I’ve lost count of how many shares I’ve rejected for my long-term income portfolio, but it’s a lot! It doesn’t matter whether they were small-caps, mid-caps or great big well-known FTSE 100 companies, they’ve all gone the same way – out the window as far as I’m concerned.
Of course, I’ve considered them in the first place because they’ve all had a large dividend yield, or perhaps an average yield but with a dividend that has been growing at an impressive annual rate. But, for me, big and growing yields are not enough on their own. I want ‘quality’ dividends, which means they must be sustainable.
The search for quality
I skip most cyclical firms. The trouble with cyclicals, as I see it, is that they often go in disguise as big-dividend-payers, but they fail the test of sustainability. Look at the fat yields available from companies such as housebuilder Persimmon, banker Lloyds Banking Group and miner Rio Tinto. At first glance, those firms look tempting for an income portfolio with their big payouts and low valuations.
But I think cyclical firms with low valuations following a period of strong profits are dangerous. In the next cyclical down-leg, they can be vulnerable to the collapse of their profits, share prices and dividends. In other words, they look their most attractive when they are at their most dangerous. What’s the point of collecting the dividend now when there’s a risk that a share price plunge down the road could wipe out my income gains?
Dividends can also be at risk because of weak business models. I reckon it’s important that a big or growing dividend is backed up with an underlying business that scores well against quality indicators, which would suggest that the company is trading in a strong and profitable niche of the market.
Quality and forward-looking opportunity
One company that I’m happy to add to my income portfolio is pharmaceutical giant GlaxoSmithKline (LSE: GSK). The dividend yield runs just above 5%, which looks attractive, although I admit it’s not perfect because the dividend has been flat for a few years and I’d prefer to see the payment rising a little annually.
Nevertheless, the company operates in a defensive sector and I see defensive businesses as operating at the opposite end of the scale from cyclical businesses. Whereas the cyclicals tend to see their profits rise and fall along with the undulations of the wider economy, defensives tend to enjoy stable incoming cash flow and profits because of evergreen demand for their products and services. As such, a defensive business is often well placed to support its dividend payments over the long haul. I think the pharmaceutical sector is fertile ground for finding decent dividend-paying firms, because customers tend to keep buying medicines whatever the general economic weather.
Indeed, GlaxoSmithKline has a stable record of incoming cash flow that supports profits and the dividend payment. There’s also a good showing on quality indicators such as the return on capital and the operating margin. Looking forward, recent news of the firm’s plans to combine its consumer health businesses with that of Pfizer in a new joint venture could unlock value. Overall, I see the shares as attractive and would be happy to add them to my income portfolio today.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.