Warren Buffett’s most recent annual letter to Berkshire-Hathaway’s shareholders was, as per usual, replete with food for thought. There is certainly much wisdom to extrapolate from the letter, however, of particular interest to most investors is what Buffett says towards the end of the letter about Berkshire Hathaway (BRKA) paying (or not, rather) dividends. While it is well known that he favors other investment strategies to create value over cash dividend payouts, it is nonetheless instructive to go over some of the more substantial sections that explain why he feels this way.
The whole passage dealing with dividends can be framed in the context of Buffett’s preoccupation with adding “materially to per-share intrinsic value”. He suggests several ways of doing this that he sees as more effective than increasing dividends.
First and foremost is the need to fend off competition: “A company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors…I ask the managers of our subsidiaries to unendingly focus on moat-widening opportunities, and they find many that make economic sense.”
This does not mean that Buffett is opposed share buybacks, however. In fact, he says at one point that “disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80 cents or less.” For Berkshire in particular, this means that shares bought back at no more than 120 percent of book value can only help a company’s stock.
This nicely clarifies the logic behind the use of book value as a guideline for Berkshire’s decision-making. As Buffett himself says quite succinctly, “Value is destroyed when purchases are made above intrinsic value”.
To close the discussion, there is a substantial passage devoted to a hypothetical situation in which even an ideal scenario for the yearly increase in a company’s dividend payments is presented as not being the most efficient means of increasing earnings. He elaborates an alternative scenario, in which all of a company’s profits are reinvested, theoretically increasing share price. The money that would have been made from dividends payments is eclipsed by a selling-off strategy, about 3 percent per year that would, while slightly decreasing the percentage of overall ownership in a given company, be far more profitable because the stock has been made significantly more valuable.
This passage is a fascinating peek into the reasoning behind Berkshire’s approach to dividends. Taking up over a third of the entire section devoted specifically to dividends, it is worth a close read. While Buffett notes at the end that Berkshire owns many companies who place far more importance on dividend payouts than it itself does, this is in no way contradictory to BRK’s approach, the nature of its business being slightly different from those of the smaller, sector-specific companies which it owns.
In all, the passage does not denounce dividend payouts, so much as questions them as a sort of given. That said, while Buffett does provide a positive instance of share buyback, he does not offer the same courtesy for dividend payouts. When he states that “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.” Berkshire’s “Big Four” consists of American Express (AXP), Coca-Cola (KO), IBM (IBM), and Wells Fargo (WFC).
The question left behind can perhaps best be resolved by keeping in mind that from the perspective of a company like Berkshire, who is involved “in so many areas of the economy, we enjoy a range of choices far wider than that open to most corporations. In deciding what to do, we can water the flowers and skip over the weeds”.