ZM - Live Off Of Dividends Forever With Enterprise Products Partners

2023-11-27 08:05:00 ET

Summary

• Living off of dividends forever requires that investors incorporate three key principles into their portfolio construction.
• Based on these three principles, we believe that EPD is a great candidate for a lifelong passive income portfolio.
• We examine how EPD meets these three requirements in-depth.

Enterprise Products Partners ( EPD ) stands out as a compelling opportunity for an investor who is building a stock portfolio for the purpose of living off of dividends for the rest of their life. EPD's remarkable track record of generating consistently growing distributions, combined with its defensive business model, high current yield, and stellar balance sheet position it as a great choice for generating significant amounts of dependable passive income for many years to come, especially in the current economic climate of elevated interest rates and a potential recession.

Living Off Of Dividend Stocks Forever

Living off dividends forever is an aspirational goal that many investors strive for, as it represents the epitome of financial freedom, where one's investments generate sufficient passive income to cover all living expenses for decades into the future. This goal, while challenging, is attainable with the proper investment strategy and temperament, especially in the current market environment, where elevated interest rates and a potential recession are causing considerable uncertainty in the markets.

In our view, investing in dividend stocks is preferable to living off of other income-generating investments such as bonds ( BND ) or rental properties because - unlike bonds - they offer the potential for both current income through dividends, long-term capital appreciation, and long-term passive income growth that offsets or ideally even outpaces inflation. Moreover, unlike rental properties, dividend stocks are truly passive investments as they require significantly less active management and are much easier to diversify properly in order to mitigate risks.

One of the biggest keys to building an effective dividend portfolio is achieving sufficient diversification across different sectors and geographies while also focusing on companies with a strong track record of consistent dividend growth. The benefit of diversification was on full display during the early 2000s when technology stocks ( QQQ ) were in a downturn, while other stocks like utilities ( XLU ) proved to be much more resilient. It was also on full display during the 2020 COVID-19 crash, when otherwise blue-chip retail REITs like Simon Property Group ( SPG ) had to slash their dividends quite steeply due to the government's lockdown of the economy. Meanwhile, technology stocks like Amazon ( AMZN ) and Zoom ( ZM ) thrived due to increased online commerce and work as a result of the pandemic. Being well-diversified across sectors helps to create a smoother stream of income and total return performance for investors across a plethora of market conditions and economic cycles.

Another important component of living off of dividend stocks for life is achieving an effective balance of current yield and long-term dividend growth in order to ensure that you have enough cash flow to cover current living expenses while also growing your income fast enough to easily outpace inflation, even during periods of elevated inflation such as we have seen over the past few years.

A third important component of dividend investing is keeping the tax implications of dividend payouts in mind. Some structures issue K-1 tax forms, while others issue 1099s. Moreover, some company payouts come primarily in the form of qualified dividends, others come primarily in the form of ordinary income/interest, while others pay out dividends primarily in the form of return on capital. Keeping these implications in mind when structuring your portfolio (and which securities you put in your retirement accounts versus your taxable accounts) can have a very meaningful impact on your long-term wealth-compounding process.

Why EPD Stock Is A Great Choice

With the key principle of diversification, balanced yield plus growth, and tax efficiency in mind, arguably the best single holding for any long-term dividend portfolio is EPD:

1. Diversification Tool

As we argued in our recent article Munger And Buffett Say Invest $100,000 For Financial Freedom: Consider SCHD , the Schwab U.S. Dividend Equity ETF ( SCHD ) provides a phenomenal combination of diversification and a balance between yield plus growth, making it a great starting point for any dividend investor looking to build a portfolio to last and grow for many decades into the future. However, one of its key flaws is that it lacks diversification into some of the more defensive sectors, with a mere 0.39% exposure to utilities and very little exposure to midstream businesses ( AMLP ).

As a result, the utility-like midstream business model of EPD which is underpinned by long-term commodity price-resistant contracts, a well-diversified portfolio of quality assets, and a stellar business model that has very low leverage, plenty of liquidity, and an A- credit rating can serve as a phenomenal diversification complement to a dividend portfolio centered on SCHD.

2. Exceptional Balance Of Yield Plus Growth

EPD's quarter-century track record of growing its distribution year after year - including a ~5% CAGR over the past several years with management implying that this growth rate should continue for the foreseeable future - combined with its 7.5% current yield, make EPD a stellar yield plus growth investment. For investors who rely on passive income for living expenses, EPD is a great choice for being able to meet current living expenses while also not having to worry about the corrosive influence of inflation on their purchasing power. Moreover, EPD has also delivered market-crushing total returns over the long term, as evidenced by its superior performance relative to the S&P 500 ( SPY ) since going public:

EPD's stellar long-term performance relative to peers was highlighted by management on its latest earnings call :

We recently did a comparison of the six largest North American midstream energy companies, those with a market capitalization over $35 billion. Since 2019, EPD is... the only midstream company to reduce unit count over this time period without material asset sales... We were also one of only three companies that grew distributable cash flow per unit by 15% or more, making EPD the only company [of our peers] to have both reduced unit count and increased DCF per unit.

3. Tax Efficiency

Last, but not least, EPD - as a Master Limited Partnerships (i.e., MLP) - provides most investors with exceptional tax efficiency in their taxable accounts. One of the most significant tax advantages of MLPs is their pass-through status. Unlike corporations, MLPs do not pay corporate income taxes. Instead, their income is 'passed through' to unitholders, who then report their share of the MLP's income, deductions, and credits on their personal tax returns. This structure avoids the double taxation typically seen in corporations, where income is taxed at the corporate level and then again at the individual level when distributed as dividends.

However, this is not the only tax benefit that MLPs afford to their unitholders. A large portion of the distributions paid by MLPs to unitholders is often considered a return of capital (ROC) rather than a taxable dividend due to significant depreciation and other deductions due to their infrastructure assets (like pipelines and storage facilities). Therefore, such return of capital distributions are not taxed in the year they are received and instead reduce the investor's cost basis, and the taxes are deferred until the MLP units are sold, potentially allowing for long-term capital gains treatment, which generally has a lower tax rate compared to ordinary income. This means that the effective/after-tax yield on EPD is even higher than it appears when compared to investment vehicles like BDCs ( BIZD ) and REITs ( VNQ ), which mostly distribute dividends that are taxed as ordinary income, as well as to regular C-Corporations, which mostly distribute dividends that are taxed as qualified dividends.

Last, but not least, upon a unitholder's death, their heirs inherit the MLP units with a stepped-up basis equal to their market value at the time of the investor's death, effectively resulting in years of tax-free passive income for the original unitholder.

With all of these tax advantages in mind, investors should be aware that MLPs like EPD issue Schedule K-1 forms for tax reporting, which can be more complex than the standard 1099-DIV forms issued by corporations. Moreover, MLPs can have state tax implications, as unitholders might owe taxes in states where the MLP operates, regardless of the unitholder's residency. Finally, holding MLPs in tax-deferred accounts like IRAs might lead to unrelated business taxable income (UBTI), which could have tax implications for the account, so keep all of this in mind when deciding whether or not and where to invest in EPD units.

Note: This is not tax advice, and I am not a tax professional. These comments are based purely on my own experience. Be sure to consult a tax advisor before making any tax-based investing decisions.

Investor Takeaway

EPD is an excellent choice for investors aiming to create a dividend-income portfolio for lifelong financial freedom thanks to its consistent history of distribution growth and its strong balance sheet which make it particularly appealing in today's environment of elevated interest rates and growing risks of recession. Moreover, its diversified midstream business model offers stability and a buffer against energy industry volatility. Finally, EPD's status as an MLP brings significant tax advantages which further enhance its attractiveness for long-term income-focused investors. As a result, we hold it as a significant holding and view it as an attractive risk-adjusted Buy right now.

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