rate of 2.5 per cent is still bad news for investors. Over 10 years inflation of this level will reduce the spending power of your capital by 22 per cent.

When you're working, inflation-protection comes from hard-earned wage rises. But once you have retired you're on your own.

You become reliant on your portfolio for your current income, and future income. The only way to maintain your spending power over time is if your portfolio to generate growth in your income stream at a rate that at least matches inflation. Hence the importance we place on the concept of yield inflation, or income growth.

Fixed income is fantastic for lots of things, but income growth isn't one of them. Fixed income is unbeatable if you are looking for security of income and capital. It also does an excellent job of providing a portfolio with a buffer against volatility. But fixed income is not the place to be if you are looking for yield inflation.

The income stream from fixed income depends on changes in interest rates and, as we know, these move up and down in cycles. They do not continually rise over time.

Consider an investor who retired in 1985 with $100,000 and invested it all in six-month deposits. Using the Reserve Bank's data, at this time this investor could have earned a hefty interest rate of 17.8 per cent, giving an annual income of $17,800 before tax. Assuming they spent all this income and weren't able to add anything to their capital, where would they be today?

According to the RBNZ again, the six-month deposit rate is currently 4.7 per cent. Thus, our investor would today be earning only $4700 from a portfolio. That represents a 73 per cent drop in income.

Once inflation is factored in - accumulated inflation in New Zealand since 1985 has been 153 per cent - the $4700 they would now be earning would have the spending power of $1833.

Nevertheless, many investors continue to have all their savings in fixed income. Unless they are in a position to be able to compound a good proportion of their interest, or are exempt from tax, this leaves them vulnerable to inflation.

Including some growth assets like property and shares can provide some protection from inflation. Shares provide returns in two ways - capital growth and dividends. Capital growth comes from a rising share price, while dividends are an income stream that is paid by the company to shareholders out of profits.

Good companies endeavour to not only pay a solid dividend but increase this dividend over time. It is these dividend increases that provide investors with inflation protection.

A number of New Zealand companies have long track records of providing growing dividends for shareholders. The average dividend growth from 2000 to 2010 for Ryman Healthcare, TrustPower, Auckland Airport, Mainfreight, Port of Tauranga and Ebos, for instance, was 278 per cent.

Since 2000, accumulated inflation in New Zealand has been 32 per cent. Some of the stocks listed above have been able to grow their dividends by 10 times this rate.

Ryman has grown its dividend by 510 per cent, from 1c per share in 2000 to 6.1c per share in 2010. This means an investor who bought Ryman shares in 2000 at a share price of 40c would today be earning a gross dividend yield of 15.3 per cent on their cost price. In 2000, their dividend yield was just 2.5 per cent.

Likewise, Mainfreight is providing a gross dividend yield of 17.7 per cent for those who bought shares in 2000 at $1.49. At this time, Mainfreight shares were providing a yield of 5.6 per cent.

Income growth also drives capital growth. The share prices of these companies have also risen strongly over the past 10 years.

Australian and overseas companies tend to have more scope to grow profits and dividends because they have more growth opportunities. Because of this they tend to pay out a lower portion of their profits as dividends, leaving them more cash to reinvest in their companies.

Some leading American companies have provided shareholders with continuous dividend growth over many decades. Some examples include Procter & Gamble, which has grown its dividend every year for 53 years, 3M, which has done so for 52 years, Coca-Cola, for 48 years and Johnson & Johnson, which has delivered 47 years of dividend increases.

A number of investment trusts also have excellent dividend growth track records. Bankers Investment Trust and City of London Investment Trust have grown their dividends every year for over 40 years.

Unfortunately, sometimes companies that have had a track record of growing their dividend hit problems. Telecom is a classic example. In 1999 it was a compelling dividend-growth stock. It offered the safety of a utility, the growth of a technology stock and a high dividend. Today, 11 years later, thanks to a range of problems, Telecom's dividend and share price have fallen by around 70 per cent.

When investing in shares for income growth, finding shares that have a solid track record of dividend growth is an important place to start, but diversification and judgment remain as important as ever.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.