Passive income is the holy grail for many investors. The idea of waking up each morning to find money has landed in your account — without lifting a finger — is a compelling one. And with a Stocks and Shares ISA, it’s entirely achievable.
But here’s my honest take: most investors ask the passive income question too early.
Before thinking about how to extract money from a portfolio, the priority should be growing that portfolio as aggressively as possible.
That means hunting for undervalued opportunities — companies trading below their fair worth, with the kind of durable competitive advantages that can compound returns over years and decades.
And I can say I’m absolutely putting my money where my mouth is. A data-backed approach to growth investing has seen my stock portfolio increase in value by 75% since the start of the year.
This isn’t magic and it’s not an overly concentrated portfolio.
Compounding to glory
The wealth-building phase is where the real magic happens, and cutting it short by pivoting to income too soon is one of the most common — and costly — mistakes I see investors make.
The larger the pot you build, the more effortless the income becomes later. A portfolio of £100,000 generating a 5% yield produces £5,000 a year. Double that pot to £200,000 and the same yield delivers £10,000 — without any extra effort or risk-taking.
Running some maths
Here’s one example.
An investor starts with nothing and chooses to invest £500 of their salary every month — using a Stocks and Shares ISA wrapper (this is just a vehicle to shield gains from tax). For this example, the long-term growth rate of the investments (the stocks) is 10% — that’s just a little above the long-term average of indexes.
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Now, after 25 years, the value of the portfolio will be £663,416. That’s a sizeable portfolio.
At this sage, in my head I’d be moving from growth-oriented investments to dividend-focused ones. A 5% yield here would generate £33,170 per year or £2,764 per month.
Of course, nothing is guaranteed. But this is how the theory works.
Where to invest?
My shares in Credo, Sandisk, Micron, Marvell, Alphabet etc have all surged recently and may be near fair value. But some of my UK holdings have underperformed in recent months.
One of these is Melrose Industries (LSE:MRO). This aerospace manufacturer combines a cheap valuation and positive long-term trends in civil aviation and defence.
Melrose, following the pullback, now trades at 11.9 times forward earnings and has a price-to-earnings-to-growth (PEG) ratio of 0.8. Not only is this a discount to the FTSE 100, it’s a huge discount to the wider aerospace sector.
And relative valuation discounts are where I’m most interested.
| Forward P/E | PEG | Net debt (£/bn) | |
| Melrose | 11.9 | 0.8 | 1.7 |
| Rolls-Royce | 32.1 | 1.9 | -1.7 |
| Safran | 23.1 | 1.3 | -1.8 |
| Airbus | 23.9 | 1.5 | -15 |
| GE | 37.5 | 2.6 | 10 |
This is just a handful of peers, but Melrose stands out. What’s more, it offers that largest dividend of the lot at 4.5%.
Supply chain constraints, impacting aircraft production, leading to lower deliveries and aftermarket sales is a concern.
However, I certainly believe investors should consider this one. Especially given its sole source supplier position on 70% of its sales.
