The Most Important Thing in Income Investing
Something More Important Than Yield and Payout Ratio?
In the past several years, the ultra-low-interest-rate environment hasn’t been that great for income investors. Because fixed-income products didn’t pay much, more and more investors found themselves adding dividend-paying stocks to their income portfolios.
As is the case with any type of investing, each income investor has their own risk profile, so there is no perfect portfolio for every investor. And when it comes to choosing the right dividend stocks, there are many different criteria. In my opinion though, there is one thing that income investors should check before putting their hard-earned money into any dividend stock: the company’s ability to generate recurring revenue.
The goal of income investing is to generate a stream of cash. That stream shouldn’t just last a year or two; rather, it should continue well into the future. And for a company to provide a long-lasting stream of dividends, it needs a revenue stream that’s also recurring.
That’s why some companies can have extremely high dividend yields today, but would actually be bad investments for income investors. In fact, the most common reason why a stock can have an ultra-high yield is that investors don’t believe its dividends are sustainable. Buying a high-yield stock before a dividend cut can result in a very costly experience. When the dividend is cut, not only is the investor’s earnings stream reduced, but they would also take a hit on the potential drop in stock price, as few things disappoint the market more than a dividend cut.
Fortunately, there are still companies that are well-positioned to generate recurring revenue. They can be found in the consumer staples, utilities, real estate, and financial services sectors, just to name a few.
In recent years, a new industry started showing its potential of generating recurring revenue: technology. While it is a rapidly changing industry, there are tech companies that have built an economic moat wide enough to generate recurring business, one example being Microsoft Corporation (NASDAQ:MSFT). The company has been dominating the desktop operating system market and the productivity software market for decades. More recently, it also became a major player in the cloud services business, which happens to be one of the fastest-growing areas in tech. The recurring business model allows Microsoft to start paying a dividend in 2004. Since then, its quarterly payout has grown by 388%.
So, is there a way to tell whether a company is capable of generating recurring revenue?
Well, doing a comprehensive analysis of the company and the industry it operates in is certainly the way to go. A company with a strong competitive advantage in a recession-proof industry is expected to keep making money. However, I believe that a company’s dividend history can also say a lot on this matter.
I know, past performance does not guarantee future results. But here’s the thing: when a company declares a dividend, while there is no guarantee, the expectation is that it will keep paying at least this much in the future. The company is aware of the consequences of a dividend cut, so if it decides to declare a certain amount of dividends, chances are it knows that its future business will be able to support future dividends at this level.
That’s why there is still a reason to like companies with solid track records in paying dividends, especially those that have been raising their payout. There is actually a name for them. Stocks with at least 25 consecutive years of dividend hikes earn the title of “dividend aristocrats.” Those that have raised dividends every year for 50 years or more are crowned “dividend kings.” Those titles are not easy to earn; among the thousands of companies trading in the U.S. stock market, there are only 18 “dividend kings.”
Of course, being able to generate recurring revenue is just a necessary condition for a solid dividend stock; it is by no means a sufficient one. At the end of the day, income investing requires hard work, and the short-term return might not be as exciting as trading the trending tickers in the tech sector. But for those that want a reliable stream of income that continues well into the future, the hard work is definitely worth it.