I invest in a Stocks and Shares ISA to generate long-term passive income. I want money to regularly drop into my account, without having to lift a finger to earn it. Well, other than the work I put into picking my shares. Here’s how I do it.
I could just buy shares offering the biggest dividend yields, then sit back and let the cash roll in. But there are pitfalls with that idea.
Companies often pay big dividends some years, and much smaller dividends other years. It’s down to how well the business performs year by year. And there’s no guarantee that a big payment one year will be followed by anything at all the next year.
Admiral Group is among the top 10 FTSE 100 dividend forecasts for 2022. But the company has previously cut its dividend four times in the past decade. A high dividend is one positive factor, but there’s more at play.
Listen and learn
Here at The Motley Fool, we firmly believe that listening to a variety of investors’ opinions can help us make better decisions. So why not look for the most popular dividend shares and go for those?
That can help us narrow down our search. But it can also go wrong. Vodafone prioritised its dividend payments for many years, and that made it a big favourite among passive income investors.
But it couldn’t afford it, and slashed the dividend by 40% in 2019. Vodafone carries enormous debt, and the dividends were not covered by earnings. If a company is not earning enough to cover its dividend, it’s sustainability is questionable.
Progressive dividends
I want to see sufficient earnings to pay for dividends, with a decent excess. How much cover is enough? It depends on the business. But anything above 1.5 times, typically, will inspire me to investigate further.
I also look for a good track record of dividend raises. That’s why I have City of London Investment Trust in my portfolio. The yield is around 5%, so not the biggest available. But the trust has lifted it every year for the past 55 years.
A reliable progressive dividend can be worth a lot more in the long term than a one-off super high yield.
Total returns
Should we ignore stocks that pay no dividends? Warren Buffett seeks companies with long histories of generating surplus cash to hand back to shareholders. And he buys them for his Berkshire Hathaway investment company.
Since Buffett took the helm in 1965, Berkshire has generated average annual returns of 20% per year. But it has never paid a penny in dividends. Instead, it reinvests all the cash.
That’s a return that could boost my wealth considerably. And it’s relative easy to convert it to passive income. All I’d need to do is sell a few shares every now and then. Above all, I want high-quality companies with superior total returns.
Reducing risk
Of course, there is no guarantee of sustainable income from any company, no matter how carefully chosen. And some big favourites from the past have ended up as major flops. But I reckon my approach, including some careful diversification across sectors, should minimise my risk.