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In the first article of this series, I wrote about quality at the income portfolio level. This article continues with the discussion with a focus on choosing quality companies to add to our income portfolio. Amongst other things, the factors that affect the quality of a company include the company's earnings consistency, its financial strength, its yield, and its dividend growth rate.

Choosing a Quality Stock for your Income Portfolio

First, let's look at choosing a quality income growth stock. It should:

  1. have a minimum yield (or not)

  2. have a minimum dividend growth rate

  3. be rated BBB+ or better

  4. earnings growth 7 out of 10 years

  5. manageable debt levels

  6. moat

  7. diversification (by sector and stock)

  8. be a fair valuation or better

1) Minimum Yield (or not)

Because we already set a minimum yield for the portfolio, I don't see a need to set a minimum yield on individual stocks. Thus, I'm not limited by the yield in my choices. That said, I'm a young investor still in my twenties, so it makes sense for me to focus more on the dividend growth rate instead of on the current yield. On the other hand, it might make more sense for folks near or at retirement to focus more on yield instead of on the dividend growth rate.

2) Minimum Dividend Growth Rate

I want to set a minimum dividend growth rate for individual holdings because if one company is growing the dividends too slowly, I can probably find a similar quality company with similar yield but higher dividend growth. For each company, I still like to see their dividends growing by more than 3% a year. It really depends on the company, which sector it is in, and its historical dividend growth rate. Looking at all of the above, I form an expectation of the minimum dividend growth rate for the company.

For example, Ross Stores (NASDAQ:ROST) has been growing its dividends at double-digit rates for the past 19 years. If it suddenly freezes or cuts the dividend, I'll most definitely sell. See my analysis on Ross Stores.

3) Rated BBB+ or Better

Obviously, the higher the rating, the higher the quality of the company. Generally, I like a S&P rating of BBB+ or better. Last month, Ross Stores' was upgraded from BBB+ to A-. Companies are upgraded and downgraded all the time. So, to add a margin of safety, investors might opt to invest in companies rated A- or higher. Other than Standard & Poors, Morningstar and Value Line also offer ratings.

4) Earnings Growth (Past and Future)

A company worthy to be added to our dividend income portfolio should have reliable earnings growth. If a company grows its earnings 7 out of the last 10 years, I consider it to have reliable earnings to support dividend growth.

Continuing with using Ross Stores as an example, I check its earnings per share by going to MorningStar.com. I type in its ticker of "ROST" at the top and press enter. Then, I click on the "Key Ratios" tab. The "Earnings Per Share" row only shows one declined EPS number from 2004 to 2005. Ross Stores increased earnings even in the last recession. So, I expect its earnings to continue to grow even in adverse economic conditions.

Future dividend growth is more or less based on future earnings growth. We cannot avoid making an estimation of the future earnings growth rate if we expect future dividend growth. Thankfully, Chuck Carnevale's FAST Graphs provide that feature. Alternatively, or in complementary to the FAST Graphs, MSN Money also gives an estimation on the EPS growth for the next 5 years. (FAST Graphs conveniently provides a yellow link to MSN Money's estimation at the bottom of the left bar.)

For example, FAST Graph's consensus estimation of EPS growth for the next 5 years is 9% for McDonald's (NYSE:MCD). MSN Money shows 9.2%. So, we can expect McDonald's dividends to continue to grow around 9% annually for the near future.

5) Manageable Debt Levels

Generally, it is wise to avoid companies with excessive debt, especially in low interest rate environment. Eventually, the interest rate will rise, even if steadily. When interest rate rises, companies which have more debt will have a harder time paying it back. Generally, a debt-to-capital ratio less than 50% is pretty safe. But that percentage is not concrete.

It also helps to compare with peers of the company you're interested in. For example, Ross Stores have a debt-to-capital ratio of 7%. TJX Companies (NYSE:TJX), Ross' competitor, has a debt-to-capital ratio of 25%. This check, provides further evidence that Ross Stores' debt is manageable.

6) Moat

Companies having a narrow or wide moat has some sort of competitive advantage which allows them to earn more profits than peers. One indicator of a company having possible moat is looking at its gross margin figures over time. Using the "Key Ratios" from MorningStar.com again, we see that ROST has been generally increasing its gross margins.

For a better understanding of moat, check out a fellow Seeking Alpha author's article. Integrator wrote an article on Why your Dividend Investments need a Moat in which he explained the different types of moat relating to intellectual property, regulation, switching costs, marketing and distribution, and location. And that the widest moat is formed from a combination of the above.

7) Diversification (by sector, and by stock)

Using S&P's GICS (Global Industry Classification Standard) organization system, we classify the sectors as follows:

  • Energy

  • Materials

  • Industrials

  • Consumer Discretionary

  • Consumer Staples

  • Healthcare

  • Financials

  • Information Technology

  • Telecommunication Services

  • Utilities

The GICS have classifications for sub-industries within those sectors as well, but for the purpose of this article, the sectors listed above will suffice. A quality income portfolio should be sufficiently diversified across those sectors. Generally, the Energy, Consumer Discretionary, Consumer Staples, Healthcare, Telecommunication Services, and Utilities are viewed as more stable and safer sectors. Therefore, some investors may allocate the majority of their income portfolio in those sectors.

To sleep well at night, I wouldn't want any sector to make up more than 20% of my portfolio.

What I mentioned just now is the the dollar amount allocated to a sector. Another consideration is the amount of dividends I'm receiving from each sector. For example, let's say I have a $10,000 portfolio. I place $1000 in each of the 10 sectors above. Another financial crisis comes along and the financial sector tanks, and it eliminated the dividends altogether. If I were getting 20% of my total dividends from the financial sector, I now receive 20% less.

Similarly, I wouldn't want to allocate excessive capital to any one company. I wouldn't want to rely excessively on one company for my dividends either. So, it's a balancing act. The former helps in preservation of capital. The latter helps in the preservation of the income stream.

8) Buy a Company at Fair Valuation or Better

Even for excellent businesses like Coca-cola, Chevron (NYSE:CVX), McDonald's, and Johnson and Johnson (NYSE:JNJ) to name a few, we shouldn't pay any price on it. At the very least, we pay a fair price. However, some companies historically command premium valuations, while others historically have lower valuations. The easiest way is to see a graph, specifically, Chuck Carnevale's FAST Graphs. In fact, I explained in detail in my previous article on How To Pick A Value Investment For Dividend Growth And Success using FAST Graphs as an illustration.

Other Considerations

Other considerations in building a quality income portfolio include inclusion of different sized companies such as small-cap and large-cap companies. So, there's a good mix of income, stability and growth. For now though, I'm sticking to big blue chip dividend payers of 5 years or more. If at one point, I have extra funds, I would probably stick with a small cap ETF for exposure instead of buying individual ones.

In Summary

To decide on a buy for the quality income portfolio, we don't necessarily need a minimum yield for the company, because we already set one for the portfolio. However, if a holding freezes or cuts its dividends or stunts its dividend growth, it will probably serve the portfolio better to find a similar company which has higher dividend growth rate to replace it with. Each new company we add should be investment grade with a rating of BBB+ or higher. In addition, this company's earnings in the past and estimated future should be bright. The company also shouldn't be weighted down with too much debt.

All the power to our stock choice if it has a durable moat. For most investors, it will reduce risk of loss of capital or loss of income if we diversify our holdings amongst sectors and stocks. So that tanking in any one sector or stock wouldn't cause us to lose our shirts by destroying the capital in that sector or stock and its expected dividends. Lastly, with all of the above checked for a company pick, we want to make sure that we're buying at fair valuation or undervaluation.

I hope this article series summed up what is needed to build a quality income portfolio by adding quality stocks one at a time in diverse sectors. I look forward to your comments and feedback.

Source: Building A Quality Income Portfolio - Part 2: At The Stock Level