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I look for three main qualities in stocks I choose for my passive income portfolio. First, a 7%+ yield, as I get 4%+ from 10-year UK government bonds — the ‘risk-free rate’ – and shares are not risk free.
Second, undervaluation. This reduces the chance that share price losses will erase my dividend gains should I wish to sell the stock. It also increases the chances of me making a profit on the stock price in that event.
And third, an underlying business set for strong earnings growth. It is ultimately this that powers a company’s dividend and share price higher over time.
My three top passive income holdings
Over 50 now, I focus on stocks that can generate high passive income so I can reduce my working commitments.
Three of them have the perfect combination of the key qualities I want in such a stock, in my view.
In order of current yield, they are Phoenix Group Holdings (LSE: PHNX), M&G (LSE: MNG), and Legal & General (LSE: LGEN).
Phoenix Group presently yields 10.2%, M&G 10%, and Legal & General 8.9%.
On the key discounted cash flow (DCF) valuation measure, Legal & General is the most undervalued – by 57% at £2.29. Therefore, a fair value for it is £5.33, although it may go lower or higher due to the vagaries of the market. The same applies to the following stock’s fair values as well, of course.
M&G’s DCF valuation shows it is underpriced at £1.98 by 55%, with a fair value of £4.40. And Phoenix Group is undervalued by 18% on a DCF basis at £5.14, with a fair value of £6.27.
Finally, for earnings growth each year to the end of 2026, analysts forecast Phoenix Group’s at 75%, M&G’s at 30.4%, and Legal & General’s at 29.6%.
How much passive income can they make me?
A principal risk for Phoenix Group is the intense competition in its sector that may squeeze its profit margins. For M&G it is any significant spike in financial market volatility that may make sustained investment gains harder to achieve. And for Legal & General, it is a resurgence in the cost of living that may cause customers to cancel policies.
That said, investors considering taking a £10,000 holding in each – around the same as I have – could make huge returns over time. This is provided they use the dividends to buy more of the stock that paid them, as I do. This is ‘dividend compounding’.
Based on an average 10.2% yield for Phoenix Group, £17,613 of passive income would have been made after 10 years and £200,535 after 30 years.
On an average 10% for M&G, these respective returns would be £17,070 and £188,374.
And on an average 8.9% for Legal & General, these respective dividends would be £14,271 and £132,984.
Assuming inflation over the period, the buying power of the income would be reduced somewhat. Even with this, though, I think these investments will make my later years a lot more comfortable than they would have been without them.
