A few weeks ago Berkshire Hathaway Inc. (BRKB) announced a second-quarter profit increase of 46 percent, reflecting improvement in their core businesses of auto insurance, energy and railroads, as well as gains from investments and derivatives. We shouldn’t be surprised. Investors have long marveled at the success of Berkshire Hathaway in building value for its shareholders; their business portfolio includes General Re, Berkshire Reinsurance, Geico, Burlington Northern Santa Fe, Mid-America Energy, Union Tank Car, Clayton Homes (the country’s leading builder and financer of manufactured homes), CORT Furniture, and a slew of common stock investments in publicaly traded companies. Berkshire owns 13.7 percent of American Express, 8.9 percent of Coca Cola, 8.7 percent of Wells Fargo and 6 percent of IBM, to list just a few. They have also acquired 28 daily newspapers across the United States, pursuing Buffett’s strategy of investing in these businesses for their ability to deliver local news not obtainable elsewhere.
Warren Buffett’s letter accompanying Berkshire Hathaway’s annual report has long been required reading for investors 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 (Buffett 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, Buffett discusses 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 percent ($240,000) annually on net worth of $2 million. Its shares on the open market sell for an average of 125 percent 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 percent (12 percent earned less 4 percent paid out.) After a decade our company’s net worth has grown to $4,317,850 (the original $2 million compounded at 8 percent per year) our annual dividend would be $86,367, and our shares would be worth approximately $5,397,000, or 125 percent of their net worth. We would still own 100 percent of the company.
Now for scenario two. Instead of paying dividends, our company decides to reinvest the full 12 percent earnings. As a shareholder, I decide each year to sell off 3.2 percent of my shares, which would give me the same beginning income of $40,000. Fast forward 10 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 percent of the $6,211,696. My shares can still be sold at 125 percent, so my investment would be worth $5,608,850 or 3.9 percent greater than in scenario one. Plus, the sum total of the annual cash received in scenario two would be nearly 4 percent 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 they prefer to sell. Pretty compelling.
Steven Weber, Gloria Harris, and Frank Weber are the investment and client services team for The Bedminster Group, providing investment management, estate, and financial planning services. The information contained herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the authors and do not necessarily reflect those from any other source. Discussion of individual stocks are informational and do not constitute recommendations to purchase.