Many investors consider Warren Buffett (Trades, Portfolio) to be the greatest value investor of all time, and this is true to a certain extent.
However, there is far more to his investment strategy today than just buying cheap stocks. The billionaire investor is on the lookout for equities that are not just cheap but also have the potential to achieve impressive earnings growth. He is also looking for companies that have the potential to return significant amounts of cash to investors.
A high return for shareholders
Buffett has explained on many occasions that he is looking for companies that earn a high return on their assets.
These companies can then choose to reinvest the capital back into the business to earn a similarly high rate of return or return cash to shareholders. Cash can be distributed through share buybacks or dividends, whichever the company prefers.
To put it another way, the core of Buffett's strategy is to find companies that can grow indefinitely and produce large amounts of cash. This has many similarities with a dividend growth strategy.
When investing for dividend growth, one tends to concentrate on companies with a high level of dividend cover and growing earnings. This combination of factors should enable the firm to pay a steady, growing dividend for the foreseeable future.
Coca-Cola (KO, Financial) is the perfect example of how Buffett's quality growth and value strategy overlaps with dividend growth.
When the Oracle of Omaha first started buying the stock in 1988, it was trading around 14.7 times forward earnings, and it had a dividend yield of approximately 3%. Buffett did not acquire the shares for their dividend, but he did buy Coca-Cola for its growth prospects and cash generation. As the company has grown, its cash generation has expanded and it has increased its dividend to shareholders.
Today, the stock offers an annual dividend of $1.68, and Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) will receive an annual income of $672 million from its investment. Against the overall cost of just under $1.3 billion, this provides a yield of 51.7% for the stock.
It is not just Coca-Cola. Buffett invested $5 billion in Bank of America (BAC, Financial) in August 2011. The preferred stock offered a yield of 5% before he converted this special issue into common stock. He has since added to the position, so the exact rate of income growth is challenging to dissect. However, since 2011, the company's dividend to investors has increased from $0.01 per quarter to $0.21.
Another example is American Express (AXP, Financial). Buffett has traded in and out of this position since his primary purchase in the late 1960s, but since the end of the 1980s, the company's per share dividend has jumped from $0.11 to $1.71 a quarter.
See's Candy
The final example is See's Candy. Possibly the best example of how investing for quality can lead to dividend income and growth, See's has yielded an ever-growing stream of income for Buffett's companies since its acquisition (it was acquired by Blue Chip Stamps before this business merged with Berkshire).
When Buffett bought the company, it was producing profits of around $5 million. See's is now generating $80 million in pre-tax profits a year according to the latest figures.
These examples show how one cannot easily fit Buffett's investment technique into a value/growth style. He is looking for quality companies that have a sensible capital allocation policy. This does not mean he is looking exclusively for dividend stocks, but these are a side effect of the quality strategy.
Buffett's strategy is also a fantastic case study of when it is not sensible to cash high-yield stocks. Low-yielding companies with growth potential can be far better income plays in the long run.
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