A lot has been written about Warren Buffett’s investment style. That’s unsurprising, since he is the most successful investor of all time. We know that a key part of his investment style is seeking stocks which trade at fair prices given their outlooks. Furthermore, Buffett seeks a wide margin of safety when investing and goes on to hold for the very long term. However, does he also seek stocks which offer strong income prospects, too?
Investment potential
During the course of his investment career, Warren Buffett has been asked about his take on dividends several times. His response has been relatively straightforward in so far as he likes to receive dividends from his investments, but only under very specific circumstances.
Those circumstances are where the company in question is unable to deliver a sufficiently high return on reinvested capital. In other words, if a company can make $1 in profit and reinvest it for future growth in order to generate more than $1 in earnings, Buffett would rather the company held on to its cash as opposed to paying it to shareholders.
Similarly, if a company is unable to generate a return on its own reinvested capital, Buffett has stated that he would rather the company paid it out to investors in order for them to invest it elsewhere.
Logical standpoint
This viewpoint is entirely logical. It focuses on being efficient with capital and means that profits from a business will always be invested in the way which offers the best long-term returns.
Investors seeking to emulate Buffett’s logical standpoint can do so relatively easily. They can buy shares in companies which either pay out the vast majority of their profit as a dividend, or else buy stocks which are able to generate a high return on capital. Both options put the onus on the investor to find companies which can generate high returns in order to provide an efficient allocation of capital.
Perhaps the one type of company which Buffett will seek to avoid is one which retains dividends and yet is unable to put them to profitable use. In other words, $1 reinvested does not offer a sufficiently high return to justify a reinvestment of capital. In such a scenario, the company should perhaps seek to pay out a higher proportion of its profit as a dividend.
Foolish takeaway
Warren Buffett seems to have a clear standpoint on dividends. In certain circumstances he favours them, while at other times he does not. This is perhaps to be expected from a man who has a ruthless focus on efficient capital allocation. And as his track record shows, his investment style has proven to be hugely successful over a long period of time.
Therefore, rather than investors simply looking at shares as ‘income’ or ‘growth’ stocks, it may be prudent to delve deeper and work out their return on capital. Doing so could help an investor to find the stocks with not only the most efficient capital allocation policies, but also those which may deliver the best returns in the long run.