My Perennial Income Portfolio

Summary

• The goal is to create a ‘stocks portfolio’ which will generate enough regular dividend cash to take care of my cash flow budget when I retire.
• The dividends should be consistent and perennial so that I do not resort to selling any of the stocks to meet my cash needs.
• The growth in dividend income should not be less than the inflation adjusted cash budget increases to retain my living standards as I go forward.
• The legacy left behind should take care of another person similarly. Or I can bequeath that for ‘a purpose’ which will fund that ‘purpose’ with a perennial sustainability.

Portfolio expectations:

I want a sustainable cash flow during my late stage life to take care of my expenses. Then this perennial income source when passed as a legacy to next generation should aid them to achieve their similar goals. If there is no such need for them, it can become a source to fund a ‘good cause’ for the society.

Stock attributes to be part of this portfolio:

The most important attribute for a stock to be included in this portfolio is its ability to make a sustainable dividend distribution. That dividend has to grow steadily year after year matching inflation or higher. The cash flow generated by the company should take care of dividend distribution and also retain enough to fund their growth for sustainability. The retained cash is for growth and replacement of their depreciating assets so that their business is sustainable. While the company can resort to debts for such growth and replenishment of asset, the debt is a risky proposition. The total debts shall be within acceptable business norms so that the company can sustain in business. I would love low debt or no debt, cash rich companies. I do not want to complicate too much. I will explain how I would go about to select ideal stocks to the portfolio, so that a novice can apply similar ideas easily.

• Those companies which have paid incremental dividends for 50 or more sequential years in the immediate past get a first preference. These are also called 'dividend kings'.
• Those companies which have paid incremental dividends for 25 or more sequential years in the immediate past get a preference. These are also called 'dividend aristocrats'.
• Those companies which have paid consistent dividend for 100+ years can be considered for the portfolio, though they might not have increased the dividends every year. A dividend freeze without a cut is acceptable for reasons of ‘growth’, ‘expansion’ or ‘sustainability’. But a dividend cut within the previous 25 years is a red flag for inclusion.
• Those companies merged or formed later, with a parent company’s history earning a position in any of the above lists, can also be considered.
• There are still companies formed in later years which provide essential services controlled by latest legislation or regulations. They consolidate/acquire the fragmented such earlier businesses or services for the benefit of all stake holders with a sustainable dividend distribution policy. These can also be considered.
• The dividend payout should be reasonable, paid out of earnings or free cash flow generated from the sustainable business. This 'sustainability' of the dividends and the sustainability of the business are the major criteria for inclusion to the portfolio.
• A few exceptional future oriented companies which have promising growth can be selectively picked and added to the list. But this will be limited, since, the risk of failure should not hurt the dividend income going forward.

In short, the companies with the dividend sustainability for a life time and beyond, gets an entry into this portfolio.

Dividend income sustainability:

Each company’s history is the best guide. One has to dig into the company’s history to find, if the company's philosophy suits the environment, takes care of all stake holders - the customers, the employees, the environment, the shareholders and just not the income or gains alone. Taking care of customers sustains a business. Employees education and growth within the organization makes the business sustainable. This includes succession plans to pass on the reins to good hands to continue the business. Acquisition of other new ideas with regular M&A activities is another factor which makes the company sustainable. The companies which have participated in developing the younger or next generation in the society, to grow and participate in the company’s sustainability are the ones which will succeed for centuries. The education of the society makes the newer generation make the required innovation and advancement which the company can absorb back for growth and sustainability. It is just not the dividend payout ratio or a dividend yield which alone matters, though these matters as an investor to take care of our intended cash flow budget. Each company’s history throws the light on to its future. Thus, it will be a nice idea to read about the history of companies we consider, make a list of progressive thinking sustainable companies as a probably candidates to be included in our portfolio. The effect of a business cycle or a 'force majeure' situation on a business is less important for the inclusion in our list. And that is the reason I accept companies which are not in ‘dividend-kings’ or ‘dividend-aristocrats’ list. I encourage readers of this article to read a ‘Harvard Business Review’ article titled ‘How Winning Organizations Last 100 Years’ by Alex Hill , Liz Mellon and Jules Goddard. You can read by clicking here.

Valuation matters – at what value to add stocks to my portfolio:

The goal of this portfolio is dividend income. If I want to earn a dividend income of $1,000 pa from a stock, how much do I have to invest at various price points? The following table showing the relative amount required to buy a $1000 dividend income at different dividend yields.

A stock earning 2% yield requires an investment of $50,000 to earn a dividend of $1,000 pa. A stock earning 5% yield requires an investment of $20,000 to earn the same dividend and the one earning 8% needs only $12,500. Quite often a novice is talked into investing a 2% yield or 2.5% yield stock which might show a higher dividend growth rate. The point made in that notion is that at a higher dividend growth rate, the dividend on the investment grows faster to reach or overtake the dividend income provided by the slower growth stock. Let us look at a table showing the probabilities with hypothetical yields and growth rates.

Dividends in year 01 or 03 or 05 or 10 or 20 in the above table are absolute dividends grown at specified growth rates without adjusting for any inflation. ' J's Div. Matched in Year' is the year in which each company growing its dividends at their specified growth rate matches that of company J yielding 8% dividend with zero growth. ‘Dividend Pay Back Years’ is the number of years it takes to earn back the investment with its own dividends growing it at the specified growth rate, while also discounting the money value with inflation %. The cumulative dividends received for 20 years (absolute or the net present value, i.e NPV, of the dividend stream discounted at inflation rates) also indicate which is the winner. One cannot safely assume that the higher growth rates for longer number of years is sustainable, since all businesses will mature with passing of years. While the discussion as to which is better might never see a conclusive winner, owing to the point that value of growth will be reflected in the appreciation of the related stock’s market price, there is also a risk associated with such growth perception. Probably the matured share will start getting valued at a much lower multiples as it is no longer that fast growing. As an investor looking for income, cash flow consistency is more important. The higher cash flow from higher yielding shares give a head start advantage to redeploy that income flow in further choices and in building the portfolio. Again, the average stock market return is approximately 6% pa over extended periods of decades and hence a higher yield lower growth shares, but growing dividends faster than inflation, appeals to me more. Note that I am not recommending unsustainable high yields with zero growth or disrupted businesses here.

The price for a stock is a value attributed by the market forces at that moment. The views change every day or within short period of a week or a month. Based on demand and supply, the price for the stock changes. The longer term prospects for the company remains the same within those very short period. The best time to add a stock to the portfolio is the worst time of value perception in the market. If you make your study and prepare a conviction list of sustainable companies, then you should not worry about the bear markets which will be near term issues. When the worst of such near-term issues are raging, the price of the share will be at a 'no one' wants price. That is the best time to add it to the portfolio. It is much easier to say than to execute. But do I want such a bad time? The short answer is 'no'. But it happens again and again, every few years. Call it a recession or epidemic or pandemic or major correction or whatever, that is the reality. As mentioned, price is what we are willing to pay for a share. In my case, it is the price I am willing to pay to earn that future dividend income at the current financial situation. When the prices reach a ‘large-safety-discounted target price’, I make a full position ‘add’. Never exceed the limit by a greater extend or go-beyond-means position. Stay well controlled within the plans you establish. Such price drops do not come every day. I should know how to manage additions to portfolio when the stocks are richly valued as well. This is a short-term trading practice, which I will not discuss in this article, but helps me to add little quantity at a time for a much lower net cash out-flow for the quantity I add. Always remember, recessions will be shorter, corrections will be even shorter, while growth will take longer. Stock prices go up slower, corrects faster and crashes faster. There is something to learn in this. Never jump to buy when the prices fall or crash or correct too fast, unless it is at a compelling target for which you have been waiting for. Otherwise wait for the trend to reasonably settle and then buy a fair split of your planned position, only if the prices are in your buy target range. It might even correct further. Wait again and make your next buy when you find some stability or trend reversal in price. Repeat ‘buy’ until the full position is filled. The prices move like sea saw in a swing until it halts and a force is given to reverse the momentum.

Credit Ratings :

The big three credit rating agencies in the US - Moody's, Standard & Poor's and Fitch control almost 95% of the ratings business. Credit Rating Agency Reform Act of 2006 regulates their internal processes, record-keeping, and business practices. The corporate bonds and notes get a rating from these agencies. A higher credit rating relative to peer companies helps them borrow at relatively lower interest rates. The dividend income is a more risky proposition than interest on borrowings, since the dividends will be paid only after the interest on borrowings are paid. However, the credit rating assigned for a company helps to know how much risk is taken in the equity investment of a company. The following table should guide how to read the 'ratings'.

I will be happy to select only those companies which have a credit rating displayed on those green colored rows in the above table. A deeper analysis can be done with debt / equity ratio of selected companies. These debt-equity evaluation norms vary with each industry. Hence, a easier way is to simply use the company's credit rating. Beware that these credit ratings assigned keeps changing with the change in financial situation of each company.

‘Diversification’ is key to protect my portfolio mission:

How can I be sure that the stocks I picked provide me the regular dividend cash flow I expect? Frankly, I have no answer. No surety either. The most I can do is to distribute the investment over a large number of companies so that my needs will not be affected badly, if one or two or few of them did not perform as I intended them to do. There is an even chance that a few could outperform and compensate for the few that failed. As a plan, I should not depend heavily on one industry or business sector, since one sector or industry can go out of preference for few years or even decades. I should not depend on one company, within each industry/sector, for more than 2% of my total annual approximate needs. That way, I can be reasonably make sure, that I will not face any major issue. More the number of companies in the portfolio with near equal allocation, i.e. well distributed, the safer I will be in achieving my goals. The economic swings for any specific industry should be tolerated so long the fundamentals of the business remain intact. With this view, let me proceed with more intricate details about my portfolio choices and components.

Utilities stocks:

Electricity, water or such basic utilities and related services are highly essential in life. Those companies in such businesses can sustain in their business for ever. The population growth will make them grow. An area or state which has a growing population can aid the growth of service provider in that zone. Even, if population growth is not there, the businesses have to stay with reasonable returns so that the population continue to enjoy related services. Efficiency is the key to remain and sustain the related business. These are required in everybody’s life every day. Even if the company gets badly managed, there will be a suitor to take over and continue the business more efficiently. The moat for the business is very high and cannot be easily replaced. There are plenty of electric and water utilities across various states which suit my portfolio.

In the above table, 'Dividend paid since' may not be accurate. The data depends on the availability of historical dividend data in each of the company’s web site or other data sources I used. Same way, the credit ratings data were updated to my database from Moody's site and might have changed since then. These are applicable to the above table and similar data tables below. So use these data after due diligence.

The time line history of many of these companies are really impressive. I am fascinated with the invention of electricity, how the companies went about generating / distributing it, how they created the sustainability of know-how by educating younger generation with related knowledge of electricity production, how they went about making the high tension / smart grids etc. for distribution, how they encouraged the R&D and maintained their sustainability inclusive of the related invention and use of electrical gadgets. The development of generating electricity using the hydro power, the steam/coal generated electricity, the oil and fossil fuel or natural gas burned generation, nuclear reactors (be aware of the risks in these processes), the wind mill generation, the solar based power and such electricity generation in the past century is impressive. The electricity is vital for everything in our society now. This invention is going to stay forever. For example, you can read the history about AEP here. You can read about Dominion Energy here and catch on further links to read the history of merged companies. These are only samples. You can search and find history about each company in their IR or on wiki. On water utilities - I do not have to talk about its importance to our life. The scarcity of potable water and the supply and disposal of waste water has created an essential industry and we cannot live without them. I can choose a dozen or all of these utilities in the above list and limit exposure to a maximum of 2.5% of portfolio value in any one company. I have allocated a total of 24% of my total portfolio to utilities. Each company should provide approximately a week's cash requirement to me. But before investing, study their history, their sustainability, their supply source, their vision to make them sustainable going forward, how they take care of environment, their supply source risk, their dividend payment consistency etc.. Some of these will become relatively attractive in valuation at some point of time to help add in portfolio.

Healthcare stocks:

Just like the essential utilities, healthcare is an essential for the society. The businesses which do the innovation to take care of our health, those involved in the related equipment manufacturing and those in the business of distributing these cannot be dispensed with. I allocated 24% of my total portfolio to these companies and limit investment to a maximum of 2% to 2.5% of total portfolio in any one company. This is again ‘future’ oriented. R&D, patents, copy rights, patent cliffs etc. are inherent in the nature of these businesses and play a major role in their valuation. Those companies which are well diversified, have a history of acquiring newer innovations, have the ability to fund such activities are preferred. I prefer those with a large list of active innovations in their portfolio, a larger pipe line of the innovations at various stages of approval process and those which have the ability to acquire new inventions. Those in the business of distributing pharma products are also included here, though they can be classified as ‘consumer staples’ depending on their major activities in related business.

Consumer Staples and Discretionary stocks:

The advantage with consumer staples as a group is that we need their products every day. They cannot grow very fast except through acquisition. But they can grow with population and consumer preference. They can grow with innovative new products which will make living easier. In a way, the demand supply is crowded. There is a bit of innovation in building the consumer preferences and making the products wanted or needed. All these companies listed below do it regularly. The choices are large and helps to minimize the per company investment risk. I will limit the maximum investment to 2% of portfolio size in any one company, often 1% to 1.5% as average investment and allocate a total of 24% for the entire group.

The list includes a few ‘sin stocks’ which some may not like to own. Smoking was a habit out of necessity in ancient history. The tradition continues. The perception changed and is considered a health hazard not only to the consumer but to people around. I for one have never smoked in my life. But do not mind holding the stocks. Some may not like to own the related stocks. The investment risk related to this is highlighted here since some of the business could go extinct. Similarly, I know exceptions made for ‘halal’ or otherwise food processing businesses. Then there are vegans and some very strict with their ideals, even to invest in other type of food businesses. Then there are people who never drink alcohol and would not like an investment in related companies. However, the choices list is reasonably large. People can diversify as much as possible with their preferences and distribute the investment. As an investment, irrespective of personal likes or views, the mass preferred items will bring in stability and growth to the related businesses and hence to the income portfolio holding them. I like more of the ‘consumer staples’ (which are consumed or perished) than the ‘consumer durable’ or ‘consumer discretionary’ (which depends on preferences). The above list reflects that. Readers can include a wide list of further choices to their preference which they feel can continue forever.

Telecommunication Services stocks:

What was attributable to electricity business in early 1900 can be attributed to telecommunication businesses today. Telecommunication will remain indispensable going forward even after another century. These businesses can be grouped under ‘information technology’ as well. But I would like to keep this separate in my portfolio allocation. In some ways, I treat these companies as essential ‘utilities’, rather than the 'information technology' companies.

I would allocate a total of 8% of my portfolio among these two companies with a ceiling of 5% of portfolio in any one company at any time based on current superior yield. These companies might disintegrate in future into communications, media, entertainment or in whichever way the future evolves. This can unlock the hidden potential valuation and create a natural portfolio diversification and expansion going forward. They can act as a proxy to the allocation of portfolio percentage to 'information technology' stocks which is the ‘future’ for the current century.

Information Technology stocks:

Information technology is a sector which is leading the innovation and advancement to society. It is a growth sector. While this is going to be the future, there will be winners and losers in this pack. The transformation and advancement are so fast, I have no ability to judge who will be real winners and stay for decades and decades. Since the portfolio intentions are clear that I want to build it for perennial income, I allocate a lower allocation of just 5% of portfolio value at this stage. Also, I would limit a maximum of 1% per company. Things could change going forward. I could see the telecommunication services as the backbone which has been liberally assigned a higher portfolio percentage for this reason. My choices at this stage is listed below:

Some could feel MA and V should be listed as ‘financials’, but they are payment processing companies using technology without taking any credit risks or exposed to loan books. I would like to limit the risk to a maximum of 1% of portfolio value in any one company, but as a collection will limit my investment to 5% of total portfolio value. Probably a 0.5% in each will help to distribute in all. Each of the companies in the above list has a strong contention to stay lucrative for a century. But nothing can be taken for granted when the theme is ‘growth’. Beware of the extremely low dividend yield for some of the companies which raise a red flag in terms of relative valuation at this stage.

Financial stocks:

'Financials' are the backbone of any economy. They have to be carefully managed. The have inherent risks in unpaid debts and mismanagement. The insurance companies are also classified as ‘financials’. The insurance business can be further classified into ‘life and health insurance’, ‘property and casualty insurance’, ‘multi-line insurance’, ‘insurance brokers’ etc. I like insurance more owing to the conservative nature of the business. Risk is an inherent nature of insurance business. Whenever there is a calamity or an epidemic or a pandemic or a recession, the stock market punishes these stocks extremely. However, you can see these companies coming out of the situation again and again. While I limit the overall allocation to just 6% of total portfolio for ‘financials’ as a group, they also provide some juicy returns depending on when we pick them. It is just easy to allocate a maximum of 0.5% of portfolio value in any one company and choose a max of 12 to 13 of these insurance and banking companies. In that way, the total income expected from these dozen companies as a group hardly covers a total of three weeks cash budget every year. It is an exposure where I limit the risks per company (0.5% is expected to generate a dividend income for a couple of day’s cash expenses per year). I would add these shares when the extreme bad news is around for this group.

Real Estate (REITs):

My portfolio will not be complete without an allocation to real estate exposure. While, a ‘home’ property to own is essential in my view (which is not part of the ‘perennial income portfolio’ of stocks), I will expose a 4 % of total portfolio to real estate via well managed REITs. My ideal choice at this moment is the following:

I like the monthly dividend distribution by ‘O’. I would allocate a 2% of portfolio allocation to each O and FRT. Be aware that these are REITs and the dividends would take a different tax treatment in a taxable portfolio account.

Industrials and Others:

We have another 5% of portfolio which I would call as ‘others’. But mostly they are ‘Industrials and Conglomerates’. These companies grow when the economy is in growth phase, flattens out when the initial growth phase of the business cycle is over and then suffers with recession. They also include ‘defense suppliers’ which will grow when the countries defense budget is strong. They are a bit 'cyclical' in that way. I limit the exposure to a selected few companies which have withstood the economic cycles admirably in the past and grew the dividend distribution consistently.

Summary of allocation and average dividend yield expected:

The target yield or amount in the above table are just an example for presentation. You can decide your target with proportionate adjustment. If I need $4,000 pm for my expenses this year (assuming the dividend growth will take care of inflation costs), I need to target a total investment of around $1,200,000 at current money so that I will earn a total dividend of $48,000 this year (though the table above shows a higher dividend income per plan). I say this year, to mean at current money values. I may not have that sort of cash to invest immediately, but portfolio plan has taken the shape and is in place. I need to accumulate and target my investments going forward. I only need to extrapolate the figures for inflation as I go forward and keep investing and watching that the plan is intact. Knowing the stocks to buy and the yield target with a clear view to the limits help to target the buys when right value opportunity comes. I can use funds to buy any one stock or a distributed collection of shares when the yields reach a desired target levels or better. Notice how the dividend income from any single company cannot have a material impact over the total annual income.

Now an important question arises as to which one of the alternative stocks I should buy, when several of my target stocks meet my target yields and I have limited cash. This depends on the relative valuation perception. I enter the identified tickers in a simple spreadsheet which displays the price at any given time, the dividend pa, the current yield, the lowest of dividend growth rates for past 1 yr, 3 yr, 5 yr or 10 yrs as likely projected dividend growth rate, the dividend payback years and the relative break even in terms of absolute dividend. All these data are pulled from a database I maintain. I also have a similar sheet where I can key in the data instead of auto fetching from my data base. This becomes handy when I feel, the data from database cannot be realistic, owing to special reasons of M&A activities or simply I do not have that company’s data in my database. I choose whichever is relatively better based on dividend cash flow they generate. I distribute the buys at times when the differences are minor. Sometimes, it could be the one which is a rare meet of my targets yields after a very long wait. In short, there is no hard and fast or rigid rules to follow. I am comfortable that I am within my set plans and not picking in a haphazard decision that some stock is available cheap or someone has tipped me as excellent or I am reading a positive SA article. If these conform with my perception then that is fine and it motivates to buy it at that juncture. But I will not venture out easily and stray from my plans without doing my due diligence if the stock fits my ‘perennial income portfolio’. By the way, I do have a short-term trading account, where I do swing trades or make quick short-term trades with the ‘waiting’ cash. But even there, I restrict my trades to the filtered list of portfolio components.

The current pandemic situation has given me yet another chance to review my portfolio allocation and perfect it to my perception. Readers could observe that there is no exposure to oil/gas and energy stocks. I have my own reservation on Oil and Gas stocks. I do not want to claim that I was expecting the current crisis with energy stocks. They will find a solution for the current crisis and some will emerge as winners. My reservation is based on my views that humanity will learn and find ways to replace oil with alternate green energy. The current oil producing companies have not learnt to diversify into alternate methods to sustain and remain in business other then drilling and pumping oil or gas. Probably diversification option is not possible commensurate with their sizes. For this reason, I have not included then in the 'perennial income portfolio'. These are absolutely my personal views. So long I find solution to keep my portfolio diversified without investing in these, I will do so.

The current dividend yield from T is very attractive. I recently added some when it was below $28 and will add more, if the prices go below $27.5.

Disclosure: I am/we are long in many stocks including T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own or trade regularly in almost all the tickers mentioned in this article.