Berkshire Hathaway (BRK.B) is one of my favorite companies. It consists of high-quality stocks that throw off more and more dividends each year. It owns operating companies like See's Candy and The Nebraska Furniture Mart which generate gobs of income for new investments. And of course, it's run by the best investor I've seen in my lifetime: Warren Buffett. The only problem these days? Berkshire doesn't pay a dividend. If I want to financially benefit from ownership of Berkshire Hathaway, then I'll need to sell shares.
While I support Buffett's rationale for retaining profits on the basis that he can create more than $1 of shareholder value for each dollar of profit that could conceivably be paid out as a dividend, the fact remains: I need to rely on Mr. Market to recognize the value of what Buffett creates. I could buy shares of Berkshire at $80 with the belief that the company is worth $110, but I am at the complete and total whim of my fellow market participants to recognize that value in order for me to make a profit.
If I want to engage in straight-up value investing that involves buying an undervalued company and then selling it at fair value, then I'm going to do it within the universe of dividend growth blue-chip stocks. John Neff, the legendary Vanguard investor who ran the Windsor Fund from 1965 to 1997 and returned 13.7% annually over that time frame, expressed my feelings on the matter much more poetically than I ever could: "One of Ben Franklin's wise observations offers a parallel: 'He who waits upon Fortune is never sure of a dinner.' As I see it, a nice dividend yield at least lets you snack on hors d'oeuvres while waiting for the main meal."
Let's look at a company like Walgreen (WAG). It currently trades at $35 per share, roughly 12x trailing earnings of $2.90. Let's say that I am confident that the company should trade more in line with its historical average, and should be worth $49.30 (or 17x earnings). Because Walgreen pays out a $0.275 quarterly check for each share of the company that I own, I don't have to frantically worry about when the company reaches its fair value. As Neff would say, I would receive $0.275 hors d'oeuvres for every three months that I wait (and the hors d'oeuvres get bigger for each year that it takes a dividend growth firm to reach fair value).
Of course, if we're investing in undervalued securities with the intent to flip them upon reaching fair value, we'd like to buy at $50 and sell at $100 the next day. But patience tends to come with the value investing territory. And the good news about value investing with a dividend growth firm is that the initial dividends become worth more when shares finally reach fair value.
Let's say that I own 100 shares of Johnson & Johnson (JNJ) at $65 with the intent to sell at $80. Let's say that the shares tread water during the first year, remaining at a constant $65. The first $61 dividend buys me .94 shares. The next payout of $61.58 takes my total up to 101.89 shares. When the third payout of $62.15 arrives, my new share count is 102.85. When the fourth payout of $62.74 arrives, my share count at the end of the year rises to 103.81. Before the first quarter of the following year arrives, the price shoots up to $80 per share.
So what just happened here? With a non-paying dividend stock that goes up to $80 a year after trading at $65, the investor enjoys a 23.07% increase. But with the Johnson & Johnson investor that received four dividend payouts before the stock reached fair value, he has turned his 100 shares into 103.81 shares worth $8,304.80. Compared to the initial investment of $6,500, this investor reaps a 27.77% gain. This is due to the presence and value increase of those $61 and $62 dividend checks. The investor who waits for Berkshire Hathaway to go from $65 to $80 per share does not enjoy this advantage.
If we buy a stock at $5 that we intend to sell at its intrinsic value of $10, we generally have to be patient for that to happen. If I want to engage in strict value investing, I want to receive some compensation for that waiting period. Dividends (and ideally, dividend growth) can provide this. Wal-Mart (WMT) traded in the $50 range for many years before reaching its recent price of $74 per share. For the investors who had to wait for this price increase, they enjoyed a nice consolation prize: dividends reinvested around $50 per share are now worth $74. If you're going to engage in value investing, you might as well receive financial benefits for your patience.