The Unlikeliest Dividend Play

Warren Buffett and Charlie Munger are two of the finest dividend investors to ever walk the planet.

Sound strange? It should. Buffett has famously eschewed dividend payouts to Berkshire Hathaway  (NYSE: BRK-B  ) shareholders while demanding fat yields from Berkshire's portfolio companies.

"Unrestricted earnings should be retained only when there is a reasonable prospect -- backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future -- that for every dollar retained by the corporation, at least one dollar of market value will be created for owners," Buffett wrote in his 1984 letter to Berkshire shareholders.

Buffett's billion-dollar secret ... exposed! 
The emphasis is Buffett's, not ours. But we heartily agree. Businesses that don't pay dividends should have a plan to produce massive returns with every dollar of retained capital -- the sorts of returns Buffett and Munger have spent decades delivering to their own shareholders.

Massive is too small a word to describe Berkshire's gains. Let's go with "ginormous" instead. Here's why: Buffett, Munger, and their top-notch managers have engineered a 20% annual return on Berkshire's per-share book value since 1965. All but three of those years (1965 through 1967), the company retained all earnings, paying no dividends.

Unfair, you say? Unethical? Name a multibillion-dollar conglomerate that pays a 20% annual yield, and you can join the chorus of sourpusses who demand that Buffett and Munger pay a dividend. Let us know when you find one.

Actually, let us save you the trouble; there aren't any. You'd have to scour to the small and mid-cap ranks just to find 10% yielders that have a history of increasing their payouts to shareholders.

Prospect Capital (Nasdaq: PSEC  ) , which yielded 12.2% as of this writing, and Annaly Capital Management (NYSE: NLY  ) , which yielded 15%, are among this rare breed. Each company has boosted its per-share dividend by at least 5% annually over the past five years. We know from history that those who begin and continue raising dividends are far less likely to stop. (Even dividend-stud Annaly's high, growing yield, should be considered cyclical, as earnings are largely are at the mercy of changes in interest rates.)

That's our money, pal 
As we see it, Buffett's dividend policy is actually a boon for shareholders. He likens us to bankers, entitled to a return on the capital borrowed from us when we invest. Dividend payments are the default, made in lieu of a proven history of effective use of capital.

In stark mathematical terms, this means capital allocation laggards such as Furniture Brands (NYSE: FBN  ) ought to be paying dividends. This home furnisher last earned more than 5% on its available capital in 2005, with returns running negative in each of the last three-and-a-half years. Last year's 14.4% decline was the company's worst performance since 1992, when Capital IQ began keeping records.

Compare that with Domino's Pizza (NYSE: DPZ  ) , a pizza delivery pioneer that's also a non-payer. The difference here is that management has proven itself; Domino's has earned more than 20% a year on its capital since 1999. The company has earned the right to be stingy.

Neither Buffett nor Munger are immune from this test. Remember: Berkshire spent 1965-1967 paying dividends, and in the ensuing decade would produce better-than-40% returns four times in 10 years.

Dividends helped produce those returns, and they're still helping Buffett and Munger today. Have a look at these yields on Berkshire's 10 largest holdings:

Company

Shares Held*

Yield

Estimated Annual Income

Coca-Cola

200,000,000

2.9%

$352 million

Wells Fargo

320,088,385

0.8%

$64 million

American Express

151,610,700

1.8%

$109 million

Procter & Gamble

78,071,036

3%

$151 million

Kraft

105,214,584

3.6%

$122 million

Johnson & Johnson (NYSE: JNJ  )

41,319,563

3.4%

$89 million

Munich Re

15,058,631

5.3%

$121 million

Wal-Mart (NYSE: WMT  )

39,037,142

2.3%

$47 million

Wesco Financial

5,703,087

0.5%

$9 million

ConocoPhillips

29,109,637

3.6%

$64 million

Sources: Capital IQ, Yahoo! Finance, and authors' calculations.
*Data as of June 30, 2010 for all except Munich Re, the holdings for which were disclosed on Oct. 14, and Wesco, disclosed Sept. 1.

In every case, Buffett and Munger bet on these stocks because they were reflective of superior businesses. We know this because we've seen their shareholder letters. Coca-Cola's sugar water is a daily staple for billions of people, including Buffett. Wal-Mart helps feed and clothe millions with cheap groceries and goods. And Johnson & Johnson's health care products are widely used around the world.

Buffett also took advantage of the last few year's market insanity to buy preferred shares of General Electric and Goldman Sachs that pay Berkshire Hathaway $800 million in annual dividends.

This deal is so good that Buffett noted in an interview that the Goldman investment alone is paying Berkshire almost $1,000 per minute the company doesn't repurchase his investment. "So I try not to answer the phone if I think Goldman's calling," Buffett said.

Berkshire Hathaway: the unlikeliest dividend play 
All told, Berkshire collects some $2 billion per year in dividends on its $64 billion portfolio -- a fat 3.3% annual yield!

This matters more than you may think. Buffett and Munger measure themselves against the return of the S&P 500, an index that yields 1.7% as of this writing. Berkshire earns more than twice that.

Consider that for a moment: Buffett and Munger, two superinvestors who need no extra advantages, are already starting with a lead on Mr. Market. They're using dividends to rig the race in their favor.

You can, too 
If Buffett's approach makes sense to you, and you're looking for further guidance on how to build a diversified portfolio that's anchored by strong dividend payers, check out our real-money Million Dollar Portfolio service. Lead advisor Ron Gross and his team have opened the portfolio to new members for a limited time. Click here and enter your email address to find out more.

This article was first published on Sept. 24, 2009. It has been updated.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Tim Beyers and Foolish editor Ilan Moscovitz strongly suggest you read Buffett's collection of letters to shareholders if you haven't already. No better investing education exists elsewhere. Tim and Ilan each owned shares of Berkshire Hathaway at the time of publication. Tim also owned shares of Prospect Capital. Procter & Gamble, Cocoa-Cola, and Johnson & Johnson are Motley Fool Income Investor recommendations. American Express, Berkshire, Coke, and Wal-Mart are Motley Fool Inside Value selections. Berkshire is also a Motley Fool Stock Advisorpick. Motley Fool Options has recommended a diagonal call position in Johnson & Johnson. The Motley Fool owns shares of Annaly Capital Management, Berkshire Hathaway, Coca-Cola, Domino's Pizza, Wal-Mart, and Johnson & Johnson; a position in which it has also written covered calls. The Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 22, 2010, at 8:37 PM, S2000magician wrote:

    If a corporation can earn a higher ROE than the return required by common shareholders, it should reinvest the money (i.e., not pay dividends); it creates more wealth for its common shareholders that way.

    If a corporation cannot earn a higher ROE than the return required by its common shareholders, it should pay every dollar it can in dividends; it creates more wealth for its common shareholders that way.

  • Report this Comment On October 25, 2010, at 3:04 PM, kurtdabear wrote:

    PSEC cut its dividend by approximately 25% two months ago, so there goes their 5-year history. The high dividend reflects the market's assessment of just how risky this stock is. Furthermore, part of the dividend is return of capital, which management raises by doing dilutive share sales. Finally, the company is leveraged to the hilt, so I wouldn't hold this company out as a good example of anything (and I own it).

  • Report this Comment On October 27, 2010, at 10:25 PM, Chemist29 wrote:

    PSEC did indeed cut its dividend (and switched from quarterly payment to monthly). However, PSEC is NOT leveraged. It sports a debt:equity ratio of about .1-.2:1, which for a BDC is EXTREMELY low, and by law they must keep it under 1:1 in order to continue to pay dividends. Its underperformed, and I keep adding it and enjoying the dividends!

  • Report this Comment On October 30, 2010, at 8:46 PM, vinney11 wrote:

    I bought PSEC right after the dividend cut, which seems to be to hard for a lot of folks to calculate. What with months vs. quarters, you might need a calculator! But I still like their "prospects". (sorry)

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