Buying shares in a Stocks and Shares ISA can be a great way of investing. But figuring out which stocks to buy with a £20,000 contribution limit can be a challenge.
To some extent, this depends on whether the aim is to build wealth or earn passive income. If it’s the latter, there are a couple of important principles I’d look to stick to.
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Passive income
The first thing to note is that passive income doesn’t always mean dividends. Some businesses choose to return cash to investors via share buybacks instead.
When this happens, existing shareholders are able to sell part of their investment without reducing their stake in the overall business. A good example of a business that does this is Rightmove.
Since 2018, Rightmove has reduced its share count by an average of 2% per year, allowing investors to sell part of their stake to generate income. This can add value when the company’s shares are underpriced.
When a stock is overvalued, though, repurchasing shares can be value destructive. So investors need to think carefully about whether a business would be better paying a dividend instead.
As well as considering the dividend yield a stock comes with, investors also need to consider buybacks. These can be more irregular, but they’re crucial to considering shares from a passive income perspective.
Durability
One of the most important things is to find businesses to buy that have good long-term prospects. It’s not much good buying a stock with a 9% dividend yield if its payouts are going to fall next year.
Finding these companies is sometimes easier said than done, but there are some clues that investors can look for. The best thing to look for is a business that has some sort of advantage over its competitors.
A competitive advantage can take a number of forms. It can be a patent or trademark, the ability to produce and distribute at a low cost, or a product that is difficult for customers to switch away from.
A good example of a company with a competitive advantage is AstraZeneca. The company’s drug portfolio is protected by patents that gives competitors no opportunity to copy its products.
Of course, there are always risks —AstraZeneca constantly needs to develop drugs through its pipeline as patents expire. But this is something investors should look at carefully before deciding to buy the stock.
Finding stocks to buy
Investing for passive income involves more than looking at dividends. Investors also need to consider share buybacks and how whether a company will be able to maintain its returns over the long term.
That can be a lot of work, but investors don’t have to understand every company. Even someone who only understands a few strong businesses can do well by working out when they are attractively priced.
In some ways, that’s the most important thing. When it comes to investing £20,000 in my Stocks and Shares ISA, the most important thing is to stick to companies that I can understand.
