How To Find Inflation-Busting Dividend Stocks

How To Find Inflation-Busting Dividend Stocks
Theodora Lee Joseph, CFA

about 1 year ago7 mins

  • Inflation-busting high dividend stocks can hold their own in the current environment, with the gap between the S&P 500 dividend yield and the US 10-year Treasury yields at the widest it's been in two decades.

  • Seek out stocks where dividend growth is sustainable: backed by strong free cash flow, a consistent historical dividend record even in tough economic times, and with defensive business models.

  • The energy sector, MLPs, and BDCs present some particular opportunities for high dividend yields

Inflation-busting high dividend stocks can hold their own in the current environment, with the gap between the S&P 500 dividend yield and the US 10-year Treasury yields at the widest it's been in two decades.

Seek out stocks where dividend growth is sustainable: backed by strong free cash flow, a consistent historical dividend record even in tough economic times, and with defensive business models.

The energy sector, MLPs, and BDCs present some particular opportunities for high dividend yields

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High-dividend stocks might not sound as thrilling as crypto, but these assets have a quiet excitement all their own. And, with the gap between the S&P 500’s dividend yield and the US 10-year Treasury yield at the widest it’s been in two decades, stocks that can beat that yield are drawing attention. Here’s how to hunt for companies that can offer you inflation-busting returns with defensive business models. And here are a few of the firms I turned up when I had a look…

S&P500 dividend yield vs US 10 year treasury yield. Source: Datastream, Finimize.
S&P500 dividend yield vs US 10 year treasury yield. Source: Datastream, Finimize.

What should you look for when hunting for dividend yields?

First, you’ll want to seek out stocks that can sustain their dividends. This means ensuring that companies aren’t funding their dividends by taking on debt or by sacrificing essential capital growth investments. Companies with high free cash flow yields and high earnings cash conversion (that is: the rate at which profits are made up of actual cash flows) tend to exhibit higher earnings quality, meaning they’re better able to sustain and grow dividends in the long term.

Second, you’ll want to keep in mind that those dividends are only sustainable as long as the management is willing to sustain them. So you’ll want to look for companies with a consistent record of maintaining those payments, even in tough economic cycles. Companies that have a well-defined capital allocation policy and capital return program tend to be more disciplined in how they spend their cash.

And third, remember that dividend yields are great, but capital appreciation is important too. Many companies that pay out high dividends do so because they have fewer opportunities for growth, while others are highly cyclical and pay high dividends to compensate investors for the risk that things could go badly. Look for companies that have defensive growth and low correlation to the markets. I’ll list a few examples below.

Where should you look?

1. The energy sector

Oil and gas (O&G) company stocks have some of the highest dividend yields because of their strong cash generation and the lack of high-return investment opportunities. These companies tend to do well when economic growth is strong, but less so in a recessionary environment. And, sure, the transition away from carbon fuels and toward renewable energy is a long-term threat to the sector, but in the short term, there’s still strong demand, and energy security is going to be a bigger focus for both Europe and the US. What’s more, China’s recent reopening is also likely to lend upward pressure to O&G demand – and, therefore, prices.

Stock: EOG Resources (NYSE: EOG)

  • Current dividend yield: 6.6%
  • Five-year average dividend yield: 1.7%
  • Free cash flow yield: 9.4%
  • Dividend streak: over 33 years

EOG is one of the lowest-cost shale O&G producers in the US. Its low cost structure means the company can achieve a return on capital employed (ROCE) of 10% even at a relatively modest oil price of $44 per barrel (for the benchmark West Texas Intermediate, or WTI). That cost structure is important in enabling the company to generate strong cash flows even at low oil prices and sustain its dividend. EOG has a consistent track record of sustaining (and growing) its dividend – even during the recession in 2008-09 and the oil price collapse in 2014. Another of its strengths is in its excellent capital deployment, where it’s committed to returning a minimum of 60% of its annual free cash flow to shareholders. Most recently, in 2021-22 the company returned an additional $5.2 billion in special dividends to shareholders. The company also has a strong balance sheet with a net cash position.

2. Midstream master limited partnerships (MLPs) and publicly traded partnerships (PTPs)

These companies can afford to be generous with their dividends because of their tax structure, which reduces their cash tax liabilities in the US. Midstream companies own the energy infrastructure that connects the production “wellheads” upstream to their clients downstream. Essentially, they don’t produce any O&G, but they’re involved in the logistics of it all: gathering, processing, transporting, and storing. That said, unlike energy companies, their revenues aren’t directly impacted by O&G prices. Instead, they operate fee-based business models where revenues are driven by production volumes. And you can get good visibility on revenue streams because contracts are long term (five to 20 years), with minimum volume commitments and tariffs that are linked to inflation. The drivers of growth and risks are similar to those in the energy sector, but without the volatility that comes from being tied to O&G prices.

Stock: Magellan Midstream Partners (NYSE: MMP)

  • Current dividend yield: 7.9%
  • Five-year average dividend yield: 7.8%
  • Free cash flow yield: 9.5%
  • Dividend streak: over 20 years

The company has most of its assets in the US, primarily transporting, storing, and distributing refined petroleum products and crude. While Magellan acknowledges the ongoing energy transition as a risk to future growth, it believes the US’s low position on the global O&G cost curve will insulate its revenues. The company doesn’t have growing opportunities for capital investment, so it’ll focus on returning capital back to shareholders through dividends and share buybacks over the next few years. The company’s high dividend yields are supported by its high free cash flow generation and the strength of its balance sheet.

Stock: Hess Midstream LP (NYSE: HESM)

  • Current dividend yield: 7.2%
  • Five-year average dividend yield: 7.4%
  • Free cash flow yield: 8.1%
  • Dividend streak: more than five years (since listing)

Like Magellan, Hess Midstream owns infrastructure assets in the US, and is predominantly exposed to US shale O&G production volumes. The company’s main client is Hess Corp., and it’s got commercial agreements that extend to 2033, providing earnings visibility through the next decade. Hess Midstream also targets an annual dividend growth of 5% over the next two years, with more than 1.4x coverage, and complements its capital return to shareholders with share buybacks.

3. Business development companies (BDCs)

As a retail investor, you might not have access to venture capital (VC) funds, but you can invest in BDCs, which are similar. These companies are like closed-end funds that invest in developing and aiding financially distressed firms. Like VCs, they’re seen as relatively high risk, with their leverage and exposure to small or distressed companies. They make most of their profits from interest repayments on loans or from the appreciation of their stakes in their portfolio companies. BDCs tend to pay high dividends because they’re regulated investment companies and can avoid corporate income taxes by distributing at least 90% of their income back to shareholders. BDCs are liquid investments because they trade on an exchange, but their portfolio holdings aren’t. Those tend to be high risk because of leverage.

Stock: Main Street Capital Corporation (NYSE: MAIN)

  • Current dividend yield: 6.9%
  • Five-year average dividend yield: 6.5%
  • Free cash flow yield: 10.2%
  • Dividend streak: three years

Main Street is an investment firm that focuses on providing long-term debt and equity capital to mid-sized US companies across a wide range of industries from construction and engineering, internet software, aerospace and defense, even food products. The company’s niche investment strategy also means it has a lower correlation to markets – and in that way, it behaves a bit like an alternative investment. Overall, the company has a positive net exposure to interest rates, meaning that dividends are likely to increase in a higher rate environment.

Are there other ways to gain yield?

If dividends are your cup of tea, you might also consider investing in the ETFs that are built around them, like the Invesco S&P Ultra Dividend Revenue ETF (ticker: RDIV; expense ratio: 0.39%), the Vanguard High Dividend Yield ETF (VYM; 0.06%), or even the Global X MLP ETF (MLPA; 0.46%), which invests primarily in MLPs. But if your risk appetite is low, you can opt instead for high-yield savings accounts, one- to five-year fixed deposits, or government bonds. Regardless of how you invest, it’s worth bearing in mind that dividends might have a different tax treatment compared to capital appreciation. So it may be best to place your high-dividend stocks in tax-advantaged accounts.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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