Warren Buffet’s letter accompanying Berkshire Hathaway’s annual report has long been required reading for investors,(including The Bedminster Group) seeking a glimpse into the strategy and thinking of the bard of Omaha. Besides an in-depth discussion of financial results, this year’s missive touches on the planned activities at the annual meeting, including a 5k run, a 194,000 square foot hall featuring products from many of Berkshire’s holdings (Buffet himself promised a shift behind the sales counter at Borsheim’s Jewelers,) and interestingly enough, dividends.
You see, Berkshire Hathaway doesn’t pay a dividend, and that fact is extremely frustrating to many investors. Isn’t a dividend a sign of a good, well-established company that cares about its shareholders? Isn’t it almost sacrilegious in the investment world to argue otherwise? Well, in his letter, Buffet elaborates on why, while many of Berkshire’s investments pay generous dividends, he has maintained a no dividend policy. His reasoning supports a pretty compelling argument that should interest and challenge those of us who invest in stocks for both growth and income.
He examines the three ways (not mutually exclusive) that companies can deploy their assets, and how Berkshire Hathaway implements this process. The first priority would be to reinvest in your existing business; in a diversified company like Berkshire, with their holdings spread across a wide swath of the economy, this offers many choices. The next approach would be to seek out new acquisitions, unrelated to their current business, with the proviso that each new holding must leave shareholders wealthier, on a per-share basis, than they were before the acquisition. Finally, excess funds can be used to repurchase the company’s own shares, when it is possible to do so at a meaningful discount to intrinsic value. But why not include a dividend payout to shareholders as well?
Here is a brief recapitulation of his argument. We’ll compare two scenarios, both based on a hypothetical company that earns 12% ($240,000) annually on net worth of $2 million. Its shares on the open market sell for an average of 125% of net worth, or $2.5 million (a reasonable assumption, since these numbers are both below earnings and price-to-book value for the S&P 500.)
In scenario one our company retains two-thirds of earnings each year, or $160,000, to reinvest in the business and pays out $80,000/year in dividends. In addition, our dividend payout would continue to grow each year by 8% (12% earned less 4% paid out.) After a decade our company’s net worth has grown to $4,317,850 (the original $2 million compounded at 8% per year,) our annual dividend would be $86,367, and our shares would be worth approx. $5,397,000, or 125% of the net worth. We would still own 100% of the company.
Now for scenario two. Instead of paying dividends, our company decides to reinvest the full 12% earnings. As a shareholder, I decide each year to sell off 3.2% of my shares, which would give me the same beginning income of $40,000. Fast forward ten years. Under this scenario the net worth of the company increases to $6,211,696, compared to $4,317,850 in scenario one. However, since I have sold shares each year over the last decade to maintain my income, I now only own 72.24% of the $6,211,696. My shares can still be sold at 125%, so my investment would be worth $5,608,850 or 3.9% greater than in scenario one. Plus, the sum total of the annual cash received in scenario two would be nearly 4% higher than in the dividend paying scenario one.
There are also other important considerations of taxes and timing. In scenario one, all cash received as dividends would be taxable; while in the scenario two, only the portion considered capital gain would be subject to tax. In scenario one, the company determines the payout policy for all shareholders, even those who would rather not receive the cash, while in scenario two each shareholder can determine the rate and timing of their payouts by choosing when and how much the prefer to sell. Pretty compelling.