Taking a long-term view as an investor, a dividend portfolio could hopefully allow me to build passive income streams for the years ahead. It is possible to build a dividend portfolio even from a standing start. Here is how I would do it.
Focus on long-term dividend potential
Rather than looking at what shares pay out at present, in building a dividend portfolio I would focus on whether I felt a company would be able to pay a sustainable dividend consistently in the years to come.
To pay dividends consistently, companies need to make a profit. But a profit is an accounting term, so perhaps surprisingly it does not always mean that a company actually has cash coming in the door. For that, I would look at a company’s free cash flow. If a company is profitable and has free cash flow, it should be able to support a dividend over the long term – if it decides to.
I could find this information by looking at companies’ annual reports, which are usually available free online.
Finding companies that could pay big dividends
In choosing stocks for my dividend portfolio, I would not just look at firms with high payouts. For example, miner Rio Tinto yields 9.6%, but I do not hold it in my portfolio partly because I see a risk that the next downturn in commodities pricing could lead to a dividend cut.
I would instead be looking for a company with some distinctive commercial advantage that might allow it to sustain or increase its dividend in coming years. That could be the unique products associated with baker Greggs, the critical infrastructure owned by electricity distributor National Grid, or the powerful brand portfolio owned by consumer goods giant Unilever.
Value and price
But even though I think such companies have the sorts of business models that could support future dividends, that on its own is not enough for me to consider buying them. I also need to look at what value they offer at their current share price.
If many other investors feel positive about a company, that could mean the share price is high. So I might not think they offer compelling value to me. For example, animal nutrition maker Dechra Pharmaceuticals is in a niche market that can support high profit margins. But its shares trade at 60 times earnings and yield only 1%. At the right share price, I could see value in Dechra for my portfolio. But for now they look too expensive to me.
Building a diverse dividend portfolio
But no matter how good any one share may seem to me, its income potential could change fast if it runs into unforeseen problems. In 2020 a lot of blue-chip FTSE 100 shares cut their dividends at short notice and some have not yet come back.
So I would hunt for shares I could buy across a variety of companies and business fields. That diversification should reduce the overall risk to my passive income streams if any one share choice in my dividend portfolio disappoints.
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Christopher Ruane owns shares in Unilever. The Motley Fool UK has recommended Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
