My 3 ‘secret’ rules I always follow when hunting passive income stocks

Like many investors chasing passive income, I made plenty of mistakes early on. At times, I would buy dividend stocks simply because the yield was high. It was exciting to see that big percentage figure — until the companies cut their payouts or the share price collapsed, wiping out years of potential income.

These painful lessons forced me to rethink how I approached dividend investing. Over time, I’ve developed three core rules that guide how I build my passive income portfolio today.

Today, I’m sharing my not-so-secret secrets so that others can avoid repeating my costly errors.

Only buy dividends covered by cash flow

I find dividends more reliable when backed by tangible cash flow. That’s why I look beyond earnings and focus on the cash dividend coverage ratio. This measures how many times free cash flow covers dividends paid. Ideally, I look for a multiple of at least two.

Anything less could signal future strain, especially if market conditions turn.

Diversify across sectors and regions

I used to pack my portfolio with UK financials, thinking the steady dividends were a sure bet. Then a sector-wide wobble knocked multiple holdings at once. Now, I spread investments across industries — from insurance to infrastructure — and also look globally.

That way, if one part of the economy struggles, other holdings can offset the impact.

Avoid yields above 8%

A sky-high yield can be a trap. In my experience, anything above 8% deserves intense scrutiny. Is it sustainable? Is the company carrying too much debt? If growth or cash flow coverage isn’t strong, I steer clear.

Chasing the biggest payout often leads to disappointment when cuts arrive.

A dividend share that ticks many boxes

One stock that broadly fits these rules is TP ICAP (LSE: TCAP). This FTSE 250 company is the world’s largest interdealer broker, operating across rates, forex, commodities and equities. In other words, it sits at the heart of global markets, connecting buyers with sellers and earning fees for its role.

However, this also means it’s sensitive to trading volumes, which can fluctuate with global uncertainty. Regulatory pressures also present a risk and any sharp downturn in market activity could squeeze fees and impact profits.

It appears to navigate these risks well, as evident in its dividend policy.

The yield currently stands at a healthy 5.66%, with a sufficient cash dividend coverage ratio of 2.9 times — comfortably covering payments. Better still, the dividend’s grown by around 8.8% a year, on average.

The company’s earnings growth has been impressive too, up 128% year on year, with revenue growing at an average pace of 2.63%. Meanwhile, its valuation also looks attractive. It has a price-to-earnings (P/E) ratio of 13.9, a strikingly low price-to-earnings growth (PEG) ratio of 0.1, and a price-to-sales (P/S) ratio under 1.

Checking the balance sheet, £6.45bn in assets overshadow liabilities of £4.37bn, and it has a conservative debt-to-equity ratio of just 0.47.

A steady, rational business

Overall, it strikes me as a well-managed operation that carefully balances profit and shareholder returns.

For those aiming to build passive income without overreaching for yield, I think TP ICAP’s worth considering. It blends reasonable growth with a solid dividend track record, underpinned by a steady business model.

As ever, I always aim to ensure each stock is part of a well-diversified portfolio.

The post My 3 ‘secret’ rules I always follow when hunting passive income stocks appeared first on The Motley Fool UK.

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Mark Hartley has positions in Tp Icap Group Plc. The Motley Fool UK has recommended Tp Icap Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.