Like it or not, higher inflation looks set to become a key theme for UK investors over the medium term. Due to uncertainty surrounding Brexit, the pound has weakened and this has pushed import prices higher. As such, being able to earn an income from dividends which stays ahead of inflation will become increasingly difficult. However, these two stocks have the potential to do just that.
With the Bank of England expecting UK inflation to reach 2.8% in 2018, National Grid's (LSE: NG) yield of 4.8% has considerable appeal. It means that the company's investors should still be able to record a positive real-terms income even if the price level rises at a relatively fast pace.
However, in addition to its high yield, National Grid also offers strong dividend growth potential. Its medium term aim is for its dividend growth to at least match inflation. Given the current dividend coverage ratio of 1.45, there is considerable headroom for National Grid to increase dividends at a faster pace than earnings growth over the coming years.
Furthermore, National Grid offers excellent defensive qualities. Its earnings outlook is highly visible and it offers almost bond-like characteristics in terms of having relatively dependable returns and lower risk than many of its index peers. And with National Grid's share price having fallen by almost 10% since the US election, it now offers significantly better value for money.
For example, National Grid has a price-to-earnings (P/E) ratio of 14.4, which indicates that it offers a wide margin of safety. Therefore, ahead of potentially higher inflation and risks such as Brexit and a Trump Presidency, National Grid appears to be an obvious buy.
While the provision of food and support services is not as robust as power transmission, Compass Group (LSE: CPG) has appealing defensive characteristics. Evidence of them can be seen in the fact that its average earnings growth rate during the last four years has been 8.3%. And while the UK economy may endure a difficult period thanks to Brexit, the defensive characteristics of the food services industry should provide a degree of stability in future.
In terms of its earnings growth rate, Compass is expected to record a rise in its bottom line of 12% in the current year and 17% next year. Alongside a dividend coverage ratio of 1.9, this provides it with tremendous scope to raise dividends at a pace that is significantly higher than inflation. In fact, Compass is expected to increase shareholder payouts by 9.1% next year and it would be unsurprising for this rate of growth to continue over the medium term.
With Compass yielding just 2.3%, many investors may be put off buying it at a time when the FTSE 100 yields 3.7%. However, Compass offers a reliable yield with the potential to grow rapidly. Therefore, it is likely to become a top pick for income investors as inflation rises.
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Peter Stephens owns shares of National Grid. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.