It’s the 6th of April! Call me crazy but I look forward to this date every year. Why? Because it is the new tax year. And a new tax year means I get a fresh allowance of £20,000 that I can invest completely tax free in my ISA account. As a finance geek, if this doesn’t get you excited, I don’t know what will.
If you are someone like me who wants to achieve financial freedom at a relatively young age, an ISA is the way to go. In essence, an ISA is a legalised tax heaven for the average person like you and me. You are able to earn dividends and capital gains absolutely tax free. By keeping your taxes low you can compound your money at higher rates over time.
An additional benefit of putting your money in an ISA account is that unlike a pension, you are able to withdraw money from your ISA without any tax charges at any time – whereas in a pension you can only withdraw money after you reach 55 years of age and any withdrawals are taxed at your marginal rate. No wonder I am so excited about the new tax year and the new ISA allowance that comes with it.
Why Do I Invest In an ISA or Invest Any Money At All? What Will I Achieve At The End?
The underlying goal of investing in a stocks and shares ISA is for me to be able to cover all my living expenses via dividend income. That way, I will no more need the money from my day job and can be financially free.
Sure I could achieve this goal by other means such as investing in rental property. But for me, ownership stakes in businesses via stocks are the best method as they are the highest returning asset class over time as well as you don’t need a truckload of money to start investing. When it comes to stock market investing, everybody starts small.
When it comes to creating passive income from the stock market, there are two common methods. The first is to follow the 4% rule where you build a portfolio of a certain amount and you sell 4% of your portfolio every year in order to get the cash you need to cover your spending. The problem with this route is that you constantly have to sell stock in order to derive income. Furthermore, I don’t like to rely on market movements to provide me a steady stream of income. I have no clue what the stock market will do tomorrow, let alone in 10 years when I plan to have retired.
The other method, which I prefer, is to invest in companies that provide me with streams of cash at regular intervals. I never have to sell stock using this method. I can preserve my capital for life. Why cut down the tree when you can simply pick the fruit?
What I have noticed is that when I never have to sell a share, I begin to act more like a business owner as opposed to a trader. I have a strong incentive to simply buy and hold ; just like Warren Buffett. This also means that I never have to sell during a market crash when stock prices are at their lowest. Instead I can be a net buyer by using dividends to buy cheap shares during a downturn.
One of the biggest drawbacks most people assert about dividend investing is the tax inefficiency. Investors that receive dividends need to pay a tax on it whilst capital appreciation till the point of sale is tax free. But luckily for me I don’t have this problem. By investing in an ISA account, I can receive dividends completely tax free! This is a huge advantage and makes dividend investing all the better.
How Much Dividends Do I currently Receive In My Stocks And Shares ISA
I have been making use of ISAs for 4 years now and the dividends I receive in this account is currently £3,278 per annum and growing. It has been hard work but I can tell you it is worth it. Every time a dividend hits my account I keep thinking that I should have started investing sooner. But I am happy with where I am today.
By investing in high quality blue chip companies, the £3,278 I currently receive in dividends each year is a good building block. The aim is for me to reach £5,000 this time next year. £3,278 may seem like a small amount after four years. But thats the nature of dividend growth investing. The initial phase is slow but there are rapid increases later on. Just look at my post titled Saving Is More Important Than Investing Early On.
I am proof of this. By going through my journey archives, you will see that every £500 milestone I reach has been faster than the last. This is due to the trifecta of new capital infusion, organic dividend growth and dividend reinvestment.
How I Plan on Increasing My Dividends Over The Next Year
There are three main ways I plan on Increasing my dividends over the next year.
1. Buying Shares In Quality Companies – The first and obvious way is to buy more shares using the fresh £20,000 allowance I am entitled to. If I had to invest the full £20,000 in a share offering a 5% yield, I could add a cool £1,000 in dividends a year to my portfolio.
2. Dividend Increases – One of the biggest areas of potential dividend growth over the next year comes from potential dividend increases. This is the advantage of buying into quality shares. The more profits a business makes, the more they are likely to send my way in dividends.
Just look at company like Procter & Gamble which has grown its dividend for 62 years straight!During this period there has been multiple recessions, including the worst meltdown since the Great Depression, the dot-com bubble and the housing bubble, the Asian financial crises, multiple international wars, ballooning government deficits, exploding national debt, countless natural disasters, political earthquakes and a maelstrom of regulatory changes in the financial industry, and Procter and Gamble still managed to increase their dividends during each of those years. This is truly amazing and that is why I aim to invest in quality companies like Procter & Gamble.
3. Reinvesting Dividends – By using the cashflow produced by dividend stocks, I can buy into even more dividend paying stocks. In essence, this ISA tax year, I will have investable cash of £23,278 as opposed to the standard £20,000 due to the £3,728 in dividend income I am expected to receive. And that number will only grow with more purchases, dividend increases and dividend reinvestments. Its a vicious cycle working in my favour.
I did a post titled my dividends are producing more dividends. This post is definitely worth a read. And if you have read it before, it is definitely worth re read.
Four years on since I started documenting my investment journey, my portfolio has so far thrown off dividends worth £6,560. Whilst I could have taken these dividends and spent them as I please, I decide to reinvest them in order to get even more dividends going forward. Going by my average portfolio yield of 4.20%. my £6,560 worth of dividends have essentially added £275 in annual dividend income. And as the years go, this figure will only get bigger. That is why I will continue to re-invest dividends in this manner until a time when my dividend income will cover all my living expenses after which I will draw on my dividends for income.
What Types Of Stocks and Shares I Buy In My ISA
My strategy is to buy into quality dividend paying companies at a reasonable price. There are a number of metrics I look at in order to identify these companies. If I were looking for something else then I’d probably look at other metrics.
Firstly, and most importantly, I want profitable companies. I want to own businesses with long track records of sustained profitability, high free cash flows and increasing dividend payouts.
I don’t invest in anything loss making. Obviously, I miss out on some wonder stocks at an early stage, but the chances of finding them are tiny and more importantly I miss out on a lot of rubbish. Many first time investors want to shoot for the stars and want to find those companies that can double their money over night. That is not the game for me. I invest in established companies companies that have a long history of being profitable. I have been burnt before with Accrol Papers and have seen others lose much more with GTAT in order to chase a quick gain. I have learnt that it is far more prudent to buy into blue chip companies that are already established and profitable.
As Warren Buffet has said “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.” Capital preservation is of utmost importance to me. If a stock I won goes down 50%, it needs to go back up 100% just for me to break even! So I avoid losing money at all costs, even if it means giving up on potential 100 baggers.
The quality of a business is also very important. The underlying economics of the business should be good. It should have some sort of economic moat that insulates it from fierce competition.
I look at proxies of company quality such as Return on Capital, Return on Equity and Operating Margin (or ROCE). Ideally I want a minimum 10% on all of these – companies with these sorts of figures have some kind of competitive advantage, which should allow them to continue to be profitable and maintain their operating margins. If you’re a long term holder this is where your research pays off, to figure out whether their moat is temporary or permanent.
Buying into quality companies should not be underestimated. As Charlie Munger, the business partner of Warren Buffet, once put it “over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.”
In assessing a company’s quality, I look at its resilience across the entire economic cycle. I enjoy pulling out annual reports across the 2007-2009 period (the financial crises) in order to see how the business did. I like companies that do well year after year, irrespective of the macroeconomic conditions.
Another important metric to look at is Free Cash Flow (FCF) and I compare this with operating cashflow, and scan back across the years. Cashflow, unlike earnings, is hard to fiddle with and good companies throw off cash. FCF can vary for many reasons but it should be positive and, on average, a decent percentage of operating cashflow. Another way of putting that is that I dislike companies with large capital expenditures – it suggests they have to spend a lot of money just to stand still. All things being equal you want a company that can make money without spending much. A good example of this is Rightmove – go and look at the company’s historical annual reports to see just how much free cash flow the company has thrown off and how this has rewarded shareholders over the years.
Next, I look at gearing – debt is always interesting. A company with net cash is safer, but potentially isn’t investing or returning as much as it could. However, I don’t want massive amounts of debt, so I generally want gearing to be well below 50%. There are exceptions that I have made as I have bought shares in companies such as Imperial Brands but I believe this business to be of high quality and thus its debt loads manageable.
One metric most people skip over but I for one place high importance on is the number of shares in issue and how this number has fluctuated over the years. As a shareholder, the worst thing is to get diluted year over year – you don’t want to see the share count rising as this means that you own a smaller share of the company and thus have the rights to a lesser share of the profits. Equally if the shares in issue are reducing then that implies a buyback – and that needs to be looked at carefully, because most companies exercise buybacks in the interest of the management and exiting shareholders, not in favour of current shareholders. Next PLC is a good example of buybacks being done right.
Once I find quality companies, I only buy their shares when they are trading at reasonable levels. I don’t want to overpay for shares so I first look at P/E and P/FCF. Other people prefer PEG or P/S, but generally the aim to figure out whether a share is expensive or not. I don’t want to pay stupid multiples, but have to also realise that it is important to sometimes pay up for certain businesses just as I did with RWS Holdings PLC.
Once I buy stocks, I intend to hold them for the long term. My strategy is to milk the dividends these stocks produce and re-invest those dividends. I think of dividends as fuel for my portfolio. Whilst dividends can produce an income today, they are also a useful cash flow tool that can be used and should be used for investment purposes. I can use the dividends of £273 a month I receive in a addition to the new cash I will invest as part of this ISA year to grow my portfolio faster. In essence, I will have investable cash of £23,278 in the next tax year as opposed to the standard £20,000.
The market can take away portfolio value but the market isn’t going to take away the cash flow the portfolio generates every month from dividends. I’m the only one that can do that by selling off shares. Sell off shares and you cut out a cash flow generating asset.
I couldn’t care less what the market’s returns are or have been, I don’t invest in the market and my yields are greater than what a passive FTSE 100 index fund can produce, so I’ll take the higher dividend income and move on thank you very much. You may not agree with the concept and that’s fine, but I believe you achieve true financial freedom when your assets paid you more income to sit at home than your job pays you to show up to work. And the goal of my investment journey is to achieve financial freedom.
Whilst the above is my strategy, it is important to realise that investing and risk is always a personal thing, and people should develop their own processes and tolerances based upon their stage of life, assets and ability to accept risk. Following other people thoughtlessly is a one way ticket to some very bad investing experiences, because we’re all different.
Even though I document most of my share purchases in the my journey section of this blog, there are some high quality share purchases I make which are kept hidden. This is because I sell a stocks list and it would be unfair to people who bought the list to disclose companies on that list.To buy the stock list, contact me via the contact form on this website or email me on firstname.lastname@example.org
How I Manage To Save The Full Annual Allowance Each Year
The single most popular question I get from readers is: “How can you afford to save the full ISA allowance every year?”
The emails that normally come with these questions are often pessimistic in nature as people can’t actually believe that the average person can save the full ISA allowance. Statements like — “Well I can’t afford to save at all because I have student loans to pay….” and “You must make a lot of money to be able to save the full ISA allowance ” to my personal favourite question “Do your parents help contribute to your ISA allowance?”
No, I am not rich. No, I don’t have rich parents. And no, I don’t have a high paying job.
For the past four years, I have invested my full ISA allocation of £15,250, £15,250 , £20,000 and £20,000. Before your start thinking that I earn a triple digit salary, I don’t. Over the past three years, I have earned £30,000, £30,000, £45,000 and £45,0000 all before taxes. So my net take home pay is less than those figures. The first two years I earned the average UK wage so I think most people can save at least £15,250 in an ISA as I have proved it’s possible.
The number one reason I am able to invest the full ISA allowance each year is because savings for me is a priority. I have learnt what advantages an ISA provides for an average Joe like me and this gives me motivation for me to save more. And if you truly knew the advantages an ISA provides in terms of the tax benefits I am sure you will save more.
Everyone has priorities in their life. Whether it is travel, that big TV or that new car or that awesome bag or shoes they saw. People consciously or subconsciously prioritise what they want more of in their lives. If you want to have more money, you need to make saving and investing your number one priority. If you want to escape the rat race, you need to make savings an investing your number one priority. And if saving and investing is your priority, trust me you will find ways to earn and save more money. You will become creative with your finances. If you are bitten by the financial freedom bug, there is no return. If you know the power of passive income, you’ll want to obtain as much of it as possible.
For example, I don’t have cable TV or a car as I know that at this point in my life I don’t really need them and the extra money I save can go in my investing accounts. I also sacrifice certain nights out with friends in order to save on costs. That doesn’t mean I live like a hermit. Life would be too boring if you focus on costs. I still go out and socialise with friends but unlike most of my friends I don’t go out every weekend. Life is about trade-offs so you can either live it up big today and blow all your money or you can put a savings plan in place to ensure that 10 – 15 years from now you won’t have to work another day in your life.
If you want to find out your priorities, ask yourself what did you spend your last £200 on? If it was two or three weekends of nonsense throwaway forget the work week behaviour, you need to change your priorities. You need to turn your life into something worth living. And that is what investing can do for you. It can buy you your freedom from the rat race. It can get you financial freedom.