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From The Archives: Warren Buffett Dividend Thoughts [Pt. 2]

Continued from part one…

As long as cash continues to flow in from Berkshire’s operating businesses, Buffett expects his conglomerate to continue to reinvest back into the business, rather than paying it out to shareholders:

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Warren Buffett Dividend Thoughts

“We expect to continue to diversify while also supporting the growth of current operations though, as we’ve pointed out, our returns from these efforts will surely be below our historical returns. But as long as prospective returns are above the rate required to produce a dollar of market value per dollar retained, we will continue to retain all earnings. Should our estimate of future returns fall below that point, we will distribute all unrestricted earnings that we believe can not be effectively used. In making that judgment, we will look at both our historical record and our prospects. Because our year-to-year results are inherently volatile, we believe a five-year rolling average to be appropriate for judging the historical record.

Our present plan is to use our retained earnings to further build the capital of our insurance companies. Most of our competitors are in weakened financial condition and reluctant to expand substantially. Yet large premium-volume gains for the industry are imminent, amounting probably to well over $15 billion in 1985 versus less than $5 billion in 1983. These circumstances could produce major amounts of profitable business for us. Of course, this result is no sure thing, but prospects for it are far better than they have been for many years.” Letter to Shareholders 1984

Warren Buffett Dividend Thoughts

Capital allocation is a large part of the dividend argument but taxes are also a consideration. Berkshire has been constructed in a way that the taxes levied on the group’s operations are relatively low. Buffett described this quirk in his 2016 letter to shareholders:

“Before we leave this investment section, a few educational words about dividends and taxes: Berkshire, like most corporations, nets considerably more from a dollar of dividends than it reaps from a dollar of capital gains. That will probably surprise those of our shareholders who are accustomed to thinking of capital gains as the route to tax-favored returns. But here’s the corporate math. Every $1 of capital gains that a corporation realizes carries with it 35 cents of federal income tax (and often state income tax as well). The tax on dividends received from domestic corporations, however, is consistently lower, though rates vary depending on the status of the recipient.

For a non-insurance company – which describes Berkshire Hathaway, the parent – the federal tax rate is effectively 10.5 cents per $1 of dividends received. Furthermore, a non-insurance company that owns more than 20% of an investee owes taxes of only 7 cents per $1 of dividends. That rate applies, for example, to the substantial dividends we receive from our 27% ownership of Kraft Heinz, all of it held by the parent company. (The rationale for the low corporate taxes on dividends is that the dividend-paying investee has already paid its own corporate tax on the earnings being distributed.)

Berkshire’s insurance subsidiaries pay a tax rate on dividends that is somewhat higher than that applying to non-insurance companies, though the rate is still well below the 35% hitting capital gains. Property/casualty companies owe about 14% in taxes on most dividends they receive. Their tax rate falls, though, to about 11% if they own more than 20% of a U.S.-based investee.”

Depending on your income tax bracket, the average investor is taxed at a rate of 15% to 20%. Considering the fact that Berkshire and its subsidiaries are taxed at a rate 50% lower, it makes a lot of sense to hold the cash in Berkshire and allow Buffett to reinvest the income (after all, he’s quite good at it). So overall, by not paying out a dividend, not only has Berkshire been able to grow to the scale that it is today, but also, investors have saved millions and possibly even billions in dividend taxes.

See also: Hidden Value Stocks

Buffett isn't the only well-known investor who has a disliking of dividends. Michael Mauboussin has also written extensively on the subject. Indeed, in a paper written during 2012, Mauboussin looked at the key differences between buybacks and dividends concluding that buybacks were far superior.

In theory, buybacks and dividends should both produce the same returns for investors, but in practice, this is never the case. For an investor to receive the same positive impact from both buybacks and dividend income, they would have to invest dividend income tax-free back into the stock at the same price that it was distributed -- both of which are almost impossible.

"Investors frequently use past total shareholder return (TSR) as a guide to anticipate future returns. Here’s a simple formula to calculate TSR, where g is the annual rate of price appreciation and d is the dividend yield: TSR = g + d(1+g) The problem is that with stocks that pay dividends, almost no investors earn the total shareholder return. This is because dividends are often taxable and generally don’t get reinvested back into the stock (either because of consumption or because the dividends are allocated to other investments). Said differently, a shareholder only earns the TSR if he automatically reinvests 100 percent of his dividends back into the stock in a tax-free account, which rarely happens. In contrast, companies that return cash to shareholders via buybacks allow their ongoing shareholders to earn the TSR."

You can find the full Mauboussin study here.