Seeking Alpha
Dividend growth investing, retirement
Profile| Send Message|
( followers)  

In Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) most recent letter to shareholders, Warren Buffett gives perhaps his most complete explanation for BRK's zero-dividend policy. (See pp. 19-21.)

I am a dividend growth investor, so I do not own shares in BRK. However, I have tried to learn as much as I can about how Buffett invests, because he loves to purchase shares of dividend-paying companies. He has expressed his enjoyment of dividends numerous times. And BRK's wholly owned companies, of course, forward dividends to headquarters like clockwork. Indeed, the managers of those companies earn bonuses based on the cash that they send to Omaha.

Many investors see a logical disconnect between BRK's failure to pay dividends and its own demand for dividends from the companies that it owns. I have never seen it that way. One point is about the companies that BRK invests in to make money. The other is about how BRK's own shareholders make money. There is no reason that they need to be the same.

BRK's investment proposition to those who invest in it has always been perfectly clear: Capital gains only. The formula for total return is Total Return = Capital Gains + Dividends. In BRK's case, dividends are zero. So all return from BRK comes in the form of capital gains (or losses). I am glad that Buffett went to such lengths this year to explain BRK's no-dividends policy. It gives me a chance to deconstruct his arguments from the point of view of an investor who wants cash dividends from his companies, the same as BRK wants cash from its companies.

So here are Buffett's key statements and assumptions as I see them. I encourage you to read the letter yourself, if for no other reason than to correct me if you think I have left a salient point out or misinterpreted something. Again, I am coming from the bias that I want cash dividends from my stock investments.

[O]ur test [for acquisitions] is simple: Do Charlie [Munger] and I think we can effect a transaction that is likely to leave our shareholders wealthier on a per-share basis than they were prior to the acquisition?

Clearly, Buffett has elevated wealth as the primary goal. As an investor, I will simply say that is not everyone's primary goal. It is not mine.

[Regarding assumptions about a hypothetical company used as an example.] The business earns 12% on tangible net worth ... and can reasonably expect to earn the same 12% on reinvested earnings.

This is a reasonable assumption for BRK, but clearly it is not reasonable for all companies. The assumption, without so stating, embeds the notion that earnings on all reinvested dollars are uniform, from the first reinvested dollar to the last. That is almost never true, as Berkshire's own results across its business lines testify. But taken as an average, the 12% return is reasonable for BRK, and I also think it is reasonable to advance the argument that he is making.

[T]here are outsiders who always wish to buy into our business at 125% of net worth.

Here, Buffett is talking about the stock market. That's where the outsiders are. He is making an assumption about the market (which determines prices) that is, on average, conservative. But we all know that the market is volatile and inconsistent, and the assumption may be far from true at key moments in a person's life when they might be forced to sell shares below intrinsic value or at a loss, even if they bought them intelligently when they were undervalued.

Absent this assumption about the constant 125% of book valuation of a company's shares, the entirety of Buffett's argument actually fails, in my opinion. Of course, I am defining failure here as falling short of convincing me why I should prefer to invest in a company that pays no dividends.

And [with dividends] we would live happily ever after -- with dividends and the value of our stock continuing to grow at 8% annually. There is an alternative approach, however, that would leave us even happier.

The alternative, of course, is selling shares to receive cash. Here, Buffett defines "happiness" as wealth. More wealth = "even happier." He has every right to determine BRK's policies, of course, but every individual gets to choose what makes them happy. As I stated earlier, Buffett offers a clear and unwavering investment proposition, and it is based on capital gains only. If that's not your cup of tea, then BRK is not for you.

And, remember, every dollar of net worth attributable to each of us can be sold for $1.25.

There is that assumption again, substituting theory for what the market actually does. Of course, Buffett has to do this, as he is comparing the wealth buildup of perhaps the best non-dividend-paying company in the world to what its wealth buildup would be if it paid dividends. Almost certainly it would be less if it paid dividends, as I would not place BRK among the many companies that waste much money, either on acquisitions, overvalued share repurchases, or dumb projects.

If maximizing wealth is your primary investing objective, Buffett's arguments are sound. It all comes back to your goals as an investor.

This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured.

This statement is completely correct. Buffett is not deceitful, his policy and reasoning are perfectly well explained.

Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded.

This is also completely correct. BRK shareholders who bought in early and held are in many cases now wealthy beyond their wildest dreams.

[D]ividends impose a specific cash-out policy upon all shareholders.

True. Some shareholders want that, while others don't. Everyone is free to accept or reject any company's investment proposition. One might expand Buffett's statement to include this obvious corollary: The lack of dividends also imposes a specific cash-out policy on all shareholders: BRK shareholders must sell shares to get any cash from their investment. There is no other way. Once they sell, they are no longer shareholders of the shares they sold.

That is the definition of a Hobson's choice: Take it or leave it.

Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them -- perhaps even most of them - are in a net-savings mode and logically should prefer no payment at all.

This, of course, is a guess on Buffett's part. He acknowledges elsewhere in the letter that, "A number of Berkshire shareholders -- including some of my good friends -- would like Berkshire to pay a cash dividend. It puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves."

Of course, the truth of Buffett's guess (and I believe that it is generally accurate) comes partly because it is self-fulfilling: Investors who want dividends are less likely to be invested in BRK, because it does not pay any.

Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)

The part about taxes is right, although it ignores investments held in tax-advantaged accounts. Many investors (including myself) accept the tax burden as a cost of doing business the way that we want to do it.

The part about what anyone would pay in the future to buy shares of BRK (or anything) is speculative, of course. Buffett's statement is based on his assumption that BRK shares always sell at 125% of book value, which of course they don't. He himself cites the example of a block of shares that BRK repurchased at 116% of book value since it instituted its buyback program. For all we know, the seller in that instance lost money on his BRK shares. (In truth, the seller probably was a multi-millionaire based on his BRK holdings.) However, we know almost for sure that the seller was forced to sell to BRK at a lower valuation than he purchased most of the shares that he sold. (I presume that if he could have gotten a better price from the open market, that's where he would have sold his shares.)

Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts.

True, although again it ignores tax-deferred accounts. As I stated before, I accept this taxation as part of my overall investing strategy. It is part my investment proposition too, just as zero-dividends is part of BRK's investment proposition.

Source: Buffett On Berkshire's Dividend Policy