Dividend stocks can be a terrific source of passive income, especially to investors with long time horizons. Compounding a £10,000 investment at 6% per year could return £293 a month after 30 years.
At today’s prices, shares that have dividend yields above 6% are generally towards the riskier end of the investment spectrum. But there is another way.
Learn from the best
When it comes to earning passive income, Warren Buffett has achieved some spectacular success for Berkshire Hathaway shareholders.
The company’s investment in American Express is a great example of this. In 1995, Berkshire completed a $1.3bn investment in the credit card company.
Last year, that investment returned $302m in dividends for Buffett’s company. That’s a 23% return on the original investment.
The success of this investment comes down to two things. One is finding a quality business to invest in and the other is giving it a long time.
With £10,000 to invest, I’d look to follow a similar approach to try and turn that into £293 a month in dividends. And there’s a FTSE 100 stock that I think could get me started today.
Growth
Buffett’s decision to invest in American Express is currently paying huge dividends, but it wasn’t always this way. When Berkshire completed its investment, the stock had a dividend yield of around 3.15%.
Since 1995, though, American Express has increased its dividend per share by an average of 7% per year. The company’s also used share buybacks to bring down its share count.
One FTSE 100 company that has been increasing its dividend at this rate over the last 10 years is Bunzl. At today’s prices, the starting yield is 2%, but the company has a strong track record when it comes to growth.
There’s no guarantee the firm can keep doing this and the risk is that this might be tough. A lot of Bunzl’s growth comes from acquisitions, which means management constantly needs to find new targets at attractive prices.
This isn’t easy, but it’s fair to say that the company has so far done an outstanding job for its investors. And if opportunities do start to become more scarce, there’s always the possibility to switch to buybacks to generate value.
Time
The other key part of Buffett’s success is giving investments a long time to develop. Turning an initial $41m in dividends into $302m in passive income takes 28 years at a 7% growth rate.
That’s a key part of how I’d look to achieve a 6% average annual return. Bunzl shares might not offer that kind of yield today, but if the dividend keeps growing at its current rate, then it will do in the future.
Achieving 7% annual growth on a 2% dividend would generate an average annual return of 6.8% after 30 years. That’s more than enough to generate £293 per month on a £10,000 investment.
This illustrates another of Buffett’s key principles. Aiming for 6% by buying something on track to achieve 6.8% leaves a margin of safety in case things falter slightly.
It’s also worth noting that this kind of result assumes that I don’t reinvest my dividends to compound my gains. That’s another way I could look to get to my goals even if things don’t quite go to plan.
