To generate robust passive income in the stock market, investors must focus on finding high-quality enterprises with stable cash flows and good long-term dividend growth prospects.
And thanks to ongoing economic uncertainty, the few that match this description are trading at tasty discounts.
Apart from securing a bargain price, buying into depressed valuations also enables investors to lock in much higher yields. And that’s why I’ve been incrementally increasing my position in XP Power (LSE:XPP).
Shares of the electronic components expert have been hammered from all sides lately, from legal battles to supply chain disruptions.
But while this series of developments has been frustrating, the underlying business remains fundamentally sound. And with a solid track record of raising shareholder payouts, a buying opportunity seems to have once again emerged for my income portfolio.
A thriving electronics enterprise
While it hasn’t been a straight line, courtesy of the pandemic, XP Power has grown its shareholder dividends by an average of 6.5% each year. While today’s yield of 4.5% is far from the largest on the London Stock Exchange, this payout level could grow substantially in the long run. Even more so considering the trend in demand for the group’s products.
As a quick reminder, XP Power designs electronic components that power industrial machinery, medical equipment, and even semiconductor manufacturing machines. With the electrification of the world accelerating, the group isn’t having much difficulty attracting new customers.
Looking at its latest interim results, sales climbed 30% and gross margins expanded by 160 basis points to 41.8%. Meanwhile, operating profits bounced back from last year’s legal fees, jumping from a loss of £45.2m to a gain of £17.3m.
Building that dividend income
With the dividend per share at 94p, investors would need to buy roughly 1,277 shares to generate a £1,200 annual passive income. But with the current share price around 2,250p, that’s not a cheap transaction. In fact, investors would need to inject approximately £28,730 of capital into this business.
However, it’s possible to build up to this amount over time and take advantage compounding to accelerate the process. If I instead invest £100 each month into this company and reinvest all the dividends received, I could hit the £28,000 threshold within 16 years.
Providing the group continues to maintain its average dividend expansion rate, this process could be significantly faster. Not to mention the boost from potential share price appreciation. In other words, it may take considerably less time to hit this goal, at which point I can cash out the dividends instead of reinvesting them.
However, as easy as this sounds, there are some caveats to consider. While XP Power looks like a solid enterprise today, it still has its weak spots.
The firm’s balance sheet debt is already incurring significantly higher interest costs following the recent rate hikes. And while operating cash flow can still cover these expenses today, net profit margins are still being squeezed.
As such, future dividend growth is far from guaranteed. And in the worst-case scenario, shareholder payouts may end up getting cut, sending the stock price firmly in the wrong direction.
All of this is to say investing carries risk. But in the case of XP Power, I believe this risk is worth taking, given the potential reward.
