Published by Bob Ciura on December 23rd, 2017
Warren Buffett, Chairman and CEO of Berkshire Hathaway (BRK.A) (BRK.B), is arguably the greatest investor of all time. Buffett took a declining textile mill and turned it into one of the largest conglomerates in the world.
Berkshire has a hand in nearly every industry in the economy. Its portfolio of business subsidiaries includes GEICO, Fruit of the Loom, See’s Candies, and many more. Berkshire also has a massive investment portfolio of publicly-traded stocks.
According to Berkshire’s most recent 13F filing with the SEC, the investment portfolio has a total value of $177.68 billion, spread across a number of blue-chip stocks.
Buffett is well-regarded as the world’s foremost value investor. While Buffett is a value investor, he is not a ‘deep value’ investor. Buffett’s investment style is to buy into great businesses at fair or better prices, rather than to buy into poor businesses at excellent prices.
In addition to hunting for value among quality stocks, Buffett also holds many dividend stocks. High quality stocks produce large cash flows, and these companies often pay out a portion of their cash flows as dividends.
For example, Buffett’s fourth-largest stock holding, Coca-Cola (KO), is a Dividend Aristocrat, a group of 51 stocks in the S&P 500 Index with 50+ consecutive years of dividend increases.
You can see all 51 Dividend Aristocrats here.
Value and income investing are not mutually exclusive—but many of the value stocks Buffett holds do pay dividends.
This article will discuss why even though Buffet is primarily known as a value investor, he is also a big fan of dividends as well.
Buffett’s Value Investing vs. Dividend Investing
In seeking value, Buffett aims to buy stocks that are trading for less than their true worth. This is often referred to as intrinsic value, or the real long-term value of a company.
Value investors seek to calculate the intrinsic value of a stock. This is done with various valuation techniques. One of the most common forms of valuation is discounted cash flow analysis, which calculates the present value of a stock based on the future cash flows of company, using a discount rate based on a firm’s cost of capital.
Meanwhile, dividend investing is the practice of buying stocks that pay dividends to shareholders, and raise their dividends over time. At Sure Dividend, we are constantly recommending investors interested in building long-term wealth, consider the list of Dividend Aristocrats.
The reason the Dividend Aristocrats can be such rewarding investments to generate long-term wealth, is that they have consistently generated returns significantly above the S&P 500 Index, and non-dividend payers.
Source: S&P 500 Fact Sheet
The ability to raise dividends over long periods of time is no small feat. Companies can massage and manipulate certain financial reporting metrics like earnings-per-share, but dividends cannot be faked. Companies must generate positive cash flow to pay dividends, and to be a Dividend Aristocrat, must demonstrate the ability to raise dividends for 25+ consecutive years.
The past 25 years included several recessions, global conflicts, and periods of great social and economic uncertainty. And yet, the Dividend Aristocrats have continued to churn out reliable profits, and pay their shareholders higher dividends each year. They are among the strongest dividend growth stocks.
Some dividend investors prioritize high dividend yields, rather than dividend growth. These investors might favor various asset classes such as Real Estate Investment Trusts—commonly referred to as REITs—or Master Limited Partnerships. These stocks tend to offer higher yields upfront, such as 5% or more, but their dividend growth is typically less reliable than the Dividend Aristocrats.
Value investors, on the other hand, prioritize finding undervalued stocks. Value investing is the search for cheap stocks—just because a company pays a dividend, does not automatically make it a good investment. Even dividend-paying stocks can be poor investments over time, if the investor buys into overvalued stocks.
Whereas dividend growth investors desire investment income, and rising streams of dividend income over time, value investors might care more about the share price appreciation that comes from an expanding valuation.
Value investing and dividend investing are technically different strategies, but they are not mutually exclusive. Not all stocks pay a dividend, and value investors prioritize finding undervalued stocks rather than simply seeking out dividend yields. That said, value stocks often do pay dividends.
What Value Investors Like Buffett Look For
At its core, value investing seeks to ‘buy $1 for $0.50″. For Buffett (who seeks quality businesses), it is all about finding high-quality companies that are under temporary distress.
If the company in question has a strong brand, and durable competitive advantages, a successful turnaround can yield impressive returns. High-quality brands and competitive advantages are key—this is a term Buffett frequently refers to as an “economic moat”.
Moats were often placed around castles to protect them from invasion. Similarly, a company that has an industry-leading brands and competitive advantages has a natural protection against competitive threats.
Industries can be disrupted by new technologies or competitors that have found a more profitable way of doing business. This can serve as a significant risk for shareholders. But the companies that insulate themselves against competitors are most likely to reward shareholders with rising earnings and dividends over time.
Dividends are often associated with the high-quality stocks Buffett looks for. The rationale makes sense—companies at the top of their industries often have highly profitable business models, with more than enough cash flow to invest in growth initiatives, and pay shareholders a dividend.
Value investing and dividend investing are related, but one is not necessary for the other. Think of them more like cousins, than siblings. A stock can be undervalued without necessarily paying a dividend.
However, investors will also find that many undervalued large-cap stocks are dividend payers. In fact, Buffett’s top 10 holdings all pay dividends to their shareholders, and many of them raise their dividends on a regular basis.
A Peek Inside Buffett’s Top Portfolio Holdings
Berkshire Hathaway is required to file 13F holdings statements with the SEC. This gives everyday investors the opportunity to peek inside the investment holdings of the world’s most successful investor.
Whereas most hedge funds employ complicated investment strategies, Buffett’s investment philosophy is simple: buy stocks of high-quality companies with competitive advantages, and hold for years. One of Buffett’s famous sayings is that his favorite holding period is forever.
Buffett’s portfolio proves that in many cases, slow-and-steady wins the race. Most of the stocks in Berkshire’s portfolio are household names that most investors are readily familiar with.
For example, Buffett’s top five portfolio holdings are as follows:
- Wells Fargo (WFC): 14.4% of assets
- Kraft Heinz (KHC): 14.2% of assets
- Apple, Inc. (AAPL): 11.6% of assets
- Coca-Cola (KO): 10.1% of assets
- Bank of America (BAC): 9.7% of assets
As previously mentioned, all of Buffett’s top 10 holdings pay a dividend to shareholders. And, in typical Buffett fashion, all of the top five stocks have strong brands and durable competitive advantages.
Wells Fargo is one of the top U.S. banks by assets. Wells Fargo has endured a tumultuous year, but it is slowly getting itself back on track. Investors may recall that the company was hit with a $185 million fine because it had opened millions of accounts for its customers, without their consent.
But the company experienced only a 3% decline in earnings in 2016. Earnings have continued to decline in 2017, but there is potential for a recovery in 2018.
Source: Quarterly Earnings Presentation, page 3
Wells Fargo remains Buffett’s largest holding, because it has a strong brand, with plenty of opportunities for future growth. It is the largest mortgage originator in the U.S., and while it is struggling right now, it continues to benefit from rising assets and loans. The U.S. economy is growing, and higher interest rates will help Wells Fargo earn higher investment income.
Wells Fargo stock trades for a price-to-earnings ratio of 16, which is well below the S&P 500 average. And, Wells Fargo increased its dividend in 2017, and has a current dividend yield of 2.5%.
Kraft-Heinz is Buffett’s second-largest holding. Buffett has a fondness for large consumer food and beverage stocks, with strong brands and economies of scale. This is Kraft-Heinz in a nutshell.
After the $45 billion merger of Kraft Foods and H.J. Heinz, Kraft-Heinz became the fifth-largest food company in the world. Today, Kraft-Heinz has more than 200 brands, eight of which each generate at least $1 billion in annual sales.
The billion-dollar brands include Kraft, Heinz, Oscar Mayer, Philadelphia, Velveeta, Lunchables, Maxwell House, and Planters.
Source: Investor Fact Sheet, page 2
Kraft-Heinz’s organic revenue was flat in 2016. The good news is, cost cuts and merger-related synergies drove 19% earnings-per-share growth over the first three quarters of 2017. Kraft-Heinz continues to generate massive integration synergies from the merger. In 2017, Kraft-Heinz expects cumulative merger-related savings to exceed $1.7 billion.
Kraft-Heinz stock trades for a reasonable price-to-earnings ratio of 19, and has a solid 3.2% dividend yield.
Next up is Apple, a relatively new holding for Buffett, having been purchased in the first quarter of 2016. Buffett’s investment portfolio has steadily added to the stock in the quarters since, amounting to a $20.67 billion stake as of September 30th, 2017.
In the most recent fiscal year, Apple grew revenue by 6%, and earnings increased 11%. Going forward, Apple will generate growth from new iPhone releases, including the iPhone 8 and iPhone X. Another catalyst for Apple is its booming services business, which includes iTunes, the App Store, Apple Pay, and more. Services revenue is now a $30 billion-a-year business for Apple, and grew over 20% last fiscal year.
Apple ended last quarter with $268 billion in cash and long-term investments on its balance sheet. Tax reform is another catalyst that could incentivize Apple to bring some of its massive cash pile back to the U.S., to the benefit of shareholders like Buffett.
Apple is an incredible brand, with an established competitive position. Apple’s brand is reportedly worth $170 billion, making it the most valuable brand in the world. This allows it to raise prices and generate high margins.
Speaking of strong consumer brands with unparalleled distribution, it is no surprise that Coca-Cola is Buffett’s fourth-largest stock holding.
Coca-Cola has increased its dividend for 55 years in a row. In addition to being a Dividend Aristocrat, Coca-Cola is also a Dividend King, an even smaller group of just 22 stocks. You can see all 22 Dividend Kings here.
Coca-Cola is the world’s largest beverage company. It owns or licenses more than 500 non-alcoholic beverages, including both sparkling and still beverages. It sells its products in more than 200 countries around the world, and has 21 brands that generate $1 billion or more in annual sales.
The core sparkling beverage portfolio includes the flagship Coca-Cola brand, as well as other soda brands like Diet Coke, Sprite, Fanta, and more. Coca-Cola also has a large portfolio of still beverages, including Dasani, Minute Maid, Vitamin Water, and Honest Tea.
Rounding out the top five is Bank of America. Like Wells Fargo, Bank of America is one of the largest banks in the U.S., and is poised to grow from rising interest rates.
On Tuesday, August 29th, Berkshire Hathaway exercised warrants to acquire 700 million shares of Bank of America. The transaction made Berkshire the largest shareholder of the company, with a roughly 6.6% stake in the company.
In addition, in 2017 Bank of America raised its quarterly dividend by 60%, to $0.12 per share. With the dividend increase, Berkshire’s investment will earn over $330 million in dividends each year.
Bank of America has a price-to-earnings ratio of 17, and a 1.6% dividend yield.
Investing can be overwhelming for those without an advanced degree in finance, but Buffett has proved is that anyone can be a successful value investor. One might assume that in order to amass the wealth that Buffett has over the years, investors need to buy stock in small-caps or speculative startups.
Buffett’s top holdings encompass a variety of industries, including the financial, consumer, and technology sectors. And, the investment portfolio holds dozens of stocks. This provides the benefit of diversification.
That said, Buffett has also said that investors should not be afraid to focus investments on their highest-conviction ideas. To that end, the top 10 holdings occupy approximately 80% of the total Berkshire portfolio.
Buffett’s portfolio also has low turnover, which helps minimize transaction costs and capital gains taxes. Brokerage commissions and taxes can eat into returns. By keeping these costs low, investors keep more of their gains. All of the value investing principles and Buffett practices presented here can be used by investors to their advantage.