How I’d invest £5,000 in dividend shares to target £500 in annual income

Our writer explains how he would aim to generate £500 of passive income annually by investing £5,000 into three UK dividend shares.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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If I wanted to boost my passive income, I could try to do it by buying dividend shares. With a lump sum of £5,000, I reckon I could set up substantial passive income streams. In fact, I would aim for £500 a year in income.

Given the ambitious target, there are risks involved. Let me explain my approach.

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Three high yielders

I would split the money evenly between three dividend paying shares that have high yields. Those shares are Diversified Energy, yielding 11.1%, Persimmon, offering 10%, and Income and Growth Venture Capital Trust, on 9.6%.

That would give me an annual passive income of around £511 if things go according to plan. I have some diversification here as the companies operate in very different business areas.

Risks with high yield shares

High yields are often accompanied by investor worries that a share may face significant risks that could see its dividends cut. Is that true here?

Diversified Energy basically sells natural gas and oil. Moves in energy prices can boost its revenues and profits. But they could also hurt them, depending on which direction prices move. While energy prices are currently strong, the market is cyclical so at some point in future they are bound to fall.

Persimmon’s dividend – which is often only narrowly covered by earnings – could suffer if the UK housing market falls. That is where Persimmon makes its profits that fund the dividend. Like energy pricing, I see housing as cyclical. At some point I expect that Persimmon may struggle to maintain its current dividend if housing prices fall a lot. That could happen tomorrow — but on other hand, the market may remain robust for years to come.

Income and Growth is less exposed to cyclical forces in my view, as it invests in a wide range of early stage businesses. Its ability to pay dividends relies on it continuing to extract more money from its investments than it puts in. As a market awash with capital pushes up prices, that could become harder to do.

Why I would consider these dividend shares

Despite the risks, I see considerable opportunity here. All three companies have proven their willingness to pay substantial dividends. I think they each have proven business models that can be highly lucrative. Although that may only be the case when conditions are favourable in their respective markets, the same could be said of most businesses.

Diversified operates 67,000 gas wells in a geographically concentrated area. That unique asset base gives it a competitive advantage. Persimmon has strong profit margins and demand for new housing in the UK remains robust. Income and Growth has demonstrated its ability to identify promising investments. For example its largest holding — almost £13m in Virgin Wines — cost it only £65,000. 

Even if a downturn did lead to the dividend being slashed in future at one of the companies, each would probably still have an asset base that could continue to deliver value in the future. So a market downturn might spell a dividend cut, but they could return in future. Persimmon, for example, previously stopped paying dividends in 2013 but restarted them in 2016. Income and Growth’s net asset value exceeds its current share price.

Fully recognising the risks, I would still consider spreading £5,000 evenly across these three dividend shares in my portfolio to target annual passive income of £500.

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Christopher Ruane owns shares in Diversified Energy. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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