Warren Buffett has spent decades explaining his investing philosophy in a highly relatable manner.
Here, I’ll consider three simple of his lessons that I’d follow if I wanted to start making passive income from dividend stocks.
1. Understand the business
This may sound obvious but if I’m going to start generating reliable income, I need to be confident that the cash flows of the underlying firm(s) are resilient.
Buffett loves well-established consumer brands that are easy to understand, such as Coca-Cola. A can of Coke is a product that basically hasn’t changed much since its founding in 1886. It’s a simple business.
However, his holding company Berkshire Hathaway also owns many insurance companies, which can be more complex to comprehend. But this industry is in what Buffett calls his personal ‘circle of competence’.
This refers to an area of expertise or industry sectors that an individual has a good understanding of due to their knowledge, skills, and experience. And sticking to this can increase the likelihood of making successful investment decisions.
Conversely, avoiding hard-to-understand areas (those outside of one’s circle of competence) is crucial.
2. Find economic moats
Warren Buffett specifically looks for companies that have an ‘economic moat’. This metaphor comes from the image of a medieval castle surrounded by a wide moat that helped prevent invaders from breaching the defences.
In a business context, an economic moat refers to the unique advantages that protect a company from competitors. These allow it to maintain its long-term profitability and market share.
The Oracle of Omaha has said: “A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.”
All the best companies/stocks have at least one sustainable competitive advantage. For Coca-Cola, its moat largely lies in its iconic and trusted brand, which fosters consumer loyalty.
While thousands of cheaper copycats have been consigned to history, Coke has increased its dividend for 62 consecutive years. Buffett’s company has been collecting these regular quarterly payouts since the late 1980s.
3. Pricing power
Associated with this is pricing power. This refers to a company’s ability to raise prices for its products or services without experiencing a significant decline in demand.
Businesses with strong pricing power can increase or at least maintain their profit margins, leading to greater resilience in various economic conditions.
Firms with limited pricing power rarely make great investments. As Buffett says, “If you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
A stock example
A 4.5%-yielding stock that I think ticks all these boxes is Games Workshop (LSE: GAW).
The Warhammer-creator’s business model is to simply “make the best fantasy miniatures in the world…and to sell our products globally at a profit.”
It has millions of loyal customers who engage passionately with its treasure trove of unique intellectual property.
That said, the firm does walk a tightrope wielding its pricing power, especially during inflationary times. But a 70% gross profit margin tells its own story.
Meanwhile, its free cash flow margin is a very healthy 39%. Companies that produce cash like this have great flexibility in allocating capital. This enables Games Workshop to regularly pay generous dividends.
