How Buffett Became an 'Accidental' Income Investor

By searching for quality, the investor has achieved income

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Jul 28, 2022
Summary
  • Buffett has never looked for income above all else.
  • However, he looks for shareholder returns.
  • This approach has lead to billions in dividends.
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Berkshire Hathaway’s (

BRK.A, Financial) (BRK.B, Financial) equity portfolio generates billions of dollars in dividend income for the conglomerate every year. The portfolio of securities, predominantly chosen by Warren Buffett (Trades, Portfolio), contains some of the most attractive dividend stocks on the market. However, they weren’t originally acquired for their dividends.

The income champions

The most apparent dividend champion in the Berkshire equity portfolio is consumer goods giant Coca-Cola (

KO, Financial).

This has been a core position for Berkshire for the past three and a half decades. Based on the company’s current dividend credentials, and the fact that the conglomerate owns 400 million shares of the business, it is currently receiving just under $800 million per annum in annual dividends from the corporation. This marks a dividend yield of around 50% on the initial purchase price.

Another example is Bank of America (

BAC, Financial), which was hardly returning anything to investors when Berkshire first invested just after the financial crisis. Today the stock supports a dividend yield of 2.6%, and the institution is also repurchasing shares at a rapid rate.

The most prominent position in the portfolio, Apple (

AAPL, Financial), is also a dividend champion. Berkshire’s yield on cost for this investment is in the region of 1.5% to 2%. That’s far above the current market yield of 0.6%.

I am referring to the yield on cost here because I want to point out how important income has become for Berkshire, even though it is not an income investor. Buffett has never invested for income. His investment strategy has been based on finding companies that generate lots of free cash flow, and return this cash flow to investors.

A side-effect of the strategy is sometimes dividend income. Companies that are generating lots of free cash flow have more scope to increase their dividends to investors. Over a period of several decades, these dividends can become substantial.

Look for quality, not income

Investing for income alone is always going to be challenging. Companies that support high dividend yields are going to be paying out a lot of cash flow to investors. It is common for companies with high yields to pay out almost all the cash flow to investors. Of course, this is not guaranteed. Further analysis will reveal the extent of the drain on cash flows and dividend cover might be a better metric to use.

The problem with this approach is that there is often no money left over for reinvesting into the business, which means there is unlikely to be any growth in free cash flow over the long term (aside from price increases and inflation).

History shows that the best performing equities over the long run are those companies that balance reinvestment back into the business and dividend growth. These companies should be able to achieve both dividend growth and earnings growth over the long run, producing an attractive combination of income and capital growth for their shareholders.

This is the approach that Buffett has always used. It has given him the portfolio he has today. It was never intended to be an income portfolio, but it has become an income portfolio because these companies have returned more cash to their investors.

The figures above exclude cash returned through share repurchases, which is another component of shareholder returns and the overall shareholder yield figure. The shareholder yield of companies like Apple and Coca-Cola is likely to be significantly above the dividend yield.

As such, I think the best way to approach the market as an income investor may be to avoid focusing solely on income and concentrate on shareholder returns as well as capital allocation above all else.

If a company has a good track record of successfully allocating capital between growth projects and shareholder returns it’s likely dividend income and capital growth will follow. The yield on cost of Buffett’s Apple investment today clearly shows the benefits of this strategy.

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Disclosures

I am/we currently own positions in the stocks mentioned, and have NO plans to sell some or all of the positions in the stocks mentioned over the next 72 hours. Click for the complete disclosure
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