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Buffett's thoughts on dividends
Old 04-01-2013, 09:48 PM   #1
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Buffett's thoughts on dividends

I have structured my equity portfolio with an eye towards blue chip dividend paying stocks but have recently had my thought process challenged by Warren Buffett in his most recent shareholder letter.

http://www.berkshirehathaway.com/letters/2012ltr.pdf

Page 19 begins his explanation of how dividends are less desirable / advantageous than capital gains to share holders. I'm curious if anyone else has read the letter and has any thoughts about the matter?
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Old 04-01-2013, 09:59 PM   #2
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IMHO it's good to have a balance of blue chip reasonable dividend paying and blue chip but perhaps low div paying stocks.

At the end of the day, if they are blue chips, one would hope you would get dividend as well as capital growth.

Also - Buffet is not dependent on ALL his wealth for retirement living is he. His wealth can go up and down like a yo yo, and he wouldn't be too flustered. A lot of it is play money for him
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Old 04-01-2013, 10:10 PM   #3
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FYI if you want more opinions on this there are huge threads on bogleheads arguing about dividend investing vs total return. Same arguments come up.

Personally, I'm in the no dividend camp for multiple reasons but tax issue that Buffet raises is a huge part of it.
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Old 04-02-2013, 07:43 AM   #4
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Berkshire is my largest or sometime 2nd largest position, so I read the annual report with great care, and also pay attention to the Motley Fools Berkshire stock board.

His comments on dividends are thought provoking but I think Josh Peter, the editor of the Morningstar Dividend Investing Newsletter
sums up my feeling quite well with the title of this months lead newsletter article.
In Buffett we trust; all other pay cash.

I'll quote fairly extensively from article but I would recommend any dividend investor at least take advantage of the free trial offer for the newsletter.

Quote:
While Buffett did spend nearly 3 pages of his 24-page missive talking about dividends and capital allocation—making it clear that he likes receiving dividends on Berkshire’s investments—paying a dividend still isn’t on his agenda.

This reaffirmation of the status quo shouldn’t surprise anyone. Since Buffett took control of a then-struggling textile manufacturer in 1964, Berkshire has paid a dividend only once: $0.10 in January 1967 on each of
what are now the Class A shares (which recently traded around $155,000 apiece). Buffett has since joked that he must have been in the bathroom when the board voted to make that payout, but a lack of dividends certainly hasn’t hurt Berkshire’s long-term performance. Indeed, the profitable deployment of retained earnings has been an essential driver of
Buffett’s outstanding record.

My long-standing view is that all companies that can pay dividends—meaning those with the established profitability and financial strength to do so—should pay dividends. It’s not just that many shareholders want and deserve a cash return on their investment,
but the fact that virtually no company is capable of reinvesting all of its internally generated resources at adequate rates of return. In this context, Berkshire is the exception that proves the rule. Thanks to his extraordinary talents and a virtually unlimited opportunity set, Buffett has demonstrated an ability to deploy Berkshire’s ample earnings at superior returns.

That being said, I think it would be a big mistake for the managers and investors in any other company to conclude that dividends are unimportant, much less undesirable. Every other business on earth is supervised by a less capable allocator of capital, and not every investor seeks the same kind of investment result that Berkshire offers today. So when Buffett goes on to suggest that Berkshire shareholders should sell off shares rather than seek a dividend, I sincerely hope that investors in other companies— as well as those firms themselves—ignore his advice

Buffett identifies four choices that are available for a company’s internally generated resources: internal reinvestment, acquisitions, share repurchases, and dividends...

Buffett’s top priority is internal reinvestment—the deployment of capital back into existing businesses at good rates of return. I have no qualms with this priority whatsoever. Let’s say General Mills GIS is choosing between (1) spending $10 million on a new product line that should generate $2.5 million worth of annual aftertax earnings and (2) paying an
extra $10 million in dividends. Assuming the expansion project has a good chance of being successful, keeping the $10 million inside the company where it can earn a 25% return on capital is obviously the better choice. Among other factors, this expansion project would allow General Mills to raise its annual dividend outlay by $2.5 million a year forever, a result whose value dwarfs a one-time payout of $10 million. If shareholders instead received that $10 million as a one-off payment, it’s highly unlikely they could all duplicate the same 25% return on capital.

The problem with these opportunities—as Buffett readily acknowledges—is that they are generally finite. General Mills can (and does) innovate new products that command higher prices and profit margins; it can nibble (and has nibbled) away at the market share of its rivals; it can (and does) look to reduce costs. But people are only going to eat so much and
are only going to spend so much on the food they eat, and there’s a limit to how much market share General Mills can grab before inviting a harsh competitive response. Once General Mills has eaten through the
projects with 25% returns, 15% returns and 10% returns, the rest of the cash needs to go elsewhere or shareholder value will be destroyed.

With hundreds of diverse business lines, Berkshire has a much broader array of internal investment opportunities than General Mills does. Profits don’t have to stay within any one line of business; Buffett can deploy the excess earnings of See’s Candies into new locomotives at BNSF or a new store for Nebraska Furniture Mart. (Please, Mr. Buffett, ask the Blumkins
to open one in Illinois!) Yet Berkshire, like the vast majority of well-established businesses today, can hardly help but generate more cash than it can put back to work internally at acceptable rates of return.

Acquisitions are Buffett’s second-favorite venue for deploying retained earnings. His record on this front is excellent—one of the best ever. In his 1984 shareholder letter, in which he also discussed Berkshire’s dividend policy, he pointed out that paying dividends in his early days at Berkshire could have been disastrous. Only by redeploying capital out of dying
businesses like textiles and trading stamps could Berkshire have survived, let alone thrived But Buffett’s acumen as an acquirer—as well as his
position—is unique. Unlike your typical CEO, he buys entire companies with the mentality of an investor, not as an empire builder looking for a fatter pay packet. Elsewhere, a variety of academic research suggests that anywhere from 50% to 90% of mergers actually destroy shareholder value.
Having watched how Intel allocates capital closely for 20 odd years, and paid attention to Cisco, Microsoft,and HPs. I agree with Josh, any large blue chip has plenty of internal projects which are extraordinarily profitable for Intel it was semiconductor R&D investment, and building chip factories, for Coke it is probably certain types of marketing expense. But at a certain point there is more cash flow than great internal ideas. What happens is the CEO and board waste money on acquisitions. Warren's unique (literally one of kind) skill is knowing the value of almost any business and almost never over paying to buy the business.

Josh goes on to discuss other aspect that Buffet brings up share repurchase and taxes. In the case of taxes, he agrees with Buffett's analysis but points that most of us have significant assets in tax deferred accounts where taxes don't matter.

Finally we get to the issue of instead of dividends why not just sell say 4% of the stock each year.
Quote:
Dividends Versus ’Sell-Offs’
After taking the option of a dividend off the table, Buffett suggests an alternative. If the shareholder wants cash, why not just sell off shares in a fixed pattern? He outlines a mathematical example, using certain assumptions he thinks are reasonable for Berkshire, that results in shareholders being 4% wealthier after 10 years by following a sell-off plan to generate income rather than receiving a dividend. Buffett’s math checks out (as I had no doubt it would), but there are two practical problems here. First, as you might expect, the results are highly sensitive
to his assumptions. If the stock traded at book value rather than his assumption of 1.25 times book, a shareholder seeking the same income would be 4% worse off on the sell-off plan than with dividends.

Second, most retirees want a fixed dollar amount of cash rather than the proceeds from selling a fixed percentage of shares. Volatility, which is your friend when you accumulate shares by purchasing a fixed dollar amount over time (a concept known as dollarcost averaging), becomes your enemy when you put the process into reverse. Let’s say you have a stock
that trades at $50, and you want to create $50,000 a year worth of income by selling 1,000 shares a year. If the stock rises to $75, you only need to sell 667 shares—but if it drops to $25, you need to sell 2,000
shares. Ask anyone who has followed a sell-off strategy since 1999 how well this has worked out.
Now to partially fund my retirement I could have sold say 3% each of my Berkshire holding each year. This would have been ~90 share, say in April starting in 2003 when I first bought Berkshire. My income would have be ~$4100 in 2003, rising to $8200 in 2008, than cratering to $5,000 in 2009. it would have recovered to $9270 this year, well ahead of inflation.

Now there are two scary things first Berkshire is less volatile than the market, but I still suffer a 40% drop in income in 2009. Second selling a fixed amount, even a conservative withdrawal rate of 3% means that I around 77 I run out of Berkshire shares to sell. Then what do I do? save enough for a gun I guess.
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Old 04-02-2013, 10:26 AM   #5
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IMO retention of earnings only makes sense where the enterprise believes that it can utilize the capital and earn a return on the capital that exceeds what the shareholder could earn if he had the cash (in the form of a dividend) and invested it in the market. While it is unusual in a historical context, many companies today have been hoarding cash with in my view slim prospects of utilizing it in operations that will earn a return in excess of the market return. Apple, Microsoft and others come to mind.

Investors invest in the stock market because they want equity like exposure. Companies hoarding cash dilutes that equity exposure in an opaque manner so the investor's AA is really a combination of equity and cash on a look through basis.
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Old 04-02-2013, 10:58 AM   #6
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No doubt Buffet/Berkshire have been very successful over many years and have made $$$$ for those lucky enough to have invested with them over the long haul. But over long haul dividends have contributed about half of total return of SP 500. Bottom line is it's all about investing in good companies when they are UNDERvalued & selling out when they are OVERvalued. Buy low-sell high. With some exceptions (e.g. regulated utilities, preferred stocks, etc), dividends are just a little icing on the cake. A little pay while waiting for valuations to turn higher.
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Old 04-02-2013, 03:38 PM   #7
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Quote:
Originally Posted by clifp View Post
Berkshire is my largest or sometime 2nd largest position, so I read the annual report with great care, and also pay attention to the Motley Fools Berkshire stock board.

His comments on dividends are thought provoking but I think Josh Peter, the editor of the Morningstar Dividend Investing Newsletter
sums up my feeling quite well with the title of this months lead newsletter article.
Thanks for the article, some very good points raised. Buffet clearly is in a league by himself when it comes to capital allocation, and the majority of companies that make acquisitions with profits do rarely see the promised increase in shareholder value. Thanks for the opposing viewpoint, I appreciate the contrary view.

Quote:
Originally Posted by clifp View Post
Now there are two scary things first Berkshire is less volatile than the market, but I still suffer a 40% drop in income in 2009.
Truth to tell, it's not like investors in many blue chip dividend payers were in a much better position in early 2009 (GE, BAC, PFE, DOW, etc). Many of my positions cut dividends AND had a similar drop in value. The phrase double-whammy comes to mind.
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Old 04-02-2013, 04:08 PM   #8
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The real money is to made after Warren's departure (RIP) and the entire schebang gets unwound one piece at a time as spin-off IPO's.
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Old 04-02-2013, 04:20 PM   #9
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Quote:
Originally Posted by jags View Post
Buffet is not dependent on ALL his wealth for retirement living is he. His wealth can go up and down like a yo yo, and he wouldn't be too flustered. A lot of it is play money for him
That doesn't really affect my opinion of his beliefs with regard to dividends. Buffett has significant street-cred built up with me when it comes to investing.

Quote:
Originally Posted by photoguy View Post
FYI if you want more opinions on this there are huge threads on bogleheads arguing about dividend investing vs total return. Same arguments come up.
I stay clear of the Bogleheads forum; I'm not entirely fond of the snide comments made from time to time about any suggestions that may not strictly adhere to the indexing philosophy. I very much appreciate hearing of alternative ideas and strategies. (Don't take that wrong, I appreciate your pointing me to some other opinions, the Bogleheads forum just isn't my kinda place).

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Originally Posted by photoguy View Post
Personally, I'm in the no dividend camp for multiple reasons but tax issue that Buffet raises is a huge part of it.
Agreed 100%.

Quote:
Originally Posted by pb4uski View Post
IMO retention of earnings only makes sense where the enterprise believes that it can utilize the capital and earn a return on the capital that exceeds what the shareholder could earn if he had the cash (in the form of a dividend) and invested it in the market.... Apple, Microsoft and others come to mind.
This is the best argument I have heard yet with regard to company's paying a dividend, and one I have to agree with. Very few CEO's with Buffett's ability to allocate capital effectively.

I'm not comfortable with the push for Apple to make an acquisition, I think it's more likely to lead to shareholder value being destroyed rather than enhanced... unless they are considering making a play for a company like Disney. I'm scared to death they are going to do something colossally stupid though, like buy Netflix.

Quote:
Originally Posted by ERhoosier View Post
Buy low-sell high.
Or like Buffett advocates, buy low - keep forever.
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Old 04-02-2013, 05:28 PM   #10
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Quote:
Originally Posted by Snidely Whiplash View Post
Thanks for the article, some very good points raised. Buffet clearly is in a league by himself when it comes to capital allocation, and the majority of companies that make acquisitions with profits do rarely see the promised increase in shareholder value. Thanks for the opposing viewpoint, I appreciate the contrary view.



Truth to tell, it's not like investors in many blue chip dividend payers were in a much better position in early 2009 (GE, BAC, PFE, DOW, etc). Many of my positions cut dividends AND had a similar drop in value. The phrase double-whammy comes to mind.
Actually that isn't really true. I keep careful track of my dividend income from March of 2008 to March of 2009 my total dividend income dropped 2% and dropped 19% to its low in April 2010.

Here are the annual distributions of SPY from 2007 to 2012
2007 $2.70
2008 $2.72
2009 $2.18
2010 $2.27
2011 $2.58
2012 $3.10

The income drop from 2008 to 2009 was 19.8% and last years dividend income is up 14% from 2008 levels. This is versus a 56% decrease in the SPY price from 2007 to 2009 and we just exceeded 2007 SPY levels today.

Now you are right plenty of blue chip companies cut dividends during the crisis, including lots of banks that I owned (largely at the recommendation of Josh Peters). But I found it psychologically much easier to deal with the modest decline in my income from 2008 to 2009 than panic over the gut wrenching share price declines.
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Old 04-02-2013, 09:39 PM   #11
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Quote:
Originally Posted by Snidely Whiplash View Post
.....I'm not comfortable with the push for Apple to make an acquisition, I think it's more likely to lead to shareholder value being destroyed rather than enhanced... unless they are considering making a play for a company like Disney. I'm scared to death they are going to do something colossally stupid though, like buy Netflix. ......
That is a major problem with companies hoarding more capital than they have use for and not distributing cash to shareholders - there becomes pressure to do something with it since it is earning a paltry return and many times that something is an acquisition. I spent the last decade of my career in M&A and it is appalling how many bad deals get done and end up destroying shareholder value. Too many M&A departments and CEOs fall in love with the deal and seeing their deal being rumored about in the WSJ/press and are hesitant to walk away from a bad deal. As a result they overpay and ultimately have goodwill writedowns which in essence just flushes shareholder money down the toilet to the sellers.
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Old 04-04-2013, 11:36 AM   #12
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Buffett says:

Quote:
We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give.
Maybe it's just me, so, Buffet uses stock to pay for deals? Or does he use cash? Is it too much of a simplification to say he converts his stock to cash? The value of the stock drops by the amount of cash taken out of the company, no? The same as issuing a dividend. Aren't earnings taxed? Lots of details.

But, isn't it all the the same? Can't take dividends or cash out of the company forever, or it goes under.

It's all in the tax details afterwards. Or am I missing something/oversimplifying? A capital gain is a gain you haven't had to realize/get taxed. A dividend that hasn't been issued/taxed.

So, what good is it to you, if your salary is all on paper, never paid? "Hey, I'm 50 and I've earned but not been paid $1.8 Mil, sell me a car." Doesn't make sense, to me. I want to "allocate capital" to a new vehicle.

-CC
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Old 04-04-2013, 04:02 PM   #13
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Quote:
Originally Posted by CCdaCE View Post
Buffett says:



Maybe it's just me, so, Buffet uses stock to pay for deals? Or does he use cash? Is it too much of a simplification to say he converts his stock to cash? The value of the stock drops by the amount of cash taken out of the company, no? The same as issuing a dividend. Aren't earnings taxed? Lots of details.

But, isn't it all the the same? Can't take dividends or cash out of the company forever, or it goes under.

It's all in the tax details afterwards. Or am I missing something/oversimplifying? A capital gain is a gain you haven't had to realize/get taxed. A dividend that hasn't been issued/taxed.

So, what good is it to you, if your salary is all on paper, never paid? "Hey, I'm 50 and I've earned but not been paid $1.8 Mil, sell me a car." Doesn't make sense, to me. I want to "allocate capital" to a new vehicle.

-CC
As rule Berkshire uses cash generated by the earnings/cashflow of all of the various Berkshire subsidiaries to either purchase companies outright or buy shares (i.e a minority stake) in large publicly traded companies.

He has used shares on rare occasion the most recent being the purchase of BNSF railroad a few years ago.

Imagine a company that earns $10/share and can grow the earning 10% per year by reinvesting them. After 5 years the company is now earning $16.10
In year 1 the company stock is $120 (meaning a P/E ratio of 12) after 5 year assuming the P/E ratio was constant $16.10 earning would mean the stock is selling for $193. That would leave the shareholder with a gain of $73 if sold the stock and paid 20% cap gains tax (15% fed 5% state) a $56 gain after tax.

Alternatively the company could pay out the $10/year to the shareholder in the form of dividends. Now depending the shareholder could take those $10 and invested it something else but if he earned less than 10% a year he'd be better off leaving the money with the company. In addition, the shareholder would be further behind because he'd have to pay $2 in taxes each year. This would only leave him $8 to invest each year.

That is why in theory not paying dividends is better. In practice unless you are Buffett, the typical CEO of a large, slow to medium growth company, isn't any better at buying outside companies than the market as whole. Plus as you point out as a retiree we actually need to cash to buy things like cars, food, etc.
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