Deferring the snowball of dividends for long-term income investors

The objectives of income investing could be divided into two broad categories: 1) to fund living expenses and retirement with portfolio distributions without accessing the capital itself, and 2) to pocket current income that could be reinvested in yield-bearing assets yield, thus facilitating the so-called “snowball” effect.

In practice, it may be that in the pre-retirement period, investors apply the second approach and then, once retirement begins, the income from the portfolio is taken out to meet daily needs. This practice is also relevant in my case.

It obviously depends on the risk tolerance and risk appetite of each investor, but I don’t think it would be wrong to say that the following elements form a structural basis of how the strategy is designed by such investors:

• Finding securities that offer attractive returns an absolute base and are certainly above what the growth-oriented indices provide.
• Keeping distribution reduction probabilities as low as possible.
• Capturing an additional layer of profitability, especially in the form of periodic dividend increases.

Effectively, it comes down to a pure buy and hold process where a significant amount of due diligence is done before investing to ensure that your snowball will gradually get bigger as time goes on.

My personal goal is to find solid income generators, add them to a portfolio and sell only if there is a fundamental change in the business (eg the company decides to venture into risky segments to accommodate growth at the expense of a strong balance sheet ). What this means is that I’m actually not that keen to experience share price appreciation as it just makes the dividend reinvestment process less attractive due to the reduced level of yield. Instead, the most important thing is to have income streams that are predictable, resistant to various types of economic uncertainties and, of course, attractive enough without the presence of speculative conditions.

In the article below, I will detail two layers that are vital to adapting such a low income snowball strategy.

Getting the slope and size right

One of the first questions investors must ask is whether to place more emphasis on growth or yield. The basic question is whether it is worth taking a lower yield at the start to eventually access a higher income portfolio that would be supported by a strong dividend growth profile.

Theoretically, the longer the time horizon, the stronger the trend should be towards bullish stocks. It is possible to find top companies that offer consistent dividends with very attractive earnings growth dynamics. Not surprisingly, however, these yields are automatically lower than what might be found in the higher yield space. One of the best proxies for this specific category is the Schwab US Dividend Equity ETF (NYSEARCA:SCHD), which includes 103 different stocks focused on large-cap dividend growth.

That said, my preference goes to higher yielding alternatives (even as an investor who has more than 20 years until retirement). Let me explain.

First, let’s take a look at two hypothetical scenarios, which I’ve tried to describe below in a (hopefully) understandable way. Scenario A assumes an initial yield of 7% and earnings growth of 2%, while scenario B is based on an initial yield of 3% and dividend growth of 10%. In my humble opinion, these are entirely realistic assumptions for risk-free income strategies given the prevailing interest rate environment.

What this graph reveals is that, following scenario B, it would take about 20 years for income growth investors to catch up with those who decided to invest in higher-yielding but slower-growing stocks. Of course, if we factored in a more notable price appreciation component, we could probably expect a better total return result for the growth scenario. However, in this case, we would also have to recognize a negative effect on returns, as each dollar reinvested would be subject to a higher asset price, making the return on reinvestment lower accordingly.

Second, whenever an investment decision is based on return assumptions that stretch far into the future, the overall risk profile automatically becomes higher. Here, I am quite skeptical about companies that would be able to deliver double-digit dividend growth statistics or close to those decades in a row. The larger the company gets, the more difficult it is to sustain the growth rate, as market shares usually erode, pricing power declines, and products/services tend to eventually be replaced by other innovative items. Now, I’m not saying it’s not possible to grow dividends at 10% for 10 or 20+ years. It’s just that the odds aren’t that great.

Third, typically when we’re talking about attractively yielding names that are backed by robust cash flows, the emerging sectors tend to be system-critical for which there will (very likely) always be a demand. For example, it is difficult to imagine a situation where real estate will no longer be needed (think REITs with nice-yielding stocks). Similarly, there is very little chance that midstream infrastructure will disappear from economic activity in the next 20 or 30 years (think MLPs). Furthermore, if we consider scenario A, achieving a growth rate of 2% per year is not that difficult or speculative. In many cases, these high-yielding stocks have their cash flows tied to long-term contracts that have a built-in component of periodic cash flow increases that are at or closely mirror the CPI.

Finally, given the time it takes for the revenue-focused strategy to outpace the capital generated by higher-yielding strategies, as well as the underlying risks involved in growth companies pursuing high growth rate targets for a long period of time, it seems more beneficial to me. to focus on juicy dividend yields that are subject to conservative growth levels.

In other words, for me, it boils down to starting with a bigger snowball and rolling it forward on a not-so-steep belay to avoid risks.

Make the snowball durable

In the process of achieving that attractive compounding effect of income investing, it is essential to take care of the risks before letting the snowball roll down the hill.

I will describe some fundamental factors that clearly reduce this process, reducing the likelihood of loss of income.

The essence here is beautifully captured by Warren Buffett’s famous quote:

If we avoid the losers, the winners will take care of themselves.

Strategy – when choosing high yielding names, we need to understand that there are usually three reasons why a particular stock offers juicy levels of income. The premium could be attributed to a financial crisis, where cash flow prospects are unclear. The second could be related to a situation where the business itself is speculative and depends, for example, on volatile commodity prices or macro-sensitive demand dynamics. And the third could be associated with the “boring business model”, where the growth trajectory does not look so attractive. When trying to access sustainable returns, the third category is where we want to be. The most common examples of this include real estate, mid-assets, public infrastructure, regulated utilities, and other sectors or companies that are well-established but do not have this profitable growth story.

Balance sheet – in many cases, where dividends were reduced, it was the lack of a robust balance sheet that did not provide the necessary protection. In fact, the notion of a lean balance sheet, almost by definition, implies a high debt profile consisting of aggressive borrowing that creates pressure on cash flows (ie through principal service components and interest cost). Having an investment-quality balance sheet not only helps mitigate financial risk, but also plays a crucial role for many “boring” companies in achieving growth. For example, for REITs holding a fortress balance sheet allows for lower cost of capital, which in turn guarantees more attractive spread capture when buying properties. The lower the cost of capital, the higher the spread potential (or alternatively, the acquisition of high quality/low capitalization rate properties may become incentivized for the business).

Dividend coverage – since the presented strategy is based on high and sustainable income, it is very important to maintain a large space in terms of dividend coverage. The conservative cash flow payout ratio helps companies that want to distribute uninterrupted streams of income protect their businesses from relying on debt or internal cash reserves to finance distributions in the event of temporary financial shocks. Another key element to why it is necessary to have an undistributed portion of cash generation is to accommodate growth without relying solely on debt capital. Thus, truly sustainable growth could be achieved.

The bottom line

To achieve attractive compounding effects from an income investment strategy, investors must first understand how to balance high yield and low growth with mediocre yield and high growth stocks. There are pros and cons to both. The key argument against the high-yield approach is that the potential for price appreciation is inherently lower, and at some point in the future, the income-growth approach could begin to deliver huge distributions. However, in my opinion, the notion that corporations post double-digit revenue growth numbers for decades on end is too speculative and uncertain. Furthermore, if income returns are the only investment objective, it would take too long for the dividend growth strategy to catch up.

Ultimately, regardless of the strategy devised, ensuring that the snowball is as resilient as possible is equally important for both scenarios. Below I highlight three specific stocks that, in my opinion, tick all the necessary boxes from a risk perspective while offering returns of 7% or more.

1. EPR Properties (NYSE:EPR), 7.2% dividend yield – see my article here.
2. MPLX LP (NYSE:MPLX), 7.9% dividend yield – see my article here.
3. Enterprise Products Partners (NYSE:EPD), 7.1% dividend yield – see my article here.