High yielding dividend stocks can seem like a dream come true for those seeking passive income. Buy stock, let the dividends roll in, then reinvest those dividends into more stock. A process known as compounding. That’s all well and good as a strategy but what about the sustainability of the dividends, what about the quality of the company providing those dividends, what about dividend growth and cover? In this article, I’ll be looking at what I think (and it’s just my opinion not advice) makes for a solid passive income generating dividend stock. A clue upfront: it’s not just about yield.
Finding dividend growth shares
There seems to be little point in focusing just on high yielding shares because the risk of a dividend cut is often too high. Finding high quality shares with dividend growth potential is very likely a better way to fuel a sustainable, growing passive income from investing in dividend shares. Especially for any investor with a long term mindset.
Consistent dividend growth can almost certainly enhance returns and reduces the reliance on capital growth, but it does require patience and the character to ride out the ups and downs that are an inevitable part of investing.
There’s nothing wrong with high yields per se, if you can be confident the company can keep paying the dividend. To try and get a grip of this, it’s likely best to look at whether free cash flow per share is covering the dividend, as well as earnings.
Investing in UK shares with resilient business models
As an investor, you are a part owner of a business. Therefore, alongside dividend growth, it’s often best to invest in businesses that will stand the test of time and has proven resilience in how it operates. This can mean investing in more mature businesses with a capability to reinvent themselves, or operating in an industry that always has demand and isn’t particularly dynamic. Though it doesn’t have to mean that though. Some younger companies could also fit the bill and companies in industries prone to disruption could still do well.
There’s no secret or shortcut here. As the saying goes: there’s more than one way to skin a cat. That certainly applies to investing. The key as always is to do research. Understand the business and the market it operates in.
As an investor you want to be able to assure yourself that the business has resilience. This could come from the positive direction of the industry, large management shareholdings in the company, solid fundamentals. Increased resilience could even come about in a turnaround situation under new management. With greater resilience comes a greater ability to pay a dividend through thick and thin. When it comes to passive income, this ability to keep paying a dividend seems a high priority. Businesses that are inherently weak won’t be able to sustain a dividend.
The key to compounding is to reinvest dividend. Evidence shows that dividends that are ploughed back into buying more shares create a virtuous circle and drive wealth creation far and above what can be achieved if dividends are taken as income. Obviously not everyone is able to invest without taking dividends for income. That’s fine. But reinvesting dividends when possible, has huge benefits.
This article from Brewin Dolphin illustrates the difference. It says that if an investor had invested £5,000 in the FTSE 100 index of leading UK shares back in 1985, that £5,000 would have grown to £27,211 by 2017. However, if they had reinvested the dividend payments in to the FTSE 100, the original £5,000 would have grown to £91,458 – more than three times as much.
With the former, the investment would have grown 444%. However, by reinvesting the dividends, the investment would have grown 1,729% overall.
David Hood, a senior investment analyst at Brewin Dolphin, says: “The long-term rewards from reinvesting dividends can be very significant. Reinvestment is certainly worth considering if investors don’t need their dividend income at the moment – and it’s straightforward to do with many investment funds.”
In another example, looking at the Standard & Poor’s 500, a £10,000 investment made 30 years ago in this leading stock market index would now be worth more than £138,700 in share price terms.
But if dividends had been automatically reinvested, its current value soars to just over £256,000.
Jason Hollands, a director of wealth manager Tilney says ‘If you don’t need to draw the income from your investments, then reinvesting dividends is a very sound move. In fact, over the long term, it can reinvigorate returns.’
What makes for a good passive income share then
Hopefully the above provides plenty of pointers towards what to look for when it comes to finding good passive income shares. While the yield is a consideration, it’s about much more than just the headline dividend yield. Dividend growth, dividend cover and investing in resilient companies with proven business models are important considerations as well I think. Then, if possible, reinvesting dividends rather than taking out the dividends as income is a good way to grow the stream of passive income for future years.
Example shares for a passive income
From a yield perspective, FTSE 100 insurer and asset manager Legal & General seems like a solid passive income dividend stock. The dividend was maintained through the pandemic showing the resilience of the business model and also the commitment of the management to the shareholder payout. While the dividend cover is below two, with decent EPS growth, the dividend doesn’t appear to be in danger of being cut. Historical dividend growth has been pretty modest but consistent.
Another share that has passive income properties is packaging manufacturer and distributor MacFarlane. It has dividend cover above three and while there was a blip in dividend growth in 2019, but most years it’s pretty steady. Overall, I think the company looks pretty good.
Other potential income generating shares
On Stockopedia I screened for UK shares with passive income potential. I wanted to find those with more than nine years of continuous dividend payments, a three year dividend CAGR of 15% or more, dividend cover of more than two and finally a dividend payout ratio of less than 50%.
There were 11 results from this screen, which was done on the 7th October 2021. They were:
- Intermediate Capital Group
- Games Workshop
- GB Group
- Advanced Medical Solutions
- Judges Scientific
- Ocean Wilsons Holdings
- Hargreaves Services
- Gulf Investment Fund (also came up in my previous article)
- Best of the Best (also came up in my prev article)
So eight of these shares have market capitalisations below £1bn, which may not be surprising given the criteria of a low(ish) payout ratio and fairly high dividend growth. The list above is by market cap in descending order.
From my perspective this is an interesting list of companies, all of which, with the exception of the Gulf Investment Fund, I was already aware of. I’ll be digging deeper in my own research into Hargreaves Services which I’ve read Simon Thompson covering before. Tandem also interests me. I’ve previously held Intermediate Capital Group and wouldn’t be against owning the shares again.
I hope this article has been helpful and highlighted some passive income shares that may be worth investigating further. As always please please please do you own research as nothing in this article is advice. I also do hope that the article provided some food for thought when it comes to how to identify passive income shares that can grow sustainably into the future.
The author owns shares in Legal & General at the time of writing.
You can also read the previous article on five ways to find great dividend shares.
I have also previously written about some of the key questions to ask when it comes to investing with passive income in mind. These questions can be found in this article.
In October 2020 I put together an example income portfolio.
If you have any questions or comments please do get in touch. It’s great to hear from readers.