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How to Build a Safe Income Portfolio, Part III

Over the last few weeks, I’ve been explaining how to build a safe income portfolio by layering investments with different yields and risk levels (How to Build A Safe Income Portfolio Part I and Part II). I introduced the idea of an “Income Portfolio Pyramid” that works like...

Over the last few weeks, I’ve been explaining how to build a safe income portfolio by layering investments with different yields and risk levels (How to Build A Safe Income Portfolio Part I and Part II). I introduced the idea of an “Income Portfolio Pyramid” that works like the food pyramid: where you would find the dietary staples of grains, vegetables and meat on the food pyramid, I put blue chips, dividend aristocrats, utilities and other low-risk, low- and medium-yielding investments that should make up the safe, reliable foundation of your portfolio. Higher-yielding, higher-risk investments like master limited partnerships (MLPs) and real estate investment trusts (REITs) can then be added according to your risk tolerance.

After I first introduced it, I received an email about the system from one reader who said his pyramid is “upside-down”: mostly higher-yielding stuff, with just a few more conservative dividend-payers. That’s okay, I noted in How to Build A Safe Income Portfolio Part II, as long as you’re realistic about and comfortable with the level of risk in your high-yield investments.

But I also want to explain why lower-yielding stocks are important in their own right.

I’ll start with this chart from Dow Theory Forecasts, which was in the latest issue of Dividend Digest:

High-Yield Pool Chart

The green line on the upper chart shows that there are currently just a little over 100 stocks yielding at least 4% in the S&P 1500. Out of those, barely a handful (only 11) earn scores of at least 80 under Dow Theory Forecasts’ stock-rating system, indicated by the grey line.

The bottom chart tells a very different story. The green line here represents the number of stocks in the S&P 1500 that yield between 1% and 3%. As you can see, over 500 stocks currently fit that category, and the number is rising. Out of those 500+ stocks, 132 score highly on Dow Theory Forecasts’ stock-rating system.

So there are a lot fewer high-yielding stocks to choose from, and if you narrow the category down with some quality requirements, it becomes even smaller. Of course, you don’t need that many stocks in your portfolio—so why not just choose from among the high-yielders? Dow Theory Forecasts Editor Richard J. Moroney addressed that question, writing:

“You may be wondering, ‘Why don’t I just go fishing in the 4% yield pool?’ Here’s the answer: You don’t want to buy weak companies just because of their yields. And if you require some quality in addition to yield, the pickings get quite slim. Stocks yielding at least 4% average subpar Quadrix Overall scores of 44, with only 11 earning scores of at least 80. And many of the higher scorers are story stocks with operational issues that increase their risk and render them unfit for our buy lists.

“For investors seeking high yields, the selections are limited. But investors who appreciate quality stocks with ‘good’ yields have plenty of options. In every month since October, more than 940 S&P 1500 Index companies paid dividends. Before last year, the last time we saw so many dividend-payers was early 1999. The dividend trend has caught hold marketwide. In January and February, 570 stocks raised, resumed, or initiated dividends, the highest during that two-month period in at least a decade.”

So selection and quality are two very important reasons to consider lower-yielding stocks.

Moroney also touches briefly on a third good reason in his last line: many dividend-paying stocks raise their dividends regularly, so that 2% yield today could easily become a 4% dividend a few years down the line. Super high-yielding stocks, on the other hand, may already be maxing out their dividend-paying capability.

Over time, a low-yielding stock that increases its dividend regularly may wind up yielding more, based on your cost, than the high-yielders in your portfolio. If you’d bought Johnson & Johnson five years ago, for example, your yield on cost now would be 3.9%—even though the current yield is only 3% and the yield was only 2.9% when you bought shares five years ago.

And if you’d bought 10 years ago, when JNJ was yielding 1.7%, your yield on cost today would be 4.4%.

The final reason to consider low-yielding stocks for your income portfolio is also related to the power of time. In short, small but reliable yearly payouts will add up impressively over just a few years. Buying $1,000 worth of 2.9%-yielding Procter & Gamble (PG) today, for example, will earn you $145 in dividends over the next five years (even without any dividend increases). You will have earned 14.5% of your original investment in dividends by buying a 2.9%-yielding stock—and holding.

When you combine this property with annual dividend increases, and gradual stock price increases (reliable dividend payers are always attractive to investors), the returns for “low-yielding” stocks can be pretty surprising.

As always, if you want more income investing ideas like the ones above, I encourage you to try a subscription the Dividend Digest, which provides 25 great ideas like the ones above every month.

Click here for details on 25 great dividend stocks.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Investment of the Week

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.