An ISA can be a vehicle to generate long-term capital return. But a lot of investors also like using their ISA to generate income by investing in dividend shares. With £20,000 in a Stocks and Shares ISA, I reckon I could generate annual income in excess of £1,000 starting in year one. Here’s how I would go about it.
Getting clear on investment objectives
First I would really try to clarify what I wanted to achieve with my ISA. Growth and income could both be attractive for me, depending on my financial situation and time horizon. If I decided just to focus on income, that would impact my investment choices. For example, some mature industries have little use in the business for the cash they generate. So they pay it out as dividends. While that could be good for dividend yield, it may mean such companies have limited growth prospects.
If I wanted to target income, though, I’d be okay with that. I could choose shares based primarily on their income potential. If there was any capital growth in the share price in future, that would be a bonus.
Balancing the ISA
I’d also decide how best to manage my risk. After all, share prices can go down as well as up. £20,000 is a sufficient sum of money to enable me to invest across a diverse set of companies and areas of business. That could help reduce my risk, if any one of my choices ran into difficulties down the line.
I’d use the £20,000 to buy £2,000 of shares in each of 10 companies. I’d also limit myself to a maximum of two companies in any given business sector so I didn’t concentrate my risk too heavily.
Tobacco shares
Tobacco is the sort of mature industry with limited growth prospects I described above. While companies are trying to woo smokers with new forms of consuming tobacco, it’s hard to imagine that tobacco consumption per capita will increase in future in most markets. There may be room for individual companies to grow, though, by consolidating, building market share, and using pricing power to boost revenues and profitability.
A couple of London-listed tobacco companies I hold in my ISA are British American Tobacco and Imperial Brands. They yield 8.3% and 8.7% respectively, so investing £2,000 in each would give me a prospective annual dividend income of approximately £340.
Both firms continue to rely heavily on cigarettes for profits, even while pushing into other areas. So there is a clear risk that declining cigarette sales in many markets could hurt revenues and profits. But from an income perspective, I am attracted to the large cash flows at these two companies.
Financial services
I’d also add a couple of financial services choices to my ISA.
I like Legal & General, with its 6.1% yield. The company operates in a range of financial fields, including insurance and investment management. Those can have unpredictable returns, due to shifts in market pricing and changes in customer demand. But over the course of years, I expect Legal & General to be able to use its large customer base and popular brand to continue to drive revenue and profit growth.
I’d also go for insurance rival Direct Line. Its yield of 8.1% actually worries me a little. Such a high yield can raise a red flag for me as to whether it is sustainable. But I reckon Direct Line can benefit from a number of factors, including an iconic brand and cross-selling opportunities to its customers. One risk to profits the company recently flagged is the rising price of second-hand vehicles, which could push up its cost to settle claims.
Natural resources
Next I’d go for two energy picks. I like the US energy majors Exxon and Chevron, which yield 5.5% and 4.7% respectively. I think their large holdings and deep experience should help both companies prosper and navigate changing patterns in energy demand and consumption. Right now I like them more than UK rivals such as Shell, which I think is making its business model less attractive due to its exaggerated focus on less profitable non-carbon fuel sources. But I would have some exchange risk as the shares are traded in New York. If the pound-dollar exchange rate move unfavourably, my dividends would be worth less even if the company continued to perform well.
Utilities
Income investors often like utilities such as energy networks and water companies. They are perceived to have fairly stable, predictable revenues. That is often reflected in fairly steady dividends.
That isn’t always the case, though. Changes in the regulatory environment or customer demand patterns can mean unexpected costs eat into profit. That is a risk at energy network operator National Grid. Delivering electricity to meet changed consumption patterns as people work from home could push up capital expenditure. But I still like the company’s 5% yield and its large competitive advantage of owning networks rivals would struggle to replicate.
I’d also put £2,000 into United Utilities. The water company has a large water business in the northwest of England that I reckon could be lucrative for decades to come. I’d be happy to buy it for its yield, which currently sits at 4.0%. Aging infrastructure could lead to maintenance costs increasing over time, which risks lower profits.
Unit trusts
Finally, I’d put £2,000 into each of a couple of unit trusts, which are collective investment vehicles exposed to a range of companies.
One is Income & Growth. It invests in early stage companies and has had considerable success in some cases. Dividends and capital gains in its stakes have helped the trust establish a good record of dividends. So far this year, the interim dividend alone equates to a 5.5% yield. That could go higher if a final dividend is declared, but it isn’t always. One risk is that inconsistent income from its holdings means the dividend can move about dramatically, down as well as up.
Finally I’d put £2,000 into F&C, the former Foreign & Colonial. While its dividend yield of 1.3% is the lowest of the 10 shares I’ve chosen, I reckon its broad global exposure makes it a decent proxy for the wider market. So I expect it could help me earn passive income in my ISA for a long time to come. One risk is that the company’s stock picks don’t keep up with wider trends in which case it could underperform the broader market.