How To Pick Stocks In Order To Build An Income Portfolio

Strategy for building an income portfolio is a popular investment strategy used by investment professionals and individual investors alike. The strategy is a semi active one and aims at earning dividends rather than capital gains as the main source of return on their portfolios. The selection of stocks for this portfolio is, however, tricky and requires a study of a number of stocks, into extended periods into their history to see how consistent they are in distributing dividends, and how likely or unlikely they are to distribute a higher or lower rate of dividends In the forthcoming period. Then there is also the question of risk return trade-off, with some believing that choosing a mid-cap or small-cap stock for this portfolio can provide better returns on account of higher dividend yields on these stocks.

So how do we determine if a stock is large-cap, mid-cap or small-cap? For that we determine the stocks total market capitalisation. This term denotes the value of a publicly traded company as determined by its investors, at any given point of time, at the stock exchange where it is listed. It is calculated as the total number of shares outstanding multiplied by the current price at which the shares of the company are trading at the bourses. Based on the total demand and supply forces in action, the companies listed on the bourses may be ranked from the most valuable company in the market to the company with the least market value. However, market capitalisation is a volatile element and keeps on changing with every trade on the stock exchange.

Other than determining the value of a company, the term is also used to get several dimensional insights into the many facets of a stock; like trading patterns, speculative interest and information sensitivity. It says a lot about the stocks when looked at in comparison to the market capitalisation of other companies in the same market or the capitalisation of the stock market as a whole. One of the ways this instrument of measurement is used is to segment the stock market into different groups, based on their market values. Companies with the highest values may be called as large-cap stocks, companies with mid-range values may be called as mid-cap stocks and remaining companies with less to least market capitalisation may be called as small-cap stocks. There is no set value in terms of units of currency as to what constitutes a large-cap, mid-cap or a small-cap company, and it differs in different markets based on a company’s individual value rankings in the respective markets where they trade.

Categorising the securities into three segments based on the above logic of differentiation helps to understand the demand and supply forces at work at any point of time in the market. It reveals the behaviour of different categories of investors like mutual fund managers, high net-worth individuals and ordinary investors in terms of their preferences in stock selection and also how often they would trade in stocks belonging to a particular segment. The differentiation also helps in understanding investor movement patterns among these market segments during different phases of economic cycles.

Over the past several years, studies have been conducted by individuals, stock market researchers and academicians alike, to understand the different facets of insight thrown by this method of capital market observation. The implicit objective of these research exercises undertaken is to determine which segment will be a better value creator under different market circumstances. The differentiation method also helps to determine what strategies may be adopted by investors with different styles of investing and objectives they seek to accomplish.

Large-cap stocks are stocks with the most investor interest. These companies generally give good dividends, but at times it is seen that yields are unattractive on account of high prices of the associated stocks. Hence investors building a medium-to-high risk, moderated portfolio invest in these stocks as this category of stocks are also the safest, with least risk of capital loss compared to mid-cap and small-cap segments. These stocks usually command the highest proportion of the total market capitalisation in a stock exchange. These stocks are generally the most traded and are the most liquid of all stocks traded on a stock exchange.

On the market capitalisation value, as you go down, the risk associated with each individual script keeps on increasing, along with their return profiles. Mid and small-cap stocks provide good investment prospects if the investor has a higher risk appetite.

Investing in mid-cap and small-cap companies, however, involves a great deal of research work along with smart portfolio construction and updation techniques required to achieve the desired results.

When building a portfolio, an investor or a fund manager aims to moderate his risk by investing in a portfolio of stocks while targeting a return higher than that of the market portfolio (a portfolio will all the stocks in the stock exchange). One of such popular portfolio types is an income portfolio. In which, the emphasis is more on higher yield in dividend income than what the market portfolio generates. Such portfolios usually are less skewed towards investing for capital gains. They require minimal portfolio churning and this save as much as possible on transaction costs. However, building and updating this portfolio is not an easy task. There are three key objectives a fund manager would try to accomplish in building and updating this portfolio in order to maximise his returns. First, he keeps the number of transactions to the minimum to keep his cost of operations low, Second, he would have a list of stocks with highest to lowest dividend yields to invest in and invest in the list where his risk matches with the expected returns. Third, he will use every market-awarded opportunity to move up the ladder on that list, so that the return potential of his portfolio may increase for his assumed level of risk. In theory, this is a semi-active technique, but difficult to implement in the event of uncertainty in earnings of a mid to small cap stock in the portfolio.

There are more dividend-paying stocks to be found in the mid-cap category than with the small cap end of the market. Small-cap stocks are usually cash strapped with a high-risk, high return profile and are ill-suited for an income portfolio. The key, however, to finding a good income stock in the mid to small-cap category that would sit well in an income portfolio is to look for two important factors; first, the company has consistent earnings and second that it is cash-rich. Only these companies are in a position to distribute cash to their investors. A number of companies in the mid-cap segment may be found that are not investing in growth and would rather distribute their earnings to the shareholders. Examples of such type of companies are well-established businesses, having a niche in the market with a limited to nil competition and a product portfolio that is static; for example, a public sector utility company.

An Income portfolio which targets mid-cap to small-cap stocks in addition to large-cap stocks will have to look into all the above aspects while simultaneously, keeping track of the risk profile of the overall portfolios with ever-changing market dynamics.

It is a myth if at all it is suggested that adding mid-cap or small-cap stocks in an income portfolio will bring in greater returns at the cost of a slight but manageable increase in the portfolio’s systematic risk. As discussed earlier, it is difficult to comprehend the total risk involved in building an income portfolio with the additional component of uncertainty in the actual materialisation of dividend income while the general risk profile of the stocks appears to remain the same. In fact, a strategy that focuses more on fundamental aspects of individual stock with good dividend yields will provide greater caution against any risk posed to such a portfolio. The strategy of buying the target scrips at dips and selling at spikes to bring down the average cost of holding has a better chance of achieving a higher yield target, albeit at higher costs.

The above discussion points to several facets of stock market as well as individual stock investing. An investor would do good if he chooses established companies with and sustainable earnings for building up his income portfolio. In fact, the most important consideration in choosing a stock for an income portfolio is stability in earnings and history of consistent dividend payments.