The UK stock market has beaten other forms of investment for more than a century. And shares that pay dividends are my top choice for earning passive income.
How can I decide which to buy?
I’ve looked around to see what the experts think. And there are some common themes. Here’s my pick of their top tips.
1: Don’t just go for big yields
Seeking the biggest yields might not be the best approach. There are reasons why a yield is high, and not always good ones.
A business can be cyclical. It might still be a good long-term investment. But it would have been a mistake to buy Rio Tinto in 2021 when it paid more than 10%, and expect to get the same every year.
Often, a company might just be in trouble. And a weak share price can make the dividend yield look good.
2: Check for earnings
Dividends should be covered by earnings. If a firm earns 50p per share, and pays a 60p dividend, where does the cash come from?
Often, it comes from a company’s cash pile. That might cover a one-year shortfall, but it can’t go on for ever.
I don’t like to pick on Vodafone. Oh, actually, yes I do. Vodafone has been paying big dividends for years, but not covered by earnings.
And in the past five years, the share price has slumped nearly 50%. That’s not a win.
3: Look for a progressive policy
I’m happy with a modest dividend yield today, if I see a policy, and long-term history, of progressive rises.
A one-off yield can fade over the years. But if dividend rises beat inflation, that can provide better long-term passive income.
Experts talk about earnings rising ahead of inflation too. That makes sense, as the dividend can’t keep going without that.
It doesn’t have to happen every year, as long as the long-term trend goes that way.
4: Watch the balance sheet
I don’t like companies with big debt. Not all agree, and some firms can manage it if they keep their earnings growing ahead of their cost of debt.
Still, enough experts out there feel the same as I do. And that’s nervous when I see big dividend yields but high debt on the books. Did I mention Vodafone?
It only takes an economic slump to put the pressure on.
5: Consider pooled investments
Most financial service providers stress the need for diversification. And one way to achieve that is to use pooled investments.
We could look for funds that target long-term dividend growth. And spreading the cash can greatly reduce the damage from any one firm turning bad.
Investment trusts are my favourites, because I get to be a part-owner when I buy the shares. And the fund managers work for me.
Some investment trusts have raised their dividends for more than 50 years in a row now.
My take
No stock market investment strategy is without risk. But these expert thoughts make a lot of sense to me.
