Here is an important description about Charlie Munger taken from page 133 of Janet Lowe's biography of the Berkshire Vice Chairman:
Munger told Berkshire shareholders that there are a large number of businesses in America that throw off lots of cash, but which cannot be expanded very much. To try to expand would be throwing money down a rat hole, he said. Such businesses don't stir acquisition desires in most corporations, but they are welcome at Berkshire because he and Buffett can take that capital and invest it profitably elsewhere.
Read that last clause again. But they are welcome at Berkshire because he and Buffett can take that capital and invest it profitably elsewhere. To me, that is what can make Altria (NYSE:MO), Lorillard (NYSE:LO), Reynolds American (NYSE:RAI), BP (NYSE:BP), and Royal Dutch Shell (NYSE:RDS.B) useful elements of a portfolio.
We all know about the long-term headwinds facing the tobacco industry, as volumes have been declining steadily at a 3% rate annually since the 1980s in the domestic tobacco market. If that trend persists, it will likely catch up with tobacco shareholders eventually unless the big three tobacco companies run successful buyback programs that can offset the lower smoking rates.
Because of its current asset structure, it's expected that Royal Dutch Shell may only be growing 3-6% annually over the next couple of years. And because BP is still working its way through its litigation and dealing with the effects of its asset shedding program, it may be looking at low growth for a couple years before reigniting the 8-12% annual growth that has historically been characteristic for the firm.
A lot of times, we get in this habit of thinking about "growth, growth, growth." It makes sense, because that is what drives future performance. But at the same time, there can be a place in your portfolio for that stock that churns out income for you to deploy elsewhere. The value of See's Candies to the Berkshire empire over the past 30-40 years isn't the fact that the company has been a fast grower, but rather, it is because Buffett has been able to extract reliable profits from See's Candies that he can deploy elsewhere to fund other opportunities.
In today's market, a 5% yield is nothing to sneeze at. If you have a reliable 5% yielder tucked away somewhere in your portfolio, it could be quite nice to simply take that money and deploy the funds into more attractive opportunities.
Picture someone with 200 shares of Royal Dutch Shell sitting in a tax-deferred account, churning out $720 per year in cash dividends. When it comes time for you to contribute that extra $5,500 to your Roth IRA, you can buy $6,220 worth of a new stock thanks to the intermingling of your Shell profits with your fresh cash contributions. You can wish, rinse, repeat this cycle for years.
Of course, in the case of the tobacco companies and the oil companies I have mentioned, one of the historically fun facts is that they have consistently delivered long-term earnings growth in excess of the modest expectations that other investors and analysts had for the firm.
Strategically, you can blend the slow growing cash cows with the fast growing opportunities in your portfolio to execute a blended income strategy that takes into account both current income and future growth.
Imagine someone that has diligently acquired 100 shares of BP for the past four years, turning a $16,000+ investment into 400 shares of the British oil giant. Right now, that would generate $864 in dividend income per year. All you'd have to do is set up a bank account where you have your investment income deposited, and from there, you could run automatic DRIP programs. You could visit www.computershare.com, enroll in the Becton Dickinson (NYSE:BDX) DRIP program, and allow $72 to be put into shares of the fast growing healthcare company each month.
Here is the appeal of doing something like that. It is all automatic. You already own the BP shares. The cash dividends it generates run on autopilot. It does not require any active effort exertion on your part. Those reliable oil dividends would then be used to automatically build up a Becton Dickinson position. At that point, you're not doing anything. Every month you stay alive, you are seeing your share ownership in Becton Dickinson construct itself automatically thanks to the intelligent investment you made in BP over the years.
There is nothing wrong with milking the profits from a steady cash cow and diverting the money elsewhere to fund higher growth opportunities. There is value in stagnant, or slow growing businesses, because they give you reliable cash income that you can use to fund higher growth opportunities. There may be a place for a reliable 5% yielder somewhere in your portfolio that you can use to funnel interesting opportunities elsewhere.
Disclosure: I am long BP, BDX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.