Investing in the stock market can be a great source of passive income. But finding quality stocks with attractive dividend yields can be challenging at the moment.
So what can I do? Should I accept lower returns from quality companies, or look for higher yields in riskier investments?
High yields
According to Warren Buffett, the answer is simple:
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If you need to get 3% and you’re only getting 1%, the answer is to quit giving 3%. It’s not to get the one up to three and do more dangerous things. You should always adapt your consumption to your income – you shouldn’t try and adjust your income to your consumption.
In other words, Buffett thinks that taking bigger risks by looking for stocks with higher yields is dangerous. I agree – if the company cuts its dividend, then the share price is likely to fall with it.
A good example of this is Hargreaves Lansdown. The stock has a dividend yield of over 4%, but I think it looks risky.
The company pays out almost all of its net income as dividends. By itself, I don’t think that’s a problem, but its earnings have been falling.
If the dividend gets cut, then I think the stock price is likely to fall. This illustrates the danger of looking for bigger returns from riskier companies.
Quality businesses
So what should I do instead? Buffett has the following advice:
People say ‘well I’ve saved all this money all my life and now I can only get 1% on it, 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%.’
I think that what Buffett has in mind here is illustrated by Rightmove. The stock currently has a dividend yield of 1.37%, which is hardly eye-catching.
Rightmove shares look like a much more durable investment to me than Hargreaves Lansdown. And that’s important when it comes to passive income.
The company distributes just under 35% of its earnings as dividends and those earnings are growing. Rightmove also boosts its shareholder returns via share buybacks.
Dividends
Warren Buffett’s advice when it comes to passive income is clear. It’s far better to accept a lower return from a quality business than look for a bigger yield from a riskier stock.
Even with the best businesses, dividend payments are never guaranteed. There’s always a risk that Rightmove’s management might decide to suspend its dividend, as they did in 2020.
The point, though, is that the company wasn’t forced into doing this. And since then, the dividend has been reinstated at a higher level than it was before it was cut.
I’m following Warren Buffett’s advice when it comes to passive income and sticking to durable businesses. Even if the yields on offer today are lower, I think I’ll do better this way over time.
