Berkshire’s Dividend Policy: Part I
Way back in 1996, when Larry Cunningham asked me to contribute a paper to his original Warren Buffett symposium at Cardozo Law School, I picked dividends as my topic. I had two reasons, (1) I had always wanted to write a paper on dividends and was looking for an excuse, and (2) Berkshire Hathaway’s absolutist policy against dividends presented the best possible excuse for a paper. The no dividends policy provided a great start point, for, while posing theoretical problems, it went hand in glove with Berkshire’s unparalleled growth record and relentless long-termism, not to mention Buffett’s status as a capitalist folk hero. I later put out a second paper on dividends, written on the occasion of the Bush tax cuts.
So it’s no surprise that I went straight for to dividend chapter when I opened Larry’s third edition of The Essays of Warren Buffett: Lessons for Corporate America. I had a feeling that times were going to have changed, and they have done so. Where payout policy was once a bedrock point at Berkshire Hathaway, there is now an incipient sense of stress. Things are changing, so much so that the third edition cannot keep up. To put together an account of treatments of payout policy in the essays in Berkshire’s Annual Reports, reference also must be made to this spring’s review of 2012. Take that together with the excerpts in Larry’s third edition and a cloudy picture emerges.
Let us trace Buffett’s views on payouts as it evolves from edition to edition of The Essays of Warren Buffett: Lessons for Corporate America.
The first edition’s dividend chapter drew in the on Berkshire’s 1984 Annual Report to offer a beautiful, common sense restatement of the Graham and Dodd wisdom. The restatement managed to make the major academic statement on dividend policy—the irrelevance theory of Modigliani and Miller—itself irrelevant without simultaneously asserting anything that a financial economist could criticize. Buffett wrote that the payout decision follows from the earnings retention decision and retention only should occur if the company can create at least one dollar of market value for its shareholders for every dollar retained.
The chapter went on to note the conflicted behavior patterns of some managers of multidivisional companies. They excelled at imposing rational payout policy on their divisions, but stumbled when it came to the group as whole, diverting cash from high performing divisions to suboptimal performers while still managing to show good numbers for the whole. There the discussion stopped.
We proceed to the second edition. Here Larry adds language from the 1999 Annual Report, which raised the prospect of share repurchases in the wake of a bad year at Berkshire. Again we got hard-nosed, unimpeachable advice. Managers of other companies were following fashion and self-interest to purchase overpriced stock, in some cases from a misplaced motivation to show optimism and in others from a crude desire to keep the stock price pumped. A double negative resulted when overpriced repurchases followed from a need to flush out the EPS effect of exercise of executive and employee stock options, with the repurchases as the value-sacrificing response to what started as a bargain, below-market stock sale.
Discipline was called for: repurchases should only be made with the stock price well-below per-share intrinsic value (“what is smart at one price is dumb at another”), provided the company was left with funds sufficient to keep the present business competitive and make good acquisitions. Buffett’s old lesson about the stock price was taught once again: don’t support your stock price with your free cash; instead rejoice when the stock price underperforms the market because it gives you the chance to create value for your continuing shareholders. But there was also a caveat. The repurchasing company should not game its own shareholders, even those minded to sell. It should disclose to them all information needed replicate the company’s estimate its own intrinsic value.
Would that bank CEOs who repurchased fistfuls of their own stock from 2004 through the third quarter of 2008 had listened to Buffett! Even so, some questions come up. Buffett’s conditions were going to amount to high hurdles. The repurchase door would not open until the Annual Report was in the shareholders’ hands, implying a limited window of opportunity. And even with the window open the stock market would be avoided—direct bids to Berkshire at or below the market price would be preferred, minimum of 10 shares A or 50 shares B. And how, if at all, could Buffett’s rules be translated to the circumstances of other businesses?
We now turn to 2011 Annual Report, included in Larry’s third edition. The story takes an historic turn. Berkshire finally announced itself ready to repurchase, provided (1) that the per share market price stood at no more than 110% of book value per share, and (2) that cash-equivalent holdings ready for reinvestment or acquisitions equaled at least $20 billion.
There ends the third edition’s story, but not that of Buffett and Berkshire. The story is continued in a second posting in this Book Symposium.
William Bratton is Deputy Dean and Nicholas F. Gallicchio Professor of Law at Penn Law School where he takes an interdisciplinary perspective to a wide range of subject matters that encompass corporate governance, corporate finance, accounting, corporate legal history, and comparative corporate law. His book, Corporate Finance, is the leading law school text on the subject. In 2009, he was installed as the Anton Philips Professor at Tilburg University, The Netherlands, the fifth American academic to hold the chair. He has taught at several other law schools, including George Washington, Georgetown and Stanford. He practiced law at Debevoise & Plimpton. Most of his scholarship can be found on SSRN here; a more complete bio appears here.