Start With A Large Snowball And Roll It Slowly But Surely

FotoDuets/iStock via Getty Images Since the Fed started to increase the interest rates in 2022, the yield chasing investors have finally accessed a better option space to cherry pick assets at meaningful yields without assuming too much of a risk. Higher interest rates have imposed a downward pressure on the valuations of duration-heavy assets such as fixed income, preferred stocks and value equities, where the cash flows are relatively stable / fixed. For example, I remember that before the outbreak of the COVID-19 one of my favorite and commonly known dividend stocks – Realty Income (NYSE:O) – yielded just ~ 3.5%, whereases the current yield for this REIT has now increased to ~ 6%. In other words, before the COVID-19 and before the Fed initiated its rate hiking cycle, it was very difficult to devise a high income strategy with limited risk. If the objective was to capture a somewhat meaningful yield around 5% or higher, investors were forced to either venture into long dated fixed income assets with zero income growth potential or go long equities, which were exposed to elevated financial risk. Luckily, the investment conditions have changed now, and there are many names out there with which investors can start building high yielding and durable portfolios. The issue, however, is this: FOMC; St. Louis Fed The chart above reflects the FOMC estimate on the future interest rates, which indicates declining level on a go forward basis. If this comes true, the prevailing conditions that render income strategies attractive will likely change, forcing the investors to again go up the risk curve to capture tangible yields. How I interpret this is that it is not the time to stay on the sidelines, and instead investors whose objective is to pocket passive income streams should consider opening the necessary exposures. The logic here is that provided that the objective function is to construct a predictable and sizeable passive income portfolio, the element of market timing or volatility is not relevant at all. So, even if the market goes down or the interest rates start to drop later than expected, the underlying passive income streams should remain stable, thereby not failing the portfolio objectives. With all of this being said, the yield chasing investors have to make a choice whether to focus more on high yielding assets or instead invest more in lower yields but that have a notable growth potential. Let me know explain why I have opted a former strategy in my portfolio construction process. Why start with a large snowball The title of this article includes a combination of a large snowball and a slow process of rolling it forward to accumulate more size. Here we have to understand that it is structurally impossible to on a sustained basis combine abnormal yields with a high income growth strategy. The logic is that the higher current yield a particular asset provides, the lower the implied growth prospects are there. Otherwise, if the asset was exposed to, say, double digit growth with a meaningful price appreciation potential, the multiple would be higher, which, in turn, should depress the entry yield level. In practice, investors can easaly mix the two strategies together by allocating certain portion of the portfolio into high yielding assets and leave the remainder for growth oriented but lower yielding equities. Yet, I have made a choice to start with a larger “snowball” and roll it forward from a “less steep incline”. There is a one fundamental reasons for this. As stated earlier in the article, the current environment has created many opportunities for investors to find a de-risked companies that provide high income. Finding investments that offer an initial yield of 7 – 8%, while having the necessary characteristics to shield these income streams and even stimulate some element of growth is not that difficult. In my opinion, the following characteristics have to be in place for us to consider a dividend protected: Investment grade balance sheet. Well-laddered debt maturity profile. Defensive business model with durable underlying demand. CapEx-light operations. Income streams that are linked to CPI or some fixed escalators. Most of these opportunities that offer 7 – 8% yields at limited risk and slight income growth potential can be found in the equity REIT, MLP and / or BDC space. Just to give you three examples, where I have assigned buy ratings: Enbridge (NYSE:ENB) – investment grade balance sheet, yielding 7.6% with a historical 5-year dividend CAGR of 4.6%. Enterprise Products Partners (NYSE:EPD) – investment grade balance sheet, yielding 7.2% with a historical 5-year dividend CAGR of 3.1%. Ares Capital (NASDAQ:ARCC) – investment grade balance sheet, yielding 9.3% with a historical 5-year dividend CAGR of 3.9%. Instead, if we were to focus on high dividend growth strategy, we would be talking about yields in a territory of 2.5 – 4%. One of the best examples, which characterizes this space is the Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD), which has a current yield of 3.4% and a 5-year dividend CAGR of 11.8%. My issue is that the difference in initial yields between these two strategies is just too wide. I have tried to plot the potential income streams of these two strategies based on relatively conservative assumptions in both cases (the chart is based on a starting principle of $100 assuming initial dividend yields, growth factor and full reinvestments – more specifics reflected in the chart assumption list). As we can see in the chart below, it would take approximately 17 years for income growth strategy to start delivering higher passive income streams. Created by author Granted, the chart also indicates that from year 17, the gap would start to widen significantly rendering the high income based strategy less attractive. However, assuming that these growth companies would be able to increase their dividends at 10% each year for more than 15 – 20 years in a row is rather risky. Over such a long period of time the consumer preferences could change, company specific risks could materialize or some macro-level shocks could force these growth companies to safeguard their liquidity profiles through, among other things, cutting back on dividend growth. While the same risks are indeed relevant for the high yield names as well, the likelihood of dividend reduction among investment grade companies that operate in boring but critical sectors (e.g., midstream infrastructure, grocery anchored properties backed with 10+ year lease agreements) is unlikely. Plus, here capturing ~2% dividend growth should not be such a huge pull given that in most cases the underlying cash flows are usually linked to some form of organic escalators. The bottom line The prevailing market conditions are extremely favorable for devising a high income strategy to accumulate a large snowball of passive income streams in a sustainable manner. It is now easier to obtain higher yields without taking excessive risks. Yet, the investors have to still choose whether to follow a growth oriented strategy versus sticking more to instruments that offer high initial yields with limited growth prospects. While a combination of these two strategies could be applied, I have chosen to construct my portfolio based mostly on 7-8% yielding assets. The reason for this is that the difference between entry yields between high income and income growth focused assets is just too wide to, even adjusting for the growth factor. It depends on several assumptions, but by investing in SCHD over the 7 – 8% yielding defensive plays, it would take circa 17 years to equalize the income streams. For me this is too long and implies many uncertainties for the growth companies to actually sustain double digit dividend growth over so long time period.

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