It's well-known that Berkshire Hathaway (BRK.A -0.98%) (BRK.B -1.03%) doesn't pay a dividend, and hasn't since Warren Buffett founded the conglomerate in 1965. The thinking goes, instead of paying out cash to shareholders (which is then taxed), Berkshire's cash is better in Buffett's hands, which he can redeploy into new businesses, whether public or private. Judging by the company's unmatched track record for 56 years, that seems like a pretty sound policy.
However, that doesn't mean Buffett himself doesn't love dividend stocks. In fact, most of Berkshire's top holdings pay ample and growing dividends to Berkshire every quarter, which Buffett can then redeploy. And since Buffett is well-known for holding his favorite stocks "forever" in an ideal world, dividend growth stocks can generate unbelievable payouts with the benefit of time, providing a lesson to us about the miracle of compounding growth.
In fact, one of Buffett's most famous investments now pays Berkshire a 50% annual dividend yield on Buffett's initial investment. Not only that, but it's in one of the safest stocks around.
Can't beat the real thing... for dividends
Over the course of 1988 and 1989, Buffett took an enormous position in Coca-Cola (KO -0.15%). Due to its rapid gains over the course of 1989, the stock quickly became Berkshire's largest holding by the end of that year, overtaking both GEICO and ABC/Capital Cities.
It should be noted that while Buffett is known as a value investor who aims to buy extremely "cheap" stocks, he didn't buy Coca-Cola at that low a valuation -- at least by 1988 standards. At the time of purchase in 1988, Coca-Cola was trading around 14.7 times forward earnings, and it had a dividend yield around 3%.
That would certainly look cheap today, but stocks weren't valued as highly back then as they are today. In fact, Coke's price-to-earnings (P/E) ratio was actually more expensive than the overall S&P 500 at that time. After all, the 10-year treasury yield was between 8% and 9% for much of that period, compared with just 1.3% today. In general, as interest rates fall, stock valuations rise.
Of note, Coca-Cola had actually gone up every year between 1980 and 1988, and had compounded at 18.7% for the five years prior to Buffett's purchase. So much for value investing!
And yet, the stock was grossly undervalued
We all know the rest of the story. Though already a large company, Coca-Cola went on to generate spectacular returns for Berkshire. Thanks to blockbuster earnings growth, Coca-Cola has raised its dividend from about $0.07 per share (split-adjusted) to $1.68 today -- an increase of 24 times. That's even greater than the 17-fold increase in Coca-Cola's stock price since then.
Based on today's dividend, Berkshire will receive $672 million in Coca-Cola dividends for its 400 million shares. This is against Berkshire's overall cost basis of $1,299 million, good for a yield of 51.7%.
Oh, and the story should get even better in March, when Coca-Cola typically raises its payout -- something it's done for the past 59 straight years, making it not just a Dividend Aristocrat but a Dividend King.
Lessons for Fools
The incredible Coca-Cola investment by Buffett can impart some stark lessons for investors.
First, Buffett was following his philosophy that "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." In this quote, Buffett, who was trained to look for cheap stocks relative to their assets by his teacher Ben Graham, is referring to his somewhat changed philosophy -- a result of his partnership with Charlie Munger.
Clearly, by 1988, Buffett could see that Coca-Cola was a competitively advantaged brand, that its products had pricing power, and that the company had a long runway for growth in international markets.
Should you come across such a company, while you should definitely be aware of the price you are paying for the stock, it's usually not a great idea to wait for a great company to become super-cheap. If you do, you could miss out on a stunning return like the one Berkshire had with Coke.
In fact, in his 1989 letter to shareholders, Buffett mocked his own tardiness to the Coca-Cola party:
... it was in 1936 that I started buying Cokes at the rate of six for 25 cents from Buffett & Son, the family grocery store, to sell around the neighborhood for 5 cents each. In this excursion into high-margin retailing, I duly observed the extraordinary consumer attractiveness and commercial possibilities of the product.
I continued to note these qualities for the next 52 years as Coke blanketed the world. During this period, however, I carefully avoided buying even a single share, instead allocating major portions of my net worth to street railway companies, windmill manufacturers, anthracite producers, textile businesses, trading-stamp issuers, and the like. (If you think I'm making this up, I can supply the names.) Only in the summer of 1988 did my brain finally establish contact with my eyes.
Another lesson for Fools? The power of long-term investing. Increasingly, the world is focused on the news of the day and other novelties such as meme stocks that can make (or lose) huge amounts of money for investors in a short amount of time. Yet in order to get truly stunning returns, things take time. That's why we at the Fool advocate holding high-quality stocks for at least five years, with an eye toward qualitative long-term factors like competitive advantage, company culture, and leadership.
As Buffett's Coca-Cola investment shows, buying quality and holding for a long time can yield huge dividends for your long-term financial health, both literally and figuratively -- even if you only pay a "fair" price.