As 2021 gets under way, many people are looking into how to earn passive income in the coming year. Passive income is exactly what it sounds like: money one receives without having to work for it. Landlords, investors and songwriters will all be receiving passive income in 2020. Here’s how I would join them by putting aside just £100 a month.
For passive income I’d focus on solid names
Starting out with just £100 each month, it can be tempting to make investment choices that claim unusually high returns. I think that’s often a mistake. With limited capital, it’s vital to focus on capital retention. Investing it into a tech name that has soared to dizzy valuations and hoping it keeps increasing is too speculative for my taste.
Instead, I’d focus on companies that are well-established, sizeable, have consistent revenues and whose business prospects look stable. I would then feel more comfortable that the shares would have less risk of plummeting in price.
Examples of such blue-chip choices include consumer goods giants Reckitt Benckiser and Unilever. I would also look into pharma names such as GlaxoSmithKline and AstraZeneca. Tobacco companies British American Tobacco and Imperial Brands are also interesting choices, along with general insurers like Aviva and Legal & General.
However, a reliable business model on a large scale doesn’t necessarily equate to passive income. For example, last year Aviva scrapped its final dividend and Imperial Brands reduced its payouts.
Similarly, companies like AstraZeneca and Reckitt have share prices that equate to a dividend yield below 3%. That isn’t especially attractive to me as an income hunter, despite the companies’ quality. That’s a common investment theme: investors bid up high-quality companies so their dividend yields are diluted. In my disciplined hunt for passive income, I’d therefore rule out many high-quality companies.
I’d go for high-yielding dividend raisers
Among the companies that survived this initial screening, I’d now look at the potential for passive income each offers.
One element of this is yield. Which companies have a high payout relative to their current price? For example, British American yields over 7% and Legal & General yields over 6%.
But a high yield now doesn’t mean there will be a high yield in future. In fact, a high yield can often suggest that the market is pricing-in a future dividend cut. So I would go through the additional screening step of looking to see whether the dividend is covered by earnings. I’d also explore whether the company has a history of raising it.
Legal & General has raised its dividend in most years, but there was a cut during the last financial crisis. By contrast, British American has raised its dividend each year for over 20 years. Earnings have comfortably covered the dividend in recent years. So if I was looking for passive income, I would begin by investing £100 a month into its shares.
With the current yield for those shares, I’d expect my monthly savings in year one to generate around £90 a year in passive income. As my portfolio grew through steady saving, I could diversify into other shares. Whatever I chose, I’d still focus on getting the right information and knowledge to follow my disciplined selection process.
