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 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 the 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 the small- and mid-cap ranks just to find 10% yielders that have a history of increasing their payouts to shareholders.

Telecom Corp. of New Zealand (NYSE: NZT), which yielded 10.9% as of this writing, and Vector Group (NYSE: VGR), which yielded 9.9%, 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 very unlikely to stop. (Even so, Vector is in a tricky position to make those payouts.)

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 Isle of Capri Casinos (Nasdaq: ISLE) ought to be paying dividends. The regional casino operator last earned more than 5% on its available capital in 2004, with returns mostly declining in the six years since. Last year's 2.3% was the company's worst performance since 1990, when Capital IQ began keeping records.

Compare that with Foster Wheeler (Nasdaq: FWLT), a construction services firm that caters to the energy industry and which is also a non-payer. The difference here is that management has proven itself; Foster Wheeler has earned more than 20% a year on its capital since 2003. The company has earned the right to be stingy.

Neither Buffett nor Munger is 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 some of Berkshire's 10 largest holdings:

Sources: Capital IQ, Yahoo! Finance, and authors' calculations.
*Data as of Dec. 31, 2009.

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. Kraft sells the food we eat daily, and there's no better recurring income stream. American Express gets close, though. The company benefits from serving well-heeled cardholders who don't mind carrying balances. And ConocoPhillips generates 35% of its revenue overseas in a world that's increasingly hungry for oil.

Buffett also took advantage of 2008'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 $59 billion portfolio -- a fat 3.2% 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 almost twice that.

Consider that for a moment: Buffett and Munger, two super-investors 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 
Now here's the best part: You needn't be a Berkshire shareholder to implement Buffett's strategy. You can do just as well or better by investing in your own basket of safe stocks with generous yields. Our Motley Fool Income Investor portfolio, for example, yields 4.3% -- well ahead of the market average.

To be fair, and as the past year has shown, not all dividend stocks are created equal. We want what Buffett wants: generous dividend payers with proven management teams, durable competitive advantages, and rock-solid financials -- all at a cheap price.

If Buffett's approach makes sense to you, and you're looking for some solid dividend payers, you can check out our Income Investor team's favorite stocks right now, free for the next 30 days. Click here for instant, unfettered access to all their research and seven "Buy First" recommendations. There's no obligation to subscribe.

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

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 at the time of publication. Procter & Gamble and Johnson & Johnson are Motley Fool Income Investor recommendations. American Express, Berkshire, and Wal-Mart are Inside Value selections. Berkshire is also a Stock Advisor pick. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Motley Fool owns shares of Berkshire and Procter & Gamble and has a disclosure policy.