[quote frm sure dividend newsletter]
“Under conditions of complexity, not only are checklists a help, they are required for success.”
- Atul Gawande, The Cheklist Manifesto
When you get right down to it, there's a great deal of complexity for selecting securities for your retirement income portfolio.
This email includes a concise checklist for identifying suitable retirement investment securities. This greatly simplifies and speeds up the process of finding the right securities for your portfolio.
Without further ado, the checklist is below.
Criteria #1: Dividend Yield
Any security you consider should have a yield at least equal to the threshold yield you need in your retirement portfolio. If you require a 4% yield, the securities you look at should yield 4% or more. This builds in a margin of safety as you only add securities
at or above your minimum yield threshold.
Note 1: To find the minimum yield you require from your portfolio, first find your average monthly expenses over a year. Then subtract out income you receive from alternate sources, like social security. Divide your expenses less other income number by your portfolio size to determine your yield threshold.
Note 2: If you aren't yet in retirement and are building your portfolio, determine your minimum yield threshold by estimating your portfolio size and expenses on your expected retirement date, and work backwards. There's greater flexibility here, so an absolute yield threshold isn't as critical. For a rule of thumb, a 3% yield threshold for those building a dividend growth portfolio leaves plenty of quality dividend growth options while maintaining a reasonably high portfolio yield.
Criteria #2: Dividend Safety
A dividend that isn't likely to continue into the future simply can't be relied upon. For dividend safety, we recommend that a security you are considering match the following requirements:
- Payout ratio under 90% at a minimum, and preferably much lower
- No dividend reduction during The Great Recession
- Ability to easily service debt
- Dividend covered by cash flows and earnings
These minimum criteria will help you avoid securities likely to reduce their dividend relatively soon. The most important factor, by far, is the payout ratio. The lower the payout ratio, the better. A 90% payout ratio is only secure for the most stable business models. A payout ratio well under this is much preferable.
Criteria #3: Dividend Growth
A stagnant dividend is not acceptable. The reality of inflation means that the purchasing power of a stagnant dividend is actually declining. Any security in which you invest should be expected to grow its dividend at least at the rate of inflation going forward, and preferably significantly faster.
Looking at historical dividend-per-share and earnings-per-share growth, as well as expected earnings-per-share growth and dividend-per-share growth in the future is a good way to get comfortable with a securities dividend growth.
A long history of steadily rising dividends is also a very good sign that future dividend growth is likely. Looking at the earnings stability of a security also helps to know if it will be able to pay rising dividends throughout the economic cycle.
Criteria #4: Portfolio Fit
Does the security fit in your portfolio? If half of the securities in your portfolio are in the energy sector, then it makes little sense to add another energy sector security. The exact portfolio weight limit for any sector is up to the individual investor, but something in the 25% range to 35% (for stable sectors like consumer staples) makes sense in our view.
Criteria #5: Individual Fit
Is the security right for you? Some people feel uncomfortable investing in tobacco companies. Others may feel uncomfortable with some big health companies or consumer staple securities that sell addictive and sugary products. If a company doesn't agree with your ethics, don't invest in it.
Second, if a security is outside your circle of competence, then skip it. By this, we mean if its business model is too difficult to understand. If you don't really understand how a business makes money then you are less likely to hold during down periods as you won't be able to diagnose if the issue the security is facing is temporary or permanent. It's better to avoid these situations than pretend we 'know it all'.
Criteria #6: Valuation
Is the security trading at or below fair value? Investing in securities trading above fair value puts your capital at risk because the security is likely to 'mean revert' to its historical fair value over time, causing losses.
In general, we prefer to invest in securities trading below their 10 year historical average price-to-earnings ratio. One should assess fair value first, and then invest only when the security in question is trading at or below fair value.
Criteria #7: Expected Total Returns
Finally, we recommend investors look for securities with high expected total returns, and screen out securities with lower expected total returns.
Expected total returns are calculated as the sum of valuation multiple change, growth on a per share basis, and dividend yield.
We recommend investing in securities with expected total returns of 10% or greater. The market has historically averaged total returns of ~9% a year. Investing in securities with expected total returns lower than the market's long-term historical average makes little sense when one could simply get greater diversification benefits from a broad market fund.
Putting It All Together
The seven criteria checklist above will generate a portfolio of safe and growing high yield securities trading at fair or better prices with solid and better expected total return potential.
[end quote]