Our purpose of buying a dividend-growth stock is to receive an ever-increasing income stream year-by-year. By buying more of these dividend growers, you would build yourself a nice dividend growth portfolio. How do we ensure that this portfolio's income will continue to grow every year?
Steps to Build a Secure Dividend Growth Portfolio
- Choose Fundamentally Sound Dividend Growers
- Ensure these Companies are at Fair Value or are Undervalue
- Ensure the Dividend Grower has a Long History of Increasing Dividends
- Reduce Risk (or Increase Stability) of the Portfolio
1) Choose Fundamentally Sound Dividend Growers
We want to make sure the company we're considering is making money, and not burdened with too much debt. Here are some metrics to consider:
- Cash from Operations is the cash generated by the company from its everyday business operations. If a company is bringing in cash from operations every quarter, it shows the company is making money. But it doesn't work if the company is overspending. So, we should also check the company's debt levels.
- Debt to Equity Ratio - Total Liabilities / Shareholders Equity
It indicates what proportion of equity and debt the company is using to finance its assets. - Investopedia
Generally, if this ratio is greater than 1, it may mean the company has too much debt on its hands.
- Quick Ratio
An indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company. - Investopedia
2) Ensure these Companies are at Fair Value or are Undervalue
One way to determine a company's valuation is to compare its Price-to-Earnings Ratio (P/E) with its peers'. Looking at McDonald's (NYSE:MCD), it has a P/E of 16.3. Its peer, Yum! Brands (NYSE:YUM) has a P/E of 21.76. On initial thought, it seems YUM is more expensive than MCD. But then, the higher P/E also indicates that YUM may have more growth potential.
Another way to determine if a company is fair value or undervalue is to compare its current P/E with its historical P/E. Generally though, "if you stick to the PE ratio of 15 as a fair value guide for most companies, you can be confident that you are investing in them at a sound valuation," as stated by Chuck Carnevale, in his article "How Can I know if My Stocks are Fairly Valued?".
3) Ensure the Dividend Grower has a Long History of Increasing Dividends
We want to make sure that the company has a strong record of increasing dividends every year because it shows it generates enough cash for the payment increases, and that management supports returning shareholder value in the form of dividends.
Thankfully, we can easily find out which companies have been raising dividends year-by-year. David Fish maintains a list of Dividend Champions, Contenders, and Challengers -- companies that have been growing dividends for 25+ years, 10-24 years, and 5-9 years, respectively.
4) Reduce the Risk of your Portfolio
It's important to know how much fluctuation of the portfolio you can stomach. Will you be at a panic when your portfolio drops by 20%? How about 30%? During the financial crisis, that's exactly what happened, and some investors went into a panic sell mode. Only first-hand experience in the stock market can help you determine how much fluctuation you can take.
To help mitigate that risk, we do our research 1) by choosing companies that are fundamentally stable, making money, and have manageable debt levels, 2) by ensuring we buy these companies when they're at fair value or undervalue, and 3) by buying companies with strong records of increasing dividends every year.
There's more we can do to reduce risk:
- Add More Stocks: The more stocks we add, the smaller the proportion of each stock is in the entire portfolio. (Of course the dollar amount you buy for each stock affects the risk because each stock has a potentially different beta.)
- Determine the Portfolio Beta: Each stock has a beta associated with it. The higher the beta, the more volatile the stock. So if you aren't one that stomachs volatility well, then ensure that the average beta of your portfolio is low. A stock with a beta of 1 means that if the general market goes up by 10%, the stock will go up by 10%.
- The portfolio beta is the weighted sum of the beta of each stock.
- Here's an example of a portfolio with the portfolio beta calculated.
|Stock||Beta||Dollar Amount||% of Portfolio||Beta Contribution to Portfolio|
1: 16.67% = 3,500 / 21,000
2: 0.09667 = 0.58 * 16.67%
3: 0.65 = SUM of "Beta Contribution to Portfolio" column
This portfolio's beta is below 1, so it's less volatile than the general market, which is good for investors who want a stable portfolio that doesn't fluctuate wildly.
It would look scary if a holding of yours drops by 20%, but looking at the big picture, the entire portfolio, and it is only down by 5%, it's not so scary after all. Besides, do we really care about the drop as long as our income stream from the dividend growth is increasing every year? I think not.