Last Updated on 23, January 2023
The other day, one of my clients informed me that he plans to take early retirement. Despite being below the statutory retirement age, his employer is offering a special package to encourage employees to voluntarily leave the company due to the ongoing economic recession. Rather than waiting for conditions to deteriorate further, he decided to apply for the early retirement package. During our conversation, he emphasized the importance of converting his investment portfolio to one that generates dividends, as his current portfolio focuses on capital gains.
Many individuals in similar situations may also require a dividend-paying portfolio to support their expenses during retirement. Here are some tips on how to construct a dividend-paying portfolio.
Income from stock dividends
Dividends from stocks can provide a source of passive income. Companies that are profitable often distribute a portion of their earnings to shareholders in the form of dividends. Some companies have a policy of distributing a certain percentage of their earnings to shareholders, while others may distribute a fixed amount of dividends to provide a level of predictability.
However, I am not in favor of investing solely for the sake of dividends. While I believe it's important to consider dividends when constructing a portfolio, the objective of the investment should not be solely to receive dividends. Instead, I believe in investing in a diversified portfolio. Investing in a portfolio of 100% dividend-paying stocks is not being diversified.
When a stock has a high dividend payout ratio, it may indicate that the company does not have any business expansion or research and development projects to spend on. This may imply that the CEO of the company does not know how to use the money effectively. This can be a red flag for a company's future prospects.
Imagine driving on the road and stopping your car. All other cars are moving forward, but relative to them, you are moving backwards. Similarly, companies that pay all their dividends to shareholders may be "stationary" and not investing in growth, which could mean they are falling behind their competitors.
When considering investing in stocks that pay high dividends, here are a few things to take note of:
- Find out where the dividends are coming from - are they from earnings or borrowings? Some companies borrow money just to pay dividends.
- Is the company free cash flow positive? Even if a company has positive earnings, it may have negative free cash flow. This can happen when it recognizes revenue but hasn't collected cash from customers, meaning it may have a large amount of receivables in its balance sheet.
- Check that the total return is not on a long-term downtrend. For example, even if the dividend yield may be 5% per year, if the share price is declining at -10% per year, the dividend is not enough to compensate for the capital loss.
Income from Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are listed investments that hold a portfolio of commercial properties such as warehouses, shopping malls, and data centers. The main motivation for investing in REITs is the ability to invest in properties at an affordable amount and to receive dividend income and potential capital gains.
By regulation, REITs are required to pay the majority of their rental income to shareholders. However, REITs are also leveraged instruments, and they usually have significant borrowings. The law requires REITs to maintain a debt ratio below a certain threshold.
However, there have been cases where REITs have suffered significant losses due to factors such as:
- Decline in property values: When property values decrease, the debt level does not decrease, and this increases the debt ratio, breaching the regulatory limit.
- Currency mismatch: When the assets and borrowings are in different currencies, the debt ratio can increase significantly if the currency of the borrowings appreciates against the currency of the assets.
- Loss of income due to a decline in the businesses of its properties: For example, during the COVID pandemic, hospitality REITs were significantly affected.
Some investors invest in REITs to gain exposure to the underlying businesses. In such cases, it may be more efficient to invest directly in the business itself. For example, when investing in a REIT that focuses on data centers, it might be more efficient to invest directly in a cloud computing ETF since the former only benefits from rental income.
When considering investing in REITs, here are a few things to take note of:
- Ensure that the underlying properties and businesses make sense to you and that they are viable in the long-run and free from any significant political and economic risk.
- Check that the currencies of assets and debts do not mismatch.
- If the underlying rental income is not in your local currency, check that the REIT provides currency hedging so that you will not suffer a decline in income if the currency turns against you.
Finally, ensure that it is tax-efficient because you do not want to pay a significant tax for receiving high dividend income.
Investing in a dividend-paying portfolio should not be done in isolation from your other investments and financial objectives. It's important to consider how it fits into your overall financial plan. For example, if you have a high-interest mortgage, it might be more beneficial to pay down the loan instead of channeling your resources into a dividend-paying portfolio. Similarly, if you are currently uninsured, it would be wise to quickly obtain coverage, as a dividend-paying portfolio will not be able to pay for a large hospital bill, but insurance could cover it almost immediately after purchase.
It is always advisable to consult a financial advisor when making investment decisions, especially when it comes to creating a diversified and balanced investment portfolio that aligns with your financial goals, risk tolerance and time horizon. A financial advisor will be able to provide you with a comprehensive analysis of your current financial situation and help you to create an investment strategy that is tailored to your specific needs.
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