This article was published on Dividend Kings on Jan. 18, 2023.
2022 was a crazy year for markets. Not because the S&P fell 18% but because the stock and bond market fell double digits simultaneously for the first time in history.
There's good and bad news for those hoping 2023 will be a kinder year for our portfolios.
The good news is that inflation is rapidly declining, and the Fed is almost done hiking rates.
The bad news? There's a lot of it.
And, of course, we can't forget that we're likely barreling toward recession in a few months.
The 3m-10yr yield curve is the best recession forecasting tool in history, according to studies from the NY, Dallas, Chicago, and San Francisco Feds.
Since the 1950s, anytime it's become inverted (gone negative), a recession has always followed within two years.
What does a -1.19% yield curve inversion mean?
This dire assessment agrees with the consensus of CEOs and economists.
|Earnings Decline In 2023||2023 S&P Earnings||X 25-Year Average PE Of 16.8||Decline From Current Level|
|13% (average, median since WWII)||$189.52||$3,189.64||20.1%|
(Source: DK S&P 500 Valuation Tool, Bloomberg Consensus)
The historically average recession brings with it a 13% earnings decline which would imply a 20% further decline in stocks.
In other words, 2023 MIGHT be another terrible year for stocks, at least until the bear market finally bottoms.
But that doesn't necessarily mean it will be. Wall Street doesn't run on certainties, only probability curves.
In fact, stocks have actually gone up in 11 of the 17 years since WWII, with negative earnings growth.
The main purpose of Wall Street is to make fools of as many men as possible." - Bernard Baruch
In other words, stocks might crash from here...or merely trade sideways and possibly shock most of Wall Street and go up.
So what's a smart investor like you to do when the stock market's potential returns for 2023 range from -25% to +25%?
I can't tell you what the stock market will do in the next week, month, or even in 2023; no one can. For every bearish argument, you can find an equally plausible bullish one.
But guess what? What happens to the economy in 2023 or even 2024 won't matter in the long term.
Perfect market timing is impossible, but even if you had the God-like power to only buy on the lowest day of the year, it would hardly make a difference.
In fact, over 40 years, from 1970 to 2019, perfect market timing delivered 22% better returns than buying on the first day of the year.
Not 22% per year, but 22% over 40 years, or 0.5% better annual returns.
Since 1928 the median 30-year S&P return is 2200%, a 23X return.
That's the standard retirement time frame, which is important for everyone under and including the age of 70.
In other words, if you buy blue-chip stocks over 30 years, you can reasonably expect a 2200% return.
If you perfectly time the market, you can expect... about 2216% returns.
Instead of turning $1 into $23, you'd turn it into $23.16... if you had the ability to nail the bottom every year for three decades.
Are you willing to risk $23 in profit per $1 invested to make an extra $0.16?
For every $1 in extra profit, perfect market timing could achieve you risk not making $144.
For context, the casino edge in Blackjack is 2%.
The reward-to-risk ratio for market timing? 0.007
Or, to put it another way, you're 131X more likely to retire rich from BlackJack than from market timing.
What's the easiest way to sleep well at night during a recession where stocks could fall as much as 27% (from here)?
How about earning a very safe 4% to 9% yield that grows in all economic and market conditions?
Imagine a portfolio that yields a safe 6% to 7% (I've built several in recent months). Imagine using a 3% to 5% annual withdrawal rule for retirement.
Guess what the after-tax yield is on a 6% blue-chip portfolio? 5.1%.
So how much should you care about stock prices if you can safely live 100% on dividends alone? Zero.
The only thing that matters is the safety of those dividends, which is a function of cash flow, balance sheet, and management long-term risk management skill.
A diversified high-yield blue-chip portfolio is the ultimate financial freedom because it doesn't rely on capital gains to maintain your standard of living.
But guess what? Dividend growth blue-chips tend to be lower volatility, which helps most people stay calm and avoid costly mistakes like panic selling during bear markets.
How would you like to match or beat the market with lower volatility even during the 2nd worst market crash in US history?
Several DK members have asked me for an update on these two telecom giants, specifically focusing on which one is the better recession buy.
So let's look at the three criteria high-yield income investors should consider with defensive dividend blue-chips.
For context, the average annual volatility for standalone companies is 28%, and for dividend aristocrats, 25%.
Verizon's average annual volatility over the last 15 years is 18% compared to 24% for AT&T.
OK, but that's just average volatility over 15 years. What about during bear markets?
|July 1998 to October 1998||-3%||-7%||-10%||-22%|
|1990 Recession (May To October)||3%||-4%||NA||-20%|
|1987 Black Monday Period||-15%||-23%||NA||-36%|
|Average Peak Decline Vs. S&P 500||-56%||-40%||-40%||NA|
|Median Peak Decline Vs. S&P 500||-57%||-50%||-43%||NA|
(Sources: Portfolio Visualizer Premium, Charlie Bilello)
AT&T averages a 19% decline during bear markets, matching that of a 60/40 and 40% less than the S&P.
But Verizon averages a 14% decline, 56% less than the S&P.
The median decline for AT&T is 14%, 50% less than the S&P.
The median decline for Verizon is 12%, 57% less than the S&P.
What does this mean for investors in these stocks? That if the S&P falls the historical 20% from here:
So on a purely defensive/low volatility basis, Verizon is the superior company.
But it's also the better choice regarding what income investors care about most, dividends safety.
Let's consider three important components of dividend safety.
First, there's the dividend track record. Ben Graham considered this an important quality metric.
AT&T was a dividend aristocrat that cut its dividend in 2022 as part of the spin-off of Warner Media.
AT&T was formerly led by Randal Stephenson, who loved big, splashy, and debt-funded deals.
He bought DirectTV even after cord cutting was going to reduce its cash flows in the future. He paid $49 billion for that deal, and then doubled the size of his next expire building mistake.
The theory behind Time Warner was also disastrous.
Time Warner owned HBO and some of the best content in the world.
Of course, it now turns out that streaming is a pretty lousy business, requiring massive subscriber bases in the hundreds of millions just to turn a profit.
AT&T's new CEO, John Stankey, decided to merge Warner with Discovery to create Warner Bros. Discovery (WBD), and offload as much debt as possible onto it.
The result was a 54% dividend hike, and shareholders were given shares of WBD, which isn't expected to pay a dividend for the foreseeable future.
Warner Bros.' Balance Sheet Looks Terrible
WBD is in the process of slashing costs, including canceling many popular TV shows and even movies that were already almost complete.
And yet its $50 billion debt inheritance from AT&T means it's expected to have a leverage ratio of almost 5X in 2023.
WBD isn't expected to turn a profit until 2024.
Needless to say, I wouldn't recommend anyone buy this 2nd tier media company.
What about Verizon's dividend track record?
VZ is a high-yield future aristocrat retirees can trust.
How can we tell? Because of the 2nd important dividend safety factor.
Let's start with credit ratings.
|Rating Agency||Credit Rating||30-Year Default/Bankruptcy Risk||Chance of Losing 100% Of Your Investment 1 In|
|S&P||BBB+ Stable Outlook||5.00%||20.0|
|Fitch||A- Stable Outlook||2.50%||40.0|
|Moody's||Baa1 (BBB+ Equivalent) Stable Outlook||5.00%||20.0|
|Consensus||BBB+ Stable Outlook||4.2%||24.0|
(Sources: S&P, Fitch, Moody's)
The rating agency consensus is that Verizon has a 4.2% chance of going bankrupt in the next 30 years, a 1 in 24 fundamental risks for stock investors.
|Rating Agency||Credit Rating||30-Year Default/Bankruptcy Risk||Chance of Losing 100% Of Your Investment 1 In|
|S&P||BBB Stable Outlook||7.50%||13.3|
|Fitch||BBB+ Stable Outlook||5.00%||20.0|
|Moody's||Baa2 (BBB Equivalent) Stable Outlook||7.50%||13.3|
|Consensus||BBB Stable Outlook||6.7%||15.0|
(Sources: S&P, Fitch, Moody's)
AT&T's fundamental risk consensus is 6.7%, about 50% higher than Verizon's, with a 1 in 15 chance that anyone buying AT&T will lose everything in the next 30 years.
Why does Verizon have a superior balance sheet?
There are two big reasons: debt ratios and cash flow.
For telecom utilities like this, rating agencies like to see 3.5X net debt/EBITDA and AT&T's leverage ratio is 3.0X, with a slight increase expected in 2023 to 3.2%.
Its net debt/EBITDA is 3.5X, at the border of investment-grade safety.
AT&T's interest coverage ratio is 3.7X, while rating agencies like to see 4+.
AT&T's spending on its 5G network is expected to run around $20 billion annually through 2027.
Fortunately, its free cash flow is expected to grow from $14 billion to $20 billion in the next five years.
This is why rating agencies aren't too worried about AT&T's ability to service its debt.
AT&T's $20 billion in FCF in 2027 is still almost $7 billion less than in 2021, thanks to the WBD spinoff.
Without the spinoff, AT&T would have a record of $27 billion in 2027 consensus-free cash flow.
What about the long-term outlook for AT&T's balance sheet?
So AT&T's outlook, at least for its balance sheet, is looking positive, though the dividend isn't expected to grow for several years and at a 1.7% annual rate through 2027.
What about Verizon?
Verizon has slightly lower leverage than AT&T.
AT&T is expected to eventually have lower leverage than Verizon, but Big Red is slightly safer now.
Verizon's spending on 5G is expected to drop significantly, resulting in free cash flow growth from $15 billion to $26 billion over the next five years.
The dividend is expected to grow slightly faster than AT&T's, 2.0% annually, with Verizon achieving a 21-year dividend growth streak in 2027.
Due to the very stable nature of telecom cash flows, 70% is a safe FCF payout ratio, according to rating agencies.
However, Verizon's free cash flow growth rate of 11% vs. a 2% dividend growth rate is expected to result in VZ's FCF payout ratio falling to a very safe 42% in 2027.
OK, so on every dividend safety metric other than FCF payout ratio, which AT&T wins by a hair due to a massive dividend cut, Verizon is the superior choice.
But there's more to a good investment than just dividend safety and low volatility.
|Investment Strategy||Yield||LT Consensus Growth||LT Consensus Total Return Potential||Long-Term Risk-Adjusted Expected Return|
|Schwab US Dividend Equity ETF||3.4%||7.6%||11.0%||7.7%|
|60/40 Retirement Portfolio||2.1%||5.1%||7.2%||5.0%|
|Vanguard Dividend Appreciation ETF||1.9%||10.2%||12.1%||8.5%|
(Sources: DK Research Terminal, FactSet, Morningstar, Ycharts)
Verizon's growth prospects are slightly better than AT&T's, and its yield is 0.6% higher.
Neither Verizon nor AT&T are expected to beat the S&P, but defensive high-yield blue-chips like these do their job if they deliver 8% or better returns.
How realistic are 9% to 10% returns for AT&T and Verizon?
That is pretty realistic, given that both have been delivering such returns for the last 38 years.
Both have delivered 10% to 11% annual rolling returns for the last four decades, and that's pretty much what long-term investors can expect from here.
Verizon Fair Value: $60
Current Price: $40
DK Rating: Potentially Very Strong Buy
Verizon is a bargain, just 8% below its table-pounding buy price.
AT&T Fair Value: $39
Current Price: $19
DK Rating: Potentially Speculative Strong Buy
AT&T is slightly undervalued than Verizon, though a speculative company with a far less dependable and less attractive dividend.
VZ has the potential for 55% total returns within three years or 16% annually.
If VZ grows as expected, it could deliver 126% returns or 15% annually over the next five years.
AT&T has the potential to deliver 30% annual returns over the next three years, more than doubling.
If AT&T grows as expected and returns to historical fair value, it could nearly triple, delivering 20% annual returns.
Let me be clear: I'm not calling the bottom in either VZ or AT&T (I'm not a market timer).
Super SWAN quality (for VZ) does NOT mean "can't fall hard and fast in a bear market."
Fundamentals are all that determine safety and quality, and my recommendations.
While I can't predict the market in the short term, here's what I can tell you about VZ and AT&T.
Both are trading at some of their lowest valuations in history.
AT&T is about 50% undervalued, though a much lower-quality company.
In terms of which is the better recession buy? The answer is clear.
Verizon offers a superior balance sheet, and stronger credit rating and hasn't cut its dividend in 38 years. AT&T cut its dividend just last year. And while its 50% payout ratio means it's not likely to do so in a recession, Verizon's 6.4% yield is superior to AT&T's, much safer, and its dividend is expected to grow slightly faster and much more consistently.
Verizon is a future dividend aristocrat, and AT&T is a failed aristocrat who chose to cut its dividend even though it could have kept paying it safely.
In a recession, with the stock market potentially set for a 20% correction from here, Verizon is likely to fall around 9%, while AT&T should decline about 12%.
Both are solid deep-value defensive choices, but I always recommend favoring safety and quality first over pure valuation, especially when you can lock in a very safe 6.4% yield and around 10% long-term return potential on a Super SWAN that averages 12% to 14% declines in bear markets.
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This article was written by
Adam Galas is a co-founder of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 5,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha).
I'm a proud Army veteran and have seven years of experience as an analyst/investment writer for Dividend Kings, iREIT, The Intelligent Dividend Investor, The Motley Fool, Simply Safe Dividends, Seeking Alpha, and the Adam Mesh Trading Group. I'm proud to be one of the founders of The Dividend Kings, joining forces with Brad Thomas, Chuck Carnevale, and other leading income writers to offer the best premium service on Seeking Alpha's Market Place.
My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives.
With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and safe and dependable income streams in all economic and market conditions.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Dividend Kings owns VZ in our portfolios.