I think the best way to do this is with a portfolio of shares that pay dividends.

How dividends work 

A dividend is like a small gift that companies pay their shareholders every year as a thank-you for investing in them. A 5% dividend yield on a £1 share would pay me 5p for each share I hold. This is in addition to any returns made if the share price increases.

Dividends on shares are calculated annually, although often paid in two or four payments a year. Subsequently, my plan would involve building a portfolio of dividend shares that pay approximately £12,000 a year.

Once the passive income stream has been established, I can begin withdrawing my returns as needed.

Dividend yields change regularly, so it’s impossible to know how much I’ll receive each year. But with a portfolio of well-selected stocks, I can aim for a conservative average of around 5%.

How my strategy could work

I’ll use the small-cap iron casting and machinery firm Castings (LSE:CGS) as an example.

Its 5% dividend yield is lower than many other UK stocks but it has an excellent track record of making regular payments. I’d aim for a good mix of reliable low-yield dividend shares and less reliable high-yield shares.

Furthermore, it’s currently estimated to be trading at 58% below fair value so could go up from here. I don’t want to dive into an overvalued dividend stock that could lose value and negate any returns I make from dividends.

On the downside, Castings earnings are forecast to grow at only 3.1%, slower than the UK average of 12.6%. Still, the dividend payments make it worthwhile.

I’ve calculated that I could reach my goal of £1,000 a month in passive income in 20 years with the following strategy.

My outcome is based on a 5% dividend yield with semi-annual payments and an expected 0.2% annual dividend increase. I’ve also calculated an expected 6% annual share price increase. This is based on the past performance of an average basket of well-performing FTSE stocks.

• First, I’d invest £12,000 into a portfolio of shares similar to Castings

• I’d use a dividend reinvestment plan (DRIP) to put any dividends earned back into the investment

• I’d contribute an additional £200 a month to the investment

In 20 years, my investment could have grown to £257,395. At this point, my average annual returns with dividend payments could be £12,081 – just over £1,000 a month.

Risks

There are risks involved with such a strategy. I can’t guarantee the dividend payments will be consistent, or remain at 5%. The share price of any stocks I include could also fall, resulting in financial losses.

For this reason, I need to carefully research all the stocks I add to my portfolio. I should ensure they have a solid history of growth potential and a track record of making reliable dividend payments.

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Some might be genuine bargains. But others turn out to be value traps, with a seemingly low valuation in fact reflecting risks that turn out to hurt business performance down the road.

Here is a trio of cheap shares I already own or would happily buy if I had spare cash to invest. All the shares have risks, but in the case of these three I am comfortable that those risks are reflected in the price.

Legal & General

The financial services giant Legal & General (LSE: LGEN) is focused on the sleepy world of pensions -– which is one reason I like it.

Managing pensions can involve substantial revenues and long-term customer relationships, setting the stage for ongoing financial success. Last year alone, Legal & General made post-tax profits of £2.3bn on revenues of £13.7bn.

That puts it on a price-to-earnings (P/E) ratio of under 7 making it a true cheap share in my view. On top of that, the FTSE 100 firm has a dividend yield of 8.9%.

Nervous markets or a tight economy could lead investors to withdraw funds, pushing down revenues and profits.

But as a long-term investor, I think those risks are acceptable for me when balanced against the valuation for the company. It benefits from a famous brand and large book of business that in some cases could stretch decades into the future.

Castings

Iron casting and machining group Castings (LSE: CGS) is another cheap share. It issued a six-monthly trading statement today (10 October) that said the company continues to trade in line with expectations.

A key risk is any substantial drop in demand for heavy trucks, which generate around three-quarters of Castings’ business. But I expect such demand to remain fairly solid in coming years. Companies need to replace aging fleets and logistics businesses remain busy.

With a P/E ratio of 10, I see it as a stock I could happily tuck away in my ISA. Its 9.5% dividend yield appeals strongly to me, although if profits fall in future the dividend may not remain at that level.

British American Tobacco

Cigarette usage is in long-term decline and is likely to stay so. Clearly that is a risk to revenues and profits at British American Tobacco (LSE: BATS).

But the decline has been happening for decades already in some markets and the firm still sold over 600bn cigarettes last year. Its premium brands allow it to charge high prices for what is a cheap product to make.

The business throws off large cash flows, supporting a 9% dividend yield. Meanwhile, as well as its legacy business, the company is forging a path to possible future profits from non-cigarette products such as its Vuse line of vapes.

Trading on a price-to-earnings ratio of 7, I think the price reflects the risks.

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The recent bear market is fast becoming yesterday’s news. And cheap shares are getting harder to find on the London stock market.

However, there are still some tempting opportunities out there. And I’d been keen to grab some of them because my belief is this bull run we’re now in has legs. 

One thing that recent difficult economic and geopolitical times have proved is the resilience and adaptability of many businesses. And I’d be keen to put my money into choice UK shares now to hold for the long term.

Technology for gaming

For example, I like the look of Playtech (LSE: PTEC). The company provides technology to the online gaming software industry.

In September with the half-year report, the business delivered a performance ahead of the directors’ expectations. And momentum continued into the second half.

Chief executive Mor Weizer said Playtech is “well placed to capitalise on the exciting market opportunities ahead.” And part of the strategy involves simplifying the business to focus efforts on the “high-growth” business-to-business (B2B) and business-to-consumer (B2C) gambling markets. Last year’s disposal of the company’s Finalto business was a “significant step” towards that goal.

Meanwhile, City analysts expect earnings to grow by about 9% this year. And with the share price near 542p, the forward-looking earnings multiple is just over 10.

To me, the valuation looks attractive. And I’m considering the stock as a long-term hold to see if the company can build growth as it embarks on a new strategic direction. However, there’s a fair chunk of debt on the balance sheet to keep an eye on. And the shareholder dividend yield is paltry.

It’s also worth me bearing in mind that the company’s financial history is patchy. So I’d be looking for new growth to emerge and improve the figures going forward. However, positive outcomes are not certain.

Parts for trucks

Another I’m looking at is Castings (LSE: CGS), the iron casting and machining company that makes a lot of stuff for heavy truck manufacturers.

November’s half-year report delivered some impressive year-on-year figures. And the company said underlying demand for heavy trucks had been strong. Indeed, there was an improvement in “the conversion of forward schedules to actual sales” compared to the prior year.

Looking ahead, the outlook statement was bullish. And City analysts expect earnings in the current trading year to March 2023 to rise by around 45%. However,  the forecast for the following year is for an increase of just 4%, or so. 

But I reckon the valuation looks modest. With the share price near 355p, the forward-looking price-to-earnings ratio is about 12. And the anticipated dividend yield is running near 4.8%. But on top of that, the business has a multi-year record of running a net cash position on its strong-looking balance sheet.

However, this is a highly cyclical business. So a long-term investment in the shares now requires me to back my bullish view about the general economy. And that situation carries its own risks.

Nevertheless, I’m interested in both these stocks and would be inclined to invest if I had some spare cash.

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IQE says that “a weak smartphone market” has resulted in reduced orders for wireless chips. The firm’s photonics division is also seeing lower forecast orders, which is likely to result in lower orders during the second half of the year.

Chief executive Drew Nelson believes that the US government restrictions placed on Chinese firm Huawei are having “far-reaching and long-last impacts” on the market in which IQE operates. In May, the company said this issue could affect up to 5% of revenue, but in today’s update, management has admitted that the total hit is now expected to be larger.

Profit collapse?

IQE now expects to report revenue of between £140m and £160m for 2019, compared to previous forecasts of £175m. Based on the mid-point of £150m, that’s a reduction of about 14%.

That may not sound too bad, but lower volumes mean that profit margins will fall too. The company says that its adjusted operating profit margin is now expected to be “significantly below” its previous guidance of at least 10%.

Management hasn’t specified how far margins are expected to fall. But based on the use of the word ‘significantly’ I’d expect a revised figure somewhere between 5% and 8%.

Using the mid-point of 6.5% as an example, my sums suggest that IQE’s adjusted operating profit is now likely to be about 45% lower than expected — I’d estimate about £10m.

It’s worth remembering that profits slumped in 2018, too.

Can the firm return to growth? It’s not clear to me. However, I thought that IQE shares looked expensive before today’s announcement, and in my view they still do.

I estimate that at 50p, the shares are probably trading on about 45 times 2019 forecast earnings. That’s too high for me, especially as this capital-intensive business has never paid a dividend. I’m going to continue to avoid this stock.

A quality engineer I’d buy

IQE’s high-tech products and jargon-filled press releases may seem exciting. But the firm appears to be struggling to convert this hype to cold hard cash.

One engineering firm that takes the opposite approach is Castings (LSE: CGS). As its name suggests, this 112-year old company makes metal parts for manufacturers, with more than 80% going to the automotive sector.

Castings has had its problems over the years. Most recently its CNC Speedwell machining division has come unstuck. But throughout the time I’ve been following this stock it’s remained robustly profitable, with a big net cash balance and a reliable dividend.

The latest figures from the firm suggest that trading is improving. Revenue rose from £133m to £150m last year, while adjusted pre-tax profit climbed from £12m to £15.3m. The firm’s foundries are said to be busier and more profitable, while new management is working hard to fix problems at CNC Speedwell.

Although a cyclical downturn is a risk, demand for commercial vehicles is said to remain strong. This is supporting Castings’ order book.

The shares trade on 12.5 times forecast earnings, with a dividend yield of 3.4%. I’d prefer to pay a little less, but this looks a fair price to me for income investors.

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It was hard for me to work up enthusiasm for the share. There didn’t seem to be much scope for spectacular growth rates, and I was worried about the inherent cyclicality in the operation as well.

A worrisome, volatile holding period

The company exports much of its product to vehicle manufacturers, and I said in 2015: “Owning the shares now is fine if the economic up-leg continues, but I wouldn’t want to be holding Castings if a downturn hits the industry.” My guess back then was that many shareholders were attracted to the stock because it appeared to be cheap, but I argued that “through the lens of cyclicality, Castings might not be as cheap as it looks.”

For the record, in October 2015 the share price stood at 436p and the forward-looking price-to-earnings rating one trading year ahead to March 2017 stood at 10.5. The anticipated dividend yield was 3.4%.

Today, the share price stands close to 442p, the forward-looking P/E rating to March 2020 is almost 14 and the anticipated dividend yield is just under 3.2%. Over the past three years and eight months, revenue, earnings, cash flow, and the dividend have all been volatile and the share price dipped as low as about 350p in March 2019 before bouncing back recently.

If you’d held since my previous article, you’d have collected just under 76p in ordinary and special dividends and made about 6p on the share price for a total return of about 82p, which works out at an overall return of around 19%.

Given all the cyclical risk you’d have taken on, I think that kind of return is low for a hold of more than three-and-a-half years. And we haven’t even seen a major slump in the industry yet. As time passes, arguably, the risk involved with holding now is even greater than it was.

A lacklustre outlook statement

The company delivered its full-year results report today. Revenue increased by almost 13% compared to the previous year and earnings per share moved up around 12%. The directors increased the total dividend for the year by just over 1.9% to 14.78p and also declared a special dividend of 15p. We could look at the dividend yield as being about 6.7% this year, although special dividends are not guaranteed in the future. Indeed, the last special dividend was paid in 2016, so it’s an intermittent occurrence.

I think the outlook statement is informative and here it is in full: “It appears at the present time our order book is sound and schedules remain stable. In particular demand for commercial vehicles is currently strong and it is hoped this trend will continue.” To me, the tone and language of that statement suggest that the directors are aware they have little control over the macro-economic cycles governing the outcomes for their business. This one is not for me and I’d rather invest in a tracker fund than take the individual company risk.

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The high-street fashion chain reported a 4.5% rise in full-price product sales for the three months to 27 April, boosted by an 11.8% hike in online sales while bricks-and-mortar shopping declined by 3.6%.

The company did put this better-than-expected performance mainly down to the warm Easter weather which had more people out shopping, and full-year guidance isn’t quite as rosy, but it still looks reasonable to me.

Full year

The year is now expected to bring in a modest 1.7% full-price sales increase, with an 8.5% drop in conventional retail sales offset by an 11% gain in online sales. Next stressed that quarterly comparisons with last year are difficult, as there have been some serious weather differences from year to year, and that obviously has an effect on the high street.

There’s a bottom-line 3.4% increase in EPS on the cards too, enhanced by the company’s share buyback plans, with £86m of an intended £300m of surplus cash already redistributed that way.

Next might not offer one of the biggest dividend yields, but it is progressive and very well covered by earnings — forecasts for the current year indicate cover of 2.7 times, which leaves a big margin of safety.

I’m always a bit twitchy when I see net debt, but Next’s at £1.1bn doesn’t look like a big cause for concern. And with the shares on forward P/E multiples of around 12, I still reckon I’m looking at a good long-term buy. Not a screaming bargain, but a good company at a fair price.

Price slump

I’m turning now to a small engineering company called Castings (LSE: CGS) which manufactures, well, castings. I’ve had my eye on the company for a while, but I’ve been disappointed by its poor share performance that has seen the price sliding over the past two years. There have been falls in earnings, but forecasts suggest a return to strong growth, starting with the year just ended on 31 March.

I perked up when I saw a 7.5% uptick in the share price on Wednesday after the firm released its full-year pre-close update.

Castings told us that, thanks to strong demand in the second half of the year, its full year should come out ahead of market expectations. Margins at the firm’s foundries are improving too, and management initiatives are apparently making a difference.

Dividends

But it’s the dividends that are the real attraction for me, and I can’t help feeling the market has not given them sufficient credit when marking down the share price. Dividend policy is conservative, maintaining strong cover by earnings. In 2016, before a couple of down years for earnings, the dividend (yielding 2.7%) was covered 2.7 times. That allowed the company to maintain progressive rises and still see cover at 1.5 times in the toughest year of 2018.

Meanwhile, the slipping share price has pushed the expected 2019 yield up to 4.1%, and with two more years of EPS gains on the cards, we’d be looking at cover back up to 2.1 times by 2021.

I’m seeing a small but well-managed company here, with a focus on providing long-term income for its shareholders. And I think the day’s price rise could presage a better year to come.

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Within that period, the company has delivered results in line with its expectations, while continued growth looks to be ahead. As a result, it has the potential to beat the UK’s main index alongside a growth stock which reported upbeat results on Wednesday.

Simple strategy

Boohoo’s strategy is relatively simple. However, as is often the case in business, a simple strategy which is accurately executed can lead to significant financial rewards. The company has been able to deliver innovative fashion items at relatively low prices alongside high levels of customer service.

With a solely online footprint, it has also benefitted from cost advantages versus bricks-&-mortar rivals, while the continued transition of shoppers from High Street to online has also provided a tailwind for the business.

Investment outlook

The company’s results released earlier this week showed that it continues to make progress with its strategy. The decision to branch out into new websites seems to be paying off, with the company’s growth rate being exceptionally high. For example, in the current year Boohoo is forecast to post a 16% rise in its bottom line, followed by further growth of 25% next year.

Clearly, buying the stock on an ultra-low valuation would be highly desirable. But given that the FTSE 100 trades close to its record high, the company has a price-to-earnings growth (PEG) ratio of 2. This suggests that while it’s not dirt-cheap, there could be significant growth potential ahead given the positive trading conditions it’s experiencing.

Improving prospects

Of course, there are other shares that could also deliver outperformance of the FTSE 100. One such stock is iron castings and machining group Castings (LSE: CGS). It reported a positive set of results on Wednesday which showed that its foundries have seen an increase in output and improved profitability compared to the previous year.

The company’s investments in robotic handling have boosted productivity, while additional investments are expected to reduce costs yet further. With its order book being solid and schedules increasing, the company appears to have a positive outlook. In fact, in the current year, it’s expected to post a rise in earnings of 27%, followed by further growth of 10% next year.

Despite Castings’ high earnings growth outlook, the company trades on a PEG ratio of 0.6. This suggests that it could offer a wide margin of safety – especially since its strategy seems to be performing well in current market conditions. With a 3.5% dividend yield, which is covered more than twice by profit, its total return could be ahead of the FTSE 100’s future performance.

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But after a big slump in 2008/09, UK manufacturing output has been steadily recovering, and the latest figures show the Manufacturing Index at its highest level in 10 years. Global economic growth has helped, and the weakening of the pound since the Brexit referendum has given Britain’s exports a significant boost.

Both of these trends tie in nicely with Rolls-Royce’s restructuring and cash-savings progressing ahead of plan, as reported at the halfway stage this year. At the time, underlying revenue was up 6% with underlying pre-tax profit up 148%.

On target

November’s update confirmed the company is on track to achieve its expectations for the year, telling us that its Civil Aerospace, Defence Aerospace and Power Systems were all performing well. The Marine division was still weak due to depressed demand from the oil and gas business, but with the black stuff getting ever closer to $70 per barrel, I can see a recovery there in 2018.

I confess I’m a little twitchy about the Rolls-Royce share price, after a one-year climb of 27% to today’s 846p. That gives us a forward P/E multiple of 24 based on forecasts for 2018, which looks a bit high. But if we really are past the bottom of the cyclical engineering downturn, the new slimmer company could be set for a return to its decades-long trend of steadily rising earnings.

The dividend is on the way back too, and though the predicted rise for this year would take it to a yield of only 1.6%, it’s a definite turn in the right direction.

Better bargain?

A smaller engineering company that impresses me is Castings (LSE: CSG) which, as its name suggests, is in the iron casting and machining business.

Thursday’s trading update confirmed that things are going as expected and spoke of “steady demand from our commercial vehicle customer base.” The firm was also able to draw a line under the costs of a couple of changes. Its new management team decided to pull out of a few projects it deemed unsuitable, which has cost £1.3m, and the reorganisation of its machining business has impacted the bottom line to the tune of £3.4m.

Full-year profit is expected to come in between £12.5m and £13.5m, with “positive” cash flows.

Current forecasts suggest P/E ratios for this year and next of 16 and 14 respectively, which is a good bit lower than Rolls-Royce’s current valuation. And I think that makes the shares a bargain at this stage in the manufacturing cycle.

Cash too

What’s more, Castings has been paying steady dividends, even while its earnings have been a bit erratic over the past few years. This year there’s a 3.2% yield on offer, with 3.3% pencilled in for the next year. It’s progressive too — around twice covered by forecast earnings, and just about keeping up with inflation.

If this is how the company has been rewarding shareholders during a downturn, I can see scope for significantly enhanced dividends in the future if the export-led manufacturing growth phase really does continue.

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However, there are other companies which could do likewise. Reporting on Friday was one stock which could offer high dividend growth potential in the long run.

Mixed performance

The company in question is iron casting and machining company Castings (LSE: CGS). Its performance in the first half of the year was somewhat mixed. On the one hand, its Foundry operations continued to perform well after a period of production and productivity improvements. They have helped to deliver a rise in sales revenue of 7.9%, with profit being up 10.5% versus the previous period. Further investment is being made in order to support an automation programme that is being rolled out.

However, in the company’s CNC Speedwell Machining operation, revenue decreased by 10.9%. It also delivered a reported loss of £1m versus a profit of £0.8m in the previous period. The business has experienced major issues, such as production problems. They have resulted in a review which has identified additional short-term costs for the business. With changes being made to the Machining business, it is expected to return to profitability in the next financial year.

Dividend potential

With Castings having a dividend yield of 3.1%, it offers a real income return at the present time. However, it is the company’s dividend growth potential which could make it a worthwhile income stock for the long run. Its dividend is covered more than twice by profit. With its bottom line due to rise by 13% in the next financial year, this could provide it with scope to increase shareholder payouts at a brisk pace. And since it trades on a price-to-earnings growth (PEG) ratio of just 1, it also appears to offer capital growth potential.

Similarly, Centrica could also increase dividends in future. The company is making major changes to its business model, and they are expected to create a business which is able to deliver greater profitability in the long run. In fact, as soon as next year the company is forecast to grow its bottom line by 2%. This means that its shareholder payouts are due to be covered 1.3 times by profit, which suggests there could be scope for them to grow.

Uncertainty

Clearly, both stocks are experiencing uncertain periods at the present time. However, they both appear to have sound strategies which could lead to stronger performance in the long run. Therefore, now could be the right time to buy them while they offer relatively wide margins of safety. Doing so could mean higher income returns in the long run.

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And while the headline figures were disappointing, I believe that this is the perfect opportunity for long-term investors to get involved in the group’s growth story. 

A transformational year 

For the year, Avingtrans reported sales growth of 7% to £22.7m and adjusted earnings before interest, tax, depreciation, and amortization of £0.7m, up 104% year-on-year. Adjusted profit before tax was £0.3m, compared to 2016’s figure of £0.1m. Unfortunately, after including costs, the company reported an unadjusted loss of £0.3m. 

However, during the year, it overhauled its business model and going forward I believe that the company can generate huge returns for investors. 

After selling its Aerospace division for a healthy profit in 2016, and returning £19m to investors, management has decided to adopt a strategy it calls “Pinpoint-Invest-Exit,” based on the “now proven strategy of ‘buy and build’ in regulated engineering niche markets.” This looks similar to the model used by engineering giant Melrose, which buys businesses, helps them reach their full potential, and then sells them on. 

As part of this strategy, Avingtrans made modest acquisitions of Scientific Magnetics and the assets of Whiteley Read Engineering during the financial year. After the year-end, the company acquired Hayward Tyler Group. According to management, “an unfortunate combination of ambitious investment programmes, acquisition and market down-cycle led HTG to an overstretched balance sheet position.” Avingtrans hopes to be able to get the business back on track and growing again. 

Buying, building and selling can be lucrative if done correctly. That said, plenty could go wrong with such a strategy and investors need to keep an eye out for the tell-tale signs that management has bitten off more than it can chew.

If the firm’s sales growth starts to slow, costs expand rapidly, and cash generation vanishes, these could be signs that the problems at HTG may be deeper than initially believed. On the other hand, if costs fall, sales continue to grow, cash generation improves, and margins widen, Avingtrans should be heading in the right direction.

Slow and steady 

Castings (LSE: CGS) is three times the size of Avingtrans, so the company’s growth is slower than that of its smaller peer. Nonetheless, I still believe that this business can achieve stellar returns for investors. 

Since the beginning of 2015 the shares have produced a total return of 45%, and as long as the company can maintain its operating profit margin of 14% and return on capital employed of 14%, the returns should continue. 

Wide margins and a high return on capital mean that the company has been able to invest for growth and return cash to investors at the same time. Book value per share has grown at around 6% per annum for the past six years, and at the end of fiscal 2017, Castings had net cash on the balance sheet of £27m. The shares currently trade at a forward P/E of 15.8 and support a dividend yield of 3%. 

As long as Castings’ business continues to throw off cash, I would not rule out the prospect of additional special dividends. 

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