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Along with many Berkshire Hathaway (NYSE:BRK.B) shareholders as well as non-Berkshire (BRK.A) shareholders that appreciate intelligent investment commentary, I spent a couple hours this weekend pouring over Warren Buffett's 2012 Letter to Shareholders of Berkshire Hathaway. In particular, I read with great interest Mr. Buffett's articulation of what constitutes a sound dividend policy.

On page 21 of the shareholder letter, Buffett called upon a witty analogy courtesy of the late Stanford professor Phil Fisher to describe a desirable dividend policy:

"Above all, dividend policy should always be clear, consistent and rational. A capricious policy will confuse owners and drive away would-be investors. Phil Fisher put it wonderfully 54 years ago in Chapter 7 of his Common Stocks and Uncommon Profits, a book that ranks behind only The Intelligent Investor and the 1940 edition of Security Analysis in the all-time-best list for the serious investor. Phil explained that you can successfully run a restaurant that serves hamburgers or, alternatively, one that features Chinese food. But you can't switch capriciously between the two and retain the fans of either.

Most companies pay consistent dividends, generally trying to increase them annually and cutting them very reluctantly. Our "Big Four" [note: when Buffett says 'Big Four', he is referring to American Express (NYSE:AXP), Coca-Cola (NYSE:KO), IBM (NYSE:IBM), and Wells Fargo (NYSE:WFC)] portfolio companies follow this sensible and understandable approach and, in certain cases, also repurchase shares quite aggressively.

We applaud their actions and hope they continue on their present paths. We like increased dividends, and we love repurchases at appropriate prices."

What I found most noteworthy about Buffett's commentary on this subject is that he chose to focus much more on behavioral economics at the expense of focusing exclusively on total returns. As you can see in the above quote, Buffett lambasts "capricious" dividend policies because they "confuse owners and drive away would-be investors." It's entirely possible that a "capricious" policy-paying out dividends when the company has excess cash relative to growth prospects (or buybacks at the prevailing market price) could lead to maximum total returns, but Buffett criticizes this approach because it would not work in real life -- an unreliably, herky-jerky dividend policy would jolt most investors to the point of revolt.

Instead, let's take a look at three words Buffett uses to describe a good dividend policy: clear, consistent, and rational. Buffett doesn't expand on how this affects his decision-making process, but I will share with you how I seek out companies with such a policy.

The first element that Buffett mentions is "clear." Remember when that special dividend craze happened last November and December? I know some investors got excited about the unexpected windfalls, but personally speaking, I was quite glad that I did not own any companies that engaged in the special dividend bonanza. Sure, it was probably nice for Costco (NASDAQ:COST) shareholders to receive a one-time dividend that was probably in the vicinity of 8-11% of their original investment, but for long-term investors, the question naturally arose: What next?

A special dividend, while nice in the moment, creates confusion for long-term investors thereafter: How will the special dividend affect future dividend increases? How much damage did this special dividend cause the balance sheet to deteriorate? Has the company weakened its ability to invest for growth going forward? And so on the questions go.

The second element that Buffett believes investors should seek from a dividend-paying company is "consistency." For me, this is one of the bedrock principles upon which I make a dividend investment. I love knowing that Coca-Cola has raised its dividend every single year since 1963, and that when February comes rolling out, the Board of Directors is going to announce a dividend hike. I love being able to predict with reasonable certainty that come April, the Board of Directors at Procter & Gamble (NYSE:PG) will announce yet another dividend increase, following an annual precedent that has continued uninterrupted since 1957.

This type of consistency may be important to investors because it can make it much easier to hold on during a bear market. Let's consider an investor that paid $25,000 to buy Procter & Gamble in 2007 at $70 per share, for a total of 357 shares. At the time, that investment represented a $457 annual income stream. As the price fell to a low of $43.90 in 2009, those 357 shares fell from $25,000 to $15,672. But here's where it gets fun-those 357 shares were now spitting out $585 in annual income. When everyone is freaking out, it's a lot easier to hold through the tough times by thinking: Why should I take a $10,000 loss to let someone else own the rights to my dividend stream that has grown every year since the 1950s and is still growing? A strategy is only worthwhile if you can stick to it in the bad times, and knowing that you will be receiving an annual increase in cold, hard cash can make it much easier to stick to a long-term strategy.

And lastly, Buffett encourages management teams to follow a "rational" dividend policy. I expect different payout ratios from different industries. For instance, tobacco is a very slow growth industry, and because there are few reinvestment opportunities, I expect 70-90% of earnings to be returned to investors in the form of cash dividends and stock buybacks. When I look to Big Oil, I expect to see lower payout ratios in the 20-45% range because commodity prices can fluctuate wildly, and energy companies need to deploy profits towards new projects that will fuel future growth. The word "rational" varies from industry to industry.

Phil Fisher once said that "practical investors usually learn their problem is finding enough outstanding investments, rather than choosing among too many." There's almost 20,000 publicly traded companies that we have to choose from, and we can probably knock that down to 300-400 if we screen for only companies that have "clear" dividend policies in place with "consistent" track records that have "rational" payout ratios relative to others in the industry. Buffett's passage in his shareholder letter that came out this weekend was useful not because it focused on finding the latest and greatest way to maximize returns with dividend stocks, but because he chose to acknowledge the psychological elements that will make an investor more likely to stick to a strategy with dividend-paying stocks.

Source: Buffett Calls Upon Phil Fisher To Explain Sound Dividend Policies