Excerpt: Warren Buffett’s investment in Coca-Cola has been outstanding. Stephen Wright thinks investors should take a similar approach to build a second income.
An investment portfolio that provides a second income can be a terrific asset. Earning extra cash can allow someone to do more, live better, or provide a more comfortable retirement.
It’s easy to think investing requires a lot of cash. But that’s a mistake – putting money aside regularly in the stock market can be a great way of earning substantial passive income.
Starting from zero
Having something to get started with does make investing easier. But even with no savings, investing part of a monthly salary in stocks that pay dividends can bring great results.
Investing £1,000 per month in stocks that offer a 5% dividend generates £325 in cash per year. Doing this for 10 years results in £3,250 in annual passive income.
That’s good, but it’s possible to do a lot better. Reinvesting the returns each year at the same rate allows the investment to grow much faster.
Doing this for 10 years results in a portfolio generating £7,120 per year. That’s a meaningful second income, but the question is how to achieve a 5% annual return.
Warren Buffett
One way of doing this is by looking for stocks that come with a 5% dividend yield. There’s nothing wrong with this, but it’s not the only approach available.
Warren Buffett has had a lot of success by buying shares in companies that can grow over time. Coca-Cola is a great example.
Back in 1994, Buffett’s 400m shares in Coca-Cola generated $75m in cash income. Since then, the dividend has increased to the point that Buffett’s stake returns $732m per year.
Buffett’s strategy of investing in companies that can grow their earnings is instructive. To average 5% over a decade, a stock doesn’t have to come with a 5% dividend yield today.
Where to start?
If I were getting started today, I’d think about buying shares in FTSE 100 oil major BP (LSE:BP). The stock currently comes with an attractive 4.7% dividend yield.
The biggest challenge for the company is the ongoing transition to renewables. While I think this is going to take longer than most analysts are expecting, there’s a clear risk here.
BP has made mistakes when it comes to investing in renewables. But I think these are causing the market to underestimate its future cash flows, creating an opportunity.
With a new CEO and a focus on shareholder returns, the company seems to be on the right track. I think the future dividends can average 5% per year over the next decade.
Dividend income
Shares in companies that distribute their profits as dividends can be a great source of extra income. And it’s possible to get started without having huge savings.
A 5% annual return and reinvesting dividends for 10 years is enough to turn a £1,000 monthly investment into a second income of £7,120 per year. And I think this is achievable.
Warren Buffett has been investing steadily in Occidental Petroleum – a US oil company – recently. I think BP also fits the bill, though, and it’s the stock I’d buy to start today.
This post was originally published on Motley Fool
