For Dividend Investors, Time Pays

Warren Buffett referred to dividends as the “secret sauce” in his recent Berkshire Hathaway shareholder letter.

In the letter, he used two examples – Coke and American Express – to make his case.

Berkshire purchased shares of Coke in 1994 for a total cost of $1.3 billion. The cash dividend Berkshire received from Coke in 1994 was $75 million. Last year, the Coke dividend paid to Berkshire was $704 million.

Buffett mentioned the following on the Coke dividend growth:

“Growth occurred every year, just as certain as birthdays. All [business partner Charlie Munger] and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.”

In February, Coke raised its annual dividend for the 61^st consecutive year.

American Express is a similar story. Berkshire’s purchases of American Express were completed in 1995 for the same dollar amount as Coke, $1.3 billion. Annual dividends paid to Berkshire have grown from $41 million in 1995 to $302 million last year.

Both Coke and American Express represent five percent of Berkshire’s net worth today, roughly the same weighting as when originally purchased.

Buffett went on to compare the performance of both investments versus a 30-year bond. According to his calculations, the purchase of an investment grade bond in the mid-1990s – in place of Coke and American Express – would now represent only 0.3% of Berkshire’s net worth and would be delivering “an unchanged $80 million or so of annual income.”

Significantly less than the $1 billion Coke and American Express – combined – pay to Berkshire annually.

Importance of Dividends in Total Return

Generally, increasing stock prices are the way most equity investors think money is made. But dividends play an important role as well.

Since 1993, $1,000 invested in the S&P 500 grew nearly nine times to $8,800 through the end of last year. With dividends, the same $1,000 grew more than 15 times to $15,306.

Dividends alone accounted for more than 20 percent of the S&P’s total return during this period, which is actually lower than decades of the past.

Dividends By Decade

Looking at S&P 500 performance on a decade-by-decade basis shows how dividend contributions varied over time. From 1930–2021, dividend income’s contribution to the total return of the S&P 500 averaged 40%.

Dividends can provide a huge tailwind on your long-term results if you diligently reinvest them over the long haul.

Not All Dividends Created Equally

Investors seeking out dividend payers may make the mistake of simply choosing companies that offer the highest yields. But sometimes a high dividend indicates a dividend cut may be looming.

A recent example was Intel, who cut their dividend 66% last month. Intel’s founder, Andy Grove, wrote the seminal book Only Paranoid Survive in 1996. Over the past decade, Intel lost its paranoid nature. 

The dividend cut was the result of excess cash being required for research and development to compete harder with companies that have stolen market share.

When seeking out dividend paying companies, it’s important to identify whether the dividend being paid will be consistent with opportunities to increase it over time, like Coke and American Express.

One way to do this is to evaluate companies based on moats. A castle with a physical moat is hard to penetrate. A business with an economic moat is equally hard to penetrate, and able to keep competitors at bay.

Examples of Moats

Moats can be evaluated across a number of categories, but there’s five that stand out, which include:

1. Switching Costs: switching from one business to another can be a costly and timely process. When it would be too expensive or time consuming to stop using a company’s products, that indicates pricing power. Architects, engineers, and designers spend their entire careers mastering Autodesk's software packages, which creates very high switching costs.

2. Network Effects: a network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, the more consumers who use American Express credit cards, the more attractive that payment network becomes for merchants, which in turn makes it more attractive for consumers, and so on.

3. Intangible Assets: Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products or allow the company to charge higher prices. For example, patents protect the excess returns of many pharmaceutical manufacturers, such as Novartis. When patents expire, generic competition can quickly push the prices of drugs down 80% or more.

4. Efficient Scale: when a niche market is effectively served by one or only a handful of companies, efficient scale may be present. For example, UPS delivers more than 24 million packages a day in over 200 countries while operating an airline, vehicle fleet, and warehousing operation. The cost of replicating this scale would be a burden for any new competitor.

5. Cost Advantage: firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Cigna controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.

A benefit of having an economic moat makes its easier to manage through difficult periods. Even in a recession, companies with a moat have the potential to manage through it given all the levers they can pull.

Judging a Moat

While it may be relatively easy to identify a moat, it can be more challenging to accurately judge the size of it. It’s even more difficult to determine how long the moat will persist.

For example, a competitive advantage created by a hot new technology might not last. Technology is littered with companies that go from playing “disrupter” to getting “disrupted” in short order. Snapchat went from generating a massive amount of attention, only to be an afterthought to Tik-Tok in a few years.

When evaluating moats, the first point of interest is historical financial performance. Companies that generate high rates of return on invested capital tend to have a moat, particularly if the returns are stable or increasing.

Yet, the past only tells us what has happened, not what will happen in the future.

In (attempting) to determine how wide a moat is it’s always fair to ask, “will the moat still be relevant in 10 or 20 years?”

Take JP Morgan for example. In recent years, there’s been a considerable movement against banks by cryptocurrency start-ups. When the proverbial “100-year storm” came last year, some of the largest cryptocurrency companies went out of business.

JP Morgan is a brand that not only survived the 2008 financial crisis but saved other banks that were insolvent during that period. Banking with JP Morgan gives many customers confidence, because their assets are with a 100-year-old brand that not only survived – but thrived – during one of the most turbulent periods in financial history.

And it’s likely their brand strength and relevance will help them retain current customers and attract new customers 10 and 20 years from now.

Summary

Dividends have historically played a significant role in total return.

When optimizing for dividends, it’s important to consider whether the dividend is sustainable. One way to do this is to evaluate companies based on moats.

Many moats can be easily identified but figuring out the width and depth requires getting under the hood. Moats can take years to build, but if the company does not have the necessary resources in place to maintain and grow it, that moat could quickly become a thing of the past.

Dividends are by no means a magical source of returns, but they do provide an edge (or slight advantage) in a portfolio. And slight edges compounded over many decades can end up feeling like magic.