I’d use this Warren Buffett approach to finding cheap UK income shares

By learning from the investment approach of the ‘Sage of Omaha’, our writer hopes to identify income shares to buy that may grow their dividends.

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Buffett at the BRK AGM

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When it comes to income shares, earning 54% of my investment back in annual dividends is the stuff of stock market dreams.

But while it may be the stuff of many investors’ dreams, is not the stuff of fantasy.

In fact, that is exactly the dividend return legendary stock picker Warren Buffett earned last year on his investment in a blue-chip household name. By applying part of his approach to owning income shares, I hope I can boost my own high-yield earnings over the long run.

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Taking a long-term approach to investing

Indeed, the long run is critical to understanding Buffett’s success in this instance, which he outlined in this year’s annual letter to shareholders in his company Berkshire Hathaway.

The income share in question is Coca-Cola. Between 1987 and 1994, Berkshire spent seven years purchasing Coke shares for a total cost of $1.3bn. That is not a small investment, even for Buffett.

In 1994, the cash dividend Coke paid to Berkshire was $75m. That was already pretty good, in my view, as it implied a dividend yield for Buffett’s investment at that point of 5.8%. The current Coke dividend yield is 3.3%.

But the real magic has come from annual increases in the payout. By last year, Coke paid Berkshire $704m in dividends. That is equivalent to 54% of the initial purchase price.

The Buffett method

Clearly, in this case, taking the long-term approach to investing has paid off handsomely for Buffett.

But there is more to it than that. There are other companies that are also in the fizzy drinks business with a less impressive dividend record than Coke.

UK rivals AG Barr and Britvic, for example, both reduced their dividends in 2020. Dividend Aristocrat Coca-Cola, by contrast, has raised its payout annually for over half a century.

When looking for income shares to buy, Buffett looks at the likely source of future dividends. He likes to buy into businesses that have very strong brands, as that can help support sales for decades to come. He also looks for a clear competitive advantage. Coca-Cola’s brand, proprietary formula, and bottling network help provide that. 

Another consideration is a firm’s balance sheet. Too much debt can mean even a successful business needs to use profits to pay down debt rather than funding beefy dividends.

Looking for dividend growth potential

Those are the sorts of things that can help persuade Buffett a company has long-term dividend growth potential. I find it helpful to apply similar search criteria when looking for income shares to buy, in the UK as well as the US.

What has Buffett, through Berkshire, done with all those billions of pounds in Coke dividends? They have been reinvested in other businesses and shares, helping to grow the overall value of Berkshire. That is an investing principle known as compounding.

Like Buffett, I also apply that approach to my portfolio. Buying the right income shares today could hopefully help me fund more purchases for decades to come!

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?

If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…

Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.

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