Earning a passive income in the stock market is a proven strategy for achieving financial freedom. And those who leveraged the chaos of the pandemic have only supercharged their gains.
At the time, the UK’s flagship index paid out as much as 7% during the height of Covid-19. And while dividend cuts were prevalent that year, shareholder payouts eventually stabilised at an average of 4%.
According to AJ Bell, the total dividends paid by FTSE 100 companies in 2020 reached just over £60bn. Since then, payouts have been on an upward journey, heading towards £83bn by the end of 2025. If that forecast is accurate, it means UK large-cap dividends have grown by 38% in the last five years. And the 4% dividend yield from June 2020 will soon be closer to 5.5%.
Assuming investors have been reinvesting all their dividends until now and factoring capital gains, that £10,000 initial investment is now worth £17,300. And at a 5.5% yield, this index strategy would be generating a passive income of £952.
That’s pretty good. But for some stock pickers, the income stream’s even more substantial.
One of the biggest dividend winners
By carefully constructing a custom portfolio, investors can reap significantly greater rewards compared to just relying on index funds. There’s no denying this investing strategy is a far riskier approach to building wealth. But those who used it to buy shares of Diploma (LSE:DPLM) are understandably laughing right now.
The industrial distribution business has expanded its market-cap by over 150% since June 2020. And during the same period, dividends have been hiked by an average of 24% a year. So while its initial 1.4% yield didn’t look all that impressive compared to its parent index, this payout’s now closer to 4.1% on an original cost basis.
Reinvesting dividends along the way paired with the group’s robust capital gains means that an initial £10,000 investment is now worth a staggering £25,480. And at a 4.1% yield, that’s a passive income of £1,045, which is set to grow potentially even higher and faster in the future.
Risk and reward
A big driver of Diploma’s recent success stems from management’s ability to navigate through hostile market environments as well as position the business to thrive when a recovery comes along. That’s translated into some impressive free cash flow generation courtesy of the rebound in aerospace and defence. And management continues to execute this strategy today, with an anticipated recovery of the European life sciences sector on the horizon.
However, the company’s also been relying heavily on bolt-on acquisitions in addition to organic growth. And as a consequence, debt levels have been rising. Acquisitions, even small ones, can cause significant headaches if the integration process doesn’t go smoothly.
Even if everything’s hunky dory, a cyclical downturn in an end-market can lead to a worse-than-expected performance, resulting in potentially significant risk. And since acquisitions are a key pillar in Diploma’s growth strategy, that’s something shareholders and prospective investors must consider carefully moving forward.
Despite already delivering solid gains, Diploma still has plenty to offer, even for new investors today. At least, that’s what I think. So despite the risks, the passive income potential of this business is worth closer inspection.
