Buffett's an Income Investor. Why Aren't You?

One of the worst misconceptions about dividend investing is that it's boring. Heck, some even think dividends are dumb. But I would argue (and I have) that for those of us who love it when someone deposits money into our brokerage accounts, dividend investing is the most powerful and low-risk form of investing around.

In fact, dividend investing is so powerful that the world's greatest investor, Warren Buffett, has made it a staple of his strategy. And that's a good reason dividend investing should be a component of your investment portfolio. Even better, you can prudently and safely use options to boost that income power further, helping you make money in any market.

Buffett, a dividend investor?!
Sure, Buffett is known primarily as a value investor, but the Oracle of Omaha has made a career of finding businesses that pump out cash like oil from a well, a trait that makes them primed to be outstanding income stocks. These cash-flow companies include high-quality insurers such as GEICO and other well-run financials such as Wells Fargo and American Express.

One of Buffett's finest picks has been a dividend monster: Coca-Cola. Buffett started acquiring Coca-Cola shares in 1988 and had 200 million shares as of March 2010, meaning he owns nearly 9% of the soda king. Coca-Cola forms 21% of Buffett's investment portfolio, followed by Wells Fargo at 18%.

In 1988, Coca-Cola wasn't the clear slam-dunk choice it appears to be today. Buffett was one of the first investors to see the enviable Coke brand as a serious competitive advantage. He's now held shares in the company for more than 20 years and has repeatedly praised the efficiency of its capital-light business model, which spits out tons of free cash.

That free cash has allowed the company to consistently raise its dividend and, in the process, create a small fortune for a long-term holder like Buffett.

Because Coca-Cola has raised its dividend by 12% on average over the past 21 years, Buffett now manages to get back about one-third of his original investment every year. If the company continues to increase its dividend at this historical rate, in about nine years Buffett will manage to get back his original investment in dividends every year!

Given Coca-Cola's steady economic performance and solid record of increasing dividends, there's every indication that it will continue those growing payouts. That's the power and excitement of income investing with a rock-solid company: increasing payouts for life. Adding that dividend dynamo to a well-diversified portfolio can round out your returns.

And that's not all ...
When screening for dividend stocks, follow Buffett's example with Coca-Cola and look for strong fundamentals, such as steady profitability and increasing growth over time.

Generally, you should avoid cyclical companies, since their potential for inconsistent profitability could endanger their dividends. Instead, focus on businesses whose products will be in demand regardless of the financial climate and are thus much more likely to ensure a steady payout.

Here are a few that fit my criteria.

Company

Dividend Yield

5-Year Dividend-Growth Rate

5-Year Earnings Growth

Colgate-Palmolive (NYSE: CL  )

2.7%

12.8%

11.6%

PepsiCo (NYSE: PEP  )

2.9%

13.7%

10.1%

Reynolds America (NYSE: RAI  )

6.0%

13.0%

4.4%

Paychex (Nasdaq: PAYX  )

3.9%

17.7%

3.2%

Yum! Brands (NYSE: YUM  )

2.0%

32.6%

7.4%

Intel (Nasdaq: INTC  )

3.4%

16.9%

4.9%

Source: Capital IQ, a division of Standard & Poor's, as of Oct. 14.

Each of these companies has a remarkably strong franchise for consumer products that we use day in and day out, as their solid earnings over five years bear out. Colgate-Palmolive offers the personal-care products that we use on a daily basis and offers great growth opportunities globally. PepsiCo provides its well-known sodas, but it's also behind the Frito-Lay brand of snacks that you see everywhere.

While the demand for cigarettes is in decline, Reynolds is still smoking, and offering investors a fat dividend. This company is the very definition of recession-resistant, but Big Tobacco is now facing significant headwinds, so this company may not be the same beast in 20 years.

Yum! is the name behind the ubiquitous and perennially successful fast-food brands Taco Bell, KFC, and Pizza Hut. You might not know Paychex personally, but there's a good chance that if you work for a small business, your company's payroll and other HR services are run through the company. And Intel's a company that dominates its core markets and goes into almost every desktop and laptop computer out there.

The indispensability of these companies' products ensures that payouts from such blue chips can grow for decades and turn even a small initial investment into a dividend dynamo -- just as Buffett did with Coke.

Follow these stock stars
Even better, you can safely use options to boost the power of these cash-gushing companies. The experts at Motley Fool Pro are focused on stars such as Intel, which can be used to generate substantial income AND nice capital gains through the power of options. And Pro has done both with Intel over the last two turbulent years in the market.

If you'd like to invest with a service that is focused on generating income in any market, we're opening Motley Fool Pro for a few days on Tuesday, Jan. 18, 2010. The service has been closed to new members since June. To learn more and receive a private invitation to join, simply enter your email address in the box below.

This article was originally published on May 27, 2010. It has been updated.

Jim Royal, Ph.D., does not own any shares mentioned in this article. American Express, Coca-Cola, and Paychex are Inside Value choices. Coca-Cola and PepsiCo are Income Investor recommendations. Motley Fool Options has recommended a write covered straddle position on Paychex. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Coca-Cola, and Yum! Brands. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (18)

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 January 17, 2011, at 4:43 PM, AHL123 wrote:

    Now here is a "foolish" question. A number of your readers are now or were in the past builders. I am in the former group. As this group has been all but wiped out over the past several years, its members are for all practical purposes asset poor and cash broke. Still, the experience of the those of us still around, and hanging by a thread is that the stock market ( reather hedge fund traders) and the derivative crowd greatly contributed to our demise. Please keep in mind that we are not the most sophisticated business people except within the narrow focus that building is and always has been.Many of us are leary to get into the stock market because of our experiences on the downside of that animal, and yet, we know we have to since our primary income food train may be permanently disabled. There are sooooo many blogs suggesting everything under the sun that it leaves our feeble minds in a dense fog. A long way around the block, but here is the question: why should we trust any of you, and what are the opportunities we may understand and even utilize within the scope of our professional experience?

    Ready for the beating... fire away...

  • Report this Comment On January 17, 2011, at 11:28 PM, PEStudent wrote:

    Buffett didn't choose Geico because it could be "pumping out cash" as the article claims. He saw it as a great idea being run by the wrong people. He bought the company -not some stock in it- fired the management and brought in his own people so it could realize its potential. Using it as a income stock example here is way off target.

  • Report this Comment On January 19, 2011, at 12:36 AM, mkj1928 wrote:

    They don't pay dividends because he can turn that money into more money. The people who own BH shares don't want dividends, they would rather have Warren turn it into some serious cash by making good investments.

  • Report this Comment On January 23, 2011, at 7:00 PM, midnightmoney wrote:

    mkj, I bought emerson electric, ebix, apple, and berkshire a year ago. Berkshire is still the laggard of the group, and still sans dividend. I'll give it another year before I sell if they aren't turning my cash into, as you say, "serious cash". Berkshire is not just overrated, but I'd say even way so.

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