A Stocks and Shares ISA can be a useful tool when trying to generate passive income over the long term. It also offers the potential for capital gain, although loss is also a possibility. Indeed, that underlines the importance of investing one’s ISA smartly.
With current valuations and dividend yields in the London stock market, I think I could realistically aim to invest a £20K ISA today with the objective of earning back half my investment within five years in the form of dividends.
I would still own the shares I spent the money on. Hopefully, they could be worth more than I paid for them five years from now.
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Looking for long-term value
How would I go about this practically?
I would be looking for companies I thought could produce sizeable dividends in the years to come but might also see share price growth.
That might sound like a tall order. After all, if a business has the sort of competitive advantage that could help it generate enough profits to pay big dividends, would its shares be trading cheaply?
Cheap valuations
Perhaps surprisingly, in some cases I think the answer is yes.
Looking at today’s London market, I see examples of what I think are cheap shares, relative to their long-term prospects.
Legal & General trades on a price-to-earnings (P/E) ratio of 6, for example, but yields over 8%. It has a strong brand, large customer base and operates in a market I expect to see resilient demand.
Compounding
Still, I always diversify my Stocks and Shares ISA to reduce my risk if one of my investment choices turns out to disappoint.
Other shares in what I see as quality businesses have low P/E ratios and yields similar to Legal & General right now. An example is British American Tobacco, yielding close to 9%. With £20,000, I would diversify by splitting my money evenly across five to 10 blue-chip shares.
But if my target is £10,000 of dividends over five years, would 8% or 9% yields be enough? After all, that could be £2,000 of dividends annually. That might sound like I would need to earn a 10% annual dividend yield on my initial £20K investment.
In fact, this is where compounding my dividends would help.
If I earned an average yield of 8.5% and compounded my dividends annually, after five years my Stocks and Shares ISA would have generated £10,000 in dividends.
Capital growth potential
But what about my capital? Could it also have grown – or might it have shrunk?
After all, Legal & General shares are down 12% over the past five years. In that period, British American Tobacco shares have fallen 38%.
Past performance is not necessarily a guide to what will happen in future. I think the business prospects for quite a few high-quality FTSE 100 businesses (including those two) are not accurately reflected in their current valuations.
So, by investing my Stocks and Shares ISA in the current market, I could try and set myself up to earn substantial dividends in coming years – and also hopefully see some capital growth.
