Sunday, July 10, 2011

Constructing a passive income stock portfolio part 3

In part 3 of this 3 part series, I will be talking about earnings growth, dividend growth and management. Please check out part 1 and part 2 if you haven't already read them. Here's part III:

Earnings growth

The passive income investor needs to grow his income over time to keep up with inflation and maintain purchasing power. To do that, investors need to look for companies that they believe will keep growing earnings at a decent rate over the long-term. After all, the only way a company can keep raising its dividend is if it is able to keep growing its profits.

I personally won’t aim to just keep up with inflation, but to beat it by a significant margin. I would look for companies that I believe can at least grow earnings at 6-7% over the long-term.

Dividend growth and management

For the dividend investor, rising profits isn’t enough. Management must be committed to raising the dividend. Investors should look back to the past to see if the company had been paying steadily rising dividends over the past 10 years or more. The company should also have raised its dividend at a rate that’s higher than the rate of inflation. 

When I say that the company should have steadily increased its dividend at a rate greater than inflation, I don’t mean that the dividend has to increase every year at a rate greater than inflation. There might be some years where the company didn't raise the dividend or only slightly raised the dividend, but I think that’s normal. What matters is that over the long-term, the increase in the dividend has outpaced inflation. Looking back over a 10 year period, I would take the average dividends paid in the starting 3 years of the period and compare it to the average dividends paid in the latest 3 years. If the average dividends paid in the latest 3 years is acceptably higher (what you find acceptable is up to you, but the dividend should have at least risen at the same pace as inflation) than the dividends paid in the starting 3 years of the period, then I would think that management is doing ok in terms of raising the dividend.     

If I were to invest for passive income, the security of my sources of income would be one of the things I would rank as most important. For a stock to be reliable in producing good returns and paying out generous dividends to shareholders, the business or stable of businesses behind the stock needs to have good fundamentals, and management needs to be competent and committed to enhancing shareholder value. A management team that’s committed to their role as stewards of shareholders’ money will do things like buyback shares when they’re undervalued, increase the dividend when there’s no other better use of capital, avoid taking on excessive risks, maintain ample liquidity and financial strength, face the brutal facts of reality and adapt accordingly,  and etc.

I wrote an article about some of the things I look at when judging the performance of a company’s management team. You can check it out here if you’re interested.

Conclusion

At the end of the day, dividend paying stocks are still stocks. And apart from certain things that the dividend investor has to pay attention to (dividend yield, dividend payout ratio, and etc.), passive income investors should focus on the same things that any other investor would normally focus on when picking stocks. Things like balance sheet strength, whether the company has good liquidity, competitive advantage, returns on equity, revenue and profit growth, how competent management is, and whether or not the stock is trading at a reasonable price.

If you have any questions or have anything that you would like to add, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio.

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.

Constructing a passive income stock portfolio part 1

There are many reasons for wanting passive income. A married couple may want passive income so they can go buy something nice for themselves every now and then, a retiree may need passive income to meet his day to day expenses, and an investor may want passive income to deploy into cash generating assets.

Passive income can be generated from real estate properties, a portfolio of bonds, a portfolio of stocks, private businesses and etc. In this 3 part series, I will be talking about the things that an investor should look out for when building a portfolio of stocks for the purpose of generating stable dividend income. In part 1 of the series, I will be talking about the dividend yield as well as something Warren Buffet calls owners' earnings and how that applies to dividend investing. Please also check out part 2 and part 3 (The articles in this series can be read in any order). Here's part I:

Dividend yield and owners' earnings

We first need to start by finding stocks that have healthy dividend yields. We also need to make sure that the dividend is sustainable in the sense that the dividend yield wasn’t inflated by the company paying out a special dividend that isn’t likely to recur, and the dividends paid out as a percentage of owner earnings is manageable.

If the company paid a very high dividend in the previous year because it received a lot of money from selling its assets, profited from its foreign exchange contracts, delivered an extraordinarily large order that’s not likely to recur anytime soon, or because of any other event that has nothing to do with the company’s normal earnings power, then there’s the risk that the dividend will not be sustainable, and investors who bought the stock for its dividend might find that the income they receive from the stock is much less than what they expected.    

Warren Buffett came up with the concept of “owners’ earnings.” Owners’ earnings is the cash that the shareholders or owners can take out from a business without affecting the current profitability and competitive position of the business. I believe that measuring the dividends paid out as a percentage of owners’ earnings can give you a much better gauge as to the sustainability of the dividend than measuring the dividends paid out as a percentage of net profit. This is the case as owner earnings take into account the capital expenditure as well as any additional capital that the company has to put up to maintain current profitability and its current competitive position (a lack of capital expenditure will lead to the company’s profitability being impaired, which will lead to dividends being cut as there are less profits to pay out dividends). Net profit might not be a reliable measure of the amount of cash a company can return to shareholders without damaging the earnings power of the business.

To measure the amount of dividends paid to shareholders as a percentage of owner earnings, we first need to calculate the owners’ earnings. Here’s how I calculate owner’s earnings: Net profit (I try and take out one-time gains or losses) + depreciation and amortization +/- certain      non-cash items - average capital expenditure needed to maintain current profitability and competitive advantage - increase in working capital (if there is).

After we get the owners’ earnings figure, we just divide the dividends the company paid by the company’s owners’ earnings. This is similar to the dividend payout ratio only that we replaced net income with owners’ earnings. We should look for companies that don’t pay out too high a percentage of owners’ earnings as dividends as this might put the dividend in risk in the event that the company has to invest more money in the business, and if the company choose to forgo investing in the business to maintain the dividend, then it will be worse as the company will be killing itself in the long-run.