Inflation is raging at four decade highs, making it increasingly difficult for investors to retire at all, much less early. Traditionally, financial planners directed clients to gauge retirement readiness according to the principles of the 4% Rule. Essentially what this rule said was that as long as they spent no more than 4% of their principal in any given year and they had their savings invested either entirely or mostly in a low-cost index fund like the popular SPDR S&P 500 ETF Trust (SPY) or Vanguard 500 Index Fund ETF (VOO), they should be able to live indefinitely off of their investments.
While this rule has worked splendidly over the past decade given that the market has marched relentlessly higher and inflation rates have been remarkably low, the world has changed. With the market trading near all-time highs and market valuation metrics like the Buffett Indicator trading at levels that are ~190% of what has traditionally been viewed as fair value, the downside potential appears to be much greater than the upside potential at the moment.
On top of that, inflation rates and geopolitical tensions are soaring. This means that risks to the macro-economic condition – and by extensions to most individual businesses – have increased dramatically. Last, but not least, this also means that saving sufficiently for retirement has become more complicated and challenging. As a result, the 4% Rule might not be so practical anymore for passive index investors. This is because the forward expected returns of the stock market have rarely been lower due to the sky-high valuation levels seen throughout the market and out-of-control inflation means that merely withdrawing 4% of one’s principal year after year may quickly not be enough to meet living expenses. At a minimum, investors should adopt a 4% plus inflationary adjustments plan.
However, if inflation continues at its current pace and the stock market continues to flounder or even sees one of its inevitable sharp pullbacks, this means that an early retiree’s principal will likely quickly decline to a level where it can no longer support early retirement. This means that a 3% or even a 2% Rule would likely be the more prudent if not realistic course of action. As a result, someone looking to retire early with an $80,000 annual budget will now have to save up to $4 million instead of the just $2 million that was deemed sufficient by many financial planners not too long ago. For many, that is an another entire lifetime of working and saving, especially given that forward returns for investments from current levels are not exactly exciting.
High Yield Investing: The Only Viable Path To Early Retirement?
What does this mean, then? Is the early retirement dream unattainable for all but the highest income earners? For the know-nothing investor, sadly this might be the case. However, for those willing to roll up their sleeves and dig into researching individual stocks, building and managing a passive income portfolio can make the 4% or even 5% dream still very attainable.
While some might appeal to the safety that broadly diversified funds like SPY and VOO offer, studies have shown that holding hundreds of stocks in a portfolio is not necessary to enjoy the benefits of diversification and in fact can often lead to “diworsification” by putting precious funds into overvalued companies, or at the very least into stocks that offer little to no income yield.
The Father of Value Investing – Benjamin Graham – estimated that an investor doing in-depth due diligence only needed a 10-30 stock portfolio to be sufficiently diversified while a study by Frank Reilly and Keith Brown showed that a diversified portfolio of 12-18 stocks typically experiences ~90% of the maximum diversification risk-mitigation benefits.
By picking a portfolio of, say, 25-30 stocks like we do at High Yield Investor, you are much more likely to avoid the big losers that plague the performance of large index funds (especially in the current environment of frothy valuations) while concentrating your precious retirement savings on undervalued, high quality investment grade businesses that pay out hefty income yields. As a result, high yield investing in individual securities is one of the few, if not only, viable paths to early retirement in the current environment.
In this article we share three top high yield picks for navigating the high-inflation environment to give you a strong start on your early retirement investing.
#1. Energy Transfer (ET)
ET is a deeply undervalued energy midstream business that owns a very large and well-diversified network of assets, most of which are well-located pipelines. These assets almost all have lengthy take-or-pay fixed fee contracts that are resistant to commodity price volatility and, most importantly, typically have inflation-linked escalators on them.
With the EV/EBITDA multiple standing at several turns below some of its investment grade peers as well as its historical valuation levels, ET units could see massive upside in the coming months and years. On top of that, ET is currently gushing free cash flow that is enabling management to rapidly deleverage the balance sheet and increase the distribution at a brisk pace.
After raising the quarterly distribution from $0.1525 to $0.175 last quarter, ET just announced another substantial hike to $0.20. This represents a stunning 31.1% distribution increase in a mere two quarters, putting the forward yield at 7.1%. While this alone would be very attractive for most retirees looking to live off of a 4% or even 5% Rule, the yield will likely continue soaring in the near future. Management has stated that its “top priority” is restoring the distribution to a $1.22 annualized rate. This would make the yield at the current unit price a very impressive 10.8%. Even at this elevated level the yield would be very safe with DCF coverage of ~2x, fully covered by free cash flow, and backed by an increasingly clean investment grade balance sheet and in inflation-resistant cash flow stream.
#2. W.P. Carey (WPC)
WPC is a broadly diversified net lease REIT with substantial exposure to the U.S., Western Europe, and a few other countries like Japan and Canada. The majority of its properties are either private storage, warehouse, or industrial in nature, making it a very defensive investment. Even its retail and office properties are well-positioned and many of them are leased to investment grade clients like governments and specialty retailers in Europe that face little e-commerce risk.
Meanwhile, the vast majority of its leases are linked to CPI, making it a great defensive investment with inflation protection. The dividend is also quite safe thanks to the REIT’s rock-solid rent collection track record and solid dividend coverage by AFFO. On top of that, the growth potential for the dividend is also picking up steam. Between a multi-billion dollar growth pipeline, inflation-linked leases that are poised to deliver strong accretion to the bottom line, and the removal of headwinds from exiting its asset management business this year, WPC should be able to pick up its pace of dividend growth as it closes in on Dividend Aristocrat status.
Last, but not least, the current dividend yield is very attractive at 5.04% and can help support a 4% or even 5% Rule driven early retirement.
#3. Enterprise Products Partners (EPD)
Last, but not least, EPD might well be the best early retirement investment around today. While its total return proposition is not quite as attractive as ET’s given that its valuation multiple is a bit higher and its forward yield prospects are a bit lower, its distribution coverage is rock solid at ~1.7x, its asset portfolio is arguably second-to-none in the industry, insiders own about 1/3 of the partnership, management has a track record that is as good as anyone’s in the industry, and the balance sheet is the best in the business with a BBB+ credit rating.
The partnership is also investing fairly aggressively in lower risk, high return growth opportunities through its recent acquisition of Navitas Midstream while its inflation-linked pipeline contracts and well-located and synergizing assets should all combine to drive solid bottom line and distribution growth for many years to come.
If you are looking for an investment that you can pour a lot of savings into to fund a 5% Rule early retirement and still sleep well at night, EPD is the best option around.
Early retirement is getting harder and harder. Buying an index fund like SPY and VOO no longer cuts it in our view given the inflationary pressures on frugal early retirement budgets and the geopolitical and macroeconomic risks facing today’s frothy markets.
As a result, pursuing a path of picking individual high yielding stocks might be the only viable means for an average-earner to realize their dreams of early retirement. However, to avoid the pitfalls that befall many unsophisticated retail investors, considerable due diligence is required to identify the high yield stocks that not only pay out sustainable income yields, but also have the potential to continue growing them for the foreseeable future in a manner that is correlated with inflationary forces.
With ET, WPC, and EPD an aspiring early retiree can lay a very solid cornerstone for their portfolio in a manner that could fund a 4-5% Rule early retirement and still be able to see cash flows increase in a correlated manner with inflation for many years to come.