A couple of weeks ago, I decided to buy shares in Legal & General (LSE:LGEN). With a yield in excess of 8%, it’s good for passive income. But there’s little point buying a stock for its generous dividend if its share price is going to tank.
High yields are only sustainable if a company’s profitable, growing, and in good financial shape. In my opinion, the FTSE 100 financial services provider meets these criteria, which is why I decided to invest.
Healthy returns
I was first attracted to the stock by its large dividend. I took a position a few days before it went ex-dividend. This means I’ll receive a final payout of 14.63p a share on 6 June. Add this to the interim amount of 5.71p and the share is yielding 8.6%.
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But the company has a long track record of steadily increasing its returns to shareholders. And — although dividends are never guaranteed — I see no reason why this shouldn’t continue.
Growth prospects
That’s because I think it’s likely to be a big winner from the higher interest rate environment in which we now find ourselves.
The company sells annuities. These are often bought via a pension fund to provide a guaranteed income for life. When interest rates go up, the amounts paid by annuities also rise.
But with the base rate remaining below 2% from January 2009 to August 2022, they have recently fallen out of favour. Also, from April 2015, the government introduced reforms enabling individuals to draw down their pensions in cash rather than requiring them to buy an annuity.
Although most economists in the UK believe we are at peak interest rates — and the next move is likely to be downwards — nobody is predicting a return to the low levels of the last decade. This should help Legal & General sell more annuities and increase its earnings.
But a bigger impact on the company’s profits is likely to come from its pension risk transfer (PRT) business. This is where the group acquires the assets and liabilities of existing pension schemes and takes on the obligations towards pensioners. The company makes money by charging a fee on the initial amount received. It then reinvests the funds hoping to earn more than it has to pay in pensions.
The company estimates there’s a pipeline of around £250bn of assets in UK schemes that are ready to be bought out. During the year ended 31 December 2023 (FY23), Legal & General completed its biggest PRT (£4.8bn) and it’s expecting a future run rate of around £8bn-£10bn a year.
Final thoughts
Despite these positives, the company had a disappointing FY23. Its adjusted operating profit of £1.67bn fell below analysts’ expectations. Its investment management business performed particularly poorly, with a 19.5% fall in profits compared to the previous year.
And it’s a business that’s sensitive to the wider economy. Any downturn in financial or property markets will adversely impacts its revenue, earnings and surplus capital. That’s probably why its share price has fallen 14% since May 2019.
But despite these risks, the prospect of receiving a generous dividend — supported by anticipated growth from the sale of annuities and the acquisition of pension schemes — means I’m now a shareholder in the company.
