When considering value shares, investors are typically wary of stocks with a dividend yield above 7%. This usually means the yield is unsustainable or the stock price has recently tanked, resulting in a comparatively high yield.
Buying stocks with a high yield might pay off in the short term but, inevitably, dividends get cut and the price falls.
However, with careful planning, it’s possible to build a portfolio of stocks that achieve a 7% yield, on average. And by investing via a Stocks and Shares ISA it’s possible to put £20k a year into this portfolio and enjoy tax-free gains.
Passive income stocks: our picks
Do you like the idea of dividend income?
The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
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Choosing cash-rich companies
I wouldn’t fall into the value trap of buying a high-yield dividend stock that just gets cut the following year. There are a few ways to check whether the company in question can keep paying its dividends.
The first thing to check is free cash flow. This is the money left over after the company has paid all its expenses and operating costs. Some companies funnel this cash back into the business, others use it to pay off debt. But companies with low debt and an efficient business model usually pay it out as dividends.
TP ICAP (LSE: TCAP) is a good example of a reliable dividend payer, with a 7% yield. This data-rich FTSE 250 firm provides settlement, intermediary services and trade execution for companies worldwide.
It’s by no means the highest dividend payer on the market, but I like its track record. It was paying a steady annual dividend of 15p per share before Covid forced a brief cut. But recovery has been quick and it’s now back to paying 15p on each £2.13 share. This speaks volumes to the company’s dedication to its shareholders.
The below graph shows the relationship between the share price and the dividend yield.
But like any company, there are some aspects that make it less than perfect. Its £2.6bn debt load is slightly higher than its equity and a recent drop in earnings means annual dividends now outweigh earnings per share (EPS). Both these are sufficiently covered by cash flows for now but that could easily change.
If earnings were expected to continue falling, it would be a bigger concern. But forecasts expect earnings to grow at a rate of 25.6% over the coming three years. This could bring the current price-to-earnings (P/E) ratio down from 22 to 9.5. That would add significant value to the shares.
However, these are just forecasts. If the UK economy takes a turn for the worse, TP ICAP’s earnings could follow suit — and that could threaten dividends.
That’s where diversity comes in
Savvy investors never put all their eggs in one basket. There are many other reliable UK dividend stocks with yields between 6% and 8%. But don’t ignore low-yield stocks with high cash flow either — in a few years, they could also have yields of 7% or more.
Adding several reliable dividend stocks to a portfolio helps to reduce risk significantly. Other good options include Aviva, RELX, and Imperial Brands — all companies with strong cash flow and a track record of consistent dividend payments.
A mix of global stocks across several industries protects against economic slumps, industry-specific risks and localised issues.
