Passive income is money I can get without working for it. I don’t need to work to set up a new income-generating business as passive income can be as simple as dividends received from shares in which I invest.
Warren Buffett is famous as an investor. And he’s also a role model in how to set up passive income streams. My aim is to earn passive income following Warren Buffett principles.
Benefit from embedded value
Buffett once said that “someone’s sitting in the shade today because someone planted a tree a long time ago.”
His investment in Coca-Cola is a case in point. The brand has enjoyed heavy marketing investment for decades, which helps drive demand now. It has built brand loyalty. That helps to give the company pricing power. Investors in the company today are benefiting from value that has been embedded in the company over decades.
Buffett spent years as a director of the firm, so Coca-Cola’s dividends weren’t purely passive income for him. But I would look to use the same principle. For example, I could invest in branded drinks manufacturer Diageo. Like Coca-Cola, its brands such as Johnnie Walker and Guinness have been built over a very long time. That has engendered brand loyalty. With a dividend yield of 2.1%, if I put £10,000 into Diageo now I’d expect to generate over £200 a year in passive income, as long as the dividend is maintained.
Of course, Diageo has risks, which include any sales decline from a fall in alcohol consumption and the vulnerability of premium pricing to an economic downturn, but the principle still works.
Making the most of opportunities
Buffett is well known for long periods of share-buying inactivity. And during the past year of frenetic stock market activity, he’s been notable mostly by his absence.
That’s because he’s happy to wait for what he sees as better-than-normal opportunities.
Consider this Buffett nugget: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble”.
We see that applied to his approach to passive income. For example, during the financial crisis, he struck a deal to help fund Goldman Sachs. Part of that involved buying preferred shares paying a 10% dividend. Buffett put out the bucket and invested $5bn.
He later said: “It’s been pointed out that our preferred is paying us $15 a second. So as we sit here, tick, tick, tick, tick, that’s $15 every tick.”
Passive income principle
That was an incredible result, although it reflected the risks associated with some financial services providers during economic downturns.
The chance to make passive income like that won’t be open to most investors. But I think I can still learn from the principle Buffett espouses here.
Instead of investing in passive income opportunities that look just okay, I would wait until something comes along that seems excellent to me. If that means I need to wait a year or two to start generating money from that passive income stream, I’ll wait. But then, when I uncover an opportunity I think looks especially promising, I’ll “put out the bucket”.
However, while I want to make the most of opportunities, even what looks like a good investment can go bad. So, like Buffett, I’d be sure to diversify my holdings.
christopherruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.