Previously we discussed creating a profile for a portfolio based on length of time held, ability to stomach risk, and amount of gains desired.
For those individuals that are in retirement they no doubt want low risk with slow and steady annual returns. Income stocks are a choice pick. What are income stocks and which ones are ripe for the picking for 2010?
Definition of Income Stocks
An income stock is a quality blue chip stock that will maintain its value while paying dividends. With the lower risk comes a lower return. Our goal should be a steady stream of income around 5 to 6 percent after inflation. While we might see some share price appreciation in the long run, our strategy is not dependent on the stock value soaring. We reserve that tactic for the growth article.
Selection for Income Portfolios
Stick to investments in these categories and similar types:
- Listed property trusts (REIT’s)
- Blue chip industrial stocks with high yield
- Income securities
- Stocks with full franking credits
There are numerous products made available by corporations and governments that we can use such as REIT’s and bonds of all types. Each type of income security needs to be individually investigated as to fitness. But what about dividend paying stocks?
We want stocks with stable prices and high paying dividends. Here we enter a conundrum. High-yields might be due to abnormally low stock prices. For instance, a stock giving a dividend of 2 dollars per share while share price is at 100 dollars seems low. If share prices fell to 20 dollars because the stock was in danger, the dividend now seems extremely high. But the risk has also risen since the company might be near bankruptcy. Of course this is an extreme example but the point is the same: be wary of stocks where the dividend seems unnaturally high.
Furthermore, you can look at a multi-year stock chart to see the potential volatility. The lower the volatility the better when it comes to income stocks. Typically these stocks will have low P/E ratios, high book values, decent market penetration, and low volatility. They may not rise quickly in bull markets but will neither be the hardest fallers in bear markets.
Consider picking stocks that have full franking credits. Franking credits refer to the amount of taxes already paid by the company. If the gross dividend was 1.00 per share they may have already paid 30 cents per share in taxes for a net of 70 cents per share. Your tax rate might be 40 percent, but if you get franking credits you can deduct the 30 percent the company already paid for a net taxation of 10 percent. Franking credits prevents the dividend from getting double taxed. Not all dividends are equal and full franking credits will help lower your taxes. A franking credit dollar saved is an investment dollar earned.
Sample Dividend Picking Criteria
- 2 - 10 billion minimum in market capitalization
- Dividends of at least 3 percent
- Low volatility (can be measure with beta. Look for numbers less than one)
- PEG ratios close to 1.5
- Diverse in industry groups
The subject of picking high dividend stocks will be dealt with more fully in another article. Now what sort of procedure should we follow for purchasing income stocks?
Tips For Purchasing Income Stocks
Just because we are buying income stocks with the goal of dividend payouts does not mean we want only buy a large amount of stocks all at once. We still need to be extremely judicious. Following these tips will help when it comes to purchasing income stocks:
- Take your time and buy during new bull markets. Although our main objective is to gain dividends, we can preserve our capital by investing at the right times. If the bull market fades into a sideways market or corrects, we still gain income. But if we buy at the peak of a bull market or beginning of a bear market, any income gains will be destroyed by capital losses on the share price.
- Buy stocks that have a low relative value. In general, income stocks will have a lower price to earnings ratio since they are not aggressively trying to increase market share and grow. Still, you should make sure that the stock is not overpriced based on book value, cash flow, earnings and P/E ratios. If the industry average has a much lower fundamental valuation than your stock, be very careful. We want slow moving stable stocks that are cheap to buy and will retain value. Picking undervalued stocks is one way to achieve this.
- Always leave a certain amount of your portfolio liquid in cash for buying opportunities. Sometimes a buy is just too good to pass on. You just need to have this stock at this price. But you don’t have any cash. This leaves the predicament of selling a stock or borrowing money. If you must sell a stock, pick one of your weaker performers or one that has a dividend the furthest away. Be careful of borrowing with interest charges since income stocks traditionally produce lower returns than growth based stocks and interest rates will need to be calculated against this. Having cash on hand, up to 10 percent of your portfolio value in cash, for a buying emergency is a good thing to do.
Examples of Income Stocks to Buys
Here is our choice of the best income stock for 2010 (ASX)*
Top 10 Income Stock for 2010
- Australand Holdings Limited (ALZ)
- Foster's Group Limited (FGL)
- MAp Group (MAP)
- QBE Insurance (QBE)
- Woolsworth Limited (WOW)
- Servecorp (SRV)
- Metcash (MTS)
- David Jones (DJS)
- Westfield Group (WDC)
*Writer does not own any of the above stocks
Conclusion to Building an Income Portfolio
As banks offer less attractive rates on long term investments, people are forced to fend for themselves when wanting a stable source of income. To make your money work for you a lot will be required as regards due diligence. There are many new products available that fight inflation and provide a little extra income over and above that. High yield dividend paying stocks are one example of this.
For investors wanting low risk and a steady flow of cash, following this advice to build an income based portfolio will no doubt be a wise investment.