By: Dividend Sensei
In the last few weeks we’ve explored why Social Security is in trouble, how to fix it easily and cheaply, and why a high-yield dividend growth portfolio is your best chance at a prosperous retirement. In this article I’d like to explain the key to living off dividends during retirement, specifically how to build a recession proof, high-yield portfolio. I’ll also offer my top five undervalued picks for getting you started on building a source of generous, safe, and steadily rising income during retirement.
The 3 Most Important Aspects To A High-Yield Retirement Portfolio
The most important thing to remember about living off dividends during retirement is that they allow you to avoid ever having to sell shares to fund your expenses. However it’s human nature to watch the value of our portfolios, which means that during a recession/bear market we are at greater risk of making stupid financial decisions, such as selling out of fear of further losses.
This is why one highly beneficial characteristic of a high-yield retirement stock is low volatility, as measured by long-term beta (how volatile a stock is relative to the S&P 500). While this isn’t necessarily a must have for a high-yield retirement stock (since the idea is you never sell no matter what the price does), it’s still a nice feature to have since it lets you sleep better at night during a market crash. As another side benefit lower volatility stocks tend to outperform the market over time. While not necessarily important for your retirement income, it will mean that you can leave a larger portfolio for your heirs.
Fortunately high-yield stocks tend to naturally be lower volatility because of three characteristics. The first of which is a stable and recession resistant business model. Remember that cash flow is king, because it’s what funds our dividends. A high-yield can either indicate a company is badly misvalued by the market, or serve as a warning sign that the payout is at risk of being cut due to poor fundamentals. This is why it’s critical for high-yield retirement stocks to have business models characterized by highly stable, recurring, and growing cash flow. Preferably cash flow that’s secured by long-term contracts with strong investment grade counter parties. If they lack contracts then we want to see a wide moat, meaning a very strong market position that ensures that competitors can’t swoop in and steal market share resulting in a reduction in cash flow that threatens our payout.
The second characteristic is about the safety of the dividend. Remember that a high-yield either indicates a company might be undervalued (which is good), or that its payout may be unsafe (a yield trap). This can happen if a company attempts to attract investor interest by growing its dividend too quickly and paying out too much of its cash flow over time. This is why you need to ensure that relevant payout ratio is low enough to allow for the dividend to not just be maintained over time, but gives the company enough retained cash flow to allow it to grow over time.
Now for regular corporations (with the exception of utilities and banks), this means looking at the free cash flow payout ratio. Over a 12 month period you want this to be below 100%, but the actual safe range will depend on the industry. For example telecom and tobacco stocks usually payout 60% to 90% which is still a safe level. For banks and utilities you’ll want to see a EPS payout ratio of no more than 55%, and 90%, respectively.
Now what about pass through stocks? These are things like MLPs, REITs, YieldCos, BDCs, and LPs, who are specifically designed (or required by law) to distribute the majority of their cash flow to investors. By design they also fund their asset growth with debt and accretive equity, meaning that you can’t use free cash flow to determine their payout safety. And because most of these stocks have high amounts of depreciation you can’t use EPS payout ratios either, because these are artificially suppressed.
This means that for pass through stocks you want to use their equivalent of operating cash flow (EBITDA) minus maintenance capex. What this is called depends on the industry/sector:
- REITs: Adjusted Funds From Operation or AFFO
- BDCs: core EPS or net interest income or NII
- MLPs: distributable cash flow or DCF
- YieldCos: cash available for distribution or CAFD
- LPs: AFFO
You can usually find the relevant cash flow per share metric listed in the earnings release. What’s a safe payout ratio/coverage ratio for these types of stocks?
- REITs: depends on the industry but usually 85% or less
- BDCs: 95% or less
- MLPs: distribution coverage ratio of 1.1 or more
- YieldCos: 90% or less
- LPs: 85% or less
So by choosing companies with highly stable, recurring cash flow that grows in all manner of economic environments, with good payout coverage, we can be confident that the income we’re relying on to pay our retirement expenses is safe and will keep on growing faster than inflation. This allows us to potentially live off 100% of the income while still enjoying a rising standard of living over time, no matter how long we live. The final critical factor to look at is the balance sheet. This is because too much debt can sink a dividend/distribution even if its well covered by highly stable cash flow. This is especially important for pass through stocks that rely on external funding sources to grow over time. If debt levels get too high this can result in a weak credit rating and borrowing costs that rise too high to make it possible to grow profitably.
The most important balance sheet metric to look at is the leverage ratio, or debt/EBITDA or debt/adjusted EBITDA. This is what credit rating agencies and bond holders mostly look at in determining whether or not to lend to a company/pass through, and at what terms. You want to check that the leverage ratio is reasonable for that industry. Remember that each industry will have different fundamentals. For example the average REIT leverage ratio is 6.0, because high debt levels are built into the nature of that industry and interest costs are easily supported by very stable cash flow generated by long-term leases. In contrast technology companies usually have low leverage (1.0 or below) because they are capital light business models that fund their growth internally.
Another factor to look at is the interest coverage ratio (EBITDA or Adjusted EBITDA/interest cost). You want to make sure this is high enough (3+) to ensure the company/pass through doesn’t run into trouble with its debt covenants. These are relative debt metric limitations imposed by bond holders. If a company violates a debt covenant then the loan can be immediately called in triggering a liquidity crisis that can force a payout cut. You can find these metrics on Gurufocus.com for free. Or if you prefer to outsource your debt due diligence you can just check the credit rating on something like Fast Graphs. A credit rating from S&P of BBB- or above is considered investment grade and is a good proxy for a safe balance sheet.
In summary the most important aspects to a good high-yield retirement stock are:
- Stable business model with recurring cash flow
- Well covered payout
- Good balance sheet
So let’s take a look at how one can apply these principles to building a low risk, high-yield retirement portfolio that can generate abundant income and provide you a comfortable retirement.