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How 'Warren Buffett method' can be boost for income seekers

How 'Warren Buffett method' can be boost for income seekers

It is now estimated that cuts to dividends globally could amount to somewhere between 15 per cent and 33 per cent. 

In the UK the fall could be as much as 50 per cent.  

Dividends are a mechanism for returning surplus cash to shareholders.  

Like other metrics such as sales growth and return on capital, their absolute level is determined by the success of the company and where it is in its lifecycle. 

Shocks such as Covid-19 tend to accelerate adverse trends already in place. 

The UK has been hit harder as many of its larger companies such as BP and Shell are in secular decline. 

Countries such as America, Germany and Switzerland, with a greater proportion of growing and financially healthy companies, have suffered much less.

The debate

Many of the arguments that rage about the importance of income in equity investment, in my view, miss this point. 

Income managers argue that long term outperformance derives from the additional return provided by reinvested dividends.  

General equity managers argue income detracts from total returns as it restricts the universe to mature or declining companies. 

In reality,  the success of any equity investment first and foremost derives from the level of return on capital the underlying company can achieve multiplied by the amount of capital invested; termed ‘economic profit’.   

Companies have a defined lifecycle involving fast growth and growing returns then higher returns with slower growth and finally falling returns.  

Faster growth in economic profit, occurs in the first two phases. 

In certain companies, this can extend for decades. 

As the companies move through the cycle, less cash is required for investment.  

In addition, better companies tend to require less capital to grow, so there is often more  surplus cash generated. 

Dividends are used to pay out the surplus. 

Harvesting this cash flow is a key part of the equity investment proposition.

Successful businesses that achieve high returns will attract competition.  

These new entrants will cause return on capital to fall back towards the cost of capital or even lower for those companies without strong competitive advantage. 

Sometimes, skilled management will be able to re-engineer the business or redeploy capital into new areas with better characteristics.

Risks

However, turnarounds are difficult and high risk.  

Dividend yields are often high at this stage reflecting both legacy pay-out ratios and the company’s higher cost of capital.  

Some income managers make the mistake of focusing too much on these situations.  On the whole, they should be left to specialist recovery managers. 

While Warren Buffett has yet to pay a dividend from his Berkshire Hathaway investment vehicle, careful reading of his letters to shareholders shows that many of his successful investments, such as See’s Candy, paid substantial dividends up to the holding company.