Billionaire investor Warren Buffett’s approach to the stock market is more complex than first appears. But while a lot of investors are familiar with some aspects of his ideology, others I think are often neglected.
One of these is about dividends. And the Berkshire Hathaway CEO has an important insight for investors who own stocks of companies that distribute their cash to shareholders.
Buffett on dividends
In a 2020 interview with CNBC, Buffett said the following about dividends:
We don’t get rich on our dividends that we receive, although we’re happy to receive them. We get rich on the fact that the retained earnings are used to build new earning power, repurchase shares, which increases your ownership in the company and Berkshire has retained earnings since we started. That’s the only reason Berkshire is worth a lot more – it’s that we retain earnings.
This is probably my favourite Buffett quote of all time. It speaks of something that’s hugely important, but often overlooked by investors who focus on dividends.
It’s natural to think reinvesting dividends in durable stocks with high yields is a good idea. But while it’s not bad, getting the most out of the stock market requires more than this.
Retaining earnings
Buffett’s approach to building wealth is to focus on what companies do with the cash they retain rather than the earnings they distribute. This is what drives earnings growth.
FTSE 100 catering firm Compass Group (LSE:CPG) is a great example. Over the last 10 years, the firm has retained around 45% of its net income and reinvested in back into the business.
Importantly, the company has managed to generate excellent returns on the cash it has retained. Outside the Covid-19 pandemic, returns on equity have consistently been above 20%.
I can’t think of many places where investors can get a return of over 20% without taking big risks. And I certainly don’t see opportunities to do this by reinvesting dividends.
Building wealth
That means investors looking to follow Buffett’s approach to building wealth should consider leaving their cash with the firm. It can almost certainly use it better than they can.
As always though, there are risks to consider. And with Compass, a key concern at the moment is the prospect of job cuts in the US, especially in the healthcare sector. This is a key market for the company and a decline could limit reinvestment opportunities. And while the share price falling offsets this risk somewhat, it doesn’t entirely remove it.
In general however, the stock’s a great illustration of Buffett’s point. As long as the firm can use its cash more efficiently than investors can, it’s a better way to build wealth than dividend stocks.
Compounding
Investing to build wealth is more complicated than just finding stocks with high returns on equity. As Buffett has noted several times, the price an investor pays is crucially important.
That’s the big drawback with Compass shares at the moment. It trades at a price-to-book (P/B) multiple of over 8, meaning investors only get around £12 in equity for every £100 they invest.
As a result, I see Compass as a stock to watch, rather than one to consider buying. But I’m aiming to follow Buffett’s advice by finding similar stocks trading at more attractive valuations.
This post was originally published on Motley Fool
