Passive income, or money one receives without working for it, has obvious appeal. Rather than having to work for every pound, at least some of one’s income arrives by cheque or bank deposit without having to lift a finger. A lot of passive income ideas seem a bit far-fetched to me. Instead, I prefer the simple option of putting a bit of money away regularly in a Stocks and Shares ISA then investing it in dividend-paying shares.
Here’s how I would start to build a passive income stream by putting aside £50 a week.
Set an income target
If someone starts a new job, they usually have an idea of what sort of salary they want. It can be useful to apply the same sort of discipline to passive income. Deciding what sort of income one wants can inform your investing strategy.
Some companies pay fairly low dividends but have a long record of dividend increases. For example, Spirax-Sarco yields just under 1%, which isn’t attractive to me as an income hunter. What is attractive, however, is that the company has increased its dividend annually for over half a century. That doesn’t mean it will keep doing so, but it is an encouraging sign that the company is committed to dividends.
Energy group DCC doesn’t have Spirax-Sarco’s half century of raising dividends, but it has nonetheless raised payouts annually for over a quarter of a century. At 2.5%, its yield is more attractive than Spirax-Sarco’s. I think both companies are well-run and have attractive business models, so would hope for future income from either.
By contrast, a higher income target might lead one to higher-yielding passive income ideas. British American Tobacco yields almost 8%, for example. But its core market of smokers has an uncertain future, and it wouldn’t appeal to all investors. Similarly, Evraz yields 11%. But it is in the cyclical mining industry, which makes me wonder whether it will pay out at such a rate in future.
Sometimes, higher-yielding shares pay out big dividends for a reason: they have limited new opportunities in which to invest excess cash, for example. Sometimes a high dividend is a signal the market expects lower returns in future. But the market isn’t always right. So, if one’s target income is high, it can be worth looking among the higher-yielding shares to see if any seem more likely to continue offering passive income at the right level.
Two passive income ideas I’d buy
I think British American Tobacco is such a share. Its 7% yield reflects investor concern about the future of the tobacco market. In developed countries, fewer people are smoking and that could hurt revenues. However, smokers are willing to pay a lot for cigarettes. That gives the company pricing power. With its portfolio of strong brands, long experience, and agreeable yield, British American Tobacco is one of the passive income ideas I’d tuck into my portfolio.
I would also pick Legal & General. The well-known insurer’s shares yield just under 7%, which is still an attractive income stream for me. While the financial market can be volatile, Legal & General’s strong brand should help build customer loyalty. It’s another of the passive income ideas I’d pick to sit back and start earning.