- To get 4% annual yield from a current portfolio, you can divide your money into two piles: high current income, and high future growth.
- The high current income pile should consist of energy companies, tobacco companies, utilities, and telecom companies.
- The second pile should consist of high-quality assets with favorable future dividend growth rates that can absorb any dividend cuts from the first pile of high-yielders.
Some of the portfolio "dilemmas" that have been presented on Seeking Alpha in recent weeks have involved discussions about portfolio construction with total portfolio values in the millions and even tens of millions. With portfolios of that size, it doesn't involve much compromising to get satisfactory income. The more interesting questions to answer are the ones that necessarily involve craftsmanship, such as trying to get $10,000 in income annually out of a $250,000 portfolio.
When searching for a solution, the first thing you do is abandon the puerilistic notion that it won't require additional risk to create a portfolio that yields 4.00% in aggregate. Instead, you recognize that constructing the portfolio does involve some additional risk, and the solution is found by managing the additional risk intelligently.
But here's how I would do it. I would mentally categorize the portfolio into two piles; the first pile is designed to create income now, and the second pile is designed to grow income (hopefully in such a way that it could offset any potential cuts from the companies paying dividends in the first pile).
I would take the first $100,000 and divide it across four sectors: high-yielding energy companies, high-yielding utility companies, tobacco companies, and telecom companies.
For energy companies, you'd want to take a hard look at Total SA (NYSE:TOT), BP (NYSE:BP), Royal Dutch Shell (NYSE:RDS.B), and Kinder Morgan (NYSE:KMI). All three companies have traditions of returning a good chunk of income generated to their shareholders. With Total SA, the yield is 5.18%. With BP, the yield is 4.59%. With Royal Dutch Shell, the yield is 4.62%. With Kinder Morgan, the yield is 5.10%.
What is the risk with those holdings? Well, Total SA's dividend sometimes gets translated across currencies in such a way that the dividend doesn't automatically increase (for instance, American investors went from collecting $2.19 in 2004 to $1.83 in 2005). With BP, the risk is that the litigation from the oil spill will force BP to sell off more than the $10 billion in planned asset sales, which could make dividend growth difficult. With Royal Dutch Shell, the risk is that lower refining profits and trouble growing volumes (remember, the company leads the world with its $451 billion in annual revenue, making it almost the size of the Netherlands) occasionally leads to frozen dividends, such as the company experienced from 2009 through 2011. With Kinder Morgan, the risk is that the $34 billion debt load could lead to higher interest expenses down the line that could have a negative impact on the firm's ability to grow the dividend.
The second sector you have to take a hard look at is utilities, the traditional source of high dividends. That means looking at companies like Southern Company (NYSE:SO) and Consolidated Edison (NYSE:ED). With Southern, you get a starting dividend yield of 4.68%. With Consolidated Edison, your starting yield is 4.74%, and the company has been raising its dividend for forty years.
The catch with these utilities is that although you're a winner in terms of high current income, the growth of the dividend is much slower. Southern's dividend has been barely keeping pace with inflation, growing at a 3.5% annual rate over the past decade. With Consolidated Edison, the dividend has been limping along with a 1.0% annual dividend growth over the past 10 years. With such negligible dividend growth, it really is a case of buying the dividend.
And then there is big tobacco: Altria (NYSE:MO), Reynolds American (NYSE:RAI), and Philip Morris International (NYSE:PM). Altria yields 5.17% annually, Reynolds will give you 5.05% per year, and Philip Morris International will pay out 4.64%. Both Altria and Reynolds American have been growing their dividends between 9% and 10.5% annually over the past ten years (with Altria, you have to manually adjust for the spin-off of Kraft, Mondelez, and Philip Morris International in 2008). With Philip Morris International, the dividend has gone up 3.5x since becoming a standalone company in 2008.
The risk with Altria and Reynolds American is that the annual volume declines that are now approaching 4% annually could eventually hinder earnings per share growth in such a way that it would become impossible to give shareholders meaningful dividend raises. The potential risk with Philip Morris International is that the company does 29.6% of its business in the European Union, and the company is seeing cigarette volumes decline by 5%-6% annually in EU countries. If that trend stays constant or accelerates, it could hinder Philip Morris International's exceptional record of dividend growth that income investors have grown accustomed to since the spin-off in 2008.
And lastly, there are telecom companies like AT&T (NYSE:T), the traditional income stock that has been a stalwart of income portfolios for over a century. The particular appeal with AT&T right now is that it is one of the few high-income producing securities that do not seem overvalued at this point in time. The company is paying out a 5.25% annual dividend, and is making $2.65 per share in normalized profits (meaning AT&T is trading at 13x earnings). Given that AT&T typically trades in the 14-16x earnings range, the fact that you can get a slight discount on a company that is paying out a high current dividend yield is probably appealing.
The catch, however, is that AT&T's $74 billion debt load (in addition to pension obligations of $56 billion, relative to pension assets of $47 billion) could slow down future growth in the dividend. In particular, AT&T has to make $3.5 billion in interest payments alone. That's why the dividend has only grown at 4% annually over the past decade, and makes it unlikely that shareholders will get a raise much in excess of inflation over the coming 5-10 year stretch.
In short, when you build a portfolio of those types of securities today, you are likely placing an emphasis on current income today, while generally sacrificing the prospect of robust linear growth at rates in excess of inflation. But what's why the $225k nest egg gets split up into two piles. The first pile is dedicated to setting aside $100,000 for those high-yielders around the 5% mark, so that you get $5,000 in annual income from them.
The other pile gives you $150,000 to work with, and only requires a blended yield of 3.33% to give you an additional $5,000 in annual income. This gives you a free hand to select high-quality companies with high dividend growth rates. You can stock it with industrial companies like General Electric (NYSE:GE) that yield 3.5% and are growing profits at 8% annually. Heck, even Coca-Cola (NYSE:KO) belongs in the conversation, as the company is growing profits in the 7%-9% range and offers an extraordinarily safe 3.15% dividend yield. The point is that the safety of the dividends in this pile, coupled with their dividend growth rates would offset any cuts in the pile of money that is designed to generate high current income.
Arranging your financial affairs is clearer when you break it into a two-step process that acknowledges the need for current income now (that does come with some risk) juxtaposed against higher-quality assets that have dividend growth rates that can cover up any dividend cuts that you experience along the way. Designating a chunk of the portfolio towards energy companies, tobacco firms, telecom firms, and utilities can get you high current income, and then you can construct the rest of the portfolio in such a way that the assets are high-quality with favorable growth rates, so that you could endure some dividend cuts on the high income side along the way and still generate the amount of annual income desired.