What is the point of putting money into a Stocks and Shares ISA? Different people have their own answers to that question.
For me, one of the benefits of tucking money away in an ISA today is the opportunity it offers me to earn future dividend income without lifting a finger. Here is how I would try to do that with £20,000.
Focus on long-term income generation
There are lots of products and services that are popular for a season or for a few years. But if I want passive income from a company a decade or more from now, I prefer to invest in firms that have a compelling long-term business offering.
So I would look for a business sector I expect to benefit from long-term demand, such as household cleaning products. I would then look for companies that have a strong position in that sector thanks to some competitive advantage. For example, both Unilever and Reckitt benefit from owning unique brands that help them charge a premium price.
Diversifying my Stocks and Shares ISA
But no matter how strong an industry or company may seem today, over the long term things can change. What if some revolutionary new cleaning technique makes the products of Unilever and Reckitt redundant, for example?
That I why I always keep my Stocks and Shares ISA diversified. With £20,000, I would have enough money so that I could diversify by investing equally in five or ten different companies across a range of business areas.
Income is the objective
Recall that in this example I am focussed on the long-term potential for passive income.
That would shape my search for shares to buy. I would pay less attention to a company’s growth prospects. Instead, I would consider what its future income potential looks like.
Partly that involves identifying an attractive business model. But a good business model can be weighed down by poor finances. So I also consider a company’s balance sheet when deciding whether to invest. Does it have lots of debt that could mean even beefy incomes down the line will not be used to fund dividends?
The role of yield
If I like a company and its finances I then consider the share price. Price matters even if I expect to hold the shares for decades because what I pay for a share affects the dividend yield I will likely earn from it. The higher the price I pay for a given share, the lower the dividend yield I will get.
Take Judges Scientific as an example. I like the company’s business model. But the shares trade on a price-to-earnings ratio of 50. That high share price translates into a yield of 0.9%. Judges has an excellent track record of dividend increases that I think could continue. But even if they keep coming, buying a share yielding less than 1% is not going to get me the sort of passive income streams I want.
In my Stocks and Shares ISA I own companies yielding more than 10 times as much, like Direct Line.
This post was originally published on Motley Fool
