Berkshire Hathaway: Understanding The Value Of Dividends

| About: Berkshire Hathaway (BRK.B)

Summary

Dividend investing has worked in the past in general, because it is simple and it captures several essential characteristics of a good business.

However, it is more useful for small investors who don't have the ability to evaluate a business.

For professionals or experienced investors, dividends are certainly not required, and there are many drawbacks to issuing dividends.

Buffett made the right choice in not issuing a dividend, and we will examine why that is the case.

The Value of Dividends

In the past, I have seen some intense debates within the Seeking Alpha community on whether Berkshire Hathaway (NYSE:BRK.B) should issue a dividend or not.

For sure, dividend investing is an investment approach that has worked in the past, and it is simple enough for newer investors to follow. However, for experienced investors, it is more important to understand why it worked instead of just looking at the historical performance, as what worked before may not work in the future.

In the following, you will find several reasons why I think dividend investing should work in general, provided with good diversification over securities and over time.

Dividends are a form of returns to shareholders

Dividends were actually much more popular prior to the 1950s, partly because the stock market was not very liquid at that time, and transaction fees were high. With transaction cost being so high, it was hard or inconvenient to profit from investments with capital gains. So dividends became a natural way of providing returns to shareholders. It also works for both publicly traded and private securities.

Although it is very easy to trade stocks today, dividends are still favorable in many cases. For one, they are one way to guard against management's misuse of capital resources. The fact is that agency problems are still rampant today. If the company doesn't return value to shareholders (through dividend or share buyback), it is often for shareholders to find that excessive cash being misused on expensive acquisitions or expansion to unfavorable (low-return) markets. Even if the cash is still being kept on the balance sheet, it is a very inefficient use of capital since it won't generate optimal returns on that capital.

Essentially, without dividends and share buybacks, or fairly predictable future dividends or share buybacks, the value of a stock is more speculative, as we have seen in some Asian family businesses. In those businesses, the majority owner tends to hoard cash and fail to distribute it to shareholders or use it wisely for decades. In this case, the stock price is reasonably depressed, leaving minority shareholders no way to profit from the investment (no capital gains, no cash distribution, and no "hope" of cash distribution in the future).

Dividends can be the evidence against financial fraud

Small investors may not be aware, but financial fraud or financial statement gimmicks are very common. In fact, I believe it is easier to find companies that play accounting tricks than find ones that don't.

However, it is difficult to play games with dividend cash payments, especially payments over many years or even decades. Financial numbers can be faked, but cash is much more reliable, especially cash being paid out. This is why I often pay a lot attention to "negative financial cash flows" over the years (for non-financial companies, usually negative financial cash flow is the distribution to investors through dividends, share buybacks, or repayment of debt).

For novice investors who may not have the skills to identify accounting tricks, following the cash distribution is certainly a good way to confirm the quality of the financial statements. It can serve as a confirmation for professional investors, too.

Dividends are a confirmation of stability and earnings power

Because cutting dividends usually brings bad headlines, company management tends to be very conservative in raising dividends. Therefore, dividends show management's conservative estimate of a business' long-term earnings power.

The caveat here is that this estimate may be the "past" estimate, not the current estimate. However, if management is increasing the dividend consistently over time, it is likely that they still believe the dividend is not too high relative to earnings power. (Of course, there are exceptions here, since management could use this method to fool investors, too.)

Several key words are very important here. First, the estimate is "long term." Second, it is a "conservative" estimate. Finally, it is an estimate coming from management (insiders), who know a lot more about the state of the company than its investors. Essentially, a conservative long-term earnings power estimate from insiders could form another solid basis for valuation -- one important method of valuation next to the liquidation value method (or "net current asset" method).

Also, this valuation method is based on cash flows instead of earnings. The GAAP earning is on the accrual basis, which is more stable than cash flow in a single year. However, cash flow is what really matters. Even though it is less stable and can swing widely over the years, the average of cash flow over years can give a much better picture of the business's intrinsic value than GAAP earnings.

Most investors are aware that the stock market tends to have huge swings between bull and bear markets. Therefore, it is important for newer investors to have some objective measure of the value of a business, like dividends, to help them make wise investing decisions.

Dividends can often be better than share buybacks

The fact is, dividends can often be better than share buybacks. This is not because they are inherently better, but because share buybacks are often poorly executed. Share buybacks tend to be executed at high prices, and therefore could destroy value. Also, dividends give investors the flexibility to invest in their favorites, which may not be the same stocks for many reasons.

Dividends are simple

One merit of dividend investing is that it is fairly simple. It is very easy to see the current dividend yield and check the historical dividend growth. Therefore, this method is much easier for newer investors to understand and practice.

The Drawbacks of Dividend Investing

There are several drawbacks to dividend investing as well.

1. A false sense of security.

Just because a company has been issuing continuous or stably rising dividends for years or even decades doesn't mean it will continue to do so for the next year.

Stocks are generally much riskier than they seem. When the business model becomes invalid, or a company loses its competitive advantage for one reason or another, its earnings power could be permanently impaired. If the business is over-leveraged, it could become insolvent as well.

But when a company offers steadily rising dividends for many years, it is human nature to get lulled into a false sense of security. This could be very dangerous for novice investors.

2. A large distribution ratio could be a reflection of less attractive reinvestment opportunity.

If the company distributes a significant portion of its cash flow to shareholders, it could be an indication that the reinvestment opportunity is no longer as attractive. Therefore, the growth could be slow, and the value from potential growth will be small.

However, this is more applicable to capital-intensive businesses. For capital-light businesses, such as high tech or information-based companies, since less capital may be needed for growth, paying a large dividend may not affect its growth rate at all.

3. Dividends have immediate tax consequences.

Dividends mean that everyone has to pay taxes immediately (except the tax deferred/exempt accounts). Some investors may want to defer those taxes to the future, and they won't have that freedom if dividends are paid to them.

Why Buffett chose not to pay a dividend

I have seen arguments that because Berkshire Hathaway didn't pay a dividend, it's no longer be a good choice for retirement investors or dividend investors. As I have shown above, there are many pros and cons of dividend investing. But in this context, there are only cons and no benefits to care too much about dividend.

For a management with both excellent capital allocation skills and integrity, virtually no benefits of dividend investing will apply here. We wouldn't worry about Buffett misusing the cash to destroy shareholder value, or the possibility of some financial fraud. Buffett would also not buy back shares at high prices, or refuse to return cash to shareholders if there are no more attractive reinvestment opportunities.

In this case, it is much better to keep the cash and reinvest it into attractive opportunities than distributing it to shareholders with an immediate tax consequence. For shareholders who need to have a stable income, they can always sell a small portion of their stocks periodically, especially given the fact that the shares are usually traded in a fairly stable price range.

Conclusion

Although there are many reasons to like dividend investing (especially for small investors), we should also notice that people like this method mostly because it is simple, not because it is accurate or any better than a more sophisticated method, such as the discounted cash flow method. It also doesn't remove the need to examine the underlying business and forecast its potential or competitive strength.

That said, when practiced conservatively, and with well-diversified bets, dividend investing should work in general over time.

However, for Berkshire Hathaway, because it has a very good manager, who has both integrity and top-notch capital allocation skills, a dividend is not required or desired here.

Disclosure: I am/we are long BRK.B.

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.