Dividend stocks are an excellent source of passive income. These stocks also produce solid returns with less volatility than others. According to a study by Hartford Funds, companies that have initiated or increased their dividends have delivered returns of 10.2% annually. This outpaces an equal-weighted S&P 500 index, which has gained 7.7% annually.
Paying and raising dividends across recessions is an impressive feat only accomplished by companies with steady revenue streams and strong cash management. One company that has increased its dividend every single year since 1960 -- a timespan that has included nine recessions -- is Cincinnati Financial (NASDAQ: CINF). Here's how this insurer accomplished this feat and why it can remain a reliable income stock for investors.
A business that grows along with the economy
Cincinnati Financial writes insurance policies for businesses and individuals, specializing in property and casualty coverage. Insurers can generate consistent cash flows because of the nature of the business.
Berkshire Hathaway Chief Executive Officer Warren Buffett has credited his company's insurance investments as being a big chunk of his company's value, saying that insurance products "will never be obsolete, and sales volume will generally increase along with both economic growth and inflation." The insurance business is resilient as long as insurers measure and price their risks appropriately. This is something that Cincinnati Financial has done a stellar job of for years now.
One way to evaluate how good an insurer is at measuring risk and pricing policies is through its combined ratio. The combined ratio is a key metric insurers use to measure the percentage of expenses plus losses on policies divided by total premiums collected. (It notably doesn't include an insurer's investment income.) The best insurance companies consistently take in more premiums than they pay in claims and expenses. Over the past 21 years, Cincinnati Financial's combined ratio has averaged 96% -- beating the industry average of 100% in the same period.
Image source: Getty Images.
Here's how Cincinnati Financial navigated a difficult time
Cincinnati Financial has done a standout job of raising its dividend for decades. If it cannot continue writing profitable policies, it could put this streak at risk. In the insurance industry, sound underwriting is essential to long-term success.
Cincinnati Financial had its share of struggles during the Great Recession. From 2008 to 2011, the insurer's combined ratio jumped to 104% -- a sign that its policies weren't profitable. Some of these struggles could be attributed to the environment for insurers at the time. After all, the industry average was around 102%. It was impressive that Cincinnati Financial still managed to increase its dividend payout, albeit modestly, to keep its streak alive. This is a testament to its strong balance sheet and cash management.
Things began to improve when Cincinnati Financial hired its current chief executive officer, Steve Johnston, in May 2011. The insurer upgraded its predictive analytic models with Johnston at the helm to better assess and price underwriting risks. It credits these predictive modeling tools and analytics, along with a trove of data, for giving it more precise pricing. Since 2011, its average combined ratio has been a superb 95%.
Why it can keep delivering for income investors
Cincinnati Financial has done a solid job of writing good insurance policies, but has recently seen its combined ratio tick up. Last year, its combined ratio was 98% -- a sizable jump from 88% just the year before.
While this jump isn't ideal, it aligns with what other insurance companies have experienced. According to S&P Global Market Intelligence data, the average combined ratio across the industry last year was 102.4%, the highest since 2017.
Insurers have dealt with increased claims costs due to more accidents and higher costs to repair and replace vehicles or property due to inflation. In response, these companies continue to raise customer premiums and become more selective about the policies they are willing to take on.
Data source: YCharts
That said, I'm not too concerned about Cincinnati Financial's recent uptick, because it is consistent with what others in the industry are experiencing. The company should have no problem maintaining and raising its dividend from here. Last year, it paid out $2.76 per share in dividends, compared to $12.83 per share in free cash flow. That gives it plenty of room to maintain and boost its dividend -- making it a reliable passive income stock to add to your diversified portfolio.
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Courtney Carlsen has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway and S&P Global. The Motley Fool has a disclosure policy.
