Warren Buffet knows the importance of passive income. The Oracle of Omaha is famous for saying that if you don’t find a way to make money while you sleep, you will work until you die. Like Buffett, I generate passive income by owning shares in companies that pay dividends. But Buffett has two important warnings about trying to get rich like this. The first is that dividends don’t make people rich. The second is that assessing opportunities to make money while I sleep requires caution.
Dividends don’t make people rich
Buffett’s first piece of advice is to stop thinking that dividends make investors rich:
We don’t get rich on our dividends that we receive, although we’re happy to receive them. We get rich on the fact that the retained earnings are used to build new earning power, repurchase shares, which increases your ownership in the company and Berkshire has retained earnings since we started. That’s the only reason Berkshire is worth a lot more—it’s that we retain earnings.
Should you invest £1,000 in Direct Line right now?
When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets. And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Direct Line made the list?
What makes investors rich, according to Buffett, is not receiving dividends. Rather, it’s retained earnings being used to generate future earnings and reduce the company’s share count. This makes investors rich by giving them a larger share of a larger company.
Don’t reach for yield
Buffett also says that I should be conservative when assessing passive income opportunities:
People say, “Well, I’ve saved all this money all my life and now I can only get 1%. What do I do?” The answer is you learn to live on 1% unfortunately. And you don’t go and listen to some salesman come along and tell you, “I’ve got some magic way to get you 5%“.
Buffett is very clear here that I should stick to high-quality investments even if dividend yields are low. This advice is particularly relevant at the moment. Interest rates have come down, resulting in stock prices climbing and dividend yields falling. Apple, for example, had a dividend yield of 2.4% in 2016, has a dividend yield of 0.5% today.
Following Buffett’s advice
I don’t want to make low-quality investments. But I also don’t want to settle for a 0.5% return. So what should I do to follow Buffett’s advice and make money while I sleep?
The answer is to look beyond the company’s dividend yield for a return on my investment. Instead of evaluating an investment using the money that a company pays out, I should do it by looking at how the company retains its earnings and uses them to make more money and buy back shares. Buffett’s point is that passive income doesn’t have to be distributed. I can make money while I sleep by having a company that I own growing its earnings and using the cash it generates to buy back its own stock.
I’ve been following Buffett’s advice to make money while I sleep. That’s why I’ve been buying shares in Citigroup, which has an opportunity to repurchase shares at advantageous prices. It’s also why I’ve been buying Meta Platforms, which retains its earnings and uses them to grow efficiently. And it’s why I’ve been buying Berkshire Hathaway, which is run by Buffett himself. The steady process of having companies retaining and compounding their earnings while repurchasing shares is how I plan to make money while I sleep.
