Billionaire US investor Warren Buffett has famously never paid a dividend to shareholders of his company, Berkshire Hathaway. So why am I talking about his methods in an article on dividend shares?
It’s simple enough. Buffett doesn’t pay dividends, but he certainly likes to collect them. Berkshire’s biggest equity holdings include many well-known US dividend shares.
Buffett’s dividend shares
I’ve been taking a look at the stock market holdings held by Berkshire Hathaway. The top 10 largest holdings by size are all well-known dividend stocks, such as Bank of America, Coca-Cola Co, American Express and Kraft Heinz.
Buffett’s biggest public holding is Apple. Berkshire’s stake in the tech giant is valued at around $120bn. And although Apple probably isn’t known as a dividend stock, it’s been paying out regularly since 2012. I estimate last year’s payout alone totalled about $13bn.
However, investments aren’t limited to the stock market. Buffett also buys whole companies, owning them privately under the umbrella of his Berkshire Hathaway holding company. When a company is privately owned, its owners have access to all the surplus cash generated by that business.
In my view, the companies owned by Berkshire are like dividend shares on steroids. I suspect most of them generate attractive cash returns for Buffett. That cash can be used to make new investments.
How I’m copying Buffett
I follow a similar approach for my income portfolio, which I hold in a Stocks and Shares ISA. As I’m still working, I don’t withdraw any of the dividends generated by my shares. Instead, I combine this cash with my monthly contributions to buy additional shares for my portfolio.
Over time, these shares also generate dividends. In other words, I use my dividends to buy more dividends. Reinvesting income in this way is known as compounding. Over time, compounding can be a powerful way to generate low-risk growth. For example, over 20 years, reinvesting a 5% annual income would give a 165% gain, even if the share price was unchanged.
Eventually, I hope to be able to cut back on working and live on my dividend income. But, until then, I’ll keep reinvesting my dividends.
What about dividend cuts?
Of course, a dividend is never guaranteed. As we saw last year when bad things happen, companies can be forced to cut or suspend their dividends without warning.
A second risk with high-yield dividend stocks is that the generous payouts could be a sign the company can’t find any growth opportunities. Over time, such stocks can lag behind the wider market.
I suffered dividend cuts last year. The income generated by my portfolio fell by around 50%. But I took advantage of lower share prices to keep buying dividend shares.
So far, my approach has paid off. Most of my bargain shares are performing well. Many of the dividends that were cut last year have now been reinstated.
I plan to keep following Buffett’s example and expect 2021 to be a much better year for dividend income.