Since making my first forays into all things financial years ago, I very quickly grasped the concept of “passive income,” income earned not from selling one’s own labor, but income generated from invested capital; in short, gaining current income without present work, but from past work. For someone who values his or her time, the appeal of this concept should be obvious.
Despite the advice of those who I like to refer to as the “growth gurus,” investors who chant the age-worn admonition to invest aggressively for growth when you’re young and save income investing for your retirement years, I’ve always gravitated toward income. I’m young now, and the way I see it, the sooner I can replace my income earned through labor with “free” income, the better. I want to have more free time when I’m young and able to enjoy it, not when I’m old and faced with limited options due to a decreased physical capacity.
For most of the time that I’ve been enamored with the concept of passive income, and following the advice of authors of several books on the subject, I focused upon bond investments of various types. The reason for this, and the rationale most of these authors operated upon, is that bonds generally deliver stable, predictable income and safety of principal, which can be recycled into a new bond for more defined income when the original bond matures. At face value, this approach makes sense. The largest potential downside of this approach is the uncertainty of future interest rates – when bonds mature and their capital is ready to be reinvested into new bonds, interest rates could be far, far lower than they were when the original bond was issued.
Investing in dividend paying common stocks, on the other hand, is an idea almost universally discouraged by these authors. The basic reason had to do with the possibility that a company could go out of business, cut its dividend, etc.
The more I investigated the pro’s and con’s of the situation, the more I realized that the advocates of bonds were greatly oversimplifying the difference. While common stocks can become completely worthless, this is not the inevitable fate of every publicly traded stock. Additionally, dividend paying stocks offer an advantage that, to my mind, bonds simply cannot beat: rising dividends. The coupon rate (the interest) paid on a bond is fixed, but the yield (dividends divided into price per share) of common stocks is not. Like a bond, the purchase of shares in a company, in terms of each purchase, is a one-time event that establishes a fixed cost for the investment, which is also true of buying a bond. The difference then is that while the cost and interest of the bond both remain fixed, the owner of dividend paying common stock can enjoy a fixed price and an increasing percentage yield over time.
However, despite this powerful advantage of dividend paying stocks over bonds, the issue of income frequency vexed me – bonds are widely available that pay monthly, but most common stocks pay quarterly (every three months), some pay bi-annually, and a small number pay just once a year (McDonald’s Corp. is one such company). While strict budgeting can overcome the problem posed by receiving one’s income only quarterly, this did not seem like an attractive prospect.
Then, one day, I hit upon an idea to solve this: since many companies pay dividends on their common stock quarterly, and different companies pay out dividends at different times, it should be possible to identify groupings of three stocks that, purchased together, would result in one of the three paying a dividend each month!
I surfed to Yahoo! Finance and began searching for a trio of dividend paying stocks, utilizing the free stock screening tools featured on that site to bring up a list of possible candidates. My selection criteria is fairly simple, allowing me to quickly sort the resulting list of stocks. If I am carrying any debts, I look for yields that exceed the interest rates on those debts (if I can’t find a trio that would offer a higher yield, I use the money I would have invested to pay down my debt). Otherwise, if I am not carrying any debts, I look for rates exceeding the yield on my ING Direct savings account (the idea here is to put surplus cash toward the best possible return at the moment, though I admit that the options I have listed here are arbitrary and arguably not “the best” – do what is reasonable for your situation). I set a maximum dividend yield of 10%, as yields higher than that tend to represent temporary, distorted pictures of how well a company is doing (really high yields on stocks generally indicate that the price of the stock, and the company, have just crashed since prices move inversely to yields). I look for Price to Earnings ratios below 20, which is a measure of how much one is paying for the earnings the company behind the stock is generating (how many dollars you’re paying to buy $1 of earnings, essentially). Finally, I look for a Price to Earnings Growth ratio, the ratio of current price per share versus expected future earnings growth, of 1.5 or less, with anything less than 1 being preferable (I am willing to tolerate something that is slightly over-valued at present vs. future valuation is the yield is right for my present needs and the company otherwise meets my criteria – more below).
I then sort through the list that results, starting with the highest yields first and working my way down from there. In checking out the companies at this point, I look at their balance sheets and their cash flows, checking for increasing income, net profits, and increased shareholder equity over time. I also check to see if a company’s dividend is erratic or stagnant. If the company I am reviewing does not show a consistent increase in shareholder value and a steadily rising dividend, I pass over it.
Finding the first stock in a trio of this sort is easy: it is simply the first one that meets my simple criteria. I make a note of its ticker symbol and the months it pays out a dividend on a sheet of paper. Then I begin searching for the second stock of the trio, following the same sorting process I’ve described, but this time with an additional criterion: the second stock in the trio must not pay out in any of the same months as the first stock. Finally, in selecting the third stock for the trio, I find a stock that meets my other requirements and that does not pay out in the same months as the first and second stocks in the trio. Once all three are identified, I then have a basket of three stocks that will pay a dividend every month of the year!
My source of investment capital is the cash I have left over at the end of each month, so with a stock trio identified with a combined average yield that satisfies my needs, I make my purchases and look forward to a future of rising dividends increasing relative yields on my original investment costs. The resulting monthly income can fluctuate in nominal terms quite a bit as dividend amounts increase at different rates (some faster, some slower), initial rates between positions can start of being very different, etc., but I think this is a minor disadvantage that can be overcome with a little bit of adjustment from time to time, both in existing positions and in layering on new purchases. In any case, I think this approach to passive income investing easily beats reliance upon bonds, since bonds don’t offer anywhere near as dynamic of an income growth opportunity… unless you keep working your fingers to the bone to come up with more cash to buy more bonds.