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It seems like lately, the stock market has been making wild price swings in both directions on a daily basis as investors try to digest uncertainty and opportunity. For those investors who don’t want to get caught up in the short-term drama, a better approach might be to take this opportunity to construct a passive income portfolio that can help you achieve your financial goals.
Stocks that pay reliable dividends are often less volatile than the broader market and tend to be associated with stable, large corporations that aren’t going away anytime soon. This can take the pressure off market gyrations and produce income without the need to sell a stock down big off its highs.
When building this portfolio, consider these three tools you can use to help generate the passive income a portfolio needs.
Image source: Getty Images.
Tool 1: Understand the relationship between stock performance and yield
A high yield isn’t necessarily indicative of a good dividend stock. For example, a dividend yield will go up as a stock price falls and go down if a stock price rises. Too big a stock price drop might create a high dividend yield that is also a yield trap and best avoided. The opposite can also hold true. As an example, let’s look at two excellent dividend stocks — Deere & Co. (NYSE: DE) and Sherwin-Williams (NYSE: SHW).
Both industrial companies have raised their dividends substantially over the last five years. Sherwin-Williams’ dividend is up 111%, and Deere’s is up 88%. What’s more, both stocks have produced market-beating returns over the last five years.
DE Total Return Level data by YCharts
Investors are undoubtedly happy with Sherwin-Williams and Deere’s five-year performance. But on the surface, Sherwin-Williams and Deere may look like bad dividend stocks because their dividend yields are lower today than they were five years ago. This is simply because each company’s stock price has risen at a faster rate than it has increased its dividend.
So instead of rolling your eyes at Sherwin-Williams’ 0.9% dividend yield, the better takeaway is that the company increased its dividend by 112% in five years. Sherwin-Williams is an industry-leading company with an excellent long-term future. Similarly, Deere yields just 1.3% but is posting record results and is guiding for its best year ever in 2022.
Tool 2: Focus on dividend track records
Any company can raise a dividend when times are good. A good stress test is to see how a company managed its dividend during tough times and periods of slowing growth.
A good starting point is by looking at the lists of Dividend Aristocrats and Dividend Kings. A Dividend Aristocrat is an S&P 500 index member that has paid and raised its dividend annually for at least 25 consecutive years, while a Dividend King has done so for at least 50 years.
By default, Dividend Aristocrats have raised their dividends every year since at least 1997. That means that the company supported dividend raises through the dot-com bust, the Great Recession, and the worst of the COVID-19 pandemic. Granted, an investor should still make sure that the company’s future is bright and that it is positioned to support raises in the years to come to keep its streak alive. But finding Dividend Aristocrats and Dividend Kings that you like can provide an excellent starting point for building core positions in a passive income powerhouse portfolio.
Tool 3: Prioritize financial strength
Some companies will prop up a dividend even when it doesn’t make sense to do so. Paying and raising a dividend for decades assumes that earnings and free cash flow (FCF) are growing too. But if the dividend is growing at a pace faster than a company’s ability to grow earnings and FCF or the company is facing slowing growth, then a dividend-raising streak can be misleading.
Even some Dividend Aristocrats and Dividend Kings have dividends that are so large that they need to be supported with debt on occasion. That’s why it’s important to look for companies that generate plenty of FCF to support their dividends, and have plenty of liquidity on the balance sheet in case they need to tap into their reserve cash to support the dividend.
A great example of a Dividend King that generates FCF well in excess of its dividend obligation is Procter & Gamble (NYSE: PG).
The table shows that P&G’s FCF has grown substantially over the last few decades, which has supported a growing dividend. So although P&G’s dividend has increased by 380% in the last 25 years, its FCF has increased by 620%. What’s more, it makes nearly double the FCF needed to pay the dividend — meaning that if growth slows and margins compress, P&G has a large cushion to which it should still be able to afford the dividend with cash. This is just one of several reasons why P&G is one of the safest, most reliable dividend stocks out there.
PG Free Cash Flow Per Share (Annual) data by YCharts
Consistency is key
The biggest mistake investors make when looking for dividend stocks is focusing too much on the yield. As we saw with Sherwin-Williams and Deere, a market-outperforming stock can often have a low dividend yield — which isn’t necessarily the fault of the company itself. In this vein, a company can be a victim of its own success, whereas poor-performing companies can have high yields not because they have grown earnings and dividend distributions but simply because the stock price has fallen.
As tempting as it may be to chase high-yield dividend stocks to bolster your passive income plans, a much better long-term strategy is to stick with companies that you can count on to outlast economic downturns and grow their dividends — even during tough times.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool recommends Sherwin-Williams. The Motley Fool has a disclosure policy.
