I don't think I'd surprise anyone by suggesting that I'm a fan of Warren Buffett's investing philosophy. If I had to guess, I'd say around half of my Seeking Alpha articles make some mention of him, I regularly quote tidbits of his wisdom and in general, it's relatively difficult to argue with the record of a man worth $46 billion. So this might seem out of character, but I'm about to suggest an investing thesis that is a touch incongruous from the "Classic Buffett" ideology. Now it should be made explicitly clear that the following will in no way undermine my previously enthusiastic support. Nor does it suggest that I believe one could benefit from routinely diverging from Buffett's accumulation of business knowledge. That would likely lead one to folly by a great degree. However, it is fun - once in awhile - to offer counterpoints to perfectly rational thought, or so I hope. I'll set the stage.
I was recently reading Buffett's lengthy biography "The Snowball" and after nearly 400 pages, I had reached the mid-1970s. Warren had closed down his partnership and by 1974 he was fully invested as stock prices were taking it on the chin. Naturally Warren wanted to buy more. But there was just one problem, as he puts it:
"I'd run out of gas. I had used all the $16 million of cash I got out of the partnership to buy stock in Berkshire and Blue Chip. So all of a sudden I woke up one day and had no money at all. I was getting $50,000 a year salary from Berkshire Hathaway and some fees from FMC. But I had to start my personal net worth over again from zero."
Now several observations should be made. First, $50,000 in 1974 was certainly nothing to sneeze at. Next, if you happen to skim the 93-page "Notes" section you will notice that his personal dividends from Blue Chip totaled about $160,000 a year pre-tax. Combined, we're talking $210,000+ in annual salary and a paper net worth of $16+ million four decades ago. In other words, Buffett's definition of "no money at all" and your definition of no money likely differ by say, $100 million in today's dollars. So we're not exactly feeling bad for the fellow. But it at least struck me as interesting -- one could be paper rich, "cash poor" and all the while having to start from square one again if he wanted to add to his business partnerships.
I have a feeling that this ideology will soon become lost in the "big numbers of Buffett," so allow us to step back and consider an ordinarily moderate investing individual. Let's say they have been saving for several years and in 1993 they're ready to make a $10,000 partnership decision. Hearing about this Buffett guy's storied investing track record and his recent purchases of Coca-Cola (KO), they decide to plunk down $10k and partner with Berkshire Hathaway (BRK.A). Specifically, Berkshire B shares (BRK.B) because they could not afford one share of Berkshire A. What does this look like? Let's use the F.A.S.T. Graphs tool to take a look:
Note that due to Berkshire's 50-for-1 class-B stock split in 2010 -- triggered by the Burlington Northern acquisition -- the original $513.33 Berkshire B price in 1993 (which at the time was 1/30th of the $15,400 Berkshire A price) becomes a split-adjusted $10.27. We see that $10,000 invested in 1993 turned into $111,194.12 two decades later. Said differently, due to Berkshire's 12.8% annual compound gains, one would have reached the famed "Peter Lynch 10-bagger" stage in just 20 years. Perhaps in another decade -- with solid business results and reasonable pricing -- that turns into $300,000. But think about that investing individual for a moment. Arguing with the investing results would be difficult. Yet what happens if they need to send Johnnie to college or simply want to add some other business partnerships to their portfolio? What do they do? "Just sell some shares!" I hear you clamor.
On the surface, this is a perfectly reasonable move. However, I see two basic issues and they both stem from the "not having any money" ideology presented in the opening Buffett quote. First, by selling shares you are depleting the wonderful ownership claim that took you years of diligent saving to obtain. Assuredly some might argue for the "I want my last check to bounce" philosophy. But for me, I'm more focused on building a collection of partnerships rather than prematurely diminishing something that I might very well need in the future. Second, what if the going market rate is less than what you might think to be sensible? Let's say it's 2009 or some inevitable period in the future whereby prices are lower than what you think is rational. Instead of the market offering $111k -- what you believe to be a reasonable estimation based on the underlying business -- the market offers say $60k. Now, much like Buffett in 1974, you're paper rich but cash poor and unmotivated to sell your undervalued existing holdings to fund undervalued new holdings. It's the same process as having to sell your house in a down market or reselling your car to a dealership a week after you drive it off the lot. Yet I do have a moderate resolution forthcoming.
To quantify the thought experiment, I decided to take the ideology to a financial calculator. Granted in the rosy world of perfect assumptions, I'm sure to miss a boat load of important criteria. But I believe this exercise will still carry weight. Let's divide the investing universe into two options: a "growth" proxy like Berkshire that doesn't pay dividends and a "dividend growth" proxy like Coca-Cola that increases its payout each year. For both we'll assume that an investor contributes $10,000 a year for 20 years. For the "growth" proxy, we'll assume a constant 10% annual increase in business results, which roughly translates to a 10% annual increase in the stock price given a reasonable purchase price and a reasonable value in 2 decades' time. Using simple TVM, that $10k yearly contribution -- $200k invested in total -- turns into $630,025; not bad at all.
For the "dividend growth" proxy, we'll assume a 7% annual increase in business/price performance and a constant payout ratio. On a price basis the same $10k yearly contributions turns into $438,652; also not bad, but nearly $200k less than the "growth" proxy. But of course, you have to account for dividends as well. Keeping things simple, on a nominal non-reinvested basis, the constant payout ratio equates to 7% yearly dividend growth. Assuming say a 3% initial investment yield, this means that in the first year you collect $300 in dividends and by the 20th year, this payout amount for the original $10k investment grows to $1,085. The next $10k contribution starts with the same $300 and grows to $1,014 in the last year and so on. In total, you would have nominally collected just over $102,000 in dividends for the last 2 decades. Interestingly, due to the higher compound rate, the "growth" proxy still works out better by about $100k on a pure net worth basis. So you could have $630k in business worth or $430k in business worth and about $100k in cash.
To complicate things slightly, with the second option you would also have an income stream of roughly $12,300 that grows each year. So the real question is not "would you rather have a net worth of $630k or $530k?" but rather "is a $12,300 growing stream of income worth more or less than $100k in a less liquid business partnership?" To be perfectly frank, I don't have an absolute answer.
Of all the rosy assumptions I made, perhaps the most simplistic was assuming that business results translated into price results. Although I would advocate that if you buy at a "reasonable" price, the business results roughly translate to price results if given enough time. If you buy below a reasonable price, then you might pick up a couple extra percentage points above the business results and consequently overpaying would indicate that your results would likely lag the performance of the underlying company. But in general if you're holding for decades on in, it's difficult to find wide dispersions between price and business results.
Still, it isn't unimaginable that Mr. Market might be willing to price your securities widely above or below what you might think reasonable. If prices were widely above what might be sensible, I have no problem advocating that the "growth" proxy works quite well. You simply sell your shares above what you think they're worth and wait for rainier days. However, given "reasonable" or better yet "unreasonably low prices" -- for example, what Buffett experienced in 1974 -- I believe the "dividend growth" proxy gives you a much better chance of "not starting your net worth over." For example, perhaps the two types of partnerships are selling for half what one might think sensible. That is, the "growth" proxy claim is going for $315k and the "dividend growth" proxy claim is going for $215k. Now if you truly believed that there were many bargains to be had in the market, including your own company, then you're in a real pickle with the "growth" proxy. You want to buy, but you're certainly not going to sell your ownership claim at half the price. Moreover, you don't have cash on hand or an investment income stream to allow you to add partnerships. You're stuck.
On the other hand, look what happens when you hold the "dividend growth" proxy in the same market. Note that your ownership claim -- which you have no interest in selling at these prices -- is worth $215k. But remember, you still have $100k in cash from the 20 years of aggregated dividends. That is, your net worth is precisely the same as in the "growth" proxy example. More than that, you now have $100k to invest in what you perceive to be an opportune array of investing bargains. Even better, you didn't have to touch your underlying partnership and you have $12k coming in as yearly growing income to boot. If you ask me, building a solid stream of income over time is the perfect solution to "not starting your net worth over."
I'd like to end this article by being perfectly clear: In no way am I shunning non-dividend paying companies. I'm not even advocating that one should greatly favor dividend growth companies, although that has been a personal decision of mine. Everyone is different with regard to their investing objectives and rationale. I even understand the greater net worth benefit of allowing a company to compound your ownership claim tax-free by reinvesting the profits into worthwhile endeavors rather than dolling them out to passive investors. There's a reason that such companies are given the "growth stock" moniker and not "second class investment opportunity" or something of the sort. For many people they're a perfectible viable option for increasing purchasing power over time. Yet for those of you looking to avoid the "paper rich, cash poor, 'starting my net worth over' again" feeling, I think I've presented a temperate and hopefully lasting solution. Or what I've tried to lay out in Charlie Munger's words: "In Monopoly parlance, you don't want to go back to Go."