Making money with minimal daily effort remains the core of the passive income idea. And the best way I have found of doing this is by investing in stocks that pay big dividends.
I use these payouts to buy more of the same stocks – known as ‘dividend compounding’. Consequently, the size of my investments grows, paying me more and more in dividends over time.
One such stock in my high-dividend portfolio is Legal & General (LSE: LGEN).
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A new financial crisis remains a risk for the shares, of course. Another is that high inflation and interest rates deter new client business.
An ideal pick for my high-yield portfolio
The company has three key features that I want to see in all my high-yield stocks.
First, it has maintained a high payout all year, based on its 2022 dividend of 19.37p per share.
Because yields fall as share prices rise, the payout has dropped recently to 7.75%. Although still a high FTSE 100 yield, the firm intends to increase the dividend by 5% in 2024.
The second feature is that despite the recent share price rise, the stock is still very undervalued against its peers. This means there is less likelihood of a major share price fall wiping out all my dividend gains.
On the key price-to-earnings (P/E) ratio, it trades at just 7.4, compared to the peer group average of 18.1.
A discounted cash flow analysis shows the stock to be around 56% undervalued at its current price of £2.50. Therefore, a fair value would be nearer £5.68, although this does not necessarily mean it will reach that level.
And the final feature of an ideal stock in my high-yield portfolio is a strong underlying business.
Legal & General’s retirement solutions operation is a market leader in the UK Pension Risk Transfer (PRT) space. This is where a company takes over other firms’ pension scheme commitments and is paid for doing so.
It is also in the top 10 in the US PRT market, which has enormous growth potential. Only around 9% of the US’s $3trn of defined benefit pension schemes have been transferred so far.
Legal & General Investment Management is also a leading global asset manager, with £1.2trn of assets under management.
Its H1 results showed it is on track to achieve its target of £8bn-£9bn by the end of this year. This on its own can prove a powerful engine for growth.
The dividend-compounding miracle
With £9,500 of savings (£26 a day for a year) I could buy 3,800 Legal & General shares today. With a yield of 7.75% a year, I would make £736.35 in the first year of dividends.
Reinvesting the dividends would give me £89,175 after 30 years if the yield averaged the same over the period. This would pay me £535 a month in passive income.
However, if I continued to pay £26 a day into this stock, I would reach this income after just six years.
Through continued dividend compounding, the portfolio would be worth £1,224,399, and paying me £7,558 a month in passive income. This is based on the yield averaging the same over the period.
Inflation would erode the buying power of the income. But the figures underline what big things can come from such small beginnings.
