Maike Currie
Maike Currie

Warren Buffett doesn’t like dividends. He believes the best way to return value to shareholders is by reinvesting profits back into a business. Despite Berkshire Hathaway being a tremendous generator of cash, it has almost never paid a dividend — the exception was in 1967 and Buffett jokes that he must have been in the bathroom when that decision was made.

Buffett’s approach glosses over the fact that a high dividend payout can instil a sense of capital discipline in companies, and is often a sign of quality.

When investing, it’s easy to fixate on capital growth. Think of the cheap share that you plan to sell when it shoots up. But a better way of making money is not losing it in the first place — that, and having the patience to compound your capital and income returns over many years.

Carl Stick, manager of the Rathbone Income Fund, calls this “winning without losing”. Central to his investment approach is an awareness of risk and he assesses companies on the basis of three risk factors: business, financial and price. Depending on how they measure up, he places stocks into distinct “buckets”.

Let’s call these the three C’s: compounders, cash cows and (quality) cyclicals. Compounders are high-quality businesses with high returns and the ability to reinvest these back into the business, generating organic growth. But don’t confuse compounders with bond proxies — companies that pay a fixed level of income but rarely one that grows.

A compounder is a company that consistently generates high returns and grows its capital base. Household goods group Reckitt Benckiser is a good example. Bunzl, Unilever and Howden Joinery are other classic “compounders”. These companies will typically have low business and financial risk, but come with a fair amount of price risk because the company’s inherent strength tends to be reflected in its valuation.

The second bucket holds those bond proxies, also known as ‘cash cows’. These are businesses that generate high returns but on a static capital case. They probably won’t grow their dividends very quickly, but you can be assured of a reliable income.

Often the ability of these companies to grow is scuppered by their sheer size (elephants don’t gallop) alongside regulatory and political pressures. Think of the big utility, tobacco and telecom stocks — mature, stable industries that will generate steady income year after year. Business and financial risk is low but comparatively higher than with “compounders”, as disruptive change can sometimes wreak havoc. Price risk has also increased in recent years, as the search for income has pushed up valuations.

The final bucket contains cyclicals or, to be more specific, quality cyclicals. Here the primary concern is the sustainability of income. These are companies that can generate earnings throughout the economic cycle and so rank high among dividend payers. Oil stocks and miners are good examples. But this part of the market has income fund managers divided — some are steering clear, others are more sanguine, focusing on cash flow not earnings and looking through the cycle.

If you expect commodity prices to bottom out, improving earnings in two to three years’ time, then it may be worth stomaching thin dividend cover. In the case of Shell, for example, Mr Stick believes that dividend cover will improve markedly if the takeover of BG goes through. This matters because Shell contributes more to the total UK dividend pot than any other stock — and the company hasn’t cut its payout since the second world war.

Assessing the business and financial risk of a company is key to gauging whether its dividend is safe — and in doing this it’s important to determine where the business is in its earning cycle. Every business has a cycle of sorts, even the most ‘defensive’. Take pharmaceutical companies.

Although the demand for drugs might not be cyclical, there is an inherent cyclicality to the industry: companies spend heavily to secure a patent but in time that protection expires and the ‘cycle’ starts again. GlaxoSmithKline, another staple in income portfolios, is a case in point. The company has seen the expiry of blockbuster drugs and with cheaper generics flooding the market, earnings are shrinking. Next Tuesday, the company will profile its drug pipeline at an R&D event for investors and analysts — and they will expect to be convinced that it has the platform to deliver earnings growth in future years.

Picking income winners might look easy, but it’s not: focus on a high yield without adequate dividend cover and you’re taking too much business risk. Choose a company with a bigger cushion and chances are the stock will be expensive and the yield lower. As with all investing, diversification is key and holding a healthy mix of compounders, cash cows and quality cyclicals is a good approach.

And what about Warren Buffett? As Berkshire continues to grow, finding investments big enough to plough excess cash into that have the ability to move the needle gets harder.

A lot of what Buffett “invests” in today he owns outright, and increasingly the largesse of cash sees the Sage of Omaha deviate from his winning formula: partnering with a private equity firm to restructure underperforming companies, buying a capital intensive business (Burlington Northern Santa Fe railroad) and most recently, a company (the $27bn acquisition of Precision Castparts) about which he admitted knowing nothing.

Maike Currie is an author, editor and investment commentator. Her role at Fidelity Worldwide Investment sees her writing and commenting on investment and financial planning matters.

maike.currie@fil.com

@MaikeCurrie

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