This Top Dividend Stock Aces “Warren Buffett Test”
July 31, 2019
“Warren Buffett Test” Identifies Top Dividend Stocks
Warren Buffett offers some simple advice for investors looking to spot top dividend stocks: bet on the jockey.
In considering a business acquisition, Buffett looks hard at the quality of the company’s management. And the allocation of capital—whether to plow profits back into the business or return proceeds to shareholders—is the most important factor in his assessment. That’s because the way executives invest our money, over time, determines shareholder value.
To assess a management team’s effectiveness, Warren Buffett developed a simple test: the “One-Dollar Premise.” Simply put, this tool evaluates how much market value executives create on every $1.00 of retained earnings that a company holds and doesn’t pay out in dividends.
This test can identify, at a glance, whether managers have prudentially invested their company’s capital over time. If executives have invested earnings into projects that produce above-average returns, the proof will eventually show up in the company’s market value.
At minimum, Buffett wants to select firms in which each $1.00 of retained earnings has translated into at least $1.00 of market value.
Let me give you a great example: Progressive Corp (NYSE:PGR), also known as The Progressive Corporation.
Because insurance is a mature sector, companies generate far more cash than they can profitably invest. In these situations, many management teams keep deploying profits back into operations to grow their corporate empires, even if that means poor results for shareholders.
Progressive, however, has refused to sacrifice investment returns for market share. Executives have done a great job of allocating capital to high-return businesses when the opportunity presents itself. Surplus money, as management clearly explains in their 2018 annual report, gets paid out to shareholders.
When considering how to deploy capital, we have consistently said that we will look first to invest to support the growth of the current and future earnings power of Progressive. If we have capital beyond what is needed to fund growth and innovation, that is, when we have “underleveraged capital,” we will return it to shareholders. We have historically used three tools to send underleveraged capital back to our shareholders: an annual dividend, share repurchases, and special dividends. We believe this approach is a strong indicator of our thoughtful stewardship of capital.
(Source: “The Progressive Corporation 2018 Annual Report,” Progressive Corp, last accessed July 30, 2019.)
We can evaluate a management team’s effectiveness ourselves through the One-Dollar Premise.
As you can see in the table below, Progressive generated $13.0 billion in net income between 2009 and 2018. From these profits, the company paid shareholders $4.9 billion in dividends and retained $8.1 billion to reinvest in the company. Over that period, Progressive’s market capitalization increased by $26.3 billion.
In other words, management created $3.26 in value for shareholders on every $1.00 retained.
Progressive Corp and the One-Dollar Premise
|
Year |
Net Income (millions) |
Dividend Payments (millions) |
Retained Earnings (millions) |
Market Capitalization (millions) |
|
2009 |
$1,060 |
$0.0 |
$1,060 |
$9,152 |
|
2010 |
$1,070 |
$764.0 |
$306.0 |
$12,800 |
|
2011 |
$1,020 |
$264.0 |
$756.0 |
$13,856 |
|
2012 |
$900.0 |
$854.0 |
$46.0 |
$14,166 |
|
2013 |
$1,170 |
$176.0 |
$994.0 |
$15,242 |
|
2014 |
$1,280 |
$892.0 |
$388.0 |
$14,364 |
|
2015 |
$1,270 |
$404.0 |
$866.0 |
$15,974 |
|
2016 |
$1,030 |
$519.0 |
$511.0 |
$20,486 |
|
2017 |
$1,590 |
$395.0 |
$1,195 |
$22,759 |
|
2018 |
$2,620 |
$655.0 |
$1,965 |
$35,484 |
(Source: Progressive Corp Corporate Filings, last accessed July 30, 2019)
So what does that all mean? It boils down to this: Progressive’s executive team stands head and shoulders above its peers in the industry.
I understand when management can create $1.00 of value on every $1.00 retained. I expect a little more in the insurance sector, where the business model tends to result in above-average returns. Progressive, however, blows its rivals out of the water.
That stewardship, as you might imagine, has paid off for shareholders. Since mid-2009, PGR stock has delivered a total return, including dividends, of 671%. By comparison, the S&P Insurance Select Industry Index produced a return of only 238% over the same period.
The bottom line: smart investors should take a page out of Warren Buffett’s playbook and bet on the jockey. And in the case of Progressive Corp, you’re betting on one of the most capable executive teams in the world.
Obviously your homework doesn’t end here. But when you combine savvy executives with a wonderful business, you have likely found a top dividend stock.
