Warren Buffet’s view of how to generate passive income remains the holy grail of making money. It is simply: “If you don’t find a way to make money while you sleep, you will work until you die.”
In my experience, the best way of doing this is by investing in high-quality shares that pay big dividends. The FTSE 100 contains several of these stocks.
Three of my long-term investment favourites are Phoenix Group Holdings, M&G, and Legal & General. These currently pay returns of 10.4%, 9.5%, and 8.6% – an average of 9.5%.
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According to savings industry figures, the average amount in UK savings accounts at the end of 2022 was around £7,500.
Given the tiny interest rates paid on these accounts, I prefer investing in high-yielding, high-quality FTSE 100 stocks.
Careful stock selection
It is not just a high dividend yield that I am looking for when looking for stocks to buy.
After all, a risk is that these can change, depending on share price movements or business fluctuations over the year. There can also be a broad-based reduction in dividends across an index in the event of a financial crisis.
So, I always look as well at the sector in which a company operates and whether it has a positive outlook. With the three companies above, for example, I am bullish on the UK financial sector.
Share prices across the sector were hit around February/March on fears of a new financial crisis. These were founded on the failures about that time of Silicon Valley Bank and then Credit Suisse. The crisis never happened, but the shares are still much lower than they were before the panic sell-off.
Additionally, the lower prices of the three stocks do not factor in their strong balance sheets and solvency ratios. After the Great Financial Crisis started in 2007, the UK’s financial system was dramatically strengthened.
I also look at a company’s share price valuation compared to those of its peers. If it looks overvalued on any of the measures I use then I ignore it. I do not want my dividend gains wiped out by share price losses, after all.
As part of this process, I look as well at the core strength of a business to determine if it is on a sustainable uptrend. This review includes short-term and long-term asset and liability ratios, new business initiatives, and senior management capabilities, among others.
The miracle of ‘compounding’
In my view, having done all the research and bought a stock, the best way to handle the investment is just to leave it.
Keep an eye on it, certainly, just to make sure things are running as they should, but otherwise, leave it. This, incidentally, is what Warren Buffett does, which is good enough for me.
Leaving the investment also means reinvesting all the dividends paid out to me over the years back into the stock to allow my returns to build up even further. In market parlance, this is ‘compounding’.
So, £7,500 invested at an average yield of 9.5% would grow to £75,000 after just over 25 years. This would generate £7,125 a year in income, or £593.75 a month.
This is provided that this average yield remains the same, of course. But it does not involve any further investments at all, except the reinvestment of dividends.
