Thursday, January 21, 2016

Evidence that Buffett likes dividend paying stocks

Warren Buffett is one of the best investors in the world. He is skilled in the art of capital allocation. I have always suspected that the Oracle of Omaha is actually a dividend investor, because he has often invested in businesses which generate more cash than necessary for their operations. As a result, most of these businesses send this excess cash to shareholders in the form of a dividend or share buybacks. He just doesn’t like to pay dividends to shareholders, because he believes he can allocate money better than shareholders. Of course, his record speaks for itself. Berkshire Hathaway is one of the rare group of companies, where shareholders were indeed better off not receiving a dividend. Unfortunately, there is only one Warren Buffett, and almost anyone else that has tried to emulate his style has been unable to do so.

Let's take a look at the holding company Berkshire Hathaway (BRK.B), which Buffett built to a $300 billion conglomerate over the past 50 years. You would notice that sending excess cashflows from a wholly-owned operating subsidiary such as Burlington Northern Santa Fe (BNSF) to Omaha is really easy, and tax-free. If the company sold a subsidiary, or sold some stock for a gain, or just earned money in the ordinary course of business, it would be taxed at 35% on all US profits above $18 million.  With dividends however, Berkshire Hathaway is taxed at a more preferential rate. If a wholly-owned subsidiary sends money to Buffett to allocate, that dividend is not taxed due to a corporate deduction called the dividend received deduction. If the corporation receiving the dividend owns more than 80 percent of the distributing corporation, it is allowed to deduct 100 percent of the dividend it receives.

If a corporation receives dividends from another corporation, it is entitled to a deduction of 70 percent of the dividend it receives. If the corporation receiving the dividend owns 20 percent or more, however, then the amount of the deduction increases to 80 percent. Therefore, a conglomerate like Berkshire Hathaway has an incentive to invest in companies that pay growing dividends, while patiently watching their value increase over time. The tax-deferred capital gains taxes provide a sort of float to Berkshire Hathaway, which further turbocharges growth in book value over time.

For example, Berkshire Hathaway is the largest shareholders in Coca-Cola (KO) with its stake of 400 million shares. Each one of those shares pays 33 cents every quarter to the tune of $132 million every 90 days. This translates into $900 in dividend income every single minute. When a company like Coca-Cola sends that big fat check for $132 million in quarterly dividend to Berkshire Hathaway every 90 days, the Omaha company pays a tax rate of approximately 10.50% on that distribution. If Berkshire were to sell those shares at $40/share, it would obtain $16.3 billion. Since the cost basis is $1.3 billion (cost basis of $3.25/share), the profit turns to a pretty cool $15 billion, which would be taxed at 35%, leaving Berkshire $5.25 billion poorer. It is no wonder that Buffett views tax liabilities on capital gains as a form of float. It is also no wonder that Buffett tends to focus on buying quality companies to hold for decades.

In his 2010 letter to shareholders, Buffett talks about about dividends from Coca-Cola from 1995, and dividends from Wells Fargo (WFC), Source: 2010 letter

"At some point, probably soon, the Fed’s restrictions will cease. Wells Fargo can then reinstate the
rational dividend policy that its owners deserve. At that time, we would expect our annual dividends from just this one security to increase by several hundreds of millions of dollars annually

Other companies we hold are likely to increase their dividends as well. 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 have also enjoyed his 2007 letter to shareholders, where he discussed his investment in See's Candies. This is an example of an investment that had low subsequent capital needs and sends all money to the sharehowner to be allocated.

"We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses."

Buffett has also discussed his preference of investing in productive assets in another one of his letters to shareholders. In his comment on gold vs Exxon-Mobil (XOM), he states;

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it
would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) 

At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400
million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most
profitable company, one earning more than $40 billion annually). After these purchases, we would
have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying
binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual
production of gold command about $160 billion. Buyers – whether jewelry and industrial users,
frightened individuals, or speculators – must continually absorb this additional supply to merely
maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its
owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). 

The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Warren Buffett is a Superinvestor, but unfortunately his career is close to an end. Dividend investors have very similar characteristics like Buffett actually. He owns businesses, that generate billions of dollars in excess capital, after being reinvested. These money are used to buy more income generating assets.

Ordinary investors have a day job or a business, where they receive money to save. They invest in themselves by taking courses, but usually there is some money left over. Buffett always keeps $20 billion in cash, as sort of a rainy day fund. He needs this money because his insurance operations might need money quickly.

Investors usually start putting money to work in stocks after they have accumulated an emergency fund that has 6 – 12 months worth of living expenses.

Buffett takes a small salary, doesn’t manage businesses he owns and only has 25 or so people at Berkshire Hathaway headquarters in Omaha, NE. He likes to keep costs low.

A dividend investor keeps costs low by managing money themselves, not paying 1% of assets to a mutual fund or an adviser, using a low-cost online brokerage and investing as much money as possible through tax-deferred vehicles such as 401 (k), Roth IRA, etc.

Buffett of course buys and holds not only businesses, but also stakes in quality companies that he intends to hold for the long-run. Dividend investors focus on companies with strong brands, strong competitive advantages, quality business models, that drown them in cash. Not coincidentally, most of Buffett’s best ideas have been quality dividend growth stocks such as American Express (AXP), Wesco, Gillette, Coca-Cola, GEICO etc.

Many use Buffett as an example that dividend investing is a bad strategy. The problem with this faulty thinking is that Buffett is an exception, rather than the rule. He is a genius knowledge accumulation machine, who has been focusing his mind on investing for 70 hours per week for the past 70 years. There aren’t any other Superinvestors I know of today, who can take his shoes.

However, I can easily identify at least 100 companies today that exhibit the characteristics that Buffett is looking for in a business. While those businesses are not automatic buys, and should not be purchased at any price before being thoroughly researched, they nevertheless provide a starting list for research for the dividend investor. Those companies are the dividend champions, which have managed to boost dividends for at least 25 years in a row.

In other words, Buffett has run Berkshire Hathaway like an investor in the accumulation stage, who buys partial stakes in businesses or whole businesses, and then uses excess profits from those businesses to acquire even more shares or whole businesses. Those excess profits are dividends of course. Buffett does have a few levers outside the control of us mere mortals, such as insurance float and ability to get deal at a preferential rates of return. However, his basic investment goal has been to purchase shares in quality companies that are selling at fair values, which will be around in 20 years with minimal changes to the business model. He extracts all the excess cash flows from those businesses in the form of dividends, and uses that cash to allocate in his best ideas.

All of this is similar to the process used by ordinary dividend investors who save money from their primary cash generator ( their job, business etc). This money is then allocated into a diversified portfolio of quality dividend growth stocks. Dividends are accumulated in cash, and then reinvested into the best ideas at the time.

Full Disclosure: Long KO, BRK.B, XOM, WFC

Relevant Articles:

The one lesson about Warren Buffett's success that no one wants to hear
Build your own Berkshire with dividend paying stocks
Warren Buffett’s Dividend Stock Strategy
Strong Brands Grow Dividends
How Ordinary Investors Can Generate Float Like Buffett

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