Legendary Investor Says Buy Dividend Growth: 2 Yields +8%

Co-produced with “Hidden Opportunities”

Seeing stubborn inflation and rising interest rates, Mr. Market is panic-stricken. Investors are afraid, and fear leads to decisions that may appear prudent in the short term but are very poor for the longer term.

Peter Lynch, one of the most successful and well know investors of all time, has a lot of timeless advice to help you through your fears.

1. Market Timing Is Futile

People spend all this time trying to figure out “What time of the year should I make an investment? When should I invest?” And it’s such a waste of time. It’s so futile. I did a great study, it’s an amazing exercise. In the 30 years, 1965 to 1995, if you had invested a thousand dollars, you had incredible good luck, you invested at the low of the year, you picked the low day of the year, you put your thousand dollars in, your return would have been 11.7 compounded. Now some poor unlucky soul, the Jackie Gleason of the world, put in the high of the year. He or she picked the high of the year, put their thousand dollars in at the peak every single time, miserable record, 30 years in a row, picked the high of the year. Their return was 10.6 – Peter Lynch at a PBS Interview

2. Invest In Businesses That Pay Sustainable Dividends

The legendary manager of Fidelity’s Magellan Fund also expressed a desire for dividends, emphasizing firms with the ability to pay during recessions and those with a long record of regularly raising dividends to shareholders.

3. Invest in companies with inelastic demand through economic cycles

There are several industry sectors where demand remains robust through bull and bear markets. These are boring companies that often perform ordinary and overlooked functions in our lives.

Mr. Lynch talks about opportunities in those industries that Wall Street finds less glamorous, such as funeral homes and waste disposal services. Such companies delivering products and services that people tend to keep buying during good times and bad are some of the best long-term investments.

There are several takeaways from Mr. Lynch’s wisdom and track record. As income investors, we adopt several of his principles, emphasizing income building. In that spirit, we have two very boring picks with inelastic businesses yielding up to 8% with decades of dividend growth.

Pick #1: ENB, Yield 6.6%

If you are seeing significantly higher heating bills this winter, you are not alone. The U.S. Energy Information Administration (‘EIA’) predicts heating bills in winter 2022-2023 will be about 11-25% more expensive than last year.

This jump in heating costs is due to several factors, including:

• Below-normal winter temperatures in some regions

• Above-average Inflation

• The war in Ukraine and the associated energy crisis

• Rising demand for electricity

In November, the average American’s energy cost was up 13% YoY, and the situation is similar for our close neighbor, Canada. Home heating costs are projected to spike ~30% in Ontario due to the above factors.

Utility companies are highly defensive investments because you don’t stop heating your home in a recession. Moreover, it is not like the other utility providers in your area offer serious incentives for you to switch. Bills will rise over time and be paid by (frustrated) customers.

Let’s look at North America’s largest midstream company by market cap – Enbridge, Inc. (ENB).

Enbridge maintains an extensive pipeline network to transport and store natural gas and hydrocarbon liquids. ENB moves ~30% of the crude oil produced in North America, transports nearly 20% of the natural gas consumed in the U.S., and operates North America’s largest natural gas utility by volume (third-largest natural gas utility by consumer count). (Source: December 2022 Investor Presentation )

Enbridge Gas serves approximately 75% of Ontario residents, the most populated province in Canada. Enbridge Gas and its affiliates deliver safe, reliable service to about 15 million people in Ontario and Quebec.

As a utility company, ENB’s rates are regulated with inflation and commodity price protections. In June, the Ontario Energy Board (‘OEB’) approved a ~20% increase in natural gas for utility providers. In September, another rate hike was approved, and ENB recently disclosed having applied to the OEB to change its distribution, transportation, and storage rates starting January 1, 2024.

This company is capable of passing on rising costs to consumers, making it an excellent long-term inflation hedge.

In Q3, Enbridge reported a 15% higher YoY Adj. EBITDA and 9% higher Distributable Cash Flow (‘DCF’). The company also provided FY 2022 DCF C$5.20 – C$5.50, which puts its C$3.44 FY 2022 dividend at a modest 64% payout.

For 2023 the company expects a higher DCF of C$5.25-C$5.65/share.

ENB also forecasts full-year EBITDA of C$15.9B-C$16.5B, which reflects ~6% growth from the midpoint of its 2022 guidance range. Attributed to growing DCF, ENB raised its dividend by 3% for FY2023 (65% payout at midpoint DCF guidance).

ENB is a recession-resistant midstream corporation with an investment-grade balance sheet. 90% of the company’s debt carries fixed interest rates, immunizing the midstream giant from these inflation-focused rate hikes. Moreover, 98% of ENB’s cash flows are underpinned by Cost-of-Service or contractual agreements, bringing high predictability to the company’s earnings.

ENB is a Canadian dividend aristocrat with 28 years of consecutive annual dividend raises. (Source: Enbridge.com)

ENB’s C$3.55 forward annual dividend payment calculates to a 6.6% yield. In addition, ENB has a C$1.5B buyback program, out of which the company has only 10% utilized. Looking at the company’s focus on dividends and buybacks, it is clear that it is a high priority for management to bring value to shareholders.

*Note: ENB declares and pays dividends in Canadian Dollars. The dividend income received by U.S. investors is variable due to fluctuating USD-CAD conversion rates.

U.S. investors holding ENB in a taxable account may experience a 15% tax withholding. However, tax-advantaged accounts such as IRAs are excluded from Canadian dividend withholding tax.

As a large midstream-utility combo, Enbridge provides the tasty combination of dividend growth and recession resistance to your portfolio. This is an excellent energy company to invest in and obtain immunity from volatile energy prices. Who said boring businesses couldn’t be fun? 6.6% (and growing) yields that can make you feel warm and fuzzy in this cold winter.

Pick #2: MMP, Yield 8.2%

Magellan Midstream Partners (MMP) owns and operates the most extensive refined petroleum products pipeline system in the U.S., with access to nearly 50% of the nation’s refining capacity. The firm has the capacity to store more than 100 million barrels of petroleum products, such as gasoline, diesel fuel, and crude oil.

MMP is a Master Limited Partnership (‘MLP’) that issues a schedule K-1 for tax purposes.

MMP Operates two core business segments, split by % of the net operating margin – refined products (72%) and crude oil segment (18%). Both are excellent cash cows with powerful multi-year asset monetization capabilities.

Crude Oil – 70%+ of MMP’s long-haul pipe capacity is supported by take-or-pay commitments from creditworthy counterparties for the next 3-6 years. This improves the predictability of this segment’s cash flows.

Refined Products – This is a more significant segment for MMP and provides a solid defense against long-term inflation because tariff changes are tied closely to the Producer Price Index as well as other market factors. MMP can easily pass on inflation pressures to its customers through contractual support.

In short, MMP’s business model is very low-risk activities (such as transportation and storage of energy commodities) supported by long-term, fee-based contracts. 85% of MMP’s operating margin is fee-based, thereby protecting the partnership’s profitability amidst volatile energy prices. (Source: December 2022 Investor Presentation)

MMP maintains a quality partnership structure with no Incentive Distribution Rights (‘IDR’). This means that shareholders will have maximum access to the company’s DCF. MMP has been an excellent distribution steward with 21 years of annual distribution raises. (Source)

In October, the MMP announced a 1% raise to the quarterly distribution, and the new distribution calculates to an 8.2% annualized yield. Along with distributions, MMP has been aggressively buying back shares. During Q3, the partnership spent $138 million to repurchase 2.7 million units at an average price of ~$50/unit. YTD, MMP has spent $377 million on buybacks (a total of $1.2 billion since the commencement of the repurchase program).

These repurchases have been so significant that MMP has been spending less on distributions. YTD, the partnership has paid 5% less YoY towards distributions (notice the smaller yellow bars for 2021 and 2022 in the below chart). MLP buybacks are a net positive for an income investor since it increases shareholder access to a growing DCF.

In Q3, MMP’s Adjusted Earnings/unit was $1.29 (12% YoY increase), and DCF grew to $290 million (12% YoY increase). The partnership reported a free cash flow of $273 million, resulting in free cash flow after distributions of $58 million. MMP is using excess cash after distributions towards development projects to expand the company’s overall assets. The partnership projects a Capex of ~$90 million in 2022, $100 million in 2023, and $40 million in 2024 towards committed expansion projects and expects them to be available for fulfillment in 2024.

MMP maintains an investment-grade balance sheet with a 3.7x leverage. This is among the lowest leverage ratios in the midstream industry, and the partnership has no debt due until 2025. At the end of Q3, MMP’s debt outstanding was $5.2 billion, and its weighted average interest rate was 4.3% YTD (a 10 bps reduction from the same period last year).

MMP presents a steady 8.2% yield from a low-risk business with steady demand and inflation-defying pricing power, making it a must-have for income investors.

Conclusion

Peter Lynch is a successful fund manager with decades of above-average returns through very simple investment principles. Most importantly, he doesn’t believe in market timing and strongly recommends against this for the average investor. Business performance and the movement of their stocks can often be uncorrelated; successful investors fight the fear and load up on such opportunities.

Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested – Peter Lynch

Peter Lynch strongly advocates diversifying investments across several categories of stocks to reduce downside risk. Most importantly, Mr. Lynch is a big fan of companies with decades of dividend growth. Both principles we hold close in our investing strategy.

The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 or 20 years in a row. – Peter Lynch

At HDO, we maintain a core portfolio of over 45 securities to diversify and protect our income. 2022 may have been a rocky year for the markets, but our portfolio income is growing strong. Fortify your income with inelastic businesses paying growing dividends. We have two picks with up to 8% yields to get you started.