Sunday, July 10, 2011

Constructing a passive income stock portfolio part 2

In part 1 of this series, I talked about the dividend yield and Warren Buffett's owners' earnings. In this article, I will be talking about the importance of competitive advantages, the nature of the business and the way a company deploys capital. You can check out part 1 and part 3 if you're interested. Here's part II:

Competitive advantage and the nature of the business

To ensure that the income or dividends we receive from the stocks in our portfolio are stable, we need to invest in companies that have a competitive advantage and sell products or services that have relatively stable demand, both in good times or bad.

If a company doesn’t have a competitive edge which makes the customer choose its products over the products of its competitors, then the company’s profits are at risk from other firms that decide to compete with the company and take its market share, this will lead to falling profits, which will in turn lead to the company slashing the dividend. That’s why it’s crucial that the company has a competitive advantage to protect its profits. Apple for example has a very strong brand and has a huge apps store which gives their IPhones and IPads an edge over the offerings of their competitors. Wal-Mart is very good at keeping costs low and passing on the savings to customers, this makes it hard for Wal-Mart’s competitors to compete with it on price. 

The type of business the company is in can also be a good gauge of whether or not the company’s profits (and therefore dividends) will be stable. For example: The earnings of a beer company or a tobacco company with a strong brand shouldn’t experience a significant drop in profits during a recession. While I don’t think that it’s conventional, some of the people I met seem to think that the rental income from real estate is without a doubt more stable than dividends from stocks. I understand that some real estate really do produce stable income for their owners, but I would rather invest in a venerable consumer products company with a portfolio of strong brands than in an apartment located in an area where there are a lot of vacant apartment units and where rent can fall anytime.

How the company deploys capital

The best kind of business is a business that throws off lots of cash and needs very little capital to expand, in other words, a business that earns superior returns on capital. These cash cows are in the best position to payout generous dividends to their shareholders. One of the best examples of a great company generating absolutely huge piles of cash for its owners is See’s Candy. Warren Buffett’s company Berkshire Hathaway bought See’s Candy for $25 million in 1972. From 1972 to 2007, See’s Candy has generated $1.35 billion in pre-tax profit for Berkshire Hathaway. Of the $1.35 billion in pre-tax profits, only $32 million needed to be reinvested in the business (you can read more in Berkshire Hathaway’s 2007 letter to shareholders). This is the kind of cash a great business throws off to its shareholders. That’s why investors should look for companies that are able to generate good returns on equity without taking on excessive debt.  

Unfortunately, there are not many businesses that both earn high returns on capital, trades at a reasonable price, and has a healthy dividend yield (a healthy dividend yield is not necessary for an investor looking to maximize wealth and not secure passive income, but it is an obvious necessity for the dividend investor, which makes his or her search even harder).While definitely not as impressive as the great companies, companies that earn above average returns on capital are acceptable candidates for a passive income portfolio.

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