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Investing in dividend stocks with strong fundamentals and long-term business prospects is one of the oldest ways of building a passive income stream over time. Legendary investors like Warren Buffett, Benjamin Graham and Stanley Druckenmiller have been staunch defenders of generating passive money by buying solid income stocks, and even getting rich through this method. Although this approach still has substantial merit today, when I look at my financial future, I don’t believe it is enough.
Selecting solid dividend stocks
The first thing I do when looking for dividend-paying shares is to scan the FTSE 100 universe for high dividend-yielding companies.
At the time of writing, Imperial Brands, Vodafone, BT, GSK and British American Tobacco all are expected to deliver a dividend yield of more than 5%, with HSBC, Lloyds Banking Group and Schroders expected to provide a dividend yield of above 4%. Meanwhile, the overall dividend yield of the FTSE 100 index is hovering around 3.2%.
These are all very attractive numbers, in my view. However, I also look at the dividend coverage ratio. As a reminder, dividends are paid from a company’s net profits. The management team can choose what to do with the net profits: to retain part of them in order to invest in the business, or buy back shares, or to deliver a portion of the profits to shareholders.
The dividend coverage ratio tells investors the number of times that a company can pay dividends to its shareholders, and it is calculated by dividing the net profit by the amount of dividends paid. In my view, a dividend cover ratio of 2.0 or above is very good. Between 1.5 and 2.0 it is decent.
For example, Imperial Brands’ dividend cover is just under 2.0, which means that the attractive dividend yield is supported by enough earnings. However, even with this extra layer of analysis, I do not feel comfortable of building my passive income stream solely from dividend stocks.
The world beyond dividends
Investing in equities means exposing my money to equity risks, such as company specific-challenges that can result in lower profits and thus, in lower dividends. Therefore, I am looking to diversify into other asset classes, like real estate and fixed income.
I like accessing real estate through REITs. These trusts can offer an easy way to access prime real estate, be it commercial or residential, across the country. One thing I keep in mind, though, is that their liquidity profiles can differ depending on what is going on in the economy but given the yield they provide, adding them into the mix seems to be a logical decision.
In terms of fixed income, I am looking at Gilts rather than Treasuries. The UK government has been more responsible than the American one with its borrowing and, therefore, the risk of devaluing the income from Gilts is lower while the risk-free protection is still there.
Therefore, as I am building my passive income stream, I am looking both at dividend stocks and beyond them to ensure that it is robust for the long term.