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Willie Keng, CFA

Willie Keng, CFA

Chief Editor

7 Things You Need to Know About Buffett’s Secret Logic — Dividends

Most investors recognize Warren Buffett as the most successful investor of all time. But there's one overlooked secret logic that compounded his wealth safely.
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Warren Buffett often speaks his 3 criteria for buying new businesses — 

1. They must earn good returns on capital in their operations

2. They must be run by able and honest managers

3. They must be available at a “sensible” price

But what really lies behind this engine of investing success is this…

 

Unlock Warren Buffett’s Overlooked Secret Logic

Warren Buffett’s investment strategy evolved a lot, since he first started Buffett Partnership in 1956. The market had huge inefficiencies then, and information was not widely available. 

The thing is, Warren Buffett first used a strategy called “cigar butt” investing, an old investing concept taken from his late mentor, Benjamin Graham. Buffett would buy distressed companies at a cheap price and sells it off later for a high profit. Similar to how you’d pick up a cigar on the floor for one last puff, before throwing it away. 

Such strategy was highly time intensive. And you had to repeatedly find new ideas to keep your returns up. Plus it could only work when information was scarce. 

Today, it’s not as effective with the internet.

“Cigar butt” investing led Warren Buffett to buy a failing textile business — Berkshire Hathaway (Ticker:BRK-A) (Ticker: BRK-B). A mistake he once regretted. But he managed to transform it into an $800 billion investment company. All using this overlooked secret logic

It was also this secret logic that made Buffett ditched his Buffett Partnership.

You see, what truly made Berkshire Hathaway the investment giant is this, and many wouldn’t know — Warren Buffett focuses on dividends. These have been the silent heroes which have been accumulating wealth for him. 

Berkshire Hathaway in many ways is a dividend machine

And our dividend growth investing philosophy has many similarities. 

Here’s 7 things you need to know about his secret logic.

 

1. This is Why Warren Buffett Loves His Dividends 

You see, by focusing on solid businesses which pays him dividends, Warren Buffett creates a predictable, consistent and growing source of cash flow. This allows him to be an effective “capital allocator”. 

Let me explain.

Warren Buffett can take the dividend income he collects, and freely allocate them to the highest yielding businesses.

Here’s something more interesting. If you look closer to what he does at Berkshire Hathaway, you’ll notice at least 30 of his more than 40 public companies he owns pays dividends. 

Exceptions are Charter Communications (Ticker:CHTR), Verisign (Ticker:VRSN) and Davita (Ticker:DVA).

The top 10 companies he held all paid dividends year after year.

  1. American Express — 18.7%

  2. Moody’s — 13.1% 

  3. Delta Airlines — 11%

  4. Bank of America — 10.7%

  5. US Bancorp — 9.7%

  6. Coca-Cola — 9.3%

  7. Bank of New York Mellon — 9%

  8. Wells Fargo — 8.4%

  9. Apple — 5.7%

  10. JP Morgan Chase — 1.9%

These are iconic American companies have weathered the test of time, and have continued to grow despite their gigantic size.

Even though he doesn’t tell you, Warren Buffett loves his dividend stocks.

 
If you truly want to grow your wealth, like Warren Buffett, you’ve to accumulate a basket of solid dividend growers at a fair price. 

That’s it.

That’s what Warren Buffett does.

 

 

2. Here’s How Warren Buffett Created 49% Annual Dividend Yield

Since 1988, Warren Buffett bought $1.3 billion of Coca-Cola (Ticker:KO) shares at $3.25 per share. It shocked Wall Street. Because everyone thought Warren Buffett loved to buy cheap, distressed stocks at a big discount. 

And buying Coca-Cola was the exact opposite of what he used to do.

In his letters to shareholders, he mentioned he expects to “…hold these securities (like Coca-Cola) for a long time… and when we own portions of outstanding businesses with outstanding management, our holding period is forever.”

Everyone knows about the iconic Coca-Cola drink. The beverage giant is well-known for a secret recipe that gets consumers coming back for more.

But little did people know that Coca-Cola was the building block of Berkshire Hathaway’s dividend machine. And this income strategy paid off very well.

Today, Coca-Cola pays a dividend of $1.60 per share. And you know what? It grew to a huge dividend yield of 49% on Warren Buffett’s initial cost of $3.25 per Coca-Cola shares.

In 2019, he collected $640 million of dividends from Coca-Cola alone. Coca-Cola has been increasing dividends over the past 32 years. 

And that’s not all. Warren Buffett’s initial $1.3 billion investment on Coca-Cola grew to $22 billion over the 32 years. That’s a $1,604% gain just sitting on the stock.

Unlike traders who rush to sell and book profits on their stocks, Warren Buffett held on to his tenaciously. Warren Buffett thinks long-term.

So, you not only have to buy solid dividend growers at a fair price, but you have to hold them for the long-term.

 

3. Buffett Lets Dividends Compound Early to Multiply His Wealth

Warren Buffett is a long-time shareholder of Moody’s Corporation (Ticker:MCO), a top provider of credit ratings. In 2000, Dun & Bradstreet spun off Moody’s. And Warren Buffett bought more of it.

Similar to Coca-Cola, Buffett knew about Moody’s durable competitive advantage. 

You see, Moody’s is a duopoly in the credit ratings market. If a company wants to issue a bond, it has to go to Moody’s or Standard & Poor’s (S&P). Both companies are the industry standard. 

Their credit ratings will only be recognized by investors and regulators. What this means is — no insurer, fund manager or bank would buy a bond without a credit rating from Moody’s or S&P.

If you’ve got power to increase prices without losing market share, you’ve got a very good business. And this allows businesses to pay rising dividends. 

Moody’s dividend yield looks a miserable 0.76% today.

It paid $2.00 dividends per share in 2019. But Warren Buffett is still winning — dividends paid from Moody’s last year yielded a massive 20% on his original cost of $10 per share back in 2000.

Accumulating dividend growers early makes all the difference over the long run.

 

4. He Buys Low Capital Cost Business to Grow Dividends

Another longtime compounder for Warren Buffett is American Express (Ticker:AXP). He realized the company’s earnings power is very strong. In the early 1990s, during the merchant fees protest, he added on to American Express. 

You can find my analysis on American Express here.

American Express goes a long way back as a horse-back mail express business, founded in 1850. Its business model combines both payment and banking solutions, under its own “closed loop” network.

“Closed looped” means American Express controls the entire payment value chain, making money from 3 distinct sources — merchant fees, credit card fees and loan income. 

In 2017, Forbes named American Express the 23rd most valuable brand in the world — worth around $24 billion. That’s almost a third of its mighty $80 billion market cap.

Its low capital costs creates massive cash flow for Warren Buffett. And ultimately delivering huge dividend income over a long period. 

In 2019, he collected $250 million of dividend income from American Express.

Warren Buffett held American Express since 1993, paid an average $8.50 per share. Last year, American Express paid out $1.64 dividends per share. 

This yielded Warren Buffett 19% on his initial cost.

Here’s more to think about. Even if American Express’s business slows down, and share price doesn’t go up as much 10, 20 years later, sitting on 19% yield is still a pretty good deal.

 

5. Warren Buffett Leverages on Unloved Stocks to Grow Dividends

If you’d read his 2011 letters to shareholders, Warren Buffett bought a big stake in Bank of America (Ticker:BAC) — $5 billion of 6% preferred stock, and warrants (rights) to buy another 700 million common stock at $7.14 per share. 

Thought investors were afraid of investing in banks, Buffett knew banks were “back on its feet”. Many were recovering from the financial meltdown of 2008 — Earnings were strong and assets still solid. 

He knew there were mistakes made with old management of Bank of America. But he also knows the bank will continue to grow after the clean up.

Bank of America paid only $0.04 dividends per share, which he would have yielded 0.56% if he exercised his $7.14 per share warrants. But he also knew the Fed would eventually approve banks to restore their dividend increase. And true enough the Fed did it.

Bank of America’s dividends multiplied 3X to $0.12 per share. In 2019, it paid out $0.66 dividends per share.

The dividends Warren Buffett received was more than what he’d get from his Bank of America’s 6% preferred stock. In 2017, he not only swapped into all his 700 million common shares, he bought even more. He sold preferred stock to cover the cost of the 700 million shares.

His average cost for Bank of America was $12 per share. 

And that gave him 5.2% yield on his average investment — a 10X yield jump from his initial warrants. 

In 2019, he collected $625 million dividend income.

 

 

6. Buffett is Always Looking Out for Dividend Growers

Even today, Warren Buffett is on the lookout for the next dividend grower. 

These are solid businesses sharing common characteristics with his other top holdings. They have either a strong brand, product or service. More importantly, they pay him dividends.

Warren Buffett accumulated Apple (Ticker:AAPL) shares over the past few years. 

In 2019, he owned $35 billion worth of Apple shares. That’s about 0.53% dividend yield on his average cost.

Here’s something to remember. Like investments he bought earlier, he didn’t bother about the tiny yield. Because he knows these companies will grow their dividends over time. Held long enough, investments like Apple are going to hit 10% to 50% yield on his cost — similar to Coca-Cola, Moody’s, American Express and more. 

Whether you’re accumulating your wealth, or already preparing for your retirement, these double-digit yields are the surest path to financial security.

This is valuable here. You might think: “Why look at dividend stocks with a yield of 1%, 2% up to 3%? When I can buy high yielding companies at 6%, 7% or even 9%?”

You see, many high yielding companies these days can be value traps. You might get 9% yield per year but you could be losing 30% on the share price. It isn’t worth it.

It’s safer to look at dividend growers which has a tiny yield but dividends rise year after year because of their businesses durable competitive advantage.

Ultimately, it’s the potential dividend growth which counts. It’s simple as that. 

 

 

7. I Agree With Warren Buffett on His Secret Logic

That’s what Warren Buffet truly does at Berkshire Hathaway.

It’s a simple, yet often overlooked secret logic — dividends create predictable, consistent and growing source of cash flow. This allows Warren Buffett to freely allocate his capital to the highest profit yielding businesses.

That’s why Berkshire Hathaway owns a lot of private businesses — GEICO, See’s Candies, Dairy Queen, Nebraska Furniture Mart, NetJets — Warren Buffett doesn’t sell these businesses at all. 

He upstream earnings from these businesses as dividends to Berkshire Hathaway and reinvest it as he pleases.

Whether you’re accumulating your wealth, or preparing for your retirement, tiny yields eventually swing into 10% to 50% yield in the long-term. They’re the surest path to your financial security.

 

Chat soon.

Always here for you,

Willie Keng, CFA

P.S. If you like to know more how to quickly spot these potential dividend growers like how Warren Buffett does, check out our Toolkit. Like slashing through the jungle, this will help you cut through the noise and direct you the quickest way to pick dividend growers safely.

Willie Keng, CFA

Willie Keng, CFA is the founder of Dividend Titan, a financial publication for self-managed investors. A former research analyst for top private banks, Willie today runs his own consulting firm. Some of his clients include asset managers and family offices. Willie has a deep passion for helping everyday investors take control of their financial future. And has spent over 10,000 hours researching, analyzing and recommending investment ideas.

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