Monday, February 11, 2013

Warren Buffett’s Dividend Stock Strategy

Warren Buffett is without doubt the best investor the world has ever seen. Starting with a few hundred dollars in 1956, he managed to transform his stake to $20 million by the time he liquidated Buffett Partnership Limited in 1969. His entire net worth by then was in Berkshire Hathaway (BRK.B) stock, a small textile mill which he transformed into a diversified holding company.

After reading his letters to shareholders, and analyzing SEC filings, I have uncovered an interesting trend in his long-term investments at Berkshire. Notably, Buffett has focused on companies which tend to grow income without much in additional capital investment. This is possible when you invest in a business that has strong pricing power, because consumers are addicted to the brand name product or because you have some other form of strong competitive advantage. The 1972 purchase of See’s Candies is a prime example of this. In his 2007 Letter to Shareholders, Buffett mentioned the following:

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses.

It is evident that he invests in businesses with minimal capital needs, and utilizes the profits to purchase other businesses. This is similar to what a dividend investor typically does – accumulate distributions and then invest them in the best long-term opportunities at the time. In essence, the 1972 investment in See’s Candies is producing mind-boggling yields on cost currently. Warren’s investments in Washington Post (WPO), Coca-Cola (KO) and American Express (AXP) have also resulted in double or even triple digit yields on cost.

In 1973, Buffett initiated a position in Washington Post (WPO) for $10,628 million. His shares have an effective cost basis of $6.15/share. At the annual dividend of $9.80/share, his company’s yield on cost is 159%.

Between 1991 and 1994 Buffett acquired over 151,670,700 million shares of American Express (AXP) at a cost of $1.287 billion, which translates into $7.96/share. His initial investment was using preferred shares that were convertible into ordinary shares at a fixed price, plus additions to his holdings. At the present annual dividend of 80cetns/share, his yield on cost is exceeding 10%.

Between 1988 and 1994, Berkshire Hathaway accumulated 400 million split-adjusted shares of Coca-Cola (KO), for $1.30 billion dollars. His average cost per share comes out to approximately $3.25. Based on the annual dividend of $1.02/share, Berkshire’s yield on cost is a stunning 31.40%/year. This means that simply by accumulating the dividends for three years, Berkshire will recover its investment, but still retain ownership in Coke and have a claim on future distributions. In his 2010 Letter to Shareholders:

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn't be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

Unfortunately, as his holding company got bigger and had billions to allocate on a monthly basis, his focus has been mostly on large-cap “elephant” acquisitions. The 2010 acquisition of Burlington Northern is a prime example of this change in strategy.

It is also interesting that most of the businesses that Buffett has purchased such as Geico, Flightsafety International or Wesco Financial had achieved either the dividend achievers or dividend champions status. His purchase of quality, wide-moat companies with growing earnings, has paid huge and rising dividends for Berkshire Hathaway. These seeds have been reinvested in additional businesses, thus expanding cash flow available for investments dramatically. This is a strategy that is similar to the strategy that many dividend growth investors tend to employ. Inspired by Buffett’s legacy, I have been quietly building my own dividend machine, mini Berkshire.

Full Disclosure: Long KO

Relevant Articles:

Buffett Partnership Letters
Dividend Champions - The Best List for Dividend Investors
Seven wide-moat dividends stocks to consider
Strong Brands Grow Dividends

6 comments:

  1. I have been reading this blog for about a year now. First let me say that I enjoy it and keep up the good work. I have yet to see a post where you discuss your positions in terms of dollar amounts. I can understand why you wouldn't want to do that, but it would be very interesting to know two things; how much total in stock do you own, and how much money in divdends does it produce per year? If you don't want to post that info it is ofcourse understandable.

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  2. DGI,

    I like the way you put that - building your own "mini Berkshire".

    That's what I'm trying to do as well. I don't have an elephant gun like Uncle Warren, but I make do with my 9 mm pistol! :)

    People often ask me why I don't invest in ETF's...but why bother when I'm creating my own and skipping the fees in the process.

    Best wishes!

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  3. I recall reading that Buffet/Berk. Hathaway had a bunch of Goldman Sachs perpetually preferred stock that pays like 1.4 million a day in dividends.

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  4. Got to do like Buffett.Buy stocks for the long term.Let them appreciate tax free.Buffett talks like he wants to pay more taxes,but lives like he doesn't.I guess he wants all the envious,greedy Democrats to love him,after he dies.

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  5. DGI,

    This also seems to be the strategy of Altria Group as it relates to the SAB Miller holding. Altria has always been a long term thinking company. The SAB stake is nearly a third of that company, market value in excess of $20B. SAB increases it's dividend regularly and is doing quite well. Altria gets to spend that dividend as they see fit, perhaps they invest in new products, make a aquisition, or use it to improve their dividend. Altria Group is a dividend growth investor too. We are in good company I think!

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  6. Looks like I start reading Buffet's letters. There is a lot of wisdom in it. I like building my own Berkshire. Started this year and my goal is very aggressive. Boost my savings and investment as much as possible.

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