£0 in savings? Here’s how I’d turn that into £7,895 a month of passive income Passive income is money earned from minimal daily effort.
And anyone with an income can make it and then turn it into a sizeable investment pot, in my view.
The way I did it initially was to invest around 20% of whatever I earned into shares that paid dividends.
The current median average salary in the UK is £34,963 a year, so after taxes it would leave £28,245. This is around £2,354 a month, so 20% of that is about £471 a month.
Big things have small beginnings Using the UK average salary example, £471 a month could be invested into one of several high-dividend-paying FTSE 100 stocks. British American Tobacco (LSE: BATS), for example, pays a 9.75% dividend currently and is part of my own high-yield portfolio.
Just £471 invested monthly in this stock could produce a £97,129 investment pot after 10 years. This would pay £8,744 a year in dividends, or £729 a month!
This is on two provisos. First, the yield averaged the same (it could be less, or more, as dividend payouts and share prices change).
And second, the dividends paid out are reinvested back into the stock – known as ‘dividend compounding’. This is the same process as leaving interest paid in a bank account to grow over time.
On the same two provisos, this £471 a month over 30 years could grow into £1,026,427. This would pay £94,742 in dividend yield a year, or £7,895 a month!
How to choose the stocks In my case, three factors are key in stock selection.
First, it needs a yield of at least 7% — but the higher the better, provided the stock quality remains good.
Second, its shares should appear to me to be undervalued against their peers, using various financial measurements. British American Tobacco, for instance, is currently trading on the key price-to-earnings (P/E) ratio at just 6.1. This compares to a peer group average of 7.8, so it looks undervalued to me.
Additionally, a discounted cash flow analysis shows the stock to be around 55% undervalued at its present price of £23.70. Therefore, a fair value would be around £52.67, but this does not necessarily mean it will ever reach that level. The third key factor in my stock selection is how the core business looks. In British American Tobacco’s case, it is transitioning away from tobacco products and towards non-combustible nicotine products, such as vapes.
So far, this appears to be going well. Its 2023 results showed adjusted profit from operations rose 3.1% in 2023 from 2022 – to £12.47bn. Analysts’ expectations are that its earnings and EPS will rise respectively by 71% and 65.1% a year to end-2026.
There are risks for me to monitor, of course. One is that its business transition is delayed for some reason. Another is any litigation from the effects of its products in the past.
This said, over time everyone will develop their own methodology for choosing stocks that are right for their investment portfolio.
Ultimately, though, good choices, regular investment and dividend compounding are all that are required to make significant passive income over time, in my experience.
BlackRock Energy & Resources Inc Trust PLC ex-dividend payment date BlackRock Sustainable American Income Trust PLC ex-dividend payment date Value & Indexed Property Income Trust PLC ex-dividend payment date
Why the UK small-cap sector is ready to shake off its shackles after a tough few years…
Jo Groves
Updated 20 Mar 2024
Disclaimer
Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by BlackRock Smaller Companies. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Legendary investor Warren Buffett shared these pearls of wisdom for investors: “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” It would be fair to say that UK equity funds have been languishing in the unpopular category for some time, having suffered a consecutive 32 months of net outflows as investors gravitated to the glitz of the magnificent seven.
However, the variation in investor appetite extends beyond a simple UK-US divide, with an additional divergence in the fortunes of small and large-cap stocks over the past few years. Fears of ‘higher for longer’ interest rates have weighed on small-cap valuations across the board, with a torpid domestic economy further adding to the woes of UK equities.
However, with macroeconomic issues beginning to ease, contrarian investors may see current valuations as a highly attractive opportunity to position their portfolio for a potential recovery in UK small-caps.
A track record of outperformance
Despite the current downturn, small-caps have outperformed their larger-cap counterparts over the long term. The stellar returns from the US mega-caps may have dominated the financial press of late but the chart below shows that investors would have made higher returns from the (UK-based) Numis Smaller Companies Index over the last 25 years than the S&P 500.
RETURNS BY INDEX
Source: FEAnalytics (as at 17/03/2024)
There are several reasons behind this outperformance: UK small-caps can offer superior earnings growth, the sector boasts a broad investable universe and limited analyst coverage can lead to pricing inefficiencies. Many UK small-caps also derive a significant proportion of revenue from overseas, making them less dependent on the domestic economy, coupled with robust balance sheets to weather an economic downturn.
In addition, UK small-caps have historically performed particularly well after a period of under-performance, and the current downturn has been longer and deeper than the stock market crashes of the Global Financial Crisis and bursting of the dot.com bubble. A recent note by my colleague showed that, since 1955, every time the Numis Smaller Companies Index had a negative (calendar) year, it has been followed by positive returns for the following three years, with an average return of 84%.
As a consequence, investors will be focusing on the catalysts needed to precipitate the long-awaited recovery in the sector. One such catalyst could be a narrowing of the disconnect between investor sentiment and company fundamentals. Roland Arnold, portfolio manager of BlackRock Smaller Companies (BRSC), remarked in a recent note: “Many smaller companies have enhanced their competitive position, strengthened their balance sheets and continued to generate volume growth in sales, but this has not been reflected in share prices.”
Another tailwind could be the green shoots of an improving macroeconomic environment for the year ahead. The risk of recession has been baked into UK equities for some time and it was notable that the major UK indices rose on recent news of the UK entering a recession. Looking ahead, the OECD currently forecasts that the UK will have the fourth-highest GDP growth amongst the G7 economies in 2024, above the average for the Eurozone, France and Germany.
Attractive valuations
Small-caps valuations tend to be hit harder than large-caps during periods of rising interest rates and elevated volatility. The steep base rate hikes in the UK have taken their toll on the valuations of higher-growth companies, with investors seeking sanctuary in lower-risk assets.
This has proved a double whammy for the UK small-cap sector, which is currently trading at a steep discount to both large-caps and its global peers. As shown in the chart below, the MSCI UK Small-Cap Index is trading at a discount of 70% and 44% to the MSCI USA and World Small-Cap indices respectively.
While investors may have been eschewing the attractive valuations on offer in the listed market, UK public and private companies have been firmly on the menu for strategic buyers over the last five years. There were more than 3,600 M&A transactions in 2023, according to PwC, with strong interest from overseas buyers helped by the strength of the US dollar against the pound.. One such example in the listed market is the £410 million acquisition of UK-based investment bank Numis, a BRSC portfolio company, by Deutsche Bank in 2023.
Private equity firms are also sitting on a record $3 trillion of dry powder and bids for portfolio companies by financial buyers have boosted returns for BRSC. The trust’s latest target was Ten Entertainment, a UK bowling alley operator, with US private equity firm Trive Capital paying £287 million for the company, a 33% premium (to the closing share price prior to the announcement). On a similar note, UK private equity firm Inflexion paid £434 million to acquire a 40% stake in BRSC portfolio company GlobalData to fund organic growth and further acquisitions.
Dividend hero status
The dividend stream offered by many of the FTSE 100 large-caps is widely appreciated, but this quality is often overlooked for smaller-cap companies. The MSCI UK Small-Cap Index offers a yield of 3.6%, comfortably above the 2.1% average yield for its global equivalent and not far below the 4.2% yield for the UK large-cap index (as at 29/02/2024).
BRSC is a newly-minted ‘dividend hero’, an accolade given by the AIC to investment trusts that have consistently increased their dividends for 20 consecutive years. Roland seeks companies with strong cashflow generation, rather than the highest-yielding options, but the current yield of 3% (as at 15/03/2024) can diversify returns beyond capital growth alone and the dividend is typically fully-covered.
Investing in UK smaller companies can be higher-risk than their larger-cap peers, however, an improving economic outlook and hoped-for interest rate cuts could prompt a re-rating of the sector. If this is the case, BRSC’s focus on market-leading companies with strong balance sheets should position it to benefit from a recovery in the UK small-cap sector.
GABI wind-up, SMT’s £1 billion buyback, Henderson trust mergers, and the latest dividend updates. Frank Buhagiar delivers the latest insights in The Corporate Box.
The Corporate Box GABI wind-up, SMT’s £1 billion buyback, Henderson trust mergers, and the latest dividend updates. Frank Buhagiar delivers the latest insights in The Corporate Box!
GCP Asset Backed Income winding itself up GCP Asset Backed Income(GABI) becomes the latest sub-scale fund to call it a day. After engaging extensively with its shareholders “…the Board has reached the conclusion that shareholder value will be best served by a proposed orderly realisation and return of capital…Shareholders will be given the opportunity to vote on a discontinuation of the Company at the Company’s annual general meeting on 15 May 2024.” – GABI announcement 14 March 2024.
Scottish Mortgage sets aside £1 billion for buybacks Scottish Mortgage (SMT) gets the “bazooka” out in an effort to blow away the discount cobwebs once and for all. “Scottish Mortgage’s public and private portfolio is delivering strong operational results, evidenced in part by free cashflow from the portfolio companies having more than doubled over the past year. Collectively, portfolio companies have adapted to a higher cost of capital and are funding their future growth. Against this backdrop and having further strengthened the Company’s balance sheet, the Board now intends to take more concerted action to address the discount to net asset value at which the Company’s shares continue to trade.” SMT announcement 15 March 2024.
The brokers seem impressed:
Jefferies: “This is the largest ever investment trust share buyback programme in absolute terms, representing 9% of SMT’s shares at the current price.”
Winterflood: “Reminiscent of Mario Draghi’s ‘Bazooka’ moment at the ECB, the SMT Board has decided on a bold move, aiming to jolt the market into a correction.”
JPMorgan: “This is a bold announcement from SMT’s Board, and represents a material step up from the previous level of buybacks, though SMT had been constrained in the past by both its level of gearing and the relatively high percentage in private holdings (which are restricted by shareholders to 30% of total assets).”
Henderson European Focus and Henderson EuroTrust to tie the knot Henderson European Focus (HEFT) and Henderson EuroTrust (HNE), the latest additions to the growing list of mergers in London’s investment company space. The proposed merger “…will be subject to approval by both HEFT and HNE shareholders and are expected to result in the Combined Trust having net assets of circa £750 million (based on valuations as at 29 February 2024). The Combined Trust is also expected to be eligible for inclusion in the FTSE 250 Index. Shareholders representing 35.4% and 37.6% of the respective issued share capital of HEFT and HNE have indicated their intention to vote in favour of the recommended Proposals.” HEFT announcement 14 March 2024.
Winterflood thinks the merger makes sense: “This proposed merger represents a continuation on the theme of consolidation within the investment trust sector over recent years, and it is the latest of a number of mergers between investment trusts in the same management group stable. In our view, this transaction makes a lot of sense, given the commonality of investment strategy and management group.”
Dividend Watch Schroder Asian Total Return (ATR) plans to increase its final dividend of the year by 4.5%. “The Board has recommended a final dividend of 11.50p per share for the year ended 31 December 2023, an increase of 4.5% over the final dividend of 11.00p per share paid in respect of the previous financial year.” ATR’s Final Results.
Foresight Solar Fund (FSFL) is targeting an above inflation rise for its 2024 dividend: “Our operational strength, the powerhouse behind our progressive dividend, enabled us to comfortably meet our dividend target of 7.55p per share for 2023 and allows us to propose an above inflation increase of 6.0% for the 2024 target dividend of 8.0p per share.” FSFL Annual Results.
Passive income is the perfect way to continue receiving an income after retirement. My pension will only stretch so far, so if I want to retire early, I’ll need something extra.
I think the best way to do this is with a portfolio of shares that pay dividends.
How dividends work
A dividend is like a small gift that companies pay their shareholders every year as a thank-you for investing in them. A 5% dividend yield on a £1 share would pay me 5p for each share I hold. This is in addition to any returns made if the share price increases.
Once the passive income stream has been established, I can begin withdrawing my returns as needed.
Dividend yields change regularly, so it’s impossible to know how much I’ll receive each year. But with a portfolio of well-selected stocks, I can aim for a conservative average of around 5%.
How my strategy could work
I’ll use the small-cap iron casting and machinery firm Castings as an example.
Its 5% dividend yield is lower than many other UK stocks but it has an excellent track record of making regular payments. I’d aim for a good mix of reliable low-yield dividend shares and less reliable high-yield shares.
Furthermore, it’s currently estimated to be trading at 58% dividend yieldso could go up from here. I don’t want to dive into an overvalued dividend stock that could lose value and negate any returns I make from dividends.
On the downside, Castings earnings are forecast to grow at only 3.1%, slower than the UK average of 12.6%. Still, the dividend payments make it worthwhile.
I’ve calculated that I could reach my goal of £1,000 a month in passive income in 20 years with the following strategy.
My outcome is based on a 5% dividend yield with semi-annual payments and an expected 0.2% annual dividend increase. I’ve also calculated an expected 6% annual share price increase. This is based on the past performance of an average basket of well-performing FTSE stocks.
First, I’d invest £12,000 into a portfolio of shares similar to Castings
I’d use a dividend reinvestment plan (DRIP) to put any dividends earned back into the investment
I’d contribute an additional £200 a month to the investment
Risks
There are risks involved with such a strategy. I can’t guarantee the dividend payments will be consistent, or remain at 5%. The share price of any stocks I include could also fall, resulting in financial losses.
For this reason, I need to carefully research all the stocks I add to my portfolio. I should ensure they have a solid history of growth potential and a track record of making reliable dividend payments.
The post How I plan to retire early with £1,000 a month of passive income appeared first on The Motley Fool UK
There’s no better way of creating wealth, in my opinion, than investing in the stock market. It’s why I use the majority of my extra cash each month to buy FTSE 100 or FTSE 250 shares in my ISA.
Forget cash accounts: they’re safe, but historically speaking, the yields on these products are far too low. Property investment provides a regular stream of passive income, but start-up costs are huge. And cryptocurrencies — while on a stunning run of form right now — are far too volatile.
Over the long term, FTSE-listed shares have delivered on average an 8% annual return. But I think I could do better. Here’s how I could turn a £10,000 lump sum investment into a £43,429 passive income.
ETFs vs stocks Don’t get me wrong: spending my cash in an index tracker fund returning 8% (through both dividends and share price rises) isn’t a bad idea. In fact, FTSE 100-tracking exchange-traded funds (ETFs) are some of the most popular investment vehicles out there. Products like the iShares Core FTSE 100 UCITS ETF allow investors to reduce risk by spreading their capital across all the companies on the index. Management fees are also pretty low (on this one the ongoing charge stands at just 0.09%).
On the downside, owning one of these ETFs means I would also have exposure to shares with histories of delivering disappointing returns. If I hand-pick individual companies I want to own instead, I have a chance of earning an annual return above that average.
A £43,429 income Let’s say I choose to buy a Footsie share with a dividend yield alone of 6%. This is about 2% higher than the average long-term yield on the index’s stocks.
If dividend forecasts hit their mark — and capital gains come in at the index’s historical average of 4% — a £10,000 investment would turn into £326,387 after 30 years, assuming that I reinvest dividends. That compares with the £162,926 I could have made with that ETF.
And if I then drew down 4% of this £326,387 a year, I would have an annual passive income of £13,055.
I could make an even-larger return with a regular cash investment as well. With an extra £200 invested in more FTSE 100 shares each month, I could eventually enjoy a yearly income of £43,429.
Famous billionaire investor Warren Buffett seems happy to keep working. Well into his nineties, he continues to lead the company Berkshire Hathaway
Despite that, Buffett said for those not wanting to work decade after decade, it is important to learn how to make money while you sleep.
What does that mean in practice – and how could it help me boost my own passive income streams?
Penny after penny
Consider as an example the consumer goods company Unilever (LSE: ULVR). It sells everyday products like shampoo and soap. In some markets, it retails them in single-use sachets for pennies apiece.
Selling a commonplace product for pennies might not sound like the stuff of fortune. But the pennies soon add up. Unilever products are used several billion times a day around the world. Thanks to its brands and unique formulations, it can charge a price premium even for mundane consumer goods.
That allows the company to earn billions of pounds in profits annually — and fund a quarterly dividend to its shareholders.
So by buying even just a single share in Unilever, I could hopefully start to earn a passive income (albeit a very modest one with a single share) in the form of dividends.
While I sleep and people from Australia to Zimbabwe wash their hair, profits would hopefully be piling up at Unilever that could help fund the dividend.
Buffett knows how to earn!
That is not lost on Buffett. Indeed, a few years back he tried to buy all of Unilever.
He did not succeed. Today I could buy shares in the consumer goods giant for a similar price to what the ‘Sage of Omaha’ was offering.
But while his attempt to take over Unilever failed, Buffett owns stakes in lots of other dividend-paying companies whose products are in daily use around the globe, such as Apple and Coca-Cola.
Buffett’s investment in Apple has been incredibly successful in under a decade. But he is a smart enough investor to know that business can be unpredictable.
So Buffett keeps his portfolio diversified across a range of different shares. I think that is an important risk management principle to apply even with a small portfolio too.
Keeping it simple
As a passive income plan, that sounds simple. I believe it is. By sticking to what Buffett terms ‘my own circle of competence’, I can find companies I think have good business models that can help support dividends.
If I can buy shares in them when they sell at an attractive price, I will hopefully start to build long-term passive income streams and make money while I sleep!
