Seiya Tabuchi
Building a passive income snowball is extremely important. As Warren Buffett once said:
If you don't find a way to make money while you sleep, you will work until you die.
The four keys to building an effective passive income snowball are:
- Owning businesses that are defensive and durable, so they can withstand the test of time and continue to generate enough cash flow to support their distributions through thick and thin.
- They also must have strong balance sheets so they are never forced to choose between cutting their dividend or saving their credit rating. Numerous investors, from Energy Transfer (ET) to AT&T (T), have learned the hard way that management teams will almost always side with their credit rating.
- An effective passive income snowball must also have promising long-term dividend growth potential to sustain and ideally grow the purchasing power of the dividends being paid out by each share in your portfolio in the face of inflation's eroding power.
- Last but not least, a good dividend snowball must pay out a sufficiently high dividend yield. Without it, you're going to have to save a significant amount of capital before achieving financial freedom, and you also take on significant growth risk, making your portfolio more speculative in nature. Growth stocks need to deliver on growing their cash flows and dividends at an aggressive clip for quite a long period of time to catch up with the passive income provided by stocks with high current yields. As the saying goes, a bird in the hand is worth two in the bush.
This article will look at each of these qualities, highlight some sample stocks that meet these requirements, and conclude with those that make good components for a passive income snowball portfolio.
#1. Defensive and Durable Business Model
We like to invest in simple businesses that generate very stable cash flows through economic cycles and deliver essential goods and services that are very difficult to displace through technological innovation. For example, we really like well-diversified portfolios of triple-net lease real estate found in the likes of Realty Income (O), Essential Properties Realty Trust (EPRT), and W. P. Carey (WPC). Diversified commercial triple-net lease real estate has long-term cash flows locked in, making it recession-resistant, and the diversified nature of the portfolio makes it resilient to other economic changes over time. We also like multifamily real estate, such as Camden Property Trust (CPT), Mid-America Apartment Communities (MAA), and AvalonBay Communities (AVB), because people will always need a place to live.
We also like regulated utilities (XLU), as electricity demand will likely only increase due to the digitization and electrification of the economy and society at large, and their regulated nature makes them quite resistant to economic downturns. Additionally, midstream (AMLP) and renewable power generation companies are appealing due to the long-term contracted nature of their assets and the increasing need for energy. Some attractive options in these sectors right now include Enbridge (ENB), which is both a midstream company, a renewable power generator, and a utility; Enterprise Products Partners (EPD), arguably the top blue-chip midstream company; and Brookfield Infrastructure Partners (BIP)(BIPC), which is well-diversified across utilities, midstream, transportation, and data sectors.
#2. Strong Balance Sheet
Companies with strong balance sheets can be found in any industry, ranging from dividend-paying tech titans like Apple (AAPL) and Microsoft (MSFT) with their massive cash stockpiles to leading dividend growth blue chips like Coca-Cola (KO). An easy way to go about identifying companies with strong balance sheets is by filtering out only those with strong investment-grade credit ratings. If the credit rating is A- or higher, investors can typically have strong confidence in the strength of the balance sheet. If it is in the BBB- to BBB+, it may still very well be in fine shape, but more detailed due diligence is likely necessary to make sure, especially in the current higher-for-longer environment.
#3. Inflation-Beating Dividend Growth Outlook
For companies with strong dividend growth track records, looking at the list of dividend aristocrats (NOBL) and dividend kings is a good place to start. However, it’s also important to look for stocks that have strong dividend growth momentum and are not merely maintaining a dividend growth streak for the sake of hanging on to the distinction that comes with it and, as a result, are only providing token increases each year. Some examples of stocks with strong dividend growth momentum include alternative asset managers like Brookfield Asset Management (BAM) and Blue Owl Capital (OWL) as well as midstream business Plains All American Pipeline (PAA)(PAGP).
#4. Attractive and Sustainable Dividend Yield
Finally, for high yields that are also sufficiently covered by cash flows, the midstream space is very attractive right now. There are also a few business development companies (BIZD) like Blackstone Secured Lending (BXSL) and Ares Capital Corporation (ARCC) that offer high dividend yields that appear to be safe for the foreseeable future. The REIT (VNQ) space also has some attractive high yields, such as EPR Properties (EPR), which recently hiked its dividend and has a dividend yield of over 8%.
Investor Takeaway: Putting It All Together
Investors have a couple of options when constructing their passive income snowball portfolios. They can take a simple approach by combining a few funds, such as the Schwab U.S. Dividend Equity ETF (SCHD) and the JPMorgan Equity Premium Income ETF (JEPI), or even the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) if they want more technology exposure, to achieve a strong combination of current yield, dividend growth, and diversification across blue-chip investment-grade businesses. However, this approach requires paying the expense ratio of the fund managers and also results in very broad diversification, thereby reducing the chance of achieving material total return outperformance over the long term. This approach also limits the ability to take advantage of opportunistic capital recycling within a portfolio as a value investor to further accelerate the compounding process.
Alternatively, if you decide to pick individual stocks, a great place to start is with a core set of blue-chip stocks that meet all four of these requirements with flying colors. These would include the likes of several that we have already mentioned in this article, such as EPD, ENB, O, and BAM, and many others that we did not mention here. Additionally, when picking individual stocks, it's important to ensure sufficient diversification by drawing from a variety of sectors without compromising on these four important factors and ideally holding at least 18 stocks in your portfolio, as studies show that this number is the minimum needed to reap most of the benefits of diversification. Alternatively, you can hold a few high-conviction blue-chip stocks and supplement them with funds like SCHD or JEPI for broader diversification.
Regardless of which path you choose, as long as you understand that the anatomy of a passive income snowball consists of defensive and durable business models, strong balance sheets, attractive long-term dividend growth profiles, and a high current dividend yield, you will likely achieve satisfactory long-term results. While our success with implementing an opportunistic capital recycling strategy over the long term motivates us to purely hold individual stocks, those who want a more passive buy-and-hold approach and do not want to spend much time managing their portfolio and studying individual stocks may find a simple combination of funds like SCHD and JEPI to be a satisfactory approach to getting them where they want to go.
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