Warren Buffett is often viewed as one of the most successful investors alive today. After all, he turned a $100,000 lump sum into a $750bn enterprise called Berkshire Hathaway. And the firm is well on its way to breaching $1trn in the coming years.
This exceptional performance took a lifetime. But it demonstrates the power of compounding when left to run. So how did he do it?
For the most part, the ‘Oracle of Omaha’ has focused on value stocks. These are top-notch companies trading significantly below their intrinsic value. In other words, he bought low to sell high. And it’s a tactic I’d follow when looking to build a passive income portfolio.
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Buffett and dividends
Investors who have been following Berkshire Hathaway for a while know that shareholders have been asking for a dividend from the firm for many years. After all, there’s around $50bn of cash & equivalents just sitting on the balance sheet as per the latest figures.
Buffett’s argument against paying a dividend is that he believes he can still earn a superior return on this capital in long run. And given his track record, I’m inclined to agree with him. But while he may not like the idea of paying a dividend, he’s certainly not opposed to receiving them.
In fact, some of his best investments have been dividend-paying companies. For example, Coca-Cola joined the Berkshire portfolio back in 1988, and the investment group has been systematically accumulating more shares over time.
Today, he owns around 400 million shares worth an estimated $22bn. That’s about an 8% stake in the overall business. And when looking at his original cost basis, the dividends from Coke have been steadily rising over the years, resulting in a 50% annual dividend yield!
Needless to say, investing in a company that can systematically increase its dividends every year can be exceptionally lucrative. And it’s the primary tactic I’d deploy to establish a second £500 monthly income stream in the long run.
Building an income portfolio
£500 a month translates into £6,000 a year. And assuming I can lock in a 5% total yield, that means I’d need to build a portfolio worth around £120,000. That’s obviously not pocket change. But by consistently investing a sizable sum, like £500 each month, it’s more than possible to reach this goal in the long run.
However, the waiting time could be significantly reduced if I’m able to identify another Coca-Cola stock. This is obviously far easier said than done. But it’s not impossible. So what traits should I be on the lookout for?
The most important factor, in my opinion, is free cash flow. Don’t forget dividends are funded by the excess earnings of a business. So a company that’s producing far more money than it needs to continue growing is likely an excellent candidate. Even more so if the company is offering goods or services that aren’t likely to diminish in demand for decades to come.
Having said all that, it’s important to realise even dividend investing carries risk. Top-notch enterprises can eventually be disrupted. And recent volatility has perfectly demonstrated how a changing macroeconomic economic landscape can throw a spanner in the works.
Nevertheless, Buffett has shown that prudent investing, paired with diversification and patience, can still yield incredible long-term returns.
