Yesterday, Berkshire Hathaway’s (BRK.B) 2013 letter to shareholders was posted on the company’s website. As a long-term follower of Warren Buffett, I voraciously read through every single word of it. I was particularly excited that Buffett spoke about dividends and dividend paying stocks on several occasions in the letter. His standing on paying dividends have always perplexed investors in Berkshire. In fact, I have even referred to him as a closet dividend investor before. In this article, I am going to post my thoughts on the letter.
At the very bottom of the letter, Warren Buffett discusses why it makes sense for Berkshire Hathaway to continue not paying dividends. In essence, he comes to the conclusion that reinvesting all profits at above average returns will serve shareholders better in the long run, than paying dividends. This reinvestment of capital refers to either direct reinvestment back into the business that generated them or by purchasing new businesses that generate high returns on equity. This sounds like a reasonable idea, and is one that Buffett has been very successful at since the mid 1960’s. One of Buffett’s arguments against paying distributions was that investors, who require income, can easily afford to sell a portion of their shares every year. In his theoretical example, all earnings were reinvested at a constant rate of return, and the stock price always traded at a premium to book value. The main issue I had with his thinking was that in the real world, things are not linear at all. Stock prices fluctuate wildly above and below book values, and reinvested rates of returns are often equally volatile.
Overall, Warren Buffett is not interested in distributing profits to shareholders in the form of dividends, because he believes that he would be much better at allocating cash than ordinary shareholders. While plowing all of realized earnings back into the business or in new ventures comes with its own sets of risks and limitations, Buffett has proven his uncanny ability to reinvest successfully. He is after all, the Oracle of Omaha, and the most successful US investor. Unfortunately, he is in his 80s, and is close to retirement. As a result, given the massive scale of Berkshire today, the success of future acquisitions might not lead to similar extraordinary performance. In addition, although keeping all earnings into Berkshire might have worked for Buffett and his followers, there are only a handful of companies which have managed to do the same, and be successful at it. In your typical US Corporation, the overpaid management is greedy for acquisitions and empire building at all costs, since they have very little if any actual stake in the business. Expanding your business is often subject to limitations, as I explained in an earlier article.
In essence, Buffett’s Berkshire is acquiring businesses, shares in businesses with its excess cashflows that didn't need to be invested in its existing subsidiaries. In a previous article I have argued that dividend investors can similarly create their own mini-Berkshire style portfolios, by investing in dividend paying stocks, and reinvesting distributions into attractively-priced shares. Incidentally, the largest four portfolio investments include Wells Fargo (WFC), IBM (IBM), Coca-Cola (KO) and American Express (AXP), all of which pay dividends. In the case of Coca- Cola and IBM, we have companies that have raised them for years if not decades. These businesses and shares generate additional cashflows that need to be reinvested. In his letter he said the following:
“Most companies pay consistent dividends, generally trying to increase them annually and cutting them very reluctantly. Our “Big Four” portfolio companies follow this sensible and understandable approach and, in certain cases, also repurchase shares quite aggressively.
We applaud their actions and hope they continue on their present paths. We like increased dividends, and we love repurchases at appropriate prices.”
Buffett focuses on businesses with the potential to generate growing cashflows over time with limited needs for investment, and then utilizes his experience as a capital allocator to reinvest profits into more income generating assets.
Full Disclosure: Long KO
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