Last week, I wrote about how I could take advantage of a stock market crash next year from the angle of buying undervalued stocks. Most of this focus came from potential share price appreciation. Yet another twist to this is the gains I could make from dividend stocks. In fact, the passive income potential from a drop in the market is huge. Here’s what I mean!
Falling stock = higher yield
The first technique I’d use is to filter for stocks that have seen a substantial jump in the dividend yield as the market crashes. For example, let’s say a company has a share price of 100p and a dividend per share of 5p. The yield is 5%. What happens if the crash means the share price falls quickly to 70p but the dividend stays the same? The yield will have jumped to 7.14%.
If I believe that the company isn’t overly impacted by the cause of the market crash then I’m going to load up. From buying the stock at 70p, I can lock in this 7.14% dividend yield. Clearly, if the dividend per share changes in the future, this yield will change. But the key element is that I’ve used the sell-off to lock in the low price.
Finding sustainable passive income
Another way I can build sustainable passive income following a crash is by weeding out the unreliable options. A sudden change in the economic climate really does show which businesses are here to stay, along with the ones that are struggling.
For example, higher interest rates next year are going to make it hard for firms that have a lot of debt. If this is the catalyst for a move lower in the stock market, I’d imagine dividends from these types of companies will be cut.
A crash would allow me to see the companies that have solid cash flow and strong profit margins under a period of financial stress. By continuing to pay out dividends over this period, it represents a good opportunity for me to buy. I can then create a stream of reliable passive income for years to come.
Trimming profits in the future
The third method I’ll use is to combine dividends with capital growth. My aim here is to buy income stocks below their fair value during a market fall. In the years that follow, I’ll be able to enjoy the dividend income. Yet I should also be able to supplement this by trimming some of my profit from the share price gains along the way.
For example, if I put £1,000 in a stock at cheap levels and it rallies 50% in the next five years, it would be worth £1,500. I could then take out £500 as passive income and leave the rest in the company.
Risk and reward
With all of my three ideas, there’s inherent risk. It’ll be impossible to pick the bottom of the market fall. So I could be left with an unrealised loss if the stock continues to plummet in the short term.
Further, dividend income is never guaranteed. Despite my best efforts, a business might still decide to cut the payment.
But I’ll be aiming to keep some cash to one side next year, to take advantage should we see a sharp tumble.
