According to Warren Buffett, if you don’t find a way to make money while you sleep, you will work until you die. Buying stocks that generate income is a great way of doing the first and avoiding the second.
Figuring out which shares to buy can be challenging and there are traps to avoid everywhere. But there are a few things investors can look for.
Quality
One of the most important things when it comes to investing for passive income is finding a quality company. This means two things.
First and foremost, it means the business has the ability to generate significant amounts of cash. If it doesn’t do this, it isn’t going to provide passive income to its shareholders.
Equally important, however, is finding an organisation that doesn’t have high ongoing costs. The more it costs to run, the less of its cash is available to investors.
One terrific example of this is Rightmove. As an online platform, it doesn’t have significant equipment maintenance costs, which allows it to return a lot of its cash to its owners.
In 2022, the business generated £198m in cash through its operations. And the capital expenditures came in at less than 1.5% of this, leaving the rest available as free cash.
Moat
A business that generates a lot of cash is great. But it’s important it has some advantage over its competitors – what Buffett calls an economic moat.
Without a moat, even a great company won’t be a good passive income investment for long. Rivals will start doing something similar, disrupting its cash generation.
There are different types of moat. A size advantage, a low cost of production, or a network effect can be a competitive advantage.
AstraZeneca is a great example of a UK business with an economic moat. Of the drug manufacturer’s 30 medicines, 25 are under patent, effectively preventing copying from competitors.
With this kind of moat, it’s also important that the company has a good pipeline. In order to maintain strong cash flows, the firm needs more drugs coming through to replace expiring patents.
Price
Finding great stocks is only half of the challenge, though. The other half is buying them at a decent price.
No business can generate an infinite amount of cash. This means it’s always possible to make a bad investment by paying too much for a stock.
Whether or not a a company’s shares are good value comes down to two things. The first is its price and the second is the amount of cash it will distribute to its owners in the future.
Diploma, for example, has a share price of £27 and paid out £45p in dividends per share last year. That’s a 1.7% return, which isn’t hugely impressive.
The business is growing, though. Over the last decade, Diploma’s dividend payments have increased by 12% per year, so future returns look set to be higher than the current ones.
Passive income
Buying stocks for passive income is simple, but not easy. There’s a lot to consider and there’s always uncertainty about the future.
Nonetheless, I think there are opportunities in great companies out there. And the UK stock market looks to me like as good a place as any to find them.
