INSIGHTS

Berkshire Hathaway, Warren Buffett’s investment company, released its latest earnings result last month.

At the same time, the 92-year-old “Oracle of Omaha” published his annual letter to shareholders.

These are always highly anticipated, and after six decades they still provide interesting economic anecdotes and pearls of wisdom for investors.

There was one that struck a chord with me this year, as it highlighted a key principle of share investing.

Under a section headed up “The Secret Sauce”, Buffett recalled the purchases of stakes in Coca-Cola and American Express, which were completed in 1994 and 1995.

He noted that each of these investments cost Berkshire Hathaway US$1.3 billion.

Back then, the annual cash dividend the company received from Coca-Cola was US$75 million, while it was US$41 million from American Express.

That implies a dividend yield of about 4.5 per cent from the combined holdings.

By 2022, the annual dividend Berkshire was getting from its Coca-Cola investment had increased to US$704 million, while American Express was delivering the company $302 million of income.

The dividends from both companies had grown steadily and consistently over the years, by around 7-8 per cent per annum.

While the dividend yield in the mid-1990s was a modest 4.5 per cent, last year’s annual income represented almost 40 per cent of Berkshire Hathaway’s initial capital investment.

As Buffett puts it, dividend growth occurred every year, just as certain as birthdays. All he and business partner Charlie Munger were required to do was cash those quarterly dividend cheques.

The steadily increasing dividends, which were driven by growth in earnings, brought with it some significant gains in share prices.

Buffett notes that today, the Coca-Cola investment is valued at US$25 billion while American Express is recorded at US$22 billion.

The numbers in this example are ludicrously high, but replicating this approach is entirely within reach of all investors, large and small.

Let’s consider an example closer to home, using the largest company on our sharemarket, Fisher & Paykel Healthcare.

Two decades ago, Fisher & Paykel Healthcare paid a regular dividend of nine cents per share in the 2002 financial year.

If you’d amassed $10,000 worth of shares in the six-months leading up to then, that would’ve meant an annual cash dividend of $409 in 2002.

Like any good business, Fisher & Paykel Healthcare has grown over those 20 years. That’s allowed it to increase its dividend by 7.7 per annum over the period, a similar growth rate to the two companies Buffett singled out.

In 2022, Fisher & Paykel Healthcare paid a dividend of 39.5 cents per share. That same parcel of shares would’ve generated $1823 in cash dividends, a more than four-fold increase in annual income.

Including imputation tax credits, this equates to an annual gross dividend yield on your initial cost price of more than 25 per cent.

Just like in Buffett’s example, the Fisher & Paykel Healthcare share price has increased substantially over this period, propelled higher by this growth in underlying earnings and steadily increasing dividends.

In addition to collecting all that dividend income over the 20 years, your original $10,000 would’ve grown to several times that.

If you’d reinvested the dividend income back into the company, rather than spending it, you’d be up even further.

Indeed, Fisher & Paykel Healthcare has been a strong performer and many other businesses wouldn’t make for such an impressive example.

Having said that, it hasn’t been the top mover over the last two decades.

Other household names (and commonly owned local shares) like EBOS Group, Mainfreight and Infratil have all posted higher returns.

Warren Buffett’s secret sauce isn’t so secret after all.

It’s simple a matter of buying great businesses that pay growing dividends, holding them for the long-term and letting the power of dividend growth build that passive income stream for you.