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Buying shares in companies that pay dividends and reinvesting the income is one way of trying to build wealth over time. But there are some sneaky issues that investors need to be aware of.
Warren Buffett knows a thing or two about making money. And the Berkshire Hathaway CEO has a clear sense of the limitations of trying to get rich by buying dividend stocks.
Warren Buffett
Never mind stuff about being greedy when others are fearful, or dancing in rooms where the clocks have no hands, my all-time favourite Warren Buffett quote is the following:
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.
In other words, it’s the earnings that are retained – not the ones that are distributed – that build wealth over time. Unsurprisingly, I think Buffett is exactly right about this.
Dividends are definitely an important part of the investment equation. But the road to building wealth by reinvesting them is more complicated than it looks.
Annoying taxes
Whether its UK or US stocks, taxes are an annoying part of dividend investing. With US shares, distributions face a withholding tax of 30% (which comes down to 15% with a W-8BEN form).
That means the dividend I get from an investment in a US company – such as Chord Energy – is only 85% of the official yield. And that can slow down the rate of compounding significantly.
With UK stocks, reinvesting the dividend to buy more shares is subject to stamp duty. So if I try and invest £100 in a stock like DCC, I end up with £99.50 in shares.
That doesn’t seem like a lot, but it can be significant as the numbers get bigger. And investors should be aware of the costs of trying to build wealth by reinvesting dividends.
A FTSE 100 compounder
In terms of building wealth, one FTSE 100 stock I like is Bunzl (LSE:BNZL). The company has been facing some challenges recently, but these aren’t due to its capital allocation priorities.
The business has been dealing with price deflation, especially in the US, which is an ongoing risk. But I think the firm has the right fundamentals to do well over the long term.
Bunzl’s main priority is to use the cash it generates to make acquisitions. This can be dangerous, but it operates in a highly fragmented market and, if done right, it helps reduce the risk.
Most importantly, the firm’s return on invested capital has been consistently above 15%. That implies the company is reinvesting its cash at higher rates than investors can find elsewhere.
Building wealth
I think investors looking to build wealth should focus on growth stocks. Specifically, they should look for businesses that can retain cash and reinvest it at high rates of return.
Bunzl is a company that aims to do this. And I’ve been buying the stock because I expect the firm to be able to grow my wealth at a better rate than I can achieve by investing dividends.
