When it comes to income shares, earning 54% of my investment back in annual dividends is the stuff of stock market dreams.
But while it may be the stuff of many investors’ dreams, is not the stuff of fantasy.
In fact, that is exactly the dividend return legendary stock picker Warren Buffett earned last year on his investment in a blue-chip household name. By applying part of his approach to owning income shares, I hope I can boost my own high-yield earnings over the long run.
Taking a long-term approach to investing
Indeed, the long run is critical to understanding Buffett’s success in this instance, which he outlined in this year’s annual letter to shareholders in his company Berkshire Hathaway.
The income share in question is Coca-Cola. Between 1987 and 1994, Berkshire spent seven years purchasing Coke shares for a total cost of $1.3bn. That is not a small investment, even for Buffett.
In 1994, the cash dividend Coke paid to Berkshire was $75m. That was already pretty good, in my view, as it implied a dividend yield for Buffett’s investment at that point of 5.8%. The current Coke dividend yield is 3.3%.
But the real magic has come from annual increases in the payout. By last year, Coke paid Berkshire $704m in dividends. That is equivalent to 54% of the initial purchase price.
The Buffett method
Clearly, in this case, taking the long-term approach to investing has paid off handsomely for Buffett.
But there is more to it than that. There are other companies that are also in the fizzy drinks business with a less impressive dividend record than Coke.
UK rivals AG Barr and Britvic, for example, both reduced their dividends in 2020. Dividend Aristocrat Coca-Cola, by contrast, has raised its payout annually for over half a century.
When looking for income shares to buy, Buffett looks at the likely source of future dividends. He likes to buy into businesses that have very strong brands, as that can help support sales for decades to come. He also looks for a clear competitive advantage. Coca-Cola’s brand, proprietary formula, and bottling network help provide that.
Another consideration is a firm’s balance sheet. Too much debt can mean even a successful business needs to use profits to pay down debt rather than funding beefy dividends.
Looking for dividend growth potential
Those are the sorts of things that can help persuade Buffett a company has long-term dividend growth potential. I find it helpful to apply similar search criteria when looking for income shares to buy, in the UK as well as the US.
What has Buffett, through Berkshire, done with all those billions of pounds in Coke dividends? They have been reinvested in other businesses and shares, helping to grow the overall value of Berkshire. That is an investing principle known as compounding.
Like Buffett, I also apply that approach to my portfolio. Buying the right income shares today could hopefully help me fund more purchases for decades to come!
