In Warren Buffett's 2012 letter to shareholders, the famous investor explained his thinking about dividends. Specifically, if and when they add value to shareholders.
The same letter was also mentioned in a recent article by fellow Seeking Alpha contributor Chuck Carnevale, which indirectly entered into a debate started by my article "Rich and Retired? Don't buy dividend stocks". However, I believe that Chuck referred to the less important parts of that letter and most importantly not to those parts that specifically treat the headline problem.
The letter is also of great importance to all Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders, as it outlines the logic behind Buffett's decision to avoid paying out dividends at least for the time being.
Buffett starts off with some basic assumptions:
We'll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The business earns 12% on tangible net worth - $240,000 - and can reasonably expect to earn the same 12% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net worth. Therefore, the value of what we each own is now $1.25 million.
Afterwards he starts describing what we could name the "Dividend Growth Scenario": What happens, if the hypothetical company pays out a dividend:
You would like to have the two of us shareholders receive one-third of our company's annual earnings and have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and capital growth. So you suggest that we pay out $80,000 of current earnings and retain $160,000 to increase the future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the one-third payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8% each year (12% earned on net worth less 4% of net worth paid out).
After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at 8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656 (125% of our half of the company's net worth). And we would live happily ever after - with dividends and the value of our stock continuing to grow at 8% annually.
Let's put these results of the "Dividend Growth Scenario" into a table, in order to get more clarity:
($) |
Net worth (Whole company) |
Earnings attributable to both shareholders (12% of Net worth) |
Market value (125% of Net worth) |
Year 1 |
2,000,000 |
240,000 |
2,500,000 |
Year 10 |
4,317,850 |
518,142 (86.357 x 3 x 2) |
5,397,312 (2,698.656 x 2) |
Then Buffett starts explaining another scenario, which we could name the "Sell-off Scenario":
Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually.
Hence, no dividends are paid out, but cash is retained and reinvested. To obtain current income, both shareholders sell some of their shares. At first sight, this approach may seem strange. But let's listen to Buffett:
Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. [...]
Under this "sell-off" scenario, the net worth of our company increases to $6,211,696 after ten years ($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.
Here's the table:
($) |
Net worth (Whole company) |
Earnings attributable to both shareholders (12% of Net worth) |
Market value (125% of Net worth) |
Year 1 |
2,000,000 |
240,000 |
2,500 |
Year 10 (72.24% of Whole company) |
4,487,080 (2,243,540 x 2) |
538,450 |
5,608.850 (2,804.425 x 2) |
As Buffett notes,
... annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! - you would have both more cash to spend annually and more capital value.
This might come as a surprise to most investors, but not to those who truly understand the magic of internal compounding.
But there are even more details to like about the "Sell-off Scenario":
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 second disadvantage of the dividend approach is of equal importance: The tax consequences for all taxpaying shareholders are inferior - usually far inferior - to those under the sell-off program. 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.
This is basically why I believe that rich, retired investors are better off by investing in non-dividend paying stocks like Berkshire Hathaway, DaVita (NYSE:DVA), DirecTV (DTV) and others. They can keep enough cash to cover their needs even without receiving current income (which would simply raise their tax bill) and can allocate a large part of their wealth to compounding machines like Berkshire Hathaway. If they do need some more money every once in a while, they can simply sell some stocks - and, if Warren Buffett's math is correct - will still be better off compared to a dividend growth strategy.
In fact, Warren Buffett concludes that
Over Berkshire's history […] the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy.
So I sincerely hope that Berkshire will continue to avoid paying dividends for a long time to come.
Disclosure: I am long BRK.B, DVA, DTV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.