There are many ways to build a wonderful nest egg from the stock market. One that I think deserves more love is buying shares for the passive income they throw off. This money can then be reinvested, allowing compounding to work its magic over time.
Strong and stable
In my view, a good income stock is one that sends more money back to its owners every (or nearly every) year, even if the actual dividend yield is relatively low. I’d much rather have this over larger-but-more-inconsistent cash payouts, especially if the underlying business is also growing.
BAE Systems (LSE: BA.) is a great example. This top-tier juggernaut has been hiking dividends for decades now.
Based on recent events, I can see this trend continuing. As a result of the awful conflicts in the Ukraine and Gaza, the £39bn cap is in something of an earnings purple patch as governments up their defence spending. Indeed, new PM Keir Starmer stated that the UK has a “cast iron commitment” to spending 2.5% of national income on defence.
In his words: “The defence and security of the nation… is the first priority of government.”
All in the price?
My one concern right now is that the valuation — at 19 times forecast earnings — is frothy. This price tag isn’t surprising. The shares are up 42% in the last 12 months alone. But it does suggest that a lot of good news is baked in.
If results even slightly disappoint from here, some of those gains might be given up. We’ve actually seen a bit of slippage in the last month, perhaps as traders look to move on.
This doesn’t mean BAE’s 2.5% yield is at risk. In fact, this year’s dividend is likely to be covered over twice by profit. That’s a good buffer, even if revenue and profit come in slightly below expectations.
However, I always think it’s sensible to hold a selection of income-bearing stocks rather than just one.
Boring but beautiful
FTSE 100 peer Bunzl (LSE: BNZL) is another stock I’d consider buying for lasting passive income.
As mentioned earlier, that ‘lasting’ bit is important. I want to feel confident that this cash will arrive, even if it means not getting a higher yield.
In truth, no dividend stream is ever guaranteed. Investing just doesn’t work that way! But I’d back this international distributor to be one of the last income stocks standing.
Bunzl specialises in getting things from A to B. Those things are crushingly dull — think food storage containers, safety boots and hygiene materials. They’re also essential for businesses and services to operate.
This helps to explain why it has been able to raise dividends year after year, even during the pandemic.
Just the start
Again, one drawback is the valuation. A forward price-to-earnings (P/E) ratio of 17 is steep compared to other firms in the industrials sector and there’s always a risk I might be overpaying. This might account for why the share price — but not the dividend stream — has been a bit volatile in recent years.
For this reason, I wouldn’t stop looking for passive income stocks if I had the funds to buy BAE and Bunzl as a foundation for my long-term focused portfolio.
This post was originally published on Motley Fool
