One of the main arguments that opponents of dividend investing make is that Warren Buffett has never paid dividends on Berkshire Hathaway (NYSE:BRK.B). He has managed to reinvest profits and buy more businesses and shares in publicly traded companies. This compounding of profits has catapulted Berkshire's Book Value from 16 in 1965 to 114,000 by 2012. So if this worked so well for Berkshire Hathaway shareholders, why don't all companies simply discontinue paying a dividend, and reinvest all of their earnings into the business?
While in theory this sounds like an excellent strategy, there are a few issues with it.
The first one is that Warren Buffett is an outlier. He is the best investor the world has ever seen, and as a result his skilled allocations of capital have resulted in great amounts of wealth for shareholders. Unfortunately, I cannot think of many other managers today, which are likely to reach his status in a few decades. I know that the Oracle of Omaha is an outlier, because there is only one Buffett, but 106 dividend champions. As a result, I find it much more probable that an investor can identify the next company to boost distributions for 25 years in a row, versus identifying the next Berkshire Hathaway.
The second issue is that it is extremely difficult to keep reinvesting money in your business to grow and achieve the same rates of return on any additional money you put to work. Essentially at some stage you enter a point of diminishing returns. If McDonald's (NYSE:MCD) or Wal-Mart Stores (NYSE:WMT) simply doubled the number of locations they had, this would not automatically double sales and profits. In fact, they would probably go bankrupt, as new stores would likely cannibalize sales of existing stores, while certainly doubling the amount of costs. In addition, it would take time to find suitable locations, build the stores, and then attract customers to shop there on a recurring basis. McDonald's almost got in trouble in 2002, because the company was simply focusing on increasing number of stores, without paying attention to same store sales in the U.S. for example. This had worked for the first 40 years in the company's history, but once there was a store in every major intersection, focusing on improving the customer experience through store renovation and new product introduction has been key in improving same-store profitability.
The third issue is that companies cannot simply merge with competitors or buy unrelated businesses in order to grow. Integrating business systems, different products and cultures can be extremely difficult, time consuming and costly. Most acquisitions don't work and fail to deliver the synergies expected. In addition regulators do not like too much concentration in industries. A prime example was the failed acquisition of T-Mobile (NASDAQ:TMUS) by AT&T (NYSE:T). For a few years, it could have been argued that insurance company AIG was following a strategy similar to Buffett's at Berkshire. The company had purchased a ton of unrelated to insurance assets, including the telecom company of Bulgaria for example. Unfortunately, it did not work.
The fourth issue is that while Berkshire does not like paying a dividend, it does seem to invest in businesses that distribute a large portion of their excess cashflows to the parent, so that Buffett can invest the money for the firm. There are many examples of Buffett's love for dividends. The first one is See's Candy, which was described as a great investment that generated high yield on cost despite the low initial and recurring capital requirements of the business. These cashflows were then used to purchase other businesses. Another famous investment by Buffett is his purchase of Coca-Cola (NYSE:KO) shares in 1988. His company is currently earning a double-digit yield on cost on this investment, and the amount of dividend income is expected to continue its upward trend. This was in particular discussed by Warren in his 2011 letter to shareholders. In addition, Berkshire's dividend portfolio generates over 1.5 billion in annual dividend income. That does not take into consideration the $300 million it generates from Bank of America (NYSE:BAC) preferred stock, nor does it consider the cash distributions from Burlington Northern Railway and the countless other businesses that Berkshire owns. In fact, I have argued that investors, who are inspired by Buffett, should build their own Berkshire Hathaway using dividend paying stocks.
Last but not least, book values and stock prices do not always have a one to one relationship. For example, during the 1998 - 2000 period, Buffett was often cited as being out of touch with reality since he didn't invest in tech stocks. This was the period when red hot technology stocks dominated investor interests, and Buffett was often ridiculed for his avoidance of the sector. As a result, after Berkshire's stock reached a high in June 1998 of 84,000, it fell all the way to 43,000 in February 2000. The stock didn't exceed its high until November 2003. Investors who simply held on to the stock, did not realize any return on investment for five long and difficult years, despite the fact that book value per share increased during the same period. In contrast, investors in dividend paying stocks have received positive reinforcement every three months, whenever the dividend checks were deposited in their brokerage accounts. Getting paid to hold shares with improving fundamentals is much easier done than holding non-dividend stocks during turbulent market conditions, hoping that the market would realize the investment's true potential.
In summary, an investment in Berkshire Hathaway exposes our investor to the whims of Mr. Market. An investment in Dividend Paying Stocks still makes the investor partially vulnerable to the whims of Mr. Market when it comes to stock prices. However, dividends provide a direct link between the company's operating performance and investors' return on investment, which are not dependent on the whims of Mr. Market. To paraphrase some of Mr. Buffett's words, even if they closed the stock market for five years, dividend investors would keep getting their dividend checks on a regular basis. And these checks would be bigger in year five than in year one.
Disclosure: I am long KO, MCD, WMT, BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.