- Buffett aims to treat shareholders as long-term partners.
- Buffett's primary focus is to compound shareholder wealth.
- The payment of dividends must be understood within this focus.
- Students of Buffett would be wise to focus on his understanding of compounding.
This article originated from an exchange to an SA recent article, Why Dividends are Irrelevant, by Safraner Investment. I had somewhat glibly observed that I rather doubt that Warren Buffett sits in Omaha counting Berkshire's dividends. In response a poster quite correctly rubbed my nose in a comment that Buffett had made in his 2010 Letter to Shareholders:
Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn't be surprised to see our share of Coke's annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.
I recall reading it and, at the time, being puzzled: this sounds so unlike everything I have heard or read by Buffett in the forty years I have known of him. So I spent some time piecing together a thought trail, which became this article.
In 1983, after the merger of the residual shares of Blue Chip Stamps into Berkshire, Warren wrote, with the incoming shareholders in mind, "Owner-Related Business Principles." It consisted of thirteen principles and largely summarized what long-term shareholders already knew. In 1996, He expanded on these thirteen principles with added commentary. He titled it "An Owner's Manual." In 1996, Berkshire acquired full ownership of Geico and issued the B shares, which greatly increased the number of shareholders. The Owner's Manual has been reprinted, with occasional additions in subsequent annual reports, including two additional principles. The latest can be found on pp 103ff here. I urge readers to study the Manual. It is full of investment insight by someone who enjoys teaching. I will consider this article a success, if it achieves nothing more than getting you to read something you should ponder long and hard.
In many ways Warren and Berkshire have served as true bellwethers. He has a rational distaste for conventionality. Back in the mid '80s, when CEOs and Wall Street pronounced stock splits good for shareholders and liquidity (today it is instant trading!), Warren told me in his office that he measured his success as CEO by how few shares trade. And, then with a smile, he added, this is a view shared neither by his fellow CEOs nor on Wall Street, which of course is compensated on turnover. In his commentary to principle 1 he adds this, "The evidence suggests that most Berkshire shareholders have indeed embraced this long-term partnership concept. The annual percentage turnover in Berkshire's shares is a fraction of that occurring in the stocks of other major American corporations, even when the shares I own are excluded from the calculation." The 2010 quote ends with, "Time is the friend of the wonderful business."
So how are we to understand his 2010 apparent endorsement of dividends? In the Owner's Manual, the word dividend is not mentioned once. Of course, Berkshire doesn't pay a dividend but still, why the 2010 mention? Since it is such an outlier, my guess is that it was made in the context of the BNSF acquisition, which added many thousands of shareholders to the roster. His purpose was to stress long-term ownership. He wants shareholders to think like owners. This is not a personal preference. In principle 14 he says this: "Obviously, Charlie and I can't control Berkshire's price. But by our policies and communications, we can encourage informed, rational behavior by owners that, in turn, will tend to produce a stock price that is also rational. Our it's-as-bad-to-be-overvalued-as-to-be-undervalued approach may disappoint some shareholders. We believe, however, that it affords Berkshire the best prospect of attracting long-term investors who seek to profit from the progress of the company rather than from the investment mistakes of their partners."
So where does Warren stand on Dividends? I think his answer would be, as he once said, "I am an agnostic, which means I'm an atheist, thank God." He does not "love" dividend paying companies: he loves companies that can create enduring intrinsic value. And he would think it nonsense not to own a company like Berkshire "because it doesn't pay a dividend." (Years ago pension funds had a rule that the fund own only dividend paying stocks. Many might still. I recall the story that Capital Cities agreed to pay a token dividend when it went public to satisfy the Sears pension fund. Tom Murphy, the long-time CEO, later said he considered that decision one of the more wasteful he had made, wasteful because of the quarterly expense of processing the dividends.)
Principle 4 in the Manual addresses the importance of cash: "Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year's capital allocation."
And then he adds as commentary, "The challenge for us is to generate ideas as rapidly as we generate cash. In this respect, a depressed stock market is likely to present us with significant advantages. For one thing, it tends to reduce the prices at which entire companies become available for purchase. Second, a depressed market makes it easier for our insurance companies to buy small pieces of wonderful businesses - including additional pieces of businesses we already own - at attractive prices. And third, some of those same wonderful businesses, such as Coca-Cola, are consistent buyers of their own shares, which means that they, and we, gain from the cheaper prices at which they can buy."
"Overall, Berkshire and its long-term shareholders benefit from a sinking stock market much as a regular purchaser of food benefits from declining food prices. So when the market plummets - as it will from time to time - neither panic nor mourn. It's good news for Berkshire."
Notice in the above: wonderful businesses "are consistent buyers of their own shares." He did not write "consistent payers of dividends."
A successful business will ultimately generate unneeded cash. The task of managers and owners alike is what to do with it. In Berkshire's wholly owned businesses, excess cash is up streamed-sent to Omaha-and reallocated, one hopes, profitably. This can be done without additional transfer costs, like taxes; and the managers are compensated on a percentage of the excess cash they send to Warren. So here Warren's thinking is not too far from those who love their dividends. The difference is that he does not demand receipt; he incentivizes his managers to utilize capital efficiently. If they can reinvest it at attractive returns he wants them to retain it and receive a larger bonus later, otherwise send it to him.
In my article on the importance of compounding, I attempted to show how this worked with See's Candy. See's is capable of being a very efficient cash generator. It could also waste cash in a hurry. As a standalone company, it would be hard pressed to put its cash to work. But under the Berkshire umbrella, wholly owned, it simply upstreams it to Warren, and he compounds it. In a recent year, Warren reported that See's had generated $80 million in pretax operating income on $40 million in invested capital. Over the decades that it has owned See's, first through Blue Chip, Berkshire has compounded the cumulative cash it has thrown off into serious money.
Some final comments are warranted to dispel many misimpressions. Most, if not all, of the marketable securities are held within the insurance companies. Insurance companies are heavily regulated. They are required to hold widely diversified equity portfolios, and conventionally many invest their capital in bonds. Up until the mid-80s, Berkshire's large equity positions had to be held outside of the insurance companies. This stricture constrained the growth of Berkshire's insurance operation. In the mid-80s Warren and Charlie were able to persuade the Nebraska Insurance Commissioner, Berkshire's primary regulator, to allow Berkshire to hold concentrated positions within the insurance companies. Both Warren and Charlie are keenly aware that this allowance can be withdrawn with a hastily arranged press conference. Much of the insurance capital is invested float: the reserves that will ultimately be paid to policy holders. Berkshire's credibility is their protection, and it has made its insurance operations incredibly attractive to those in need of insurance protection.
To minimize double taxation, insurance companies pay about 11% tax on dividends received. They pay the regular corporate rate of 35% on realized gains. So, to maximize the value of the insurance capital, Warren is balancing an 11% current tax with a 35% deferred tax. Since by nature he thinks very long term he will favor the latter, but he lives in the here and now, and, as he quoted a race car driver, in order to win the race you first have to finish.
So, what lesson can Buffett teach us? What differentiates most investors from Buffett? It is his keen understanding of compounding: what is done with the cash generated from a business you own determines how well you will to eat. Many investors think their job is done if they buy stocks that pay them a regular, growing dividend. It is not. If a company holds on to the cash and consistently reinvests it at a high return, you are on your way to riches. If it, however, pays it out in the form of a dividend and you reinvest it poorly you are destined to a mediocre existence. As an investor you hire the management of a company, whose stock you buy, to compound your money. If the company pays you a dividend then some of the burden of compounding reverts to you. If you consume it, which eventually you might, or do nothing with it you have only the dividend, nothing more.
When Buffett took control in 1965 of a textile company headquartered in New Bedford, Mass., named Berkshire Hathaway, it was a mediocre business. It became the company we know today because Buffett had the skill to take the free cash flow and reinvest it over the past 45 years at better than a 20% compound annual rate. The beginning value is insignificant. A modest initial stake will compound to a very large stake, if the rate on the reinvested capital is high. As Warren said to me years ago, "compound at 20% for 20 years and you will be rich." He did not condition that by saying that I needed to start out with a large inheritance, which I didn't have. Nor does he imply an initial stake when he says, "Life is like a snowball; the trick is finding wet snow and a long hill." We miss his point if we spend our time lamenting not having an initial stake: better we spend our time looking for wet snow and a long hill, that is, an investment capable of compounding for years to come. This also the great investment that Charlie Munger reminds us allows us to sit on our patoot: we don't have to continually get up and do something with the cash returned to us quarterly. And sitting in Charlie's favored position is a great place to think and read.
So, in sum, Buffett is not a lover of dividends per se; he does not spend his time counting the dividends Berkshire receives. On the other hand, he is keenly focused on the efficient compounding of capital. He is not doctrinaire in how he achieves that. The thoroughness with which he has thought about compounding capital should make him a teacher to all interested in investing.