Many individuals will be making New Year’s resolutions right now. And for some, this will involve trying to generate more passive income.
Here, I’ll set out three simple steps that could help turn a portfolio into a more reliable dividend machine.
Don’t assume everything that glitters is gold
Rather than getting excited at the prospect of a mouth-wateringly high dividend yield, I reckon it’s better to see it as a red flag. Or at least initially while investigative work begins.
Stocks offering exceptionally high yields are often compensating for underlying business risks, such as declining earnings, a massive debt pile, and/or weak cash flow.
One simple thing to check is the free cash flow (FCF) payout ratio. This measures the percentage of a company’s FCF paid out as dividends. It’s calculated by dividing dividends paid by FCF.
A high ratio could indicate that the company is allocating most of its available cash to dividends, leaving little for growth investments or emergencies.
That said, every stock is different, and FCF is just one factor to consider when evaluating a company’s financial health and prospects. And, of course, dividends are never guaranteed.
But by assuming that massive yields are potential red flags, it should reduce the risk of diving head-first into a yield trap.
Diversify the portfolio
The second step is to diversify across different sectors and companies. We’ve seen recently how UK housebuilders have been crushed, with earnings and dividends down substantially across the industry.
A portfolio brimming with housebuilders would be a misfiring machine, as both the value of the shares and the income from them would be under severe pressure.
Fortunately, there are many sectors and different types of options, including investments trusts. One of my favourite is BBGI Global Infrastructure (LSE: BBGI) from the FTSE 250.
This is an investment trust that owns and manages infrastructure projects through public-private partnerships. These include bridges, hospitals, motorways, and schools across Europe, Australia, and North America. These assets generate stable, government-backed income.
As the chart above shows, investors have turned bearish on BBGI stock. That’s primarily due to the higher interest rate environment, which makes the financing of new projects much more expensive. If inflation spikes and rates stay elevated for longer, the share price could continue to struggle.
However, the forward yield is now 7%. I reckon that’s attractive for a company that estimates its portfolio could continue paying a progressive dividend for the next 15 years, without needing further acquisitions.
The share price hasn’t been this low since 2015.
Reinvest dividends
Finally, one of the most powerful tools in building future passive income is compounding.
To really fuel this wealth-building phenomenon, an investor would reinvest cash dividends rather than spend them. This allows a portfolio to grow faster over time, as each reinvestment increases the future income potential.
Many brokerage platforms now offer dividend reinvestment plans (DRIPs) that automatically reinvest dividends at little or no additional cost. I did this back in October with the last payout from my BBGI shares.
Over the years, the effect can be dramatic. For example, £5k invested in a stock that goes nowhere but yields 7% consistently would become £20k inside 21 years, due to the power of compounding dividends.
