The most interesting discussion in Warren Buffett (Trades, Portfolio)'s 2012 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders is centered around dividends, and it involves an examination of when dividends do or do not make sense for shareholders. Buffett noted that a profitable company has various options for allocating its earnings, which are not mutually exclusive.
First option: Organic growth
The management of the company is advised to first explore reinvestment opportunities within its existing business, such as projects aimed at improving efficiency, expanding geographically, extending or enhancing product lines or strengthening the company's competitive position. Buffett wrote:
"A profitable company can allocate its earnings in various ways (which are not mutually exclusive). 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."
Buffett acknowledged that even Berkshire has not been immune to making mistakes in the past. Reference is made to the conglomerate's 1986 annual report, in which it was described how two decades of effort and capital investments in the original textile business proved to be futile. Buffett expressed a desire for the business to succeed, and kept investing in that business, but he eventually realized that merely wishing for success is not effective in the business world.
Despite past errors, Berkshire’s primary focus remains on intelligently deploying available funds within its various businesses. The letter highlights significant fixed-asset investments and acquisitions made in 2012 as evidence of successful capital allocation within Berkshire. The company's diverse range of operations offered it a wider array of choices compared to most corporations.
Second option: Acquisitions
The next step in capital allocation is the search for acquisitions unrelated to the current businesses. The criterion for such acquisitions is whether they are likely to increase shareholder wealth on a per-share basis. Overall, Berkshire’s record is deemed satisfactory by Buffett, resulting in shareholders being wealthier due to funds being used for acquisitions rather than dividends or share repurchases. He wrote:
"Our next step, therefore, is to search for acquisitions unrelated to our current businesses. Here our test is simple: Do Charlie and I think we can effect a transaction that is likely to leave our shareholders wealthier on a per-share basis than they were prior to the acquisition?"
However, Buffett acknowledged that making meaningful and sensible acquisitions becomes more challenging as Berkshire's size grows. Nevertheless, he noted large deals can still significantly enhance per-share intrinsic value, with the acquisition of BNSF cited as an example. The importance of price in share repurchase decisions is emphasized, with disciplined repurchases being seen as a prudent use of funds when shares are trading below intrinsic value.
Third option: Share repurchases
The Oracle of Omaha also briefly touched on share repurchases, writing:
"The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less.
But never forget: In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value. The directors and I believe that continuing shareholders are benefitted in a meaningful way by purchases up to our 120% limit."
Finally, dividends
The discussion then shifts to dividends, and Buffett making assumptions and using some financial calculations demonstrates an essential case study to understanding the case for and against paying dividends. He argued that compounding wealth is faster when selling a portion of stock at above book value in scenarios where no dividends are paid, as compared to scenarios where dividends are collected. Buffett ran through the calculations in detail on page 20 of the shareholder letter, which is worth reading if you want to see the assumptions and details of Buffett’s calculation. Essentially, if the company is earning a high return on tangible net worth, paying dividends requires the shareholder to reinvest that case at an equivalent rate, and any reinvestment in the company is diluted if the stock is trading above book value.
Buffett observed that, historically, a sell-off policy toward Berkshire's stock would have produced superior results for shareholders compared to a dividend policy. Furthermore, the non-dividend approach allows investors to raise needed cash by selling a portion of their stock, which can also result in realizing a premium to book value. If the shareholders do not need the cash, they can simply do nothing.
Two additional arguments in favor of a sell-off policy are presented. First, dividends impose a specific cash-out policy on all shareholders, which may not align with their individual preferences for cash flow. The sell-off alternative allows shareholders to make their own choices between cash receipts and capital accumulation.
Second, the tax consequences of the dividend approach are deemed inferior for taxpaying shareholders compared to the sell-off program. Under the dividend program, all cash received by shareholders is subject to taxation, while the sell-off program results in taxation only on the gain portion of cash receipts. He wrote in reference to a case study example provided in the letter:
"Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)"
Buffett highlighted how this strategy has worked with his own net worth. Despite giving away plenty of his Berkshire holdings between 2005 and 2012, his net worth has grown substantially as the company's book value has compounded quickly.
Hamburgers or Chinese goods?
Finally, Buffett summed everything up by saying:
"Above all, dividend policy should always be clear, consistent and rational. A capricious policy will confuse owners and drive away would-be investors. Phil Fisher put it wonderfully 54 years ago in Chapter 7 of his Common Stocks and Uncommon Profits, a book that ranks behind only 'The Intelligent Investor' and the 1940 edition of 'Security Analysis' in the all-time-best list for the serious investor. Phil explained that you can successfully run a restaurant that serves hamburgers or, alternatively, one that features Chinese food. But you can’t switch capriciously between the two and retain the fans of either."
Lessons learned
The core lesson is total return is more important than dividend return. Paying dividends imposes a cash flow on all shareholders and requires them to find new investment opportunities. For a maturing business in a sunset industry, this may well be often the best strategy, although share buybacks may be an even better approach. But for a company with investment options at high rates of return, returning capital to shareholders is not a particularly great strategy.
