I want to share with you the most important things to look for when building an income-generating portfolio.
Even though high-yielding securities grab all the headlines, double-digit yields aren't everything.
A lot of companies that pay a high yield do it because they have to. They are subject to rapid and unexpected changes or have limited growth potential. Investors are less likely to hold these riskier assets without being compensated with a high yield.
If you are selective, high-yielding securities are a nice addition to your portfolio; as long as you have more stable assets to protect your overall capital.
Essentially what I'm saying is... it's important to know that yield is only part of the story.
Lower-yielding securities are often overlooked by income investors. But securities with a yield less than 5% can be very powerful portfolio builders.
Just as you can't judge a book by its cover, income investors shouldn't judge a security just on yield alone.
For instance, it seems like a no-brainer to invest in a bond yielding 5% rather than a stock with a modest 3% yield. But if that low-yield stock can grow just 3% a year -- while maintaining its 3% yield -- it can do better than a 5% yielding bond in just three year's time. In 10 years, you can double your money with a low-yielding -- but growing -- security.
From the chart below, you can see what I am talking about.
So what so you look for when trying to find the perfect combination of growth and yield?
Here are four traits I look for...
1. Dividend Track Record: I look to see that a company has a history of raising its dividend. To me, it demonstrates a commitment to its dividend policy and a willingness to share its growing income with shareholders. And if a company is raising its dividend now, it is unlikely to be stingy in the near future.
2. Low Payout Ratio: I want a company that has room to grow its dividend, and the payout ratio is one way to judge how much room it has. The payout ratio measures the percentage of a company's earnings it pays out in dividends. For instance, if a company earns 75 cents per share in a quarter and pays a 25 cents per share dividend, then its payout ratio is 33% ($0.25/$0.75).
While there is no exact rule of thumb, a lower payout ratio indicates that a company has more income it could dedicate to dividends. A high payout ratio indicates the company may already be paying out all that it can afford.
[Note: The payout ratio is a less meaningful number for real estate investment trusts (REITs), business development companies (BDCs) and master limited partnerships (MLPs), which all must pay out 90% or more of their income by law.]
3. Revenue Growth: Some companies have to resort to cost-cutting or share reduction to boost earnings per share (EPS). I want a company that has found an easier path to growth -- one that has grown top line revenue and hasn't had to resort to accounting tricks to achieve bottom line growth.
Show me a company that is selling more goods and services and I'll show you a stock that has the potential to appreciate.
4. A Compelling Story for Future Growth: The past and present are good guidelines for selecting a low-yielding stock with potential to grow. But the day you buy a stock, the future is what's key.
I have to be able to tell myself a simple story that convinces me a company will continue to grow. Does it have a new compelling product or technology? Is it capitalizing on a new consumer trend? Is it expanding its business into new, fast-growing, geographic regions?
The simpler the story, the more comfortable I am. If it involves too many chapters -- or if the planets have to align -- then it may not be a story worth investment.
Risks to consider: Just because a company has a history of growing dividends doesn't guarantee it will continue to do so. A change in leadership or some type of headwind can change all that overnight.
Action to Take --> More often than not, if a company has a ton of cash in the bank, a history of growing dividends and a prosperous looking future, it could be a much better buy than a company paying a fat dividend.
This is such a crucial lesson for investors to understand -- in fact, it's a critical element of what I call the "Dividend Trifecta" -- the three key elements to building a successful dividend portfolio. If you can master the Dividend Trifecta, then you'll be well on your way to a large, secure income stream when you need it most. [To learn more about the Dividend Trifecta, go here.]