Warren Buffett looks for great businesses trading at fair or better prices suitable for long-term holding.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
– Warren Buffett
What is a ‘wonderful company’?
It’s a business with a strong and durable competitive advantage.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
– Warren Buffett
Warren Buffett focuses on quality and the long-run. There’s an index filled with Buffett’s wonderful businesses. This Index makes finding high quality businesses easy.
The Index I’m referring to is the Dividend Aristocrats Index. The Dividend Aristocrats Index is comprised of 50 businesses with 25+ years of dividend payments without a reduction.
A business must have a strong and durable competitive advantage to pay increasing dividends for 25+ consecutive years.
Warren Buffett puts his money where his mouth is.
He has invested in 4 Dividend Aristocrats. This article takes a look at Warren Buffett’s 4 Dividend Aristocrat holdings.
Coca-Cola (KO) announced a 6% dividend increase on February 18th. This is the 54th consecutive annual dividend increase for Coca-Cola. Coca-Cola’s dividend streak started when Lyndon B. Johnson was president…
The company’s long dividend streak puts it in especially rarefied air. Coca-Cola is one of only 17 Dividend Kings – dividend stocks with 50+ years of consecutive dividend increases.
When investors think about Coca-Cola, the first thing that springs to mind is the iconic soda.
Coca-Cola is much more than just a soda company.
- Coca-Cola is #1 globally in NARTD still beverages
- Coca-COla is #1 globally in NARTD sparkling beverages
- Coca-Cola has 20 brands that generate >$1 billion a year in sales
Notes: NARTD means Non-alcoholic ready to drink, ‘still’ is non-carbonated, ‘sparkling’ is carbonated.
Warren Buffett likes investments that are easy to understand. It’s not because Warren Buffett is not intelligent (estimates put his minimum possible IQ at 140, and likely much higher); it’s because there’s less that can go wrong with simple business models.
Coca-Cola’s business model is very simple.
Step #1: Leverage advertising budget and competency (create demand)
Step #2: Leverage global distribution system (supply product)
Step #3: Sell low-priced products at high margins to wide audience (profit)
Coca-Cola’s simple business model is easy to understand – but virtually impossible to replicate.
The company’s built up brand equity, global scale, and presence in an extremely slow changing industry make it very likely Coca-Cola will continue to grow for decades to come.
Coca-Cola supports its strong brand competitive advantage through advertising spending. Coca-Cola has spent over $3 billion per year on advertising in each of its last 3 full fiscal years. This comes to about 7% of revenue per year spent on advertising.
Only PepsiCo (PEP) can come close to matching Coca-Cola’s advertising spending in the NARTD industry. Coca-Cola’s income versus peers are shown below to give an idea of the company’s power in the NARTD industry:
- Coca-Cola annual income of $7.3 billion
- PepsiCo annual income of $5.4 billion
- Pepper Snapple (DPS) annual income of $0.7 billion
- Monster (MSNT) annual income of $0.5 billion
Note: More than half of PepsiCo’s income comes from food products, not beverages
Coca-Cola’s competitive advantage is self-reinforcing. The more Coca-Cola spends on advertising, the stronger its brands become, the more money it makes, and the more it can advertise.
Note that the company does not advertise only soda. It has built more non-carbonated billion dollar brands than carbonated billion dollar brands.
In addition to its brand based competitive advantage, Coca-Cola also has a global distribution network that gives it a cost advantage over smaller peers.
There’s no doubt that company’s like Facebook (FB) and Apple (AAPL) have very strong competitive advantages in their fields. What sets Coca-Cola apart is how slowly the NARTD industry changes.
100 years ago people were not using smartphones or social media. They were drinking Coca-Cola (the company was founded in 1892) and other non-alcoholic beverages.
100 years from now, will people be using smartphones and social media? Who knows, but probably not. The pace of change in the technology sector is rapid. That’s great for customers, but not great for the current industry leaders. The NARTD industry is the opposite. It serves a very basic human need (thirst) that will not go away no matter how advanced technology becomes.
Skeptics will say that 100 years from now doesn’t matter to them. And in a sense, that’s true. You could change 100 years to 10 years though, and there would still be questions about rapidly changing technology.
The ‘100 years’ example above underscores the difference in risk between Coca-Cola and most other investments. You don’t have to worry about product obsolescence with Coca-Cola (on a broad scale; individual brands will of course come and go). This reduced risk is likely what appeals to Warren Buffett.
Warren Buffett purchased the bulk of his Coca-Cola holdings in 1988. Today his yield-on-cost on Coca-Cola stock is over 50%. Each year, Coca-Cola pays Warren Buffett about half of his initial investment amount. That is the power of investing in great businesses for the long run.
Today Coca-Cola is likely a bit overvalued relative to its growth prospects. The company’s stock makes a compelling purchase when its price-to-earnings ratio drops below that of the S&P 500’s for long-term investors looking for low-risk and consistent dividend growth.
#2 Procter & Gamble
Procter & Gamble (PG) was founded in 1837. Warren Buffett developed a large stake in the company indirectly. Here’s how:
In 1989 Warren Buffett purchased a large amount of Gillette stock. In 2005 Gillette was acquired by Procter & Gamble. This gave Buffett a large stake in Procter & Gamble.
Like Coca-Cola, Procter & Gamble is a Dividend Kings. The company has increased its dividend payments for 59 consecutive years.
The company is the second largest consumer products corporation in the world. Only Apple has a larger (much larger) market cap than Procter and Gamble. The company currently has a $219 billion market cap; the 13th largest in the world.
Procter & Gamble has 21 brands that generate more than $1 billion a year in sales – 1 more than Coca-Cola.
The image below shows Procter & Gamble’s key brands:
Source: Procter & Gamble 2015 Shareholder Meeting Presentation, slide 19
Procter & Gamble’s competitive advantage is similar to Coca-Cola’s. The company sells branded products that are disposable, reusable, and exist in slow changing industries.
There is just not much room for disruptive innovation in the paper towel (Bounty), toilet paper (Charmin), fabric care (Tide), toothpaste (Crest), or toothbrush (Oral-B) industries.
This slow change allows Procter & Gamble to invest heavily in brand building. The company spends between $8 billion and $9 billion a year on advertising – between 11% and 13% of revenues a year. Another way to look at this is that Procter & Gamble reinvests about 50% of its profits before advertising costs back into advertising to build its brands.
This strategy is not without its pitfalls.
Procter & Gamble has experienced excellent growth over the long run, but has struggled in recent years.
- 1999 through 2008: Earnings-per-share growth of 10.3% a year
- 2009 through 2015: Earnings-per-share growth of 2.0% a year
The company’s sluggish growth recently is a result of over-diversifying. The company acquired too many brands, spreading managerial focus (and advertising budget) to thin. This has resulted in poor earnings growth.
The company has since corrected course by divesting its non-core brands. The new Procter & Gamble is a leaner, more focused company. Results are following. Procter & Gamble saw constant-currency adjusted earnings-per-share grow 9% in its most recent quarter versus the same quarter a year ago.
It is likely that Procter & Gamble continues to compound earnings-per-share at 7% to 9% a year going forward. The company can manage this level of growth through:
- Sales growth of 3% to 4% a year
- Share repurchases of 2% a year
- Margin improvements of 2% to 3 a year
Advertising and continued global expansion and rising GDP (over the long run) in emerging markets will help Procter & Gamble to hit its sales growth targets.
The company regularly uses excess cash to repurchase shares; Procter & Gamble returns around 100% of its earnings to shareholders through dividends and share repurchases.
Margin improvements will be generated through continued cost cutting and a greater focus on efficiency. Margin improvements are one of the key drivers behind the company’s 9% constant currency earnings-per-share growth in its most recent quarter.
Earnings-per-share growth of 7% to 9% a year combined with Procter & Gamble’s current 3.3% dividend yield gives investors in this relatively low risk company expected total returns of 10% to 12% per year.
The company’s growth will likely be slower over the next year due to the global growth slowdown. The strong United States dollar in particular is having negative effects on Procter & Gamble. On the plus side, low oil prices do provide lower input costs for Procter & Gamble, slightly improving margins.
Procter & Gamble is currently trading for an adjusted price-to-earnings ratio of 20.6. The company is likely trading around fair value at this time given its above-average expected total returns and safety.
Wal-Mart (WMT) is the largest retailer in the world. The company has generated sales of $482 billion over the last 12 months.
Each week, nearly 260 million customers and members visit Wal-Mart’s 11,535 stores under 72 banners in 28 countries and e-commerce websites in 11 countries.
The company has struggled since stock price highs of $88.51 reached in January of 2015. Wal-Mart stock fell all the way to $55.83 in November of 2015; a 36% drawdown.
Since November, the company’s stock has rebounded 18.8%. Wal-Mart’s stock price tells a story.
Wal-Mart’s success is driven by its low prices.
The company’s stock price declines are being driven in large part by wage increases for the company’s workers which reduce margins.
Wages are one of the largest expenses at Wal-Mart. A large part of the company’s ability to keep prices is low is to pay low wages. Wage increases have caused operating income to decline by 16.4% versus the same quarter a year ago.
Wal-Mart is gambling these wage increase will create a more incentivized work force that will drive greater revenue growth over the long run. The company is also likely increasing wages to prevent backlash from paying ‘unfair wages’.
Wal-Mart grew constant currency revenue 2.2% in its latest quarter. While this isn’t tremendous growth, the company’s decline over the past year is a result of falling margins rather than falling sales.
The company recently closed stores that were not a good fit for Wal-Mart’s strategy going forward. Excluding these store closures, the company’s management is expecting constant currency revenue growth of 3% to 4% a year in its next fiscal year. With store closures, constant-currency revenue is expected to be relatively flat.
When a company sees revenues decline, that means it is losing customers.
Wal-Mart’s operations continue to generate more sales than any other company in the world. The company’s business model is viable.
Operating margin declines are due to wage increases. The company will not increase wages rapidly every year. When wages stabilize, Wal-Mart will return to growth.
The company generates tremendous free cash flows (even with higher wages). Wal-Mart generated $15.9 billion in free cash flow in its fiscal 2016 (Wal-Mart’s fiscal year ends January 31st). The company returned $10.4 billion to shareholders in the form of dividends and share repurchases over the year.
At current prices, Wal-Mart has a shareholder yield of nearly 5%. The company’s dividend yield is 3% and it repurchased around 2% of shares outstanding in its last fiscal year. Share repurchases were depressed from what they could be as the company is investing heavily in wages and digital growth.
When operations normalize, Wal-Mart investors should expect solid total returns from the following sources:
- Revenue growth of 3% to 4% per year
- Dividend payments of 3% per year
- Share repurchases of 2% to 3% per year
- Margin improvements of 0% to 1% per year
Together, this comes to expected total returns of between 8% and 11% per year.
An investment in Wal-Mart today will likely generate double-digit returns over the long-run due to valuation multiple gains. Wal-Mart is likely undervalued at current prices. The company is trading near its highest dividend yield ever. In addition, the company has a low price-to-earnings ratio of 14.6
Wal-Mart generates more revenue than any business in the world; more than 4x that of Amazon (AMZN). The company has paid increasing dividends for 43 consecutive years. The company has a strong and durable scale based competitive advantage.
The company is a favorite of The 8 Rules of Dividend Investing due to its above average 3% dividend yield, low stock price volatility, low price-to-earnings-ratio, and solid expected total returns.
AT&T (T) is Warren Buffett’s highest yielding dividend stock. AT&T currently has a 5.2% dividend yield – more than double the S&P 500’s 2.3% dividend yield.
AT&T shareholders are not new to dividends. The company has paid increasing dividends for 32 consecutive years.
As has been discussed in this article, Warren Buffett looks for businesses with strong and durable competitive advantages.
AT&T does not disappoint in this department.
The company’s competitive advantage comes from being one of two dominant players in the oligopolistic United States telecommunications market.
Note: Verizon (VZ) is the other dominant company.
AT&T and Verizon alone have more than 60% of the United States Telecommunications market. Sprint (S) and T-Mobile (TMUS) together have another 30% market share.
There are 3 main reasons why the telecommunications industry lends itself to a few, mega cap corporations:
- High up-front costs of building infrastructure
- Expensive wireless spectrum usage costs
- Brand recognition and scale advantages
Wireless spectrum usage is controlled and auctioned by the United States government. AT&T spent $18.2 billion in the last spectrum auction. In total, the auction raised $44.9 billion for the FCC. The next auction will begin in March of 2016.
With auctions measured in billions of dollars, entrance into the wireless market in the United States is severely restricted. There just aren’t any startups that can throw billions of dollars around.
AT&T’s large network, well-known brand, and ability to pay tremendous sums in spectrum auctions give it a strong competitive advantage.
The company is more similar to a utility than most other dividend growth stocks due to the subscription based model of wireless.
AT&T regularly pays out around 70% of its profits as dividends. This aligns shareholder interests with management as most cash flows are distributed directly to shareholders.
The money that is reinvested back into the business must be scrutinized carefully to invest in only the best growth projects.
With a 5%+ dividend yield, AT&T does not need to deliver rapid earnings-per-share growth to give shareholders above average expected total returns.
The company’s management is expecting long term earnings-per-share growth of between 4% to 6% a year. AT&T’s earnings growth plans revolve around key recent acquisitions:
- Nextel Mexico
- Lusacell (a Mexican wireless provider)
Financial details of these acquisitions are shown in the image below.
Source: AT&T 2015 Analyst Presentation, slides 39 and 42
AT&T’s plan to expand into Mexico is the logical ‘next step’ geographically. The company is investing $3 billion to extend its high-speed mobile internet to 100 million Mexican consumers by 2018.
Customers on AT&T Mexico plans will be able to make calls on their Mexican plan while in the United States to others on AT&T plans. This ‘2 countries, 1 plan’ approach should have wide appeal in Mexico and for Mexican immigrants to the United States.
AT&T’s DirecTV acquisition will expand the company’s offerings. The strategic rationale behind the DirecTV acquisition is to expand digital content distribution. As a bonus, it also gives AT&T better cross-selling opportunities and cost-cutting possibilities.
It is likely AT&T’s management hits its 4% to 6% a year earnings-per-share growth estimate.
This growth combined with the company’s current 5+% dividend yield gives investors expected total returns of 9% to 11% a year from AT&T.
AT&T stock is trading for a price-to-earnings ratio under 14. Telecommunications stocks have historically traded for low price-to-earnings ratios which reflects there lower-than-average growth. AT&T is likely either fairly valued or somewhat undervalued at current prices.
Warren Buffet has invested 20% of his portfolio in Dividend Aristocrat stocks. The percentage of his portfolio in the 4 Dividend Aristocrats outlined in this article is shown below:
- Coca-Cola makes up 13% of Warren Buffett’s portfolio
- Procter & Gamble makes up 3.2% of Warren Buffett’s portfolio
- Wal-Mart makes up 2.6% of Warren Buffett’s portfolio
- AT&T makes up 1.2% of Warren Buffett’s portfolio
Warren Buffett’s investing success shows that investing in high quality businesses trading at fair or better prices for the long run can produce very favorable results.