Esa Hiltula
The objectives of income investing could be split into two broad categories: 1) to fund living expenses and retirement with the portfolio distributions without tapping into the principal itself, and 2) to pocket current income that could be reinvested back in yield-bearing assets, thereby facilitating the so-called “snowball” effect.
In practice, it might be so that during the pre-retirement period, investors apply the second approach and then once the retirement kicks in, the portfolio proceeds are taken out to cover daily needs. This practice is relevant in my case as well.
It obviously depends on each investor’s risk tolerance and appetite for risk, but I do not think it would be wrong to say that the following elements form a structural basis on how the strategy is devised by such investors:
- Finding securities that offer yields that are attractive on an absolute basis and are definitely above what the growth-oriented indices provide.
- Keeping the probabilities of distribution cuts as low as possible.
- Capturing an additional layer of returns, mostly in the form of periodic dividend hikes.
Effectively, it boils down to a pure play buy and hold process, where a significant amount of due diligence is done before investing to really make sure that the snowball will gradually become larger as time progresses.
My personal goal is to find solid income compounders, add them to a portfolio and sell only if there is a fundamental change in the business (e.g., company decides to venture into risky segments to accommodate growth at the expense of sound balance sheet). What this means is that I am actually not that keen on experiencing share price run-ups, as it just makes the dividend reinvestment process less attractive because of the reduced yield level. Instead, the most important thing is to have income streams that are predictable, resistant to different kind of economic uncertainties and, of course, attractive enough without the presence of speculative conditions.
In the article below, I will elaborate on two layers that are vital for accommodating such de-risked income snowball strategy.
Getting the slope and size right
One of the first questions that the investors have to ask themselves is whether to put a heavier emphasis on growth or yield. The underlying question is whether it is worth taking a lower yield at the start to ultimately access a larger income portfolio that would be supported by a strong dividend growth profile.
Theoretically, the longer the time horizon, the heavier the bias should be put towards growth-oriented stocks. It is possible to find blue-chip firms that provide consistent dividends with very attractive income growth dynamics. Not surprisingly, however, these yields are automatically lower than what could be found in the higher yield space. One of the best proxies for this specific category is Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD), which includes 103 different large-cap dividend growth focused stocks.
With that being 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 have tried to depict in (hopefully) understandable fashion below. The scenario A assumes starting yield of 7% and income growth of 2%, while scenario B is based on starting yield of 3% and dividend growth of 10%. In my humble opinion, these are completely realistic assumptions for de-risked income strategies given the prevailing interest rate backdrop.
Created by author
What this chart reveals is that by sticking to scenario B, it would take ~ 20 years for income growth investors to catch up with the ones who have decided to invest in higher yielding, but slower growth securities. Granted, if we took a more notable price appreciation component into account, we could likely expect a better total return result for the growth scenario. Yet, in that case, we should also recognize a negative effect on the yields as each dollar reinvested would be subject to a higher asset price, making the reinvestment yield lower accordingly.
Second, whenever an investment decision is based on some return assumptions that stretch far into the future, the overall risk profile gets automatically higher. Here, I am quite skeptical about companies that would be able to deliver double-digit or close to that dividend growth statistics for decades in a row. The larger the company gets, the more difficult it is to sustain the growth rate as usually the market shares become exhausted, the pricing power diminishes and products / services tend to eventually be substituted with other innovative items. Now, I am not saying that growing dividends at 10% for 10 or 20+ years is not possible. It is just that the odds are not that high.
Third, usually when we talk about attractively yielding names that are underpinned by robust cash flows, the sectors that pop up tend to be system-critical for which there will (highly likely) be always a demand for. For example, it is difficult to imagine a situation, where real estate will no longer be necessary (think of nicely yielding equity REITs). Similarly, the chances are very low that midstream infrastructure will disappear from the economic activity in the next 20 or 30 years (think of MLPs). Furthermore, if we think of scenario A, achieving 2% growth rate per annum is really not that difficult or speculative. In many instances, these high-yielding stocks have their cash flows linked to long-term contracts that carry an embedded component of periodic cash flow bumps, which are at or closely reflective of CPI.
Finally, given the time needed for income growth focused strategy to surpass the capital generated by higher yielding strategies as well as the underlying risks involved around the growth companies actually delivering of high growth rate targets for a long period of time, I find it more beneficial 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 larger snowball and rolling it forward on a not that steep scope to avoid risks.
Making the snowball resilient
In the process of achieving that enticing compound-effect of income investing, it is critical to take care of the risks before letting the snowball down the hill.
I will describe a couple of fundamental factors that clearly de-risk this process, reducing the probabilities of income loss.
The essence here is nicely captured by Warren Buffett’s famous quote:
If we avoid the losers, the winners will take care of themselves.
Strategy – when picking high-yield names, we have to understand that there are typically three reasons why a particular security offers juicy income levels. The first one could be attributable to a financial distress, where the cash flow prospects are unclear. The second one could be related to a situation in which the business itself is speculative and dependent on, say, volatile commodity prices or macro-sensitive demand dynamics. And the third one could be associated with “boring business model”, where the growth trajectory does not look that attractive. When trying to access sustainable yields, the third category is where we want to be. The most common examples of this include real estate, midstream assets, public infrastructure, regulated utilities and other sectors or companies that are well-established, but lack that lucrative growth story.
Balance sheet – in many cases, where the dividends have been cut, it was the lack of a robust balance sheet that did not provide the necessary protection. In fact, the notion of a weak balance sheet, almost per definition, implies an elevated debt profile, which consists of aggressive borrowings that create a pressure on cash flows (i.e., through principal and interest cost service components). Having an investment grade balance sheet does not only help mitigate the financial risk, but it also plays a crucial role for many “boring” businesses in making the growth happen. For instance, for REITs possessing a fortress balance sheet allows to reduce the cost of capital, which in turn warrants a more attractive spread capture when buying properties. The lower the cost of capital, the higher the spread potential (or alternatively, acquiring high quality / low cap rate properties can become accretive to the business).
Dividend coverage – as the outlined strategy is predicated on high and sustainable income, it is very important to maintain ample headroom at the dividend coverage end. Conservative cash flow payout ratio helps companies that want to distribute uninterrupted income streams shield their businesses from relying on debt in case or internal cash reserves to fund the distributions in case of temporary financial shocks. Another critical element on why it is necessary to have some undistributed portion of cash generation is to accommodate growth without reliance on only debt related capital. This way, a truly sustainable growth could be achieved.
The bottom line
To achieve attractive compounding effects from an income investing strategy, investors have to first understand how to balance high-yield and low growth with mediocre yield and high-growth securities. There are pros and cons for both of them. The key argument against the high-yield approach is that the price appreciation potential is inherently lower and at some point far in the future, income growth-based approach could start delivering outsized distributions. Yet, in my opinion, the notion of corporate registering double-digit income growth figures for decades in a row is too speculative and uncertain. Plus, if the income return is the only investment objective, it would take just too much time for the dividend growth strategy to catch up.
Finally, irrespective of what strategy is devised, making sure that the snowball is as resilient as possible is equally important for both scenarios. Here below I am highlighting three specific securities, which, in my opinion, tick all of the necessary boxes from the risk perspective and at the same time offer yields that are 7% or above.
