A Stocks and Shares ISA can be a useful tool when trying to generate passive income over the long term. It also offers the potential for capital gain, although loss is also a possibility. Indeed, that underlines the importance of investing one’s ISA smartly.
With current valuations and dividend yields in the London stock market, I think I could realistically aim to invest a £20K ISA today with the objective of earning back half my investment within five years in the form of dividends.
I would still own the shares I spent the money on. Hopefully, they could be worth more than I paid for them five years from now.
Looking for long-term value
How would I go about this practically?
I would be looking for companies I thought could produce sizeable dividends in the years to come but might also see share price growth.
That might sound like a tall order. After all, if a business has the sort of competitive advantage that could help it generate enough profits to pay big dividends, would its shares be trading cheaply?
Perhaps surprisingly, in some cases I think the answer is yes.
Looking at today’s London market, I see examples of what I think are cheap shares, relative to their long-term prospects.
Legal & General trades on a price-to-earnings (P/E) ratio of 6, for example, but yields over 8%. It has a strong brand, large customer base and operates in a market I expect to see resilient demand.
Still, I always diversify my Stocks and Shares ISA to reduce my risk if one of my investment choices turns out to disappoint.
Other shares in what I see as quality businesses have low P/E ratios and yields similar to Legal & General right now. An example is British American Tobacco, yielding close to 9%. With £20,000, I would diversify by splitting my money evenly across five to 10 blue-chip shares.
But if my target is £10,000 of dividends over five years, would 8% or 9% yields be enough? After all, that could be £2,000 of dividends annually. That might sound like I would need to earn a 10% annual dividend yield on my initial £20K investment.
In fact, this is where compounding my dividends would help.
If I earned an average yield of 8.5% and compounded my dividends annually, after five years my Stocks and Shares ISA would have generated £10,000 in dividends.
Capital growth potential
But what about my capital? Could it also have grown – or might it have shrunk?
After all, Legal & General shares are down 12% over the past five years. In that period, British American Tobacco shares have fallen 38%.
Past performance is not necessarily a guide to what will happen in future. I think the business prospects for quite a few high-quality FTSE 100 businesses (including those two) are not accurately reflected in their current valuations.
So, by investing my Stocks and Shares ISA in the current market, I could try and set myself up to earn substantial dividends in coming years – and also hopefully see some capital growth.