A Simple Guide to Building a Strong Dividend Portfolio

By: Andrew McShane

Supplement your Investments with Strong Dividends

You are about to learn...

  • The Basics of a Dividend Portfolio
  • The Benefits of a Strong Dividend Portfolio
  • How to Build a Dividend Portfolio
  • A Few Top Dividend Stocks

A strong dividend portfolio can provide investors another source of income on top of the returns they receive from their stocks. Few things in the financial world make people smile more than getting money deposited in your brokerage account from time to time in the form of a cash dividend.

Much has been written over the years on how to buy stocks for a dividend portfolio, yet many people still tend to incorrectly select the highest yielding dividend stocks, regardless of the underlying health of the company paying the dividend.

There needs to be significant consideration as to whether the company is healthy enough to afford paying the dividends they’ve committed to pay.

The Basics of a Dividend Portfolio

Before we go any further let’s make sure we agree on what we mean by the term dividend portfolio (or sometimes call a dividend stock portfolio).

Interest rates on bonds and bank certificates of deposit have declined significantly in recent years. As a result, some investors have looked to dividend income from stocks and mutual funds to take the place of some of that lost interest income.

The dividend income is generated by buying stocks as part of a diversified portfolio, typically for the long term, and collecting the dividend when the payout occurs.

The Benefits of a Dividend Portfolio

There are two way to make money investing in stocks. One way to make money is via the capital gains when you sell shares at a price more than the price you paid to buy the shares. The other way to make money with stocks is via the dividends (or distributions for a master limited partnership stock) paid by the company during the time you are a shareholder.

Over the long term stock prices tend to vary significantly, whereas dividends tend to be more steady, normally with small dividend increase on an annual basis.

Although there is no “sure thing” when it comes to investing in stocks, if you pick healthy companies that generate strong cash flow, you should be able to lock in a portion of your future income before you worry about the stock appreciation.

Building a Dividend Stock Portfolio

As you start to research stock to buy for a dividend stock portfolio, here are some things to look for in the companies you consider:

  • You want to invest in profitable companies. Perhaps this is obvious, but it goes right to the heart of the sustainability of the dividend.

Dividends are paid out of the earnings of a company. Or even more specifically dividends are paid out of the cash flow generated by the earnings of the company.

  • The lower the payout ratio, the better the company is for consideration for an income investor. The payout ratio is the dividend per share divided by the earnings per share.

If the company has a payout ratio below 50% that is generally considered safe. The more above 50% a payout ratio gets, the more questionable it is whether the company will be able to maintain the dividend in the future.

A payout ratio above 100% means the company is paying out more in dividends then it is making in profits. This is not sustainable and is a sign future dividends may be reduced if profits don’t improve.

  • Look for companies that have not only a long history of paying dividends, but also increasing them over time.

Josh Peters, author of The Ultimate Dividend Playbook, had a great quote “The safest dividend is the one that has just been raised”.  Meaning that some of the best dividend companies to invest in are those that raise their dividends on a regular basis.

There is even a name for the kind of companies that raise their dividends on a regular basis. Dividend Aristocrats are companies within the S&P index that have increased their dividend payout for at least 25 consecutive years.

  • If the dividend yield (dividend rate divided by the stock price) is too good to be true, then look very closely at the company. Any stock paying a dividend of greater than 6% should be looked at closely for consideration of investment.

A Few Top Dividend Stocks

Everyone’s investing needs are different so you should not invest in any of the following companies without doing your own due diligence.

What follows is an example of a mini model dividend portfolio, along with some facts and opinions about each company.

I’ve included 8 stocks, which is likely not enough for a diversified portfolio. You will likely want between 20 and 30 stocks in your portfolio, so use these 8 as examples of the beginnings of a portfolio.

Abbvie (ABBV): Well-run pharmaceutical company, 5% yield trading at less than 10 times earnings, with a dividend payout of less than 50%.

Altria (MO): The classic sin stock, selling tobacco products. Yield of 8%+, was just raised by 2.4%.

Bristol Meyers (BMY):  Also a well-run pharmaceutical company trading at less than ten times earnings, yielding 3.1% and a low payout ratio of approximately 30%.

Dominion Resources (D): A well respected retail utility, 3.2% yield, with a payout ratio of approximately 70%.

Enterprise Product Partners Limited Partnership (EPD): A well covered 10% yield with lots of insider ownership. One of the few oil and gas stocks I would invest in trading at very depressed prices for such a stable business.

Pepsi (PEP): An iconic brand for a consumer staple. Very strong and stable cash flow. Payout ratio of 75% with a safe 3% yield.

Realty Income Corporation (O): A real estate investment trust yielding 4.7% that is a titan of real estate investing.

ATT (T): Another fantastic brand buoyed by strong growth in their cellular network. A 65% payout ratio and a 7% yield. Significant debt on the balance sheet but being paid down quickly.

Sum them all up and you’ve got the beginnings of a dividend stock portfolio that yields 5.5%. That is a good start to achieving a 10% annual return, with the other 4.5% coming from stock appreciation as the companies grow their earnings and cash flows.

In Summary

Congratulations on considering the start of a dividend stock portfolio. Such a portfolio can give you two ways to win by increasing your wealth through the receipt of dividends and the appreciation of the share price.

Be sure to not just look at the amount of the dividend being paid.

Be sure to look at the underlying fundamentals of the company paying the dividend to make sure it is sustainable for years to come.

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