With a lot of UK shares still offering what seems like good value, that can mean opportunity for an investor with an eye on passive income. Even in the top flight FTSE 100 index of blue-chip British shares, there are currently yields of 7%, 8%, 9%, and even 10% on offer. With such an array of choices, how can one find the right shares to buy?
Every investor is different, but here is the approach I will be taking in November.
Know what you’re looking for!
When I look for high-yield shares to buy, the first thing I do is ignore the yield!
That might sound counterintuitive. But it is important to remember, always, that no dividend is ever guaranteed to last.
Sometimes, when a company looks like it may do worse in future than now, its share price falls. That can mean the yield gets higher and higher due to the falling share price. Then, sometimes, the dividend gets cut. The yield falls back to earth (sometimes to zero) and the dividend cut can also lead to investors dumping their shares, sending the price down yet further.
So, my approach is to look for great companies I expect to keep generating sizeable free cash flows. I also consider their valuation, including how much, if any debt, they carry on the balance sheet. Only if I find a company I like at a price I also like do I then consider yield.
Think about the source of dividends
In that situation, I turn to considering whether the business is likely to keep on generating enough free cash flows to support its dividend – and whether the board looks likely to do so.
After all, free cash flows can be used for share buybacks, building the business, or a host of other uses. They will not necessarily be used for to pay dividends to shareholders.
As an example, consider Ithaca Energy. On paper it has a current dividend yield of 31%. Such a high yield automatically raises a red flag for me.
Ithaca has already seen a big dividend cut this year, but still has a juicy yield. But in the first half, total production fell 30% year on year and net cash flow from operating activities fell 19%. The volatile energy market could mean bigger, smaller, or even no dividends down the line, I reckon.
Focus on quality and a proven business model
By contrast, consider a share like Aviva (LSE: AV).
It operates in the insurance market. I think that benefits from long-term demand as well as good forward visibility.
That is not to say that prices cannot move around. Insurance is competitive and, although policy prices have soared in recent years, they could fall sharply if a rival decides to try and boost market share by competing on price. Given Aviva’s higher dependence on its core UK market than a few years ago when its business was more internationally diversified, I see that as a risk.
But I think Aviva, with its 7.6% dividend yield, is a share investors in search of passive income should consider buying.
It has a large customer base, strong brands, and has streamlined its business in a way I think could help it grow long-term profits. All for a price-to-earnings ratio of just nine.
