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:
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.
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.