Warren Buffett’s take on Dividends

By Ser Jing Chong - March 4, 2013 |

 

As always, Warren Buffett’s latest annual letter to Berkshire Hathaway (NYSE: BRK) shareholders never ceases to impress. Besides commenting on Berkshire’s results for 2012, Buffett also waxed lyrical on investing issues such as how to approach investing during times of uncertainty in the markets and the accounting treatment related to intangible assets.

There was also a discussion on when would dividends make sense for shareholders – an issue that has been bugging loyal Berkshire shareholders for years as Buffett has never seemed keen to give out dividends.

Some investors are accustomed to receiving dividends from our investments, and to look for good dividend yields for income. Since the start of 2012, the Straits Times Index (SGX: ^STI) has returned 21.6%, utterly overshadowed by the nearly 43% increase in the FTSE Straits Times Real Estate Investment Trust Index (SGX: FSTAS8670.SI). The latter index measures the performance of various REITs.

Currently, the STI’s dividend yield is around 2.5%, much lower than the dividend yield of 5.3% for the FTSE ST REIT index. The difference in the performance between the STI and the FTSE ST REIT index since the start of 2012 shows how much investors value a good dividend yield (technically, the ‘dividend’ payments given by REITs are known as ‘distributions’, but for discussion purposes in this article, a ‘dividend’ and ‘distribution’ would mean the same thing). But, investors who are too focused on a good dividend yield might be missing the forest for the trees.

Buffett himself wrote that Berkshire ‘relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves’ but suggested that shareholders in Berkshire would be better off if they sold off shares annually for cash flow rather than depend on dividends.

This was the argument laid out by Buffett:

• Companies A and B have equal net worth of $2 million each. Both businesses earn 12% on its net worth and any retained earnings can be reasonably expected to earn the same rate of return in the future. Outsiders who wish to purchase shares in those two businesses are also more than willing to fork out a 25% premium on its net worth.
• Company A pays out 1/3 of its 12% earnings on net worth as dividends each year and reinvests the rest while Company B retains all its earnings for reinvestments. For illustrative purposes, in the first year Company A would pay out $80,000 in dividends and reinvest $160,000 while Company B reinvests all $240,000 of its earnings.
• Shareholders in Company B elect to sell off 3.2% of their business every year for cash flow to make up for the lack of dividends. In the first year, that 3.2% of the business would also generate $80,000 worth of cash flow – Buyers are willing to pay a 25% premium on the net worth of the business.

This is what would happen after 10 years (without consideration of taxes):

	Company A	Company B
Net Worth after 10 Years	$4.3m (the original $2m compounded at 8% per annum)	$6.2m (the original $2m compounded at 12% per annum)
Value of original shareholders’ stake in the company after 10 Years	$5.4m (a 25% premium over $4.3m net worth of the company)	$5.6m (a 25% premium over the remaining 72.2% stake that original shareholders have in the company’s net worth).
Total Cash Value extracted from Company after 10 years	$1.159m in dividends	$1.182m from selling 3.2% of existing stake in the company each year at a 25% premium to its net worth.

From the table above, we can see that shareholders in Company B have performed better financially over Company A’s shareholders. Of course, the assumption is that both companies would always be trading at a 25% premium to net worth and that a 12% return on net worth can be achieved over the long run. Not many companies can warrant such ideal assumptions but isn’t the aim of investing finding great companies – companies that can warrant such assumptions – to invest in over the long run?

Shareholders would surely have different capital needs in different stages of their lives. A reliable dividend yield might make sense for a shareholder who depends on it for income.

But for shareholders whose aim is maximum appreciation upon his investment funds over the long term, then perhaps the focus should not always be upon the dividend yield. Instead, investors could look at whether a non-dividend paying company can reinvest capital at high rates of return over the long run and then sell his shares accordingly for cash flow.

The caveat in our local situation is of course the inability to buy and sell individual units of shares because trades must be done in lots of a 1000 shares – this makes selling small stakes in individual holdings extremely difficult to achieve. But, for individuals with substantial amounts of capital ready for investing, then Buffett’s gentle admonishment on the merits of not paying a dividend would certainly be some food for thought.