The investment universe today is littered with CDs, bonds, and Treasury notes that produce yields slightly above 0% and don’t even come close to exceeding the rate of inflation. Income-oriented investors seeking a reasonable return on their capital can still achieve a solid, safe and growing stream of dividend income if they select their picks carefully. However, selecting investments based on nothing more than a high current yield can result in a disastrous fall in the share price of a stock if the dividend proves to be unsustainable.
Criteria important to assure growth and safety
When investing to produce an income stream, it is critical to select businesses that have a history of paying regular dividends with a consistent track record of increasing the dividend amount, have a payout ratio that shows management’s commitment to rewarding shareholders and are engaged in delivery of a product or service that is a necessity for its customers. We also must be able to buy the shares at the right price.
It is very easy to find businesses that meet one or two of these requirements; finding businesses that meet them all is a completely different matter. To add even more difficulty to the task, we need to spread our investments across several unrelated industries to reduce volatility and risk.
Commercial real estate
For the real-estate portion of the portfolio, it is hard to find a better opportunity than Realty Income Corp (NYSE:O). When a business likes to refer to itself as “The Monthly Dividend Company,” has trademarked the phrase, and paid a monthly dividend for the last 515 consecutive months, you can bet it’s serious about providing its shareholders with a steady stream of income. All an investor has to do is take a quick glance at the homepage and you will see the intense focus this business has on consistently paying and increasing the dividend rate for shareholders.
Realty Income Corp (NYSE:O) owns over 3,500 properties that it leases under long-term agreements to national retail chains and other commercial interests. The cash flow from these agreements produces the dividends.
The monthly dividend announced on May 8 of 18 cents per share produces an annual yield of 4.15%; extraordinarily strong in our current environment but below the long-term average for Realty Income Corp (NYSE:O). The current dividend yield, although attractive, is the one cautionary note regarding this business as the average yield since 1995 has been 7.4%. However, given the focus of this business on paying and increasing dividends, it deserves serious consideration as a cornerstone investment within any income-based portfolio.
Communications technology and the Internet are such integral aspects of our lives today that it is inconceivable to construct a balanced portfolio without including at least one technology business. Additionally, the large technology businesses have balance sheets overflowing with cash and, in many cases, very low valuations.
When I think of the Internet, I can’t help but think of the term “backbone of the Internet,” which has oft been applied to Cisco Systems, Inc. (NASDAQ:CSCO), my pick for the technology-related portion of the income portfolio.
Based on its most recent quarterly report, Cisco Systems, Inc. (NASDAQ:CSCO) is holding over 41.6%, or $46.38 billion, of its market capitalization in cash and short-term investments; an enormous amount of cash. Even without considering this cash hoard, Cisco Systems, Inc. (NASDAQ:CSCO) is currently trading at only 9.37 times the consensus earnings estimates for 2014.
If calculated after discounting the cash on hand, the 2014 price-to-earnings ratio falls to only 6.32. The current dividend yield of 3.28% requires a payout ratio of only 33%. Not only is it easily maintained, there is a lot of room for increases. Since Cisco Systems, Inc. (NASDAQ:CSCO) started paying dividends on March 29, 2013, it has increased the payment three times for a total increase of 183%, displaying management’s understanding of the need to return profits to the owners of the business.
When considering a long-term investment in Cisco Systems, Inc. (NASDAQ:CSCO), investors should also consider the fact that many of the large tech companies have recently become much more aggressive in their efforts to distribute some of their large cash holdings to investors through increased dividends, special dividends, and share buybacks. The management team at Cisco Systems, Inc. (NASDAQ:CSCO) is proving its willingness to participate in this practice and will continue to do so going forward.
Private equity and wealth management
I am well aware that a great deal of effort has been put forth to demonize the arena of private-equity investing, but at the end of the day there are two sides to every story. It is not my purpose to debate the virtue, or lack thereof, of the private-equity and wealth-management business. It is my job to figure out how to best position myself to profit from it.
KKR & Co. L.P. (NYSE:KKR) manages a group of private-equity funds and other investment vehicles that manage clients’ money for the purpose of achieving long-term capital growth. Founded by Henry Kravis and George Roberts in 1976, the business debuted on the public stock exchange in 2010 with the original founders holding the posts of co-chairmen and CEOs, positions they continue to hold. With a 37-year record of successful management performance, this business exhibits great stability and consistency.
The 6.34% dividend yield, couple with an aggressive payout ratio of 60%, serve as ample evidence of the commitment management has to rewarding shareholders. Coupled with the long-term record of success built by the current leadership, this is an excellent location in which to place a long-term investment in anticipation of achieving both growth and increasing income.
Three businesses in three different industries are not enough to provide a diversified income-producing portfolio. But it does get interested investors about halfway there. Those who are interested in this style of investing who allocate half of their capital available for income investing evenly among Realty Income Corp (NYSE:O), Cisco, and KKR & Co. L.P. (NYSE:KKR) will begin to draw an average dividend yield of 4.45% on the capital allocated. Be sure to watch for my follow-up piece, which will present three more picks across three new industries to complete the base of a well-diversified portfolio for income investors.
The article Building an Income Fortress With Dividends originally appeared on Fool.com and is written by Ken McGaha.
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