How to build an income portfolio using 12 simple steps
Today’s guest post is from investor Kanwal Sarai. Kanwal loves dividends like My Own Advisor does and is on a mission to empower his readership.
Investing doesn’t have to be difficult. In fact, I taught both my kids at the age of nine how to build an income generating portfolio. That financial education continues in our house today!
For today’s post, I want to share my 12-step plan about creating an income portfolio that might help you earn growing income each year regardless of market conditions.
Let’s get into my details!
Growing income each year regardless of market conditions?
I have been a value investor for over 21 years, and each year my portfolio has generated more income regardless of market conditions. In the last 21 years my portfolio has survived the following:
- 1999-2000 collapse of the technology bubble.
- 9/11 market crash.
- 2002 market downturn leading to market lows last reached in 1997 and 1998.
- 2008 financial crisis.
- 2020 market crash due to COVID-19 (and we’re not done yet?)
How to survive market crashes?
I feel there are two principles to surviving market crashes:
- Invest for the long-term.
- Only buy quality stocks when they are undervalued (priced low).
Mark wrote about his plan to survive a stock market crash and benefit from it – things I believe in as well.
Avoid mistakes (as much as you can)
By following my two key principles listed above, I believe you can try to avoid these common investing mistakes:
- Buying stocks on a hunch or gut feeling because the price might rise.
- Buying a stock because it’s popular.
- Investing in a company and not knowing that its debt, payout ratio, or P/E is too high.
- Investing in a company that’s not profitable.
- Allowing the media noise to confuse you and influence any investing decisions.
- Thinking short-term.
My 12-steps shared to help you build your income portfolio
To combat some of those investing mistakes and more, I’ve come up with a set of 12-steps designed to invest in quality companies when they are undervalued (priced low). Let’s break them down in detail.
Step 1: Do you understand the product or service offered by the company?
I’m not convinced you need to be an expert in everything the company is doing, but you should be able to explain to your grandmother how this company is making money. For example, what does Walmart do? Walmart buys products at wholesale and sells them to the public at retail prices from their stores worldwide. It’s that simple. My bottom-line: if you don’t understand what the company is selling or how they make money you shouldn’t buy the stock.
Step 2: Will people still be using this product or service in 20 years?
If you are going to invest your hard-earned money for the long-term you should consider if that company is going to be around for the long-term as well. I suggest you avoid investing in companies that relate to any novelty, because I don’t believe they will last.
Step 3: Does the company have a low-cost durable (lasting) competitive advantage?
Consider companies that are virtual monopolies in their industry or at least they make it very difficult for new competitors to enter their space. For example, Rogers, Bell, and Telus run the majority of telecommunications in Canada. If you own a cell phone or have internet access you likely need one of those companies to deliver the data.
Our largest five banks in Canada run the majority of banking in this country.
When you think of soft drinks, Coca-Cola, and Pepsi automatically come to mind. Coca-Cola is the world’s largest beverage company and operates in over 200 countries. If you were to start a soft drink company today you would have to spend billions in marketing and you still would not get to where Coca-Cola is today in terms of brand recognition and loyalty.
Step 4: Is the company recession proof?
If you lose your job are you going to go out and buy a new car? If you are worried about being laid off are you going to go on an expensive vacation overseas? Of course not. I avoid investing in automobile manufacturers, airlines, or hotels, since I don’t see these industries as recession proof. But you still have to eat, you still have to heat your home in the winter, and turn the lights on at night. Step 4 has become even more important during COVID-19, it’s made us realize what companies and industries are profitable these days.
Step 5: Has the company had consistent earnings growth?
Remember you are investing your hard-earned money; you want to make sure you invest in companies that have a history of profitability. I recommend looking at a company’s 10-year or 20-year average Earnings Per Share (EPS) growth rate. I think the EPS growth must be 8% or more.
Step 6: Has the company had consistent dividend growth?
At the end of the day the dividends are yours to keep. Dividends paid can help you cover your living expenses and more. Although nobody can predict the future, and as Mark often says, dividends while great are never guaranteed – I do believe a company with a history of growing their dividend can give you a high degree of confidence that the company will continue to pay their dividend and continue to increase over time. I recommend looking at a company’s 10-year or 20-year average dividend growth rate. I like dividend growth rates at 8% or more.
Should you be interested, here is a list of some Canadian companies that have been consecutively increasing dividends for more than 15 years:
Disclosure: I currently own in the table above: CWB, ACO.X, EMP.A, IMO, ENB, CNR, CNQ, TRP, FTT, SU.
Editor’s note/My Own Advisor: Some companies above have recently decreased their dividend. E.g., SU, dividend cut down 55% due to COVID-19 pandemic and crashing oil prices. I know. I own it. Table above was a point in time. Future dividend increases are never guaranteed.
Step 7: Does the company have a low payout ratio?
All things considered equal which of the following two companies would you invest in?
Earnings Per Share: $1.25
Dividend Per Share: $2.26
Payout Ratio = Dividend/EPS = $2.26/$1.25 = 180%
Earnings Per Share: $1.25
Dividend Per Share: $0.84
Payout Ratio = Dividend/EPS = $0.84/$1.25 = 67%
I like Company B! Company B has a lower payout ratio and should have room to increase their dividend in the future. I like companies where the payout ratio is consistently less than 75%.
Step 8: Does the company have low debt?
I personally try and avoid investing in companies that carry too much debt, these companies will have a hard time surviving a market downturn; even with low interest rates. I like companies where the debt is 70% or less.
Step 9: Does the company have a good credit rating?
I recommend you look at the S&P Credit Ratings, a company must have a minimum S&P Credit Rating of “BBB+”. You can quickly look up ratings directly at S&P Global Ratings (you’ll need to create a free account in order to see the rating).
Step 10: Does the company actively buy back its shares?
When companies’ buyback their shares, the number of shares outstanding are reduced, which makes the existing shares worth more. Consider looking at the number of shares outstanding in the previous year and compare that to the number of current outstanding shares.
Step 11: Is the stock undervalued (priced low)?
We’ve all heard the phrase “buy low and sell high”. Consider the following example using dividend yield to signal value:
- Share Price: $35
- Dividend Per Share: $1
- Dividend Yield = Dividend/Share Price = $1/$35 = 2.86%
But what happens to the dividend yield if the stock price drops to $20?
- Share Price: $20
- Dividend Per Share: $1
- Dividend Yield = Dividend/Share Price = $1/$20 = 5.00%
As you can see, buying an undervalued (priced low) stock can be signaled by a higher dividend yield.
Why is that important?
I have three parts to my Step 11:
Step 11.a: The P/E Ratio must be 25 or below.
A lower P/E ratio will indicate the stock is trading at a lower price. A higher P/E generally indicates a more expensive stock price.
Step 11.b: Ensure that the current dividend yield is higher than its average dividend yield (for value).
Before you invest in any company, review the dividend yield. A current dividend yield that is higher than the average dividend yield can signal value.
Step 11.c: The P/B Ratio should be 3 or less.
The book value of a stock is theoretically the amount of money that would be paid to shareholders if the company was liquidated and paid off all of its liabilities. Therefore, a stock trading closer to book value is going to be cheaper than a stock that is trading at a much higher price.
Step 12: Keep your emotions out of investing.
Lastly, with all my metrics above – I believe you must remove your emotions from any stock selection process. I’ve learned it’s easy to get emotionally attached to a stock or company, it’s easy to panic when markets crash, it’s easy to jump-in when stock prices are skyrocketing.
I’ve come up with my 12-steps as a path to keep my investing discipline and patience intact for long-term success. I hope those 12-steps above can benefit you too. Check out my site to learn more anytime.
Thanks to Mark for his time on this site and I look forward to your comments on my 12-step investing approach.
Disclosure from Mark: any investing methodology or stocks mentioned on this site are not investing advice. Should you wish to seek counsel or a second opinion before you make any major financial decision, then I suggest you consult a fee-for-service planner. All investing decisions have risk. Please choose wisely.