Value Investing

From The Archives: Warren Buffett On Unwise Dividends [Pt. 1]

Warren Buffett has famously, always refused to payout a dividend to shareholders of Berkshire Hathaway. This has put off some investors, so I thought it would be interesting to take a look through some of Berkshire’s old letters to gather some of Buffett’s insights on the topic of dividends and try to shed some more light on why he believes that his holding company does not need to make a payout.

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“Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis.  Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics).  The managers at fault periodically report on the lessons they have learned from the latest disappointment.  They then usually seek out future lessons. (Failure seems to go to their heads.)

In such cases, 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.”

The above quote, taken from Buffett’s letter to shareholders in 1984, gets to the core of the dividend issue; the poor allocation of capital. Most managers allocate capital poorly, which leads to falling returns across the businesses they operate.

From The Archives: Warren Buffett On Unwise Dividends

If a manager is a good allocator of capital, then there’s no such issue and dividends should not be paid out. However, if a manager makes terrible decisions, the payment of dividends can be a sensible way to deploy capital without wasting cash. The letter continues:

“Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities.  Shareholders of public corporations understandably prefer that dividends be consistent and predictable.  Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital.  Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often.  But over time distributable earnings that have been withheld by managers should earn their keep.  If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.”

In the 1984 letter, Buffett goes on to sue Berkshire as an example of why dividends are not sensible for good capital allocators. Specifically, he writes:

“In fact, significant distributions in the early years might have been disastrous, as a review of our starting position will show you.  Charlie and I then controlled and managed three companies, Berkshire Hathaway Inc., Diversified Retailing Company, Inc., and Blue Chip Stamps (all now merged into our present operation).  Blue Chip paid only a small dividend, Berkshire and DRC paid nothing.  If, instead, the companies had paid out their entire earnings, we almost certainly would have no earnings at all now - and perhaps no capital as well.  The three companies each originally made their money from a single business: (1) textiles at Berkshire; (2) department stores at diversified; and (3) trading stamps at Blue Chip.  These cornerstone businesses (carefully chosen, it should be noted, by your Chairman and Vice Chairman) have, respectively, (1) survived but earned almost nothing, (2) shriveled in size while incurring large losses, and (3) shrunk in sales volume to about 5% its size at the time of our entry.  (Who says “you can’t lose ‘em all”?) Only by committing available funds to much better businesses were we able to overcome these origins. (It’s been like overcoming a misspent youth.) Clearly, diversification has served us well.”

Put simply, if Berkshire had returned cash to investors via dividends during its early years, the company would have had nothing to invest in more lucrative businesses.

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