Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1984 letter.
Buffett dedicates a whole section of the 1984 shareholder letter to addressing the question of dividend policy, saying “Dividend policy is often reported to shareholders, but seldom explained." Unfortunately, 40 years later, this is still the case.
Dividend policy
Very often companies will state something along the lines of “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the inflation." Great. Why? Companies rarely share an analysis of how they came to this policy, even though this is very important. Buffett says because allocation of capital is crucial to business and investment management, “we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.”
"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let’s call these earnings “restricted” - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused."
In today’s words, this might be called “maintenance capital expenditure” (as opposed to growth capex). Next and more importantly is the portion of earnings which can, with equal feasibility, be retained or distributed. In Buffett’s opinion, “management should choose whichever course makes greater sense for the owners of the business.” However, Buffett warns us:
"This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors."
Therefore, owners thinking about whether a company’s unrestricted earnings should be retained or paid out need to conduct an opportunity cost analysis. The problem is, opportunity cost is not a straightforward analysis. The process is difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, but rather a fluctuating figure. So, Buffett recommends:
"Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment."
The analysis applies to corporate managers in determining whether subsidiaries should distribute earnings to their parent company. Buffett believes that “At that level, the managers have no trouble thinking like intelligent owners.” However, the pay-out decision at the parent company level is often another story as CEOs and chief financial officers frequently have trouble putting themselves in the shoes of their shareholder-owners.
"With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO’s business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company."
Buffett notes that shareholders can’t simply compare the recent history of total incremental earnings to the recent history of total incremental capital because this relationship may be misleading due to how the core business has performed. For instance, under inflation:
"Companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business."
What we need to watch out for is companies which show good returns both on equity and on overall incremental capital have but then proceed to allocate retained earnings to economically unattractive, or even disastrous projects. The strong core business performance can mask these capital (mis)allocations. Often the root cause of the problem is “high-priced acquisitions of businesses that have inherently mediocre economics." Managers then beg for forgiveness but often then fail to learn any lessons. Note, M&A is not automatically bad, but can be.
According to Buffett, "shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is."
Conclusion
Buffett is not saying that dividend payments should be volatile. It’s understandable that investors prefer dividends to be consistent and predictable. So, this means that dividends “should reflect long-term expectations for both earnings and returns on incremental capital." As the long-term corporate outlook should not be volatile, the dividend doesn’t have to be volatile. This might mean pure play companies (or those with a clear and focused strategy) that have a moat would be the best types of companies to invest in for the dividends. The key is that any distributable earnings that management doesn’t pay out must generate attractive returns, and as Buffett says, “If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.”
