Owning dividend shares can be a great way of earning passive income. But working out which stocks to buy can be a tricky business.
A high dividend yield is often a sign of investor pessimism, but great companies don’t often trade at low prices. So what’s the best way to aim for a yield of 7% or higher?
Strategy 1: look for mistakes
There are a number of stocks that have dividend yields above 7%. From the FTSE 100, two obvious examples are British American Tobacco and Vodafone.
In both cases, investors are doubtful that these payouts are going to prove durable. Demand for smoking seems likely to decline and telecoms is an industry with high capital intensity.
Nonetheless, it’s possible investors are overestimating the obvious headwinds for both businesses. So for someone who has a reason for thinking this is the case, either stock could be worth buying.
I’m not a fan of either of these companies, but I do like Supermarket Income REIT as a stock with a 7% yield. The rising share count is a risk, but I think the dividend looks sustainable going forward.
Strategy 2: wait for it
For investors that can’t see an obvious opportunity at 7%, another strategy is to be patient. This involves buying something with a lower yield and have it grow over time.
Unilever is an example of a stock that might fit the bill here. The yield today is around 4%, but the company has been steadily increasing its dividend for over 25 years.
If this continues, then investors only have to buy the stock and wait for the return on an initial investment to reach 7%. And it might keep going after that if they wait long enough.
The risk with this strategy is that the company’s growth prospects might not turn out to be as durable as they have been until now. But reinvesting dividends can help push the process along.
Investing £20,000
Right now, £20,000 is the maximum that UK residents can invest in a Stocks and Shares ISA. This provides protection against dividend tax, which could well be valuable going forward.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Of the two strategies above, there’s no rule saying investors have to pursue one or the other. Spreading an investment between both types of stock seems like a good idea to me.
Investing inevitably comes with risks – any individual business might falter for reasons that might even be beyond their control But I’d hope to limit this risk by diversifying my investment portfolio.
With stocks like Supermarket Income REIT that can provide big returns now and Unilever that could grow steadily, a 7% average return looks possible over time. That’s my view, anyway.
Thinking long-term
With dividend investing, the most important thing is to avoid taking unnecessary risks to try and get a bigger return sooner. Thinking about the long term is crucial.
A stock with a big yield that won’t prove durable isn’t a good long-term investment. Equally something that doesn’t pay much today but will do well in future could be a great stock to buy.
That’s not to say that every stock with a high yield is one to avoid – sometimes the market is wrong. But there’s much more to dividend investing than looking for a big return today.
