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How to invest in income stocks

The idea behind income investing is to put together a portfolio of assets, usually stocks, that generates income for the investor. Because a steady income stream is the goal, the portfolio should have a low amount of risk.

Income investing has not been that popular lately, given that we have been in the greatest bull market of all time. Momentum and growth at a reasonable price investing styles have been more in favour. 

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But as we get older and richer, capital growth becomes less important and income becomes more important.

Here’s how to invest in income stocks.

Find a company with an enduring moat

When it comes to income, we want to make sure that our investment is protected with a large moat. We want stocks in companies with untouchable positions in their markets – think Coca-Cola. Any drinks start-up funded with a few million is not going to make a dent in Coca-Cola’s global domination.

Or what about Unilever? It’s highly likely you have several of its products in your house. Anyone wanting to take on the might of Unilever would have to fight on many fronts to wrestle sectors and territories from the company’s vise-like grip.

Find a company with strong and stable cash flows 

Companies that generate consistent cash year-on-year are quality candidates for income investing. We don’t want a business that one year makes a huge amount of cash only to do poorly the next. Companies that are able to convert plenty of their steadily growing profits into cash are companies we can consider for a dividend-oriented portfolio.

We also need to make sure that the dividend is more than several times covered by cash flows. A good rule of thumb is that the dividend should be covered three times. That way the company can manage minor problems without any risk to the dividend. It would take really serious problems to raise the risk of the dividend being cut.

Find a company where the dividend is not likely to be cut 

If a company has a dividend yield above about 8%, it may be a sign that the market does not view the dividend as sustainable. 

The market is normally efficient regarding larger-cap stocks, so if a company with an usually high dividend yield were a good investment, then everyone would take advantage – which would increase the price and reduce the yield.

Ideally, we want a moderate dividend yield of about 3% to 5%. A long track record of sustained dividends, or even better, of growing dividends, is also something to look for in a candidate for an income investor’s portfolio.

By picking companies that have enduring moats, consistent cash flows and a high profits-to-cash conversion ratio, as well as a sustainable dividend, we can create income portfolios that will grow in a slow and steady manner. 

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Michael Taylor does not hold a position in any of the stocks mentioned. The Motley Fool UK owns shares of and has recommended Unilever. 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.