A dividend yield above 7% has typically been a ‘amber’ flag for income investors. While there are always exceptions, most firms offering such a chunky payout are usually trending towards the realm of unsustainability. And considering a stock typically tanks following a dividend cut, falling into a yield trap can be a costly mistake.
However, thanks to the 2022 stock market correction, high payouts are seemingly all around, even in 2024. The market has begun to recover steadily, but plenty of dividend-paying businesses remain in the gutter despite cash flow stabilisation. And at the end of the day, it’s cash flow that ultimately determines whether shareholder rewards can continue.
As such, the idea of building a 7%-yielding Stocks and Shares ISA isn’t as far-fetched today as it once was. So how can investors pull off this lucrative income feat?
Cash is king
As previously hinted, a dividend yield alone is a fairly useless metric. While it gives investors a sneak peek at what they can expect to earn, it tells them nothing about sustainability. That’s why when looking at prospective income investments, my attention is drawn immediately to free cash flow generation.
Free cash flow is the money a company has left over after covering all its operating and capital expenses. Generally speaking, a firm has four primary choices of what it can do with this excess capital.
- Let it accumulate as cash on the balance sheet
- Pay down debts to reduce leverage
- Buy back shares
- Pay a dividend
Which path a company decides to take is ultimately up to the management team. And often, firms will end up doing a combination of these. However, suppose a firm already has plenty of liquidity in the bank and minimal debt on its books. In that case, the last two options have far more excess capital at their disposal.
Therefore, if I stumble upon a cash-generative, high-yielding enterprise with these traits, I start paying close attention.
Building a 7% ISA
Constructing an income portfolio is a fairly similar process to any other type. Rules surrounding capital allocation to ensure diversification don’t really change. The key difference is the approach to hitting the 7% payout target.
Today, around 10% of the FTSE 350 index offer yields of 7%, or more. However, solely focusing on these stocks could be a crucial mistake. Don’t forget that 7% is the destination, not the starting point. And in the long run, investors could reap significantly better results by targeting income-paying companies with the capability of growing dividends over time.
That way, a modest yield today could turn into a substantial and sustainable one in the future. This emphasis on cash flow can also be a powerful buffer during periods of economic instability.
When times are tough, growth could stumble, and earnings get compromised. But the firms that can churn out cash consistently are far more likely to be in a stronger financial position to not only weather the storm but continue paying dividends as well.
