Warren Buffett, the world famous CEO of Berkshire Hathaway, is not a dividend investor, per se, but his general approach is one that dividend investors should take to heart. And it isn't hard to do that if you step back and follow this simple game plan. Here's an easy dividend blueprint that you can use to create an income stream that grows every year.
Step 1: Understand what Buffett is doing
Buffett doesn't actually invest in dividend stocks as a goal even though he does own many dividend stocks. Simplifying his approach, Buffett basically tries to find good companies, buy them at attractive prices, and then hold them for the long term so he can benefit from the growth of the businesses he's acquired.
Image source: The Motley Fool.
This is, basically, what a dividend investor should be doing, too. In fact, interestingly enough, Benjamin Graham, Buffett's mentor, specifically highlighted a reliable dividend history as a way to identify attractive stocks in his seminal work The Intelligent Investor. With this foundation, built on Buffett and Graham, you can start to build out your own system.
Step 2: Create a fishing pond
There are thousands of stocks you could buy, but you only want to buy reliable dividend stocks if you are a dividend investor. The easy way to slim your pool of candidates down to a manageable number is to only consider companies with a history of increasing their dividends on an annual basis. A good place to start is stocks that have increased their dividends for at least 10 consecutive years. That's an impressive dividend record and suggests a business is being run well.
Of course, getting onto the list of Dividend Kings is the highest honor a dividend stock can be awarded. Dividend Kings have increased dividends annually for at least 50 years. A good business model that is executed well in both good markets and bad ones is needed to achieve a record like that. You can decide how strict you want to be on the dividend streak, but this simple screen will materially reduce the work you have to put in finding good companies.
Step 3: Find attractively priced businesses
Valuation is a complex discussion that can be simplified if you use dividends again. Dividends tend to be fairly consistent from year to year, so dividend yield can work as a rough gauge of valuation. Use it by looking for stocks with historically high dividend yields. Before you pull the trigger to buy something (after step 4), you can double check the valuation with more traditional valuation metrics like price-to-sales and price-to-earnings ratios.
To be fair, you could switch step 3 with step 4 and be just fine. But it will likely reduce your work if you do step 3 first to further cut down the size of your research list.
NYSE: O
Key Data Points
Step 4: Find a business you like
At this point, you should have a fairly short list of companies to examine. Look them over and make sure you think they are, actually, good businesses -- and, perhaps more importantly, that they will be a good fit for your investment temperament. There's no point in buying a turnaround stock if you prefer boring tortoise-like investments.
A great comparison point here is Realty Income (O +0.59%) and United Parcel Service (UPS +1.65%). Realty Income is a large and diversified real estate investment trust (REIT) that has increased its dividend annually for 30 years. It prides itself on being boring. The yield today is 5.3%, which happens to be toward the high side of the stock's 10-year yield range. Realty Income is the kind of dividend stock that a conservative investor could love.
NYSE: UPS
Key Data Points
United Parcel Service is one of the largest and most important package delivery companies. The industrial company is in the middle of streamlining its business as it works to enhance its profitability. This effort, however, has increased costs at the same time that it is reducing revenue and the financial statements are a nightmare right now.
If everything goes according to plan, UPS will become a better company, but this is a clear turnaround story. The dividend has been increased annually for 16 years and the 7.3% yield is near the highest levels ever for the stock. But you'll need a strong stomach to buy it, which means that it will be an acquired taste.
Step 5: Hold for the long term
This final step is where Buffett's approach comes back into play. Presumably you've found some good companies and bought the ones that looked attractively priced. Now, you have to hold on for the long term. This is where the magic happens because growing businesses often increase their dividends over time. You've already honed in on dividend growers, but you need to stick around (and keep tabs on the stocks) to benefit from that dividend growth.
Investing is always a work in progress
Don't expect perfection, as every investor makes mistakes (even Buffett). But if you keep the logic simple and focus on reliable dividend stocks you'll likely be able to keep your mistakes to a minimum. And, over time, that should allow you to create a growing income stream from your dividend stock portfolio.
