Index fund investors gravitate toward the S&P 500 for its ability to compound returns over time, mainly through the growth of the U.S. economy. However, the vast majority of those returns stem from capital gains. In fact, the average stock in the S&P 500 yields just 1.54% at the time of this writing.
In other words, the S&P 500 usually produces a large return, but very little of the return is guaranteed. Investors that want a higher likely return, even if it comes at the expense of capital gains, may look for dividend stocks with yields that are higher than that of the S&P 500.
Pipeline giant Kinder Morgan (KMI -0.64%) is a high-yield dividend stock with a yield of 6.2%. And although Kinder Morgan's growth prospects are certainly not as attractive as those of the broader stock market, it has what it takes to support its existing dividend and future dividend raises as well. Here's why Kinder Morgan is worth a look.
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A high-quality dividend
The key to any quality dividend stock is supporting its dividend with free cash flow (FCF) instead of debt. The goal is to grow FCF over time, and, in turn, the dividend as well.
KMI Free Cash Flow Per Share (Annual) data by YCharts
Kinder Morgan has done a good job of growing its FCF and its dividend. The extra FCF has helped the company pay down debt and reduce its leverage.
A growing dividend is a reason to hold a stock even if the stock price itself doesn't do too much. This has been the case with Kinder Morgan, whose stock price has gone essentially nowhere in recent years, but its dividend has increased by more than 40%.
The result has been a 34.3% total return over the last five years, which is quite a bit higher than an investor could have gotten from a risk-free asset or most bonds. However, it's lower than the 75.6% total return from the S&P 500.
The ideal high-yield dividend stock investor isn't someone who is actively trying to beat the market, but rather wants to generate a steady stream without the need to sell stock.
Viewing the balance sheet as a fail-safe
Even the best dividend-paying companies go through times when their FCF may come up short of their dividend obligation. Instead of cutting the dividend and losing shareholder trust, a better alternative is to maintain a healthy balance sheet where cash on hand, or even debt, can be used to pay dividends in a pinch. Kinder Morgan got into trouble in 2014 because it had a highly leveraged balance sheet, a more volatile business model, and a dividend it couldn't afford.
The Kinder Morgan of today is a much leaner business. Not only does it generate gobs of predictable FCF, but it also sports a balance sheet with very little leverage.
KMI Net Total Long Term Debt (Quarterly) data by YCharts
In the above chart, you can see the impact of the company's deleveraging efforts. Getting the balance sheet back in order has been a key focus of Kinder Morgan management. It's a prime reason why the company's growth had more or less stagnated and capital spending was down. However, now that Kinder Morgan has regained its footing, investors are seeing elements of Kinder Morgan returning to growth -- as you can see from the increased spending over the last couple of years.
Supporting future dividend increases
With Kinder Morgan generating stable FCF and the balance sheet in good order, the question now is whether Kinder Morgan can chart a path toward growing FCF over time. Future FCF depends on the usefulness of Kinder Morgan's infrastructure assets. The existential threat for the company is the gradual decline in oil and gas consumption. After all, renewable energy is comprising a growing share of the U.S. energy mix. And carbon reduction goals depend on accelerated renewable energy investment. The Inflation Reduction Act offers tax credits for renewable energy projects, and hurts the investment thesis for fossil fuel-based power generation.
But despite all of these risks, there's no denying that oil and natural gas transportation remains a critical industry in the U.S. Pipelines also serve a vital role in transporting natural gas to liquefied natural gas terminals, which cool and condense natural gas for export.
In sum, Kinder Morgan may not have a path toward breakneck growth. But it operates in a leading position in an industry with high barriers to entry. And its project backlog suggests there are plenty of opportunities worth funding that the company believes will support future dividend growth.
A dividend you can count on
The dividend is the main selling point for investing in Kinder Morgan stock. All signs point toward the dividend being well supported by present and future projects.
The one concern is that after a few years of rapid dividend growth, Kinder Morgan has hit the brakes and has only made marginal increases over the last four years.
However, it has started repurchasing its own stock, which is another way to drive shareholder value.
All told, investors shouldn't expect sizable capital gains from Kinder Morgan stock or outsized dividend increases. But that's ok, because the reliability of its existing 6.2% dividend yield should be enough to drive home the investment thesis on its own.
