If a company has the low debt and healthy cash flow required to throw off juicy dividends, it follows that the balance sheet is intrinsically sound enough to sustain the company through bear markets and rising inflation.

What’s more, research shows that dividend growers outperform high-dividend yielders during Federal Reserve tightening cycles.

Accordingly, if I had to pick the single best investment to hedge against inflation and still provide income, it would be the Vanguard Dividend Appreciation Index ETF (VIG).

The easiest way to protect yourself against rising inflation is to hold companies that can withstand inflationary periods. Those are generally companies that wield strong pricing power in their markets and have the flexibility to pass along higher costs.

One way to separate the wheat from the chaff is to look at dividend yields. Companies that have consistently increased their dividend payouts across business cycles, particularly inflationary bursts, clearly enjoy pricing clout.

During the worst of the coronavirus pandemic, as many S&P 500 companies slashed dividends to conserve cash, VIG’s constituent companies by and large held steady with their payouts.

The stream of dividend income from the fund’s holdings has helped bolster its performance during downturns. When the market plunged 37% in 2008, the fund declined just 26.6%. As the following chart shows, VIG has historically been a consistent performer:

Vanguard doesn’t disclose the precise method it uses to construct the fund’s index, but its process is clearly focused on high-quality securities. For example, a company only merits inclusion if it has increased its dividend in each of the last 10 years.

The average stock in the fund’s portfolio tends to command a lower price-to-earnings multiple than the S&P 500, while having higher historical sales and earnings growth. The fund’s constituents also have lower payout ratios and clean balance sheets.

As a result, the ETF strikes an excellent balance between growth and value investing, while ensuring that its holdings pay growing and sustainable dividends. The fund’s investment strategy has also led it to select holdings that show superior revenue growth relative to their peers.

The bluest of the blue chips…

The fund’s holdings represent the cream of blue-chip dividend payers. Many of these companies are familiar names that produce household brands.

VIG’s top five holdings (listed here in order of ranking) are recognized as leaders in their respective industries: Microsoft (NSDQ: MSFT), JPMorgan Chase (NYSE: JPM), Johnson & Johnson (NYSE: JNJ), Walmart (NYSE: WMT), and UnitedHealth Group (NYSE: UNH).

The fund is well-diversified, with allocations spread roughly evenly among several sectors, with financial services (19.8% of assets), health care (16.57%), and technology (16.31%) representing the top three.

Think of dividend growth investing as a total return-focused equity strategy with a defensive bias. VIG meets that description and is suitable as a core holding in any portfolio.

During the previous bull market, many investors did well by owning dividend stocks that got bid up because of low interest rates. However, amid rising interest rates, weaker dividend paying stocks are increasingly at risk.

Chasing yields can lead to catastrophe. Buying quality dividend growers is a safer path to income as well as market outperformance.

With net assets of $71.2 billion, VIG’s yield is 1.93%. The expense ratio is a low 0.06%. This ETF is an inexpensive option for adding an inflation-beating stream of income to your portfolio, while providing downside protection during this bear market.

Editor’s Note: Knowing your risk tolerance will help you decide which investment strategy is right for you. For example, if you have a low risk tolerance, you may want to emphasize safe haven investments even though your time horizon indicates you could be more aggressive.

If you’re investing for income, your focus should always be on the health of the underlying business. The best dividend stocks are the ones that are in good shape and growing, so they can maintain and raise their payouts. For our special report on safe, high-income stocks, click here.

John Persinos is the editorial director of Investing Daily.

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