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The stock market’s arguably one of the easiest ways to build passive income. While its far from a risk-free process, even small investors can eventually go on to build a substantial second income stream that can pave the way towards financial freedom.
So how big would a portfolio need to be to start generating a sustainable long-term passive income of £50,000 a year?
Crunching the numbers
The London Stock Exchange houses some of the most lucrative income stocks in the world, averaging a dividend yield of 4%. For reference, those invested in the S&P 500 are lucky to get 2%, and it’s a similar story with the European STOXX 600 index (although it is slightly higher).
However, by not relying on index funds, investors can be far more selective and focus solely on higher-yielding opportunities. Obviously, the higher the yield, the greater the risk. Yet it’s still possible to bump up the payout to around 5% without adding too much additional exposure. And at this level of payout, a £50,000 passive income would require an investment portfolio valued at £1m.
Reaching £1m
Building to a seven-figure portfolio’s a challenging goal. But by staying disciplined and continuing to invest consistently, it’s a financial dream that many individuals can eventually achieve. In fact, with just £500 a month and a 10% annual return, the process would take roughly 30 years, just in time for retirement for those who start early.
Now the question becomes, which stocks should investors buy to earn that 10% return? Picking winning stocks to buy is no easy feat. Even the most thorough of investment research can be completely invalidated by an unforeseen external threat. Just look at how many high-flying companies were derailed by the pandemic.
However, over the long run, the pattern becomes clear. Winning stocks are fundamentally strong businesses generating ample free cash flow with a long list of competitive advantages. And by focusing solely on finding these opportunities, investors can expect to earn above-average returns even if they make some mistakes along the way.
Winning stock example
One business that’s outperformed over the last 15 years is Howden Joinery (LSE:HWDN). The vertically integrated fitted kitchen (and now fitted bedroom) supplier has vastly outpaced the market since 2010, delivering an average return of 18.2% a year!
There are plenty of other companies operating in this space. But what sets Howden apart is the fact that it exclusively deals wth tradesmen. This simple decision means its depots can be located in cheap-to-rent industrial estates rather than expensive high streets.
It also transforms tradesmen into a free source of marketing. And by allowing each depot manager to earn a share of their depot’s profits, it nurtured an entrepreneurial culture that has resulted in exceptionally low manager turnover.
Of course, the upward journey hasn’t been smooth. Most of the demand comes from home renovation projects. And when economic conditions are poor, there aren’t that many households looking to spend upward of £10,000 on a new kitchen.
Fortunately, when times are good, Howden generates a lot of excess cash. And this liquidity can support it through the storms while many of its competitors struggle. And even today, I think this business deserves a closer look from investors seeking to eventually build a £50,000 passive income.
