How to Create a Passive Income Portfolio

To create a passive income portfolio, you can invest in bonds or stocks that generate interest or dividend income without you having to lift a finger. I prefer to invest in stocks which have outperformed bonds in the long run.

I also like the concept of investing in stocks because I’m owning stakes in businesses and benefiting from their profits (although I also take on their risks). This is markedly different from purchasing bonds for which you’re lending your money to governments or corporations for interests in return.

In fact, dividend investing is my favorite way to generate passive income. There are so many safe dividend stocks to choose from. Even in a booming stock market like today, you can still find quality businesses at good valuations.

Here’s how to create a passive dividend income portfolio:

  • Buy stocks that offer safe dividends at good valuations
  • Diversify but don’t di-worsify
  • Aim for a low-maintenance portfolio that’s replicable, scalable, and can be largely automated
grow a money tree

Buy stocks that offer safe dividends

The U.S. and Canadian stock markets offer yields of 1.8% and 2.8%, respectively. There are plenty of safe dividend stocks that offer higher yields of about 3-6%.

However, typically, the higher the yield of a stock, the slower its dividend growth will be. (Sometimes, high yielders don’t increase their dividends.) Similarly, low yield stocks tend to increase their dividends faster. Typically, dividend growth stocks are safer and better than stocks that simply maintain their dividends.

Buy stocks at good valuations to protect your invested capital and maximize your gains.

Here are a few examples.

A high yield example

NorthWest Healthcare Properties REIT (TSX:NWH.UN) owns a high quality portfolio of medical office buildings and hospital properties in major markets in Canada, Brazil, Germany, The Netherlands, Australia, and New Zealand.

The healthcare REIT generates stable cash flows from having a high occupancy of about 96% and a weighted average lease expiry of 13 years. Additionally, it gets organic growth from having more than 70% of its net operating income indexed to inflation. It also has CAD$370 million projects in its development pipeline that’ll also add to growth.

NWH.UN has an adjusted funds from operations (FFO) payout ratio of about 89%. REITs tend to have high payout ratios, but the REIT’s payout ratio is still at the high end. So, logically, it didn’t increase its cash distribution from 2012 to 2018 but maintained its cash distribution. As a result, investors should aim to lock in a high yield from the stock.

NWH.UN has yielded 6% to 10.5% in the past. Now, it yields 6.7%, which is closer to the lower end of its yield range. Interested investors should aim to buy the stock closer to a yield of 8%, or CAD$10 per unit.

NWH.UN Dividend Yield (TTM) Chart
NWH.UN Dividend Yield (TTM) data by YCharts

Moreover, the stock has a net asset value (“NAV”) of $12 per unit, which is awfully close to its latest stock price of CAD$11.90. So, the stock is pretty much fully valued here. And it’d be more prudent to look for a pullback. A dip of about 16% will lead to a CAD$10 stock price.

To summarize, the nature of NorthWest Healthcare Properties REIT’s business is very stable. It has high occupancy and long-term leases to sustain stable cash flow that supports its dividend. It has a high payout ratio and doesn’t tend to increase its cash distribution.

So, investors should aim to buy it at a high yield. Because it pays out monthly cash distributions, investors can compound their investment using the cash distributions at a faster rate versus dividends that are normally paid out every 3 months.

A decent yield and stable growth example

Toronto-Dominion Bank (TSX:TD)(NYSE:TD) is a top 10 North American bank with a focus on lower-risk retail banking, serving consumers and small businesses. It generates about 92% of its earnings from its Canadian and U.S. retail segments.

At CAD$76.50 per share of writing, TD stock is fairly valued and offers a yield of about 3.9%. In the last 20 years, it has increased its dividend per share by about 11% per year on average. Going forward, it should be able to increase its dividend by at least 7-10% per year.

A low yield and high growth example

UnitedHealth Group (NYSE:UNH) has an enterprise value of about US$289 billion and is the largest private health insurance provider in the U.S. Because of its large scale, UNH earns industry-leading margins.

It is an example of a low-yield but high-growth stock. It only yields 1.7%, but it just increased its dividend per share by 20% this month. And its five-year dividend growth rate is about 27%.

Currently, the stock trades at a decent value. At about US$252 per share, it trades at a blended price-to-earnings ratio (P/E) of about 18.4, while it’s estimated to increase earnings by 13-14% per year over the next 3-5 years.

Diversify but don’t di-worsify

Companies in the same industry are subject to the same challenges. So, for your passive income portfolio, you want to get safe dividends from different sectors and industries because a diversified set of stocks can lead to a safer dividend income stream and a lower volatility portfolio.

To prevent from di-worsifying, or diversification that makes it worse for your portfolio, aim to buy the best stocks from selective industries. The key sectors or industries to explore for safe dividends include utilities, REITs, and energy infrastructure.

Generally, to maintain a safe passive income portfolio, you don’t want to have more than 25% in a single sector or more than 5% in a stock. You don’t have to be too hung up on these allocation rules when you’re building your portfolio (especially early on) because you’re going to add to your positions over time.

You might buy stocks based on your income needs. However, if you have a long investment horizon, such as saving for your retirement that’s coming up in 10 years or later, you want a mix of stocks with:

  • low yield and high growth, and
  • decent yield and stable growth

Dividend growth stocks with higher growth tend to deliver greater dividend growth and price appreciation over the long haul.

How to aim for a low-maintenance portfolio?

For an income portfolio to be truly passive, we want it to be low maintenance. This means it requires as little attention from us as possible — perhaps one that only requires quarterly or even annual reviews.

One way to do this is to aim to only buy the best dividend stocks from selective industries at good valuations and never sell. This way you only have to focus on your buying decisions. Your goal is to never invest in sub-par businesses which should significantly lower your chances of making a bad investment, losing money, or getting dividend cuts. You’ll also lower your trading fees this way.

Aim for a low-maintenance portfolio that’s replicable, scalable, and can be largely automated.

Example of creating a passive income portfolio from dividend stocks

Assuming you’re starting your passive income portfolio from scratch, set up your chequing account to automatically transfer a set amount, say, $50-$3,000 every month to your savings account to be ready for investment.

The more the better, but the important thing is to get the savings program started — no matter how small the savings may appear in the beginning.

Once you’ve saved enough to make your trading fee worthwhile, identify the best stock to buy at the time. Generally, I view paying 0.5% to 1% for the trading fee as acceptable. (If you have little savings to work with initially, you might go with a diversified dividend ETF to increase the portfolio value first.)

There are 11 sectors, and here are some top quality stocks for consideration when they’re trading at good valuations.

EnergyEnbridge (TSX:ENB)(NYSE:ENB)
IndustrialsUnion Pacific (NYSE:UNP)
Consumer DiscretionaryStarbucks (NASDAQ:SBUX)
Consumer StaplesPepsi (NASDAQ:PEP)
Health CareUnitedHealth
FinancialsTD Bank
Information TechnologyMicrosoft (NASDAQ:MSFT)
Telecommunication ServicesComcast (NASDAQ:CMCSA)
UtilitiesFortis (TSX:FTS)(NYSE:FTS)
Real EstateRealty Income (NYSE:O)

Previously, we already discussed that TD Bank and UnitedHealth are good-valued stocks to consider right now. From the list above, also throw in Enbridge and Comcast which are also either fairly valued or undervalued.

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Disclosure: As of writing, we’re long ENB, UNH, TD, and CMCSA.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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