How I’m targeting inflation-beating passive income like Warren Buffett

Key points

• A high dividend yield won’t necessarily provide protection against inflation
• I explain how I’m aiming to beat inflation by focusing on reliable growth stocks
• Lessons from one of Warren Buffett’s most successful investments

With inflation now running at around 5% in the UK, I’m finding it harder to find passive income stocks with a dividend yield above inflation. I can find just 20 FTSE 100 stocks with a forecast yield of 5%, or more.

A few of these shares are in my portfolio, but many of them are miners or housebuilders. I think these sectors could suffer if the cost of living keeps rising. Instead, to protect my investments from inflation, I’m following Warren Buffett’s strategy for building passive income.

The ‘Sage of Omaha’ probably wouldn’t describe himself as a dividend investor. But he has said many times that he likes investing in businesses which generate cash and can deliver steady long-term growth.

I think that earnings growth is the key to beating inflation, not dividend yield. Over longer periods, my experience is that share price and dividend growth are linked to profit growth. It makes sense, really. A company with rising profits is probably becoming more valuable.

Of course, this relationship isn’t guaranteed. In the short term, share price movements can happen regardless of earnings. Popular trends, or poor sentiment towards certain sectors, can lead to big share price movements which can catch investors by surprise. Plus, there’s always the risk of a market crash, as we saw in 2020.

Why I’m focused on growth

If a company’s profits are rising by 10% per year, there’s a good chance its dividend will rise by a similar amount. Typically, I’d also expect the share price to keep pace with this growth.

In this scenario, the total return from my investment may be rising by around 10% each year. If inflation is 5%, then my investment is beating inflation and providing a rising income.

On the other hand, if a stock I own provides an 8% dividend yield which stays flat each year, then the real value of my passive income is falling.

With inflation at 5%, the spending power of a fixed annual payment would fall by 22% in five years.

Passive income stocks I’d like to buy

I still care about dividend yield. But I’m happy to accept slightly lower yields today from stocks such as these, which I think will deliver reliable long-term growth. This is very similar to the approach that’s used by Buffett to identify his favourite type of “forever” holdings.

Buffett believes that “time is the friend of the wonderful business”. One great example of this is his investment in Coca-Cola. He has spent $1.3bn on Coca-Cola shares since 1988. But today, this investment is worth more than $20bn.

The dividend income from Buffett’s 9% stake in Coca-Cola is now more than $640m per year — around 50% of his original investment. What this means is that he doubles his original investment every two years.

I don’t know if I’ll ever find my own Coca-Cola investment. But my aim is to follow this model of buying good businesses with long-term growth potential. I reckon this is the best way to generate passive income and stay ahead of inflation.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.