The Best Thing Warren Buffett Has Said All Year

Includes: BDX, BRK.B, CL, GE, IBM, JNJ, KMB, KO, PG, XOM
by: The Conservative Income Investor

Normally, I have to dig up the transcripts to Buffett's meeting with shareholders or go to the Berkshire (NYSE:BRK.B) Shareholder Letter to find the best "Buffettisms", but I think that the most intelligent thing Buffett has said all year comes from the opening two paragraphs of Buffett's editorial in Fortune Magazine this past February. In this article, Buffett did a brilliant job of defining risk in a common sense manner that you won't find in many academic journals:

"Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway, we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability -- the reasoned probability -- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk."

This is probably one of the best lessons that an investor can keep in mind throughout an investing career - the notion that volatility is not the same thing as risk, but rather, the real risk is that investors make investments that lose purchasing power (the reason why "emergency funds" are an exception to this are because their function in a portfolio is immediate liquid access, making day-to-day fluctuations highly undesirable).

This is a meaningful insight on Buffett's behalf because it is somewhat counterintuitive. Ten year government bonds yield 1.5% and thirty-year bonds yield 2.5%. You can watch Procter & Gamble (NYSE:PG) fall to $61 and General Electric (NYSE:GE) fall to $18 and look at your $10,000 bond investment and think, "I'm perfectly safe. I made $150 this year and my bond investment is worth $10,150." But this type of steady income accrual may give investors a deceiving sense of security. As long as inflation runs at a greater rate than 1.5% annually, this bond investor will be decreasing his purchasing power. He may think he is making steady, safe money, but at the end of each year, he is able to buy fewer hamburgers, cases of beer, and baseball tickets than he could the year before. That's the dangerous part about owning bonds that yield less than the rate of inflation. And imagine if you had to pay taxes on that, to boot!

That's why I tend to gravitate towards dividend paying stocks as a legitimate method to fight inflation. It can be difficult trying to gauge your purchasing power based on the current market prices of an investment - Oh, Becton Dickinson (NYSE:BDX) is at $73 today! Derrr, now it's worth $72! Whoa, up to $74! It's hard to get a handle and measure purchasing power based on that.

But most mega-cap dividend growth stocks give investors cash checks every three months. And a quick look at the dividend growth rates of "typical" dividend growth stocks like Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), IBM (NYSE:IBM), Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL), and Kimberly-Clark (NYSE:KMB) over the past ten years can give you an idea of how dividend growth rates of these firms stack up against inflation, which ran at 3-4% over the period.

To be sure, I'm not promising anyone that dividend growth stocks are perfect. For instance, IBM shareholders get a great dividend growth from IBM, but the initial dividend yield is quite low (around 1.5%). And it's highly likely that the dividend growth rates for Johnson & Johnson and Kimberly-Clark will be lower over the next ten years while the inflation rate has a reasonable chance of running a bit higher.

But still, these dividend stocks listed above share one character trait that is crucially important for investors. They have a high expectation of increasing their earnings and dividends by an annual rate that is higher than inflation. For me, this is my low threshold definition of successful investing. I want to see the earnings and dividends of my stock holdings grow by a higher rate than inflation so that I know that I was better off forgoing consumption today by investing for tomorrow. If inflation yields 5% for the next five years but Coke raises earnings and dividends by only 4%, I would receive more goods by spending my money today instead of waiting five years to be able to purchase less. But this is exactly what makes dividend growth investing with these firms seem so intelligent - there is a high likelihood that they will grow their dividends by a rate greater than inflation over the long-term, and this seems to be the surest way for me to realize my investing goal: to increase purchasing power.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.