Forget dividend investing? Here’s the Warren Buffett method for building wealth over time

Dividend stocks are a great choice for investors looking for passive income. But when it comes to building wealth, Warren Buffett has a better strategy.

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Warren Buffett at a Berkshire Hathaway AGM

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Warren Buffett knows the secret to building wealth. And while Berkshire Hathaway owns a number of dividend stocks, the Oracle of Omaha is clear that receiving dividends isn’t what has made him rich.

According to Buffett, what matters isn’t whether or not a business distributes its profits as dividends. Rather, it’s the company’s ability to reinvest its earnings internally – in other words, its growth prospects.

Dividend stocks

It’s hard to see how Buffett’s success isn’t the result of dividends. Coca-Cola – a classic example of a dividend stock – is Berkshire’s fourth-largest stock investment and one of Buffett’s most famous successes. 

But, as the Berkshire CEO explains in the most recent letter to shareholders, the reason that Coca-Cola has been such a good investment is that it has gradually grown its earnings. As Buffett puts it:

The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. 

Berkshire receives a lot more in distributions from Coca-Cola now than it did 28 years ago. But this isn’t the result of reinvesting dividends – Buffett hasn’t added to Berkshire’s Coca-Cola investment since 1994.

Rather, it’s the result of Coca-Cola finding a way to make more money. This means it can increase the amount it returns to shareholders, causing the value of the stock to rise.

As Buffett points out, a similar investment in a stock that didn’t grow would only be returning around $80m for Berkshire today. Over time, the value of a growing company is tremendous.

Growth stocks

When it comes to building wealth, growth stocks are Buffett’s clear preferences. These are shares in businesses whose priority is finding ways to increase their earnings per share.

Different firms pursue growth in different ways. Some look to develop their existing operations, others aim to acquire new business, some use their cash for share buybacks, and some do a mixture of these.

Halma and Diploma, for example, aim to both improve their existing businesses and acquire new ones. And Rightmove looks to grow its revenues while reducing its share count through share buybacks.

None of this is to say that growth stocks don’t pay dividends – Halma, Diploma, and Rightmove all return cash to investors in this way. But their main priority is increasing their earnings per share over time.

As a result, growth stocks generally aren’t obvious choices for investors looking for passive income. They’re focus is on increasing the value of their business, not providing income to shareholders.

For investors looking to build wealth gradually, though, growth stocks are ideal. Their aim is to use the cash they generate to make themselves worth more in the future than they are today. 

Building wealth

The Warren Buffett method for building wealth is about finding companies with good growth prospects. With Coca-Cola, the amount Berkshire Hathaway receives in dividend payments has gone up by over 800%. 

That has nothing to do with reinvesting dividends or seizing an opportunity at a time when share prices were low. It’s simply the result of the company finding a way to increase the value of its shares over time.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Stephen Wright has positions in Berkshire Hathaway. The Motley Fool UK has recommended Halma Plc and Rightmove Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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