One excellent way to build wealth and passive income is by investing in income stocks.
According to a study by Fidelity, dividends account for 40% of the S&P 500's total returns. When inflation is high, as it was in the 1940s and 1970s, dividends account for as much as 71% of the market's returns.
Berkshire Hathaway chief executive officer and renowned investor Warren Buffett likes three dividend-paying stocks: U.S. Bancorp (USB -0.20%), Bank of America (BAC 1.53%), and Chevron (CVX 0.75%). So why not take your cue from an expert? Investing $69,000, split among these three companies, would net you $10,000 in income in the next five years.
1. U.S. Bancorp: $4,025 in passive income on a $23,000 investment over five years
U.S. Bancorp provides banking services throughout the Midwest and West regions through its 2,200 branches and is one of Berkshire Hathaway's largest holdings.
U.S. Bancorp benefits from rising interest rates because of the nature of the banking business. Traditionally, banks have made money from the difference between the interest paid out on deposits and the interest earned on loans.
Some banks, like JPMorgan Chase and Citigroup, bring in money from investment banking to boost earnings. U.S. Bancorp doesn't have this option and relies on net interest income as its primary source of earnings. However, its focus on traditional banking puts it in a strong position to take advantage of rising interest rates.
Return on equity (ROE) is a metric that shows how well a company generates profits from investors' money. Because U.S. Bancorp focuses on lending, it's selective about the loans it makes. As a result, it delivers an ROE that leaves its banking peers in the dust.
USB Return on Equity data by YCharts.
The bank sacrificed short-term profits last year to give it the flexibility to invest in higher-yielding assets this year and beyond. The bank's net interest income grew 3.6% in the first quarter, and its commercial loan balances increased 10.5% from last year. In its March 31 filing, the bank projects that a gradual increase in interest rates of 2 percentage points would increase its net interest income by 3.3%.
U.S. Bancorp trades at a dirt-cheap valuation with a price-to-earnings ratio (P/E) of 10.5, and it offers investors a dividend yield of 3.55%.
2. Bank of America: $2,668 in passive income on a $23,000 investment over five years
Bank of America provides banking services across the U.S. and internationally and is the second-largest bank in the U.S. -- it has nearly $2 trillion in deposits, trailing only JPMorgan Chase. The bank is also Berkshire Hathaway's second-largest holding.
Bank of America is highly sensitive to interest rates and stands ready to reap the benefits from rising rates. According to the bank, a 1% increase in interest rates would result in an additional $5.3 billion in net interest income over one year, or 12% more than 2021's net interest income.
Investors should note that rising interest rates can impact the broader economy. Inflation remains high, and the Federal Reserve is committed to bringing it down by increasing the federal funds rate, or the rate banks charge each other for overnight loans. These rate increases could lead to reduced economic growth, which would mean slower loan growth for banks.
However, Bank of America is ready to exit this era of ultra-low interest rates. Like U.S. Bancorp, Bank of America is cheap, sporting a P/E ratio of 9.5, and it delivers investors a dividend yield of 2.34%.
3. Chevron: $3,692 in passive income on a $23,000 investment over five years
It's no secret that gas prices have skyrocketed. Rising crude oil and natural gas prices make energy stocks attractive, which is why Chevron is now Berkshire Hathaway's third-largest holding.
Drilling and exploration give Chevron good margins for rising oil and gas prices. Still, the company could also perform if these were to drop thanks to its midstream (transportation and storage) and downstream (refineries) businesses.
Chevron's business is booming; revenue grew 70% in the first quarter, while profits quadrupled. Consumer demand for oil will remain high as COVID restrictions ease globally and more people travel. The oil giant has committed to buying back as much as $10 billion of its shares, which will support the stock price, and it delivers investors a dividend yield of 3.14%.
