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With my £20k ISA allowance (that is, my contribution limit), I’d invest in shares and build a growing dividend stream to finance a second income.
My approach would have three strands. First, I’d look for stocks with a chunky dividend yield now.
Big-dividend stocks would give me a decent-sized cash income stream sooner rather than later. The money would give me choices. For example, I could draw it for a second income, or reinvest it to help build up the share account so it’s capable of paying an even bigger income later.
The power of growth
A second strand would be to look for companies that have a good rate of dividend growth. Dividends are good, but an income stream that gets bigger over time can be even better.
The progress a company makes with dividend payments often reflects the success and growth of the underling business. That means a decent dividend-grower can often deliver its shareholders a rising share price too.
The third strand would be to ignore dividends and focus just on the growth of an enterprise. Often, fast-growing businesses don’t pay dividends, or pay tiny ones. Instead, they tend to reinvest their cash flow back into operations to generate even more growth.
If the capital value of my portfolio is rising, I can choose later how to use the gains to generate a second income. I could draw money directly from the portfolio by selling shares, for example. Or I could reinvest the money into big-dividend-paying stocks or dividend growers.
For my big-dividend stocks, I’d consider names such as Legal & General, Renewable Infrastructure, MONY Group and others. Meanwhile, for my dividend-growers I’d target companies like RELX, BAE Systems, Halma, DCC and similar.
For growth, I’d tend to consider smaller companies with a long runway ahead. Names on my watchlist now include ME International, Gamma Communications, Wilmington and Spectra Systems (LSE: SPSY), which deals in machine-readable, high-speed banknote authentication, brand protection technologies, and gaming security software.
Trading well and a robust outlook
At the end of September, the company delivered a strong set of half-year results and a positive outlook statement. Meanwhile, City analysts expect normalised earnings to increase by a whopping 70% this year and 110% in 2025.
With the share price in the ballpark of 246p, it’s been adjusting to the progress of the business and stair-stepping higher.
However, with such big anticipated earnings increases, one risk for shareholders is the business may fail to keep up its rate of growth, perhaps because of not winning contracts it’s pitched for. It could even miss current estimates. If that happens, the valuation could be left ‘stranded’ at too high a level.
For the time being though, the forward-looking earnings multiple is just over seven for 2025 when set against the forecast. However, Spectra Systems is a FTSE AIM-listed small-cap stock with a market capitalisation of just £117m. So, although the multiple looks undemanding at first glance, I’d expect it to be lower than some because of the risks that come with smaller businesses.
Nevertheless, despite the uncertainties, I’d conduct further research and consider the stock now for inclusion in a portfolio financed by my £20k ISA allowance.
