Warren Buffett is known for his investment success. He's led Berkshire Hathaway to a compounded annual gain of nearly 20% over the past 57 years. That's compared to a gain of 9.9% for the S&P 500 Index. Buffett's strategy includes many key elements. And one of those is buying stocks that reward shareholders through dividend payments.
Dividends bring you income every year -- no matter what the particular stock or the general market is doing. This is great all of the time, but it's especially welcome during tough market times. Should you follow Buffett's lead and add dividend stocks to your portfolio? Let's find out.
Coca-Cola and American Express
First, let's take a closer look at how Buffett has benefited from dividends. He mentioned two examples in his recent letter to Berkshire Hathaway shareholders: Coca-Cola (KO 0.15%) and American Express (AXP 2.56%). Buffett completed purchases of these stocks in the mid-1990s and has held on since.
Back then, Coca-Cola paid Berkshire Hathaway a total of $75 million in annual dividends. That payment has since increased to a mind-boggling $704 million. As for American Express, the initial dividend payment of $41 million has climbed to $302 million.
Of course, it's important to keep in mind that Buffett didn't buy just a handful of shares. His portfolio includes 400 million Coca-Cola shares and more than 151 million shares of American Express. In fact, each of these positions makes up about 5% of Berkshire Hathaway's value.
Clearly, dividend stocks have played a role in Buffett's success. But most of us don't have Buffett's resources -- so can't expect to collect hundreds of millions of dollars in passive income from one stock. Dividend stocks still can be a valuable addition to our portfolios though.
Let's return to the example of Coca-Cola. The stock, not including dividend payments, underperformed the S&P 500 Index over the past five years. But if we look at the total return, including dividends, an investment in Coca-Cola actually outperformed the benchmark.
An opportunity to reinvest
So, dividend stocks can boost your overall performance over time. And these players also offer you an opportunity to collect some extra income each year to save or spend -- or automatically reinvest into that same stock. These dividend reinvestment plans help you grow your investment through compounding -- and could result in huge gains over time.
To give yourself the best chance of benefiting from a dividend year after year, it's a good idea to refer to the list of Dividend Kings. These are companies that have increased their dividends for at least the past 50 years. This shows rewarding investors is important to them, so it's likely they'll continue increases.
Regarding Coca-Cola's dividend payments, Buffett wrote in the shareholder letter, "We expect that those checks are highly likely to grow." Coca-Cola makes the list of Dividend Kings.
It's also worth examining a company's financials and level of free cash flow. Strong free cash flow shows us that a company has the resources to continue lifting its dividend. Using Buffett's favorites as an example, we can see that the free cash flow of Coca-Cola and American Express has been on the rise in the double digits over the past five years.
KO Free Cash Flow data by YCharts
All of this means you shouldn't be discouraged if you calculate that your investment in a particular dividend stock will only bring you, say, $100 this year. This payout could boost your overall portfolio performance in the near term. And over the long term, if reinvested in the same stock -- or in another stock or asset -- it could significantly grow your money.
So, even if you don't have Buffett's resources, his strategy of investing in dividend stocks can be a winning strategy for you too.
