Much of Warren Buffett's wealth has come from his investments increasing in value over time. He's done a great job choosing quality companies that have gained market share and grown earnings. But some billionaire investor wins don't involve actual stock performance. In fact, these wins come in annually, no matter what the particular stock does.
I'm talking about Buffett's successes with dividend stocks. The chairman of Berkshire Hathaway considers passive income a key part of long-term investing, and these types of stocks have turned his portfolio into a money-making machine. Here's some great news: You don't have to invest billions to build your money-making portfolio. Let's find out how to follow Buffett's lead with an investment of any size.
Beating the S&P 500 over time
First, let's consider Buffett's story. He's led Berkshire Hathaway to a compounded annual gain of nearly 20% over 57 years, largely beating the performance of the S&P 500. The benchmark index recorded a compounded annual gain of 9.9% in that period.
Buffett's strategy involves choosing solid companies that he considers undervalued and holding on to for the long term. Many of these companies also pay dividends.
One good example is Coca-Cola (KO), which also happens to be one of Buffett's top long-term holdings. He bought 400 million shares of the world's biggest non-alcoholic beverage company over a seven-year period ending in 1994 and has held on ever since. In 1994, Coca-Cola's dividend payments to Berkshire Hathaway totaled $75 million. That progressively increased, reaching more than $700 million last year. Meanwhile, Buffett didn't have to do anything except continue owning the shares.
My colleague Sean Williams recently wrote that Berkshire Hathaway is set to generate more than $6 billion in dividend income over the coming 12 months -- and most of that will come from five stocks, including Coca-Cola.
So, it's clear holding onto dividend stocks for the long term can pay off. Regarding the Coca-Cola dividend, Buffett wrote in last year's shareholder letter: "Growth occurred every year, just as certain as birthdays."
But what if you only collect a small amount in passive income after investing a small amount in a particular stock? you might ask. Well, that still could set you on the path to growth. That income may pick up as the company increases its dividend and/or if you progressively add to your investment in the stock. You also might consider reinvesting your dividend payments in the stock, which will increase your holding -- and lead to higher dividend payments down the road.
Where to get started
Now, let's consider an important point: how to choose a top dividend stock. A great place to get started is with the list of Dividend Kings or stocks that have raised their payments for at least the past 50 years. This track record suggests rewarding shareholders is important to these companies -- so it's likely they'll continue along the same path. And this means you probably can count on them for dividend growth over the long haul.
Before diving in, though, it's also key to consider a company's financial situation. Does the company have the ability to keep paying out a dividend or raising payouts? For this, we should look at the company's recent earnings reports to be sure it isn't struggling to grow or facing a wall of debt. Then, we should pay particular attention to free cash flow.
Again, let's turn to Buffett favorite Coca-Cola as an example. The company's free cash flow tops $9 billion and generally has been on the rise. That's allowed it to pay out 79% of its free cash flow in the form of dividends. All of this means there is reason to be confident about Coca-Cola's ability to continue lifting its dividend.
KO Free Cash Flow data by YCharts
Understanding the business
One more thing to keep in mind before buying a dividend stock is this: Don't buy a stock uniquely for its dividend. It's essential to buy shares in a company only when you understand that company's business and are optimistic about its future. Only then will you be able to follow that player's progress and know whether you should stay invested, add to your holdings, or sell.
Finally, dividend stocks should be part of a balanced portfolio that matches your particular needs. If you're a cautious investor looking for passive income, you may want to favor dividend players. You might prefer young growth stocks and owning fewer dividend stocks if you're an aggressive investor.
With all of this in mind, whether you have a few dollars or a million to invest, you're ready to take on the world of dividend stocks -- and, like Warren Buffett, gradually turn your portfolio into a money-making machine.
