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I really hate to admit I’m this old.

I remember when a gallon of gasoline cost only 25 cents. I remember my parents’ first home. It was a little 1,200 square foot bungalow in the heart of Austin, Texas, which cost them $8,000 over 45 years ago. The same home now has a property tax valuation of almost $200,000. Today, as I anticipate sending off a high school senior to college, his first year of tuition costs roughly what it cost my parents to send me to college all four years just over 20 years ago.

Death and taxes? Why don’t we add inflation to one of three sure things in life!

Addressing this “sure thing” is the goal of this article series. We are pitting dividend growth stocks against high-yield fixed income (specifically preferred shares) to see how each investment measures up against the inevitable eroding power of inflation.

  • Part One: We attempted to mimic the growth power of dividend growth stocks into fixed income, by reinvesting shares. The outcome? It required setting aside 40 – 50% of all dividend income for the purpose of reinvestment simply to match the average rate of inflation of 3% cumulative per year.
  • Part Two: We left fixed income alone and let the average rate of inflation take its toll. The result? While the higher dividends with fixed income initially outperforms, total income will eventually reach par with dividend growth stocks with a growth rate that is outpacing inflation. For a match-off between NextEra Energy (NYSE:NEE) with a dividend of 4% and an average growth rate of 7.45% vs. NextEra Energy Capital Holdings (FGE) with a fixed coupon of 7.45%, I calculated the crossover at 9 years, while others calculated crossovers at the 11-, 12- and 13-year mark.

The easy conclusion to make after the first two installments is that investors should only invest in lower yielding, higher dividend growth stocks. However, for many of those approaching or in retirement, immediate low yield won’t work. Higher income is needed now. The question that will be answered in Parts Three and Four of this series:

Can I have both high income AND inflation protection?

The answer is: YES…with caveats.

Possible Inflationary Scenarios

Amongst academics and economics there is a debate about how bad inflation really will be in 2012, given the current low interest rate environment and sluggish economy. According to the Financial Forecast Center, inflation is actually expected to curve downward in 2012. The "Moore Inflation Predictor" found on inflationdata.com also predicts a downward trend into mid-2012.

The CBO predicts this lower inflation / low interest rate environment will likely exist through 2013.

However, for the long-term investor it’s important not just to look one year ahead, but 10 or 20 years down the road. While we cannot predict the future, we can look at the past as a roadmap.

Looking at the last 20 years, you can see the annual rate of inflation tipping at times above 6%. As well, when you chart the rate of inflation back to the 1970s, some years the rate of inflation was over 10%.

Applying this to our investments, we must ask ourselves: are we really money ahead if we only account for 3% inflation per year? The correct answer is “no.” Accounting for 3% inflation only keeps up with an average rate of inflation. In years where inflation exceeds 3%, we will not be money ahead.

Therefore we need to have our benchmark for dividend growth set higher than 3%. Realistically, to beat inflation we need to be looking at a 6% benchmark, with the understanding that some years have been historically even higher.

Dividend Growth Stocks with High Yield and Inflation-Busting Power

So far in this article series, the most obvious investment for worry-free inflation-busting is dividend growth common stocks. The question now becomes - which ones should we choose? Are there choices that provide high yield as well as high dividend growth? Using David Fish’s Champions, Contenders and Challengers list, which was just updated 12/30/2011, let's look for high yield choices which will meet or beat our benchmarks for inflation.

We first screen for high yield using Five Plus Investor’s benchmark for high yield - 5% or more. The next screen uses the most conservative figure for dividend growth as listed among the 1-, 3-, 5- and 10-year averages. We then divide our choices into two selections: the “good” and the “best.” “Good” choices will have YOY dividend growth between 3 – 5%, which should match the inflation rate of most years. The “best” choices will be growing their dividends 6% or more.

We find a limited selection of choices using this screen:

RATING

Company

Symbol

Industry

Yield

Growth

BEST

Altria Group, Inc.

MO

Tobacco

5.53%

9.2%

Good

Vector Group Ltd.

VGR

Tobacco

9.01%

5.0%

Good

Corp. Offc Prop.

OFC

REIT-Office

7.76%

3.8%

Good

TC Pipelines LP

TCP

MLP-Oil & Gas

6.49%

3.1%

Good

Buckeye Partners

BPL

MLP-Oil & Gas

6.41%

5.1%

Good

Kinder Morgan

KMP

MLP-Oil & Gas

5.46%

5.6%

Good

Plains All- Amer

PAA

MLP-Oil & Gas

5.42%

4.0%

Good

National Health Inv.

NHI

REIT-Health

5.91%

4.5%

Good

Avon Products

AVP

Personal Prods

5.27%

4.5%

Good

Enterprise Product

EPD

MLP-Oil & Gas

5.28%

5.3%

Good

Citizens Holding

CIZN

Banking

5.02%

3.5%

BEST

Dynex Capital

DX

REIT-Mortgage

12.27%

14.9%

Good

PennantPark Inv.

PNNT

Financial Svcs

11.10%

3.9%

Good

StoneMor Ptnrs LP

STON

Cemeteries

9.98%

3.2%

BEST

Omega Healthcare

OHI

REIT-Health

8.27%

9.2%

BEST

Triangle Capital

TCAP

BDC-Fin’l Svcs

9.83%

7.1%

Good

Exterran Partners

EXLP

MLP-Oil & Gas

9.68%

3.4%

Good

Boardwalk Ptnrs

BWP

MLP-Nat. Gas

7.63%

3.2%

Good

Teekay LNG

TGP

MLP-LNG Tran

7.60%

4.9%

Good

Teekay Offshore

TOO

MLP-LNG Tran

7.52%

5.3%

BEST

National Cinemedia

NCMI

Media

7.10%

10.7%

Good

NuStar GP Hldgs

NSH

MLP-Propane

6.49%

5.8%

BEST

Genesis Energy

GEL

MLP-Oil & Gas

6.10%

7.5%

BEST

Crestwood Mdstrm

CMLP

MLP-Nat. Gas

6.05%

11.2%

BEST

NuStar GP Hldgs

NSH

MLP-Oil & Gas

5.95%

6.8%

Good

Holly Energy Ptnrs

HEP

MLP-Oil & Gas

6.51%

4.9%

BEST

Spectra Energy

SEP

MLP-Oil & Gas

5.88%

8.5%

BEST

Astrazeneca PLC

AZN

Drugs

5.83%

12.0%

BEST

Targa Resource

NGLS

MLP-Oil & Gas

6.25%

7.0%

BEST

Energy Transfer

ETE

MLP-Oil & Gas

6.16%

6.4%

BEST

Cheviot Fin’l Corp.

CHEV

Banking

6.45%

9.1%

Good

TransAlta Corp.

TAC

Utility-Electric

5.74%

5.3%

BEST

Birner Dental Mgmt

BDMS

Med. Supplies

5.50%

9.1%

BEST

Reynolds Amer.

RAI

Tobacco

5.41%

8.1%

BEST

Alliance Resource

ARLP

MLP-Coal

5.05%

12.8%

There are 36 choices. Not bad, but there are some problems, especially if you are looking for BEST choices.

First of all, there are almost no choices with a proven track record. The list is ranked with Champions at the top, then Contenders and Challengers. Champions are the most reliable performers, with 25+ years of consistent dividend increases. There is only one choice rated as BEST that is a “Champion”: Altria (NYSE:MO). The remaining BEST choices are either “Contenders”, with 10 to 24 years of increases, or “Challengers” which have the least experience at increasing their dividend (up to 9 years).

Second, there are several choices ranked as BEST that have abnormally high yields due to extreme selling pressure. Several have made David Fish’s “Dividends in Danger” series. These include Avon (NYSE:AVP) and Cheviot Financial (NASDAQ:CHEV).

Third, two choices present a potential moral dilemma to investors. I am speaking of tobacco companies, which may disqualify Altria and Reynolds America (NYSE:RAI) with some investors.

Finally, sector choices are limited. The BEST high-yield performers are heavy oil and gas. Most of the remaining choices are financial in nature. If you take out these two sectors, along with tobacco and "Dividends in Danger," you have only three choices: Astrazenica (NYSE:AZN), National Cinemedia (NASDAQ:NCMI) and Birner Medical (NASDAQ:BDMS). Furthermore, you have no sector representation at all for consumer goods, conglomerates, industrial goods, or technology.

With such a limited selection of choices an investor is hard-pressed to come up with enough choices to create a well-diversified portfolio.

Broaden Your Definition of High Yield

If we are to create a well-rounded retirement portfolio of inflation-busting instruments, we can’t do it with only high yield (5% or more) dividend growth stocks.

The solution? Broaden your definition of high yield. We need to consider not only the yield we want now, but the yield we want 5 or 10 years from now.

If you broaden your horizon on yield, you can create a more balanced, diversified portfolio. This can be as easy as choosing a stock with close to a 5% yield that also has double-digit dividend growth, such as Lockheed Martin (NYSE:LMT), which will likely create a 5% yield-on-cost (YOC) after being held only a year or two.

Using once again David Fish’s CCC list we discover that when we lower yield to 3 to 4%, it opens up the dividend growth investing universe quite a bit. We find 61 BEST selections for 6% or more YOY dividend growth, many with double-digit growth, and many more selections found on the more established “Champions” and “Contenders” list:

RATING

Company

Symbol

Industry

Yield

Growth

BEST

Kimberly-Clark

KMB

Personal Prods

3.81%

7.2%

BEST

Clorox Company

CLX

Cleaning Prods

3.61%

9.5%

BEST

Johnson Johnson

JNJ

Drugs/Cons. Prd

3.48%

6.6%

BEST

Abbott Labs

ABT

Drugs

3.41%

9.3%

BEST

Procter & Gamble

PG

Consumer Prods

3.15%

9.1%

BEST

PepsiCo, Inc.

PEP

Beverages et al.

3.10%

7.0%

BEST

Illinois Tool Works

ITW

Machinery

3.08%

6.3%

BEST

AFLAC, Inc.

AFL

Insurance

3.05%

7.9%

BEST

Unisource Energy

UNS

Utilities/Electric

4.55%

7.7%

BEST

Sunoco Logistics

SXL

MLP-Oil & Gas

4.20%

7.0%

BEST

Novartis AG

NVS

Drugs

4.12%

16.7%

BEST

Watsco, Inc.

WSO

Electronics

3.78%

8.4%

BEST

NTT DoCoMo, Inc.

DCM

Telecom

3.74%

13.6%

BEST

PartnerRE Limited

PRE

Insurance

3.74%

7.9%

BEST

National Bank

NKSH

Banking

3.72%

6.5%

BEST

Unilever plc

UL

Consumer Prods

3.70%

7.5%

BEST

ConocoPhillips

COP

Oil & Gas

3.62%

12.0%

BEST

NextEra Energy

NEE

Utilities/Electric

3.61%

7.0%

BEST

Northeast Utilities

NU

Utilities/Electric

3.60%

7.3%

BEST

UGI Corporation

UGI

Utilities/Electric

3.54%

6.9%

BEST

Southside Bancs

SBSI

Banking

3.32%

9.4%

BEST

Nippon Telegraph

NTT

Telecom

3.25%

17.1%

BEST

Flowers Foods

FLO

Food Processing

3.16%

12.9%

BEST

Met-Pro Corp.

MPR

Ind. Equipment

3.14%

6.1%

BEST

Harris Corporation

HRS

Telecom. Equip.

3.11%

12.8%

BEST

Span-America Med

SPAN

Med. Equipment

3.08%

7.1%

BEST

Chevron Corp.

CVX

Oil & Gas

3.05%

6.9%

BEST

Axis Capital Hldgs

AXS

Insurance

3.00%

7.5%

BEST

Williams Partners

WPZ

MLP-Oil & Gas

4.98%

6.0%

BEST

Lockheed Martin

LMT

Aerospace/Def.

4.94%

21.1%

BEST

Textainer Group

TGH

Transportation

4.81%

12.9%

BEST

Alliance Hldgs GP

AHGP

MLP-Coal

4.69%

19.7%

BEST

Empresa et al.

EOC

Utility/Electric

4.67%

30.6%

BEST

Shaw Communic.

SJR

Telecom

4.66%

8.7%

BEST

Waste Mgmt

WM

Waste Mgmt

4.34%

7.9%

BEST

Avista Corporation

AVA

Utilities/Electric

4.27%

8.6%

BEST

China Mobile Ltd

CHL

Telecom

4.20%

8.1%

BEST

Strayer Education

STRA

Education

4.12%

23.1%

BEST

Alliant Energy

LNT

Utilities/Electric

4.08%

6.7%

BEST

Digital Realty Trust

DLR

REIT-Industrial

4.08%

20.7%

BEST

CMS Energy Corp.

CMS

Utilities/Electric

3.80%

27.3%

BEST

Darden Rests

DRI

Restaurants

3.77%

25.4%

BEST

Hasbro

HAS

Recreation

3.76%

14.8%

BEST

Somerset Hills

SOMH

Banking

3.73%

12.1%

BEST

Tower Group, Inc.

TWGP

Insurance

3.72%

47.0%

BEST

CNOOC Ltd.

CEO

Oil & Gas

3.67%

10.6%

BEST

Rogers Communic.

RCI

Telecom.

3.62%

15.9%

BEST

Heathcare Svcs Gp

HCSG

Business Svcs

3.59%

6.3%

BEST

Raytheon Co.

RTN

Aerospace/Def.

3.65%

12.1%

BEST

Sempra Energy

SRE

Utilities/Gas

3.49%

6.2%

BEST

Intel Corporation

INTC

Technology

3.46%

12.6%

BEST

BHP Billiton plc

BBL

Mining/Oil Gas

3.46%

13.0%

BEST

Hanover Insurance

THG

Insurance

3.43%

12.5%

BEST

Wisconsin Energy

WEC

Utilities/Electric

3.43%

10.0%

BEST

Northrop Grumman

NOC

Aerospace/Def.

3.42%

7.1%

BEST

Oil-Dri Corp. of Am

ODC

Chemical-Spec.

3.36%

6.5%

BEST

NV Energy, Inc.

NVE

Utilities/Electric

3.18%

8.9%

BEST

Microsoft Corp.

MSFT

Technology

3.08%

12.9%

BEST

Arch Coal, Inc.

ACI

Mining

3.03%

8.1%

BEST

General Mills

GIS

Food Processing

3.02%

7.8%

BEST

Evercore Partners

EVR

Financial Svcs

3.01%

15.5%

Conclusion

For investors who require high yield now, especially those in retirement, there is no easy answer to beating inflation. Fixed income with fixed coupon provides current high yield - but no inflation protection. Current high-yield dividend growth provides inflation protection - but few choices in terms of diversification. If your income threshold can stand it, a high-yield investor stands a better chance of creating a more well-rounded, diversified and inflation-beating portfolio by adding a few lower-yield, high dividend growth stocks to his high-yield portfolio.

Next installment: fixed income that stands up to inflation.

Source: Dividend Growth Vs. Fixed Income Challenge, Part 3: Inflation-Busting Dividend Growth Stocks