An investment portfolio is a means to an end. A vehicle for taking you from where you started to where you want to be. In most cases, the destination isn’t just a dollar amount but what those dollars will allow you to do.

A pot of $1.5m by the time you finish working might be your target. But the desired result is really having enough money to fund a secure and happy retirement. Likewise, your financial goal might be $20,000 per year in dividend income. But the real goal is having enough passive income to fund your travels.

Whichever way you slice a financial goal, choosing investments that are aligned with it is an important step towards success. If your goal is to generate passive dividend income, choosing a portfolio full of companies that don’t pay a dividend is unlikely to be of much use. By contrast, targeting investments with qualities likely to support a solid and growing dividend could be more suitable.

Today’s article looks under the hood of Morningstar Australia’s model income portfolio.

The stated aim of this portfolio is to provide investors with “greater risk-adjusted returns and a higher sustainable franked dividend yield than the S&P/ASX 200 Accumulation Index in the long term.” This is reflected by the kind of companies it seeks to invest in.

Here is how the portfolio’s factsheet puts it: “Morningstar focusses the portfolio's exposure on companies with competitive advantages, a market price offering margin of safety, a sustainable dividend yield above the benchmark, and franking credits.”

This leads to some interesting exclusions from the portfolio. As of the latest update on July 30, there was no room for CBA. No Fortescue, Santos or Woodside. And no Woolies, Wesfarmers or Coles. So what did make the portfolio, as of the end of July 2024?

Here is a three stock sampler from the portfolio’s top ten as of then. All three of these shares currently have a Morningstar Star Rating of four stars or higher, a forward dividend yield higher than the ASX200, and have a moat according to our analysts.

For an explanation of terms like Star Rating and Moat, please see the note at the foot of this article.

Bapcor (BAP)

  • Moat rating: Narrow
  • Star rating: ★★★★
  • Share price September 2: $4.89
  • Fair Value estimate: $7.30

Bapcor sells replacement vehicle parts to trade and retail customers. As of July 31, it was the tenth biggest holding in the model portfolio.

Bapcor’s trade segment, which is fronted by the Burson parts business, provides around 80% of group earnings. Its retail brands Autopro and Autobarn have performed poorly over the past year amid cyclical weakness. This – and a prolonged wait to secure a new CEO – has weighed on Bapcor shares, which have fallen to a material discount versus Angus Hewitt’s Fair Value estimate of $7.30.

Hewitt’s Narrow Moat rating for Bapcor is underpinned by scale advantages in its trade parts business. Burson’s large store network allows it to provide a much broader range of parts more quickly and more reliably than smaller peers. As these smaller firms make up an estimated 40% of the Australian market, there could still be plenty of share to take.

More Burson store openings could compound Bapcor’s advantage and spur further earnings growth over the coming years. Hewitt’s forecasts for fiscal 2025 estimate that Bapcor could pay a fully franked dividend of around 18 cents per share. This compares to a 15 cents per share payout in 2024. At a current share price of $4.89, that represents a forward yield of around 3.7%.

Aurizon (AZJ)

  • Moat rating: Narrow
  • Star rating: ★★★★
  • Share price September 2: $3.45
  • Fair Value estimate: $4.50

Aurizon was the model income portfolio's eighth biggest holding as of July 31.

Aurizon operates the Central Queensland Coal Network (CQCN) railway under a lease agreement until 2109. As well as charging coal haulage firms for access to the CQCN, Aurizon also has its own haulage operations transporting coal and other bulk items.

About half of Aurizon’s pre-tax earnings come from charging for access to the CQCN, while another third come from coal haulage. As a result, the outlook for Aurizon's business still depends most on how much metallurgical coal is produced and exported from Australia (and Queensland in particular). Meanwhile, the company’s main strategic focus is on growing its earnings from non-coal segments.

Morningstar’s base case is that Australian met coal exports remain relatively flat over the medium term, even if demand from China and coal prices softens. This stems from the fact that Australia is a low-cost producer thanks to its high quality mines located nearby to ports.

Aurizon’s Narrow Moat rating stems from its leasehold on the impossible to replicate CQCN.
Our Aurizon analyst Adrian Atkins forecasts that Aurizon can pay a 60% franked dividend of around 20 cents per share in fiscal 2025. At a current share price of $3.36, this represents a forward yield of almost 6%. At these levels, the shares trade below Atkins’ Fair Value estimate of $4.50.

Telstra (TLS)

  • Moat rating: Narrow
  • Star rating: ★★★★
  • Share price September 2: $3.93
  • Fair Value estimate: $4.50

Telstra was the model income portfolio's sixth biggest holding as of July 31.

Telstra is a dominant player across every segment of Australia’s telecommunications space. Brian Han’s Narrow Moat rating stems mostly from scale-based cost advantages. Telstra can spread costs such as technology upgrades and marketing over a far larger customer base than competitors.

Han also thinks Telstra benefits from aspects of efficient scale. By this he means that the relatively small, mature and low-growth nature of Australia’s telecoms market makes it less attractive for new entrants to spend billions of dollars replicating Telstra’s infrastructure assets.

The outlook for Telstra’s earnings and dividend rely largely on two factors: continued growth in mobile and cost-control in its declining fixed line business.

Han’s forecast for Telstra’s 2025 financial year includes a fully franked payout of 18 cents per share, which would be unchanged from this year. At a share price of $3.92, that translates to a forward yield of just over 4.5%. Telstra shares trade at a 13% discount to Han’s Fair Value estimate of $4.50 per share.

More articles on income investing:

Get more Morningstar insights in your inbox

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.