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Dividend shares are a natural choice for investors looking for passive income. Companies that return most of their profits to investors, however, often have limited growth prospects.
This means income investors often miss out on some of the best opportunities. But there’s a smart strategy for getting around this and it comes from no less than the one and only Warren Buffett.
FTSE 100 returns
Over the long term, the FTSE 100 has generated an average return of 6.89% a year. And while the future doesn’t have to resemble the past, I think that’s a reasonable expectation.
After 30 years, that’s enough to turn £20,000 into something that generates £9,164 a year. But I think investors who want to achieve that return need to try and keep their options open.
Someone who only considers dividend shares risks missing important opportunities. Rolls-Royce, for example, has been a great stock over the last few years despite not paying a dividend for most of that time.
Anyone who overlooked Rolls-Royce recently has found it much more difficult to match the FTSE 100’s overall return. Fortunately, this doesn’t have to include passive income investors.
Warren Buffett
Despite having more cash than it knows what to do with – at least in the short term – Berkshire Hathaway doesn’t pay a dividend. Buffett explained why at a past shareholder meeting.
With the stock currently trading at a price-to-book (P/B) ratio of 1.59, every $1 the organisation retains as equity increases its market value by $1.59. And this is key to the firm’s dividend policy.
In its current financial position, Berkshire has a choice about what to do with every $1 per share it earns. Paying it out as a dividend means investors get exactly $1.
Retaining it, however, lets investors make $1.59 by selling $1 in equity. As Buffett points out, this is a more efficient way to earn passive income – and it doesn’t rely on the firm paying a dividend.
Growth stocks
With a 1.88% dividend yield, private equity firm 3i (LSE:III) isn’t an obvious stock for income investors. But it’s been one of the FTSE 100’s top performers over the last 10 years.
This isn’t an accident – the organisation has shifted from raising capital from third parties to investing its own assets. And this has changed the company’s prospects dramatically.
A good example is its stake in a European discount retailer called Action. This has generated returns of over 20% a year since the FTSE 100 firm’s initial investment in 2011.
As a result, Action now accounts for more than 72% of 3i’s portfolio and this brings risk. But it’s also a good demonstration of the unique opportunities available to private equity investors.
A stock to consider buying
While 3i does pay a dividend, it retains the majority of its net income for future opportunities. In this regard, it looks a lot like Berkshire Hathaway – and the similarities don’t end there.
At a P/B ratio of 1.5, investors can generate cash by selling part of their investment the way Buffett describes for Berkshire shareholders. And this can be more efficient than a dividend.
I’ve added to my stake in 3i recently and I’m looking to keep buying at today’s prices. And passive income investors looking to outperform the FTSE 100 should consider doing the same.
