I am not shy about discussing my dividend investment portfolio, however, that has not limited my recent fascination with all things Buffett (who as discussed below feels differently on the subject for Berkshire Hathaway). As soon as I finished The Snowball: Warren Buffett and the Business of Life I immediately downloaded all of his shareholder letters. If you are new to Buffett (beyond reading what other’s think he is thinking on investment sites) I would recommend reading the two books in this order as it gives you an idea as to what is going on in his life.
I have yet to finish the letters but I have already written about:
- A sliver of Warren Buffett’s 1979 letter in which he raised an interesting point regarding why insurance companies would purchase long term bonds when they are worried about long term inflation?
- Why Buffett never wanted to split Berkshire Hathaway
- Buffett’s Major Business Principals
Buffett Discusses Dividend Policies
It is always interesting to look at a topic from Buffett’s own words rather than an article discussing another article. So below are some quotes from the dividend policy section of his 1984 Letter (with my thoughts thrown in…like they matter):
Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI”. And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.
I recently read my first 10-K so my experience with the subject is, admittedly, embarrassingly low despite investing most of my non-qualified money with dividend champions. Notwithstanding, I believe there is value in being that discipline to know there is a “shareholder bill” looming.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
I don’t believe companies should jeopardize their main purpose – profitability – for an unsustainable dividend policy, however, at what point are profits reduced when there is no expected dividend? Obviously an unanswerable question.
Restricted earnings need not concern us further in this dividend discussion. Let’s turn to the much-more-valued
unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.
This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
Re-read the added emphasis! Fantastic. The question then arises for corporations is if the current management has an adequate grasp on whether they are, or can, increase market value.
To illustrate, let’s assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course – reinvestment of the coupon – would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
An analysis similar to that made by our hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or paid out. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment
Good or bad, I think that a CEO of a company that has had a long and storied dividend history has his or her hands tied when making that decision. He or she knows that they better be damn sure if they are going to cut a dividend.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each
wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have
been unwisely retained.
This letter came out in 1984; I was three years old, but doesn’t it feel like today’s CEOs operate in a word where “long-term corporate outlook” means quarter to quarter?
Why Doesn’t Berkshire Hathaway Pay a Dividend?
Buffett explains, in his own words, why BRK doesn’t pay a dividend,
Let’s now turn to Berkshire Hathaway and examine how these dividend principles apply to it. Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.
In fact, significant distributions in the early years might have been disastrous, as a review of our starting position will show you. Charlie and I then controlled and managed three companies, Berkshire Hathaway Inc., Diversified Retailing Company, Inc., and Blue Chip Stamps (all now merged into our present operation). Blue Chip paid only a small dividend, Berkshire and DRC paid nothing. If, instead, the companies had paid out their entire earnings, we almost certainly would have no earnings at all now – and perhaps no capital as well. The three companies each originally made their money from a single business: (1) textiles at Berkshire; (2) department stores at Diversified; and (3) trading stamps at Blue Chip. These cornerstone businesses (carefully chosen, it should be noted, by your Chairman and Vice Chairman) have, respectively, (1) survived but earned almost nothing, (2) shriveled in size while incurring large losses, and (3) shrunk in sales volume to about 5% its size at the time of our entry. (Who says “you can’t lose ‘em all”?)
Only by committing available funds to much better businesses were we able to overcome these origins. (It’s been like overcoming a misspent youth.) Clearly, diversification has served us well.
We expect to continue to diversify while also supporting the growth of current operations though, as we’ve pointed out, our returns from these efforts will surely be below our historical returns. But as long as prospective returns are above the rate required to produce a dollar of market value per dollar retained, we will continue to retain all earnings. Should our estimate of future returns fall below that point, we will distribute all unrestricted earnings that we believe can not be effectively used. In making that judgment, we will look at both our historical record and our prospects. Because our year-to-year results are inherently volatile, we believe a five-year rolling average to be appropriate for judging the historical record.
Our present plan is to use our retained earnings to further build the capital of our insurance companies. Most of our
competitors are in weakened financial condition and reluctant to expand substantially. Yet large premium-volume gains for the industry are imminent, amounting probably to well over $15 billion in 1985 versus less than $5 billion in 1983. These circumstances could produce major amounts of profitable business for us. Of course, this result is no sure thing, but prospects for it are far better than they have been for many years.”
Said succinctly – I can make more money with keeping earnings than you can!
Will Buffett’s View on Dividends Change my Investing Views?
Not for my dividend investment portfolio which I consider just one piece, however, it has inspired me to think about building another “piece.” I think I would like to find mini-BRKs and allow them to make that decision for me using the same criteria Buffett has.