Passive Income: A Five-Step Guide

Passive income, usually in the form of dividend payments from common stocks, is one of the main reasons why people come and visit my site. Sometimes, though, there can be a tension between the search for passive income and value investing. The sustained and expected dividend cuts among oil stocks is the latest example of how searching for passive income and making attractive investments can sometimes come into conflict.

A question that frequently comes up, then, is: How do you build a portion of your portfolio that produces passive income which is highly reliable and gives you a regular source of passive income that can be deployed to make new investments or meet living expenses?

To answer that question, I have prepared a five-step guide that ought to put you in the position to find excellent candidates in the stock market that generate passive income.

Step 1. Only consider companies that have raised their dividends for 25 years, commonly known as “Dividend Aristocrats.” There is a list of 25 such firms in existence, usually available if you sift through David Fish’s spreadsheets or check out the list of current Dividend Aristocrats through the S&P 500 website or a general search engine inquiry.

You should keep in mind that the purpose of this harsh limitation is to find historically great candidates for long-term passive income. There are companies that would make great sources of passive income that won’t survive this screen (think Visa, Hershey, or Dr. Pepper) but the purpose is to create a screen that winnows you down to great candidates of passive income. In other words, we are concerned that what we get right is correct rather than worrying about the good things that would be left out.

Step 2. Filter the list further to candidates that have a ten-year track record of at least 5% dividend growth per year. This filter screen removes firms like Consolidated Edison, which are great at generating reliable passive income but don’t really give you passive income that results in purchasing power gains because the long-term dividend growth rate basically inflation. Ideally, you want passive income generators that give you purchasing power gains to deploy rather than a purchasing power equivalency that shows no gains over time.

Step 3. Look for at least a ten-year track record of 5% annual earnings growth. This speaks to the sustainability of the dividend growth as it indicates that the health of the business itself is giving you sharp lifts in passive income rather than arbitrary decisions of the Board. Given the strength of the U.S. dollar, it shouldn’t be a concern whether the ten-year dividend growth rate exceeds the earnings per share growth rate. If you have at least 5% earnings growth, there is going to be a high probability that the passive income source is stable.

Step 4. You want to manually remove and financial and tech stocks. While these companies can be great sources of passive income over the long haul (see how much higher Wells Fargo and IBM’s dividends are compared to 2000, 1990, 1980, and so on), they may pose a risk of a dividend cut during an extended period of adverse economic cycle for the history. Bad times for Wells Fargo look a lot harsher than bad times for Colgate-Palmolive, and this does affect the reliability of passive income on an annual basis even if the difference becomes a round error over the long term.

Step 5. Look for a dividend yield that is at, or above, the ten year average dividend yield for the firm. This is a value filter. Normally, you can’t use dividend payouts as a screen for value unless the company is well established with a very length documented dividend history. Given that these are the types of companies we are screening for passive income, it is useful criterion because it is almost always true that Coca-Cola will be selling at a more attractive valuation when its dividend is 3.5% compared to 2.5%.

From there, you will have a very winnowed list. You will see companies like Walgreens, ExxonMobil, McDonalds, PepsiCo, Procter & Gamble, Kimberly-Clark, Johnson & Johnson, Colgate-Palmolive, Coca-Cola, Brown Forman, Becton Dickinson, Abbott Labs, and 3M. These are the ideal candidates for passive income consideration when your objective is truly reliable passive income that grows at a rate faster than inflation.

Each of those five steps tests a different element of quality that gives you a very, very high chance of creating a passive income stream that will grow each year. Heck, that first step alone is crazy effective, as a given Dividend Aristocrat only faces a 4% probability of a dividend cut in a given year (based on the historical cuts of then-existing Dividend Aristocrats between 1985 and 2014). The other four steps try to reduce that 4% probability of a cut even further by considering business characteristics that are philosophically consistent with a high-quality passive income stream.

Sources Consulted: