Berkshire’s Dividend Policy: Part II
Part I of this post left off with the 2011 Berkshire Annual Report, included in Larry Cunningham’s third edition of The Essays of Warren Buffett: Lessons for Corporate America. There the story of Berkshire payout policy took 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.
Events then took still another turn. It seems that the 110% rule was relaxed to 120%, with Berkshire purchasing a big block of stock at 116% during 2012. (See BRK News Release here.) A look at the cash flow statement gives the totals: $1.296 billion repurchased in 2012 versus $67 million in the previous year and 0 the year before that.
Yet there is apparent dissatisfaction: this year’s Annual Report notes that “a number of Berkshire shareholders – including some of my good friends – would like Berkshire to pay a cash dividend.” Why? Cash and cash equivalents on the 2012 Berkshire balance sheet total $49.992 billion, far north of the $20 billion minimum cited a year earlier.
Meanwhile, the annual Berkshire vs. S&P 500 comparison favors the S&P 500 for the third time in four years. Maybe the 120% plus full disclosure test is thought to leave open too small a payout window. If Berkshire stock refuses to cooperate with the payout policy by holding its value, there’s only one alternative: the old-fashioned mode of dividend.
Thus does Buffett mount the battlements to make the case for the historic no dividends policy. I hope Larry won’t mind if I anticipate his fourth edition and quote it in full (from this year’s Annual Report):
We’ll start by assuming that you and I are the equal owners of a business with $2 million of net worth. The business earns 12% on tangible net worth—$240,000—and can reasonably expect to earn the same 12% on reinvested earnings. Furthermore, there are outsiders who always wish to buy into our business at 125% of net worth. Therefore, the value of what we each own is now $1.25 million.
You would like to have the two of us shareholders receive one-third of our company’s annual earnings and have two-thirds be reinvested. That plan, you feel, will nicely balance your needs for both current income and capital growth. So you suggest that we pay out $80,000 of current earnings and retain $160,000 to increase the future earnings of the business. In the first year, your dividend would be $40,000, and as earnings grew and the one third payout was maintained, so too would your dividend. In total, dividends and stock value would increase 8% each year (12% earned on net worth less 4% of net worth paid out).
After ten years our company would have a net worth of $4,317,850 (the original $2 million compounded at 8%) and your dividend in the upcoming year would be $86,357. Each of us would have shares worth $2,698,656 (125% of our half of the company’s net worth). And we would live happily ever after—with dividends and the value of our stock continuing to grow at 8% annually.
There is an alternative approach, however, that would leave us even happier. Under this scenario, we would leave all earnings in the company and each sell 3.2% of our shares annually. Since the shares would be sold at 125% of book value, this approach would produce the same $40,000 of cash initially, a sum that would grow annually. Call this option the “sell-off” approach.
Under this “sell-off” scenario, the net worth of our company increases to $6,211,696 after ten years ($2 million compounded at 12%). Because we would be selling shares each year, our percentage ownership would have declined, and, after ten years, we would each own 36.12% of the business. Even so, your share of the net worth of the company at that time would be $2,243,540. And, remember, every dollar of net worth attributable to each of us can be sold for $1.25. Therefore, the market value of your remaining shares would be $2,804,425, about 4% greater than the value of your shares if we had followed the dividend approach.
Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! — you would have both more cash to spend annually and more capital value.
This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured.
Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the argument for the sell-off policy becomes even stronger. Over Berkshire’s history— admittedly one that won’t come close to being repeated—the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy.
Aside from the favorable math, there are two further—and important—arguments for a sell-off policy. First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40% of earnings is the policy, those who wish 30% or 50% will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them—perhaps even most of them—are in a net-savings mode and logically should prefer no payment at all.
The sell-off alternative, on the other hand, lets each shareholder make his own choice between cash receipts and capital build-up. One shareholder can elect to cash out, say, 60% of annual earnings while other shareholders elect 20% or nothing at all. 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.)
The second disadvantage of the dividend approach is of equal importance: The tax consequences for all taxpaying shareholders are inferior—usually far inferior—to those under the sell-off program. Under the dividend program, all of the cash received by shareholders each year is taxed whereas the sell-off program results in tax on only the gain portion of the cash receipts.
Let me end this math exercise—and I can hear you cheering as I put away the dentist drill—by using my own case to illustrate how a shareholder’s regular disposals of shares can be accompanied by an increased investment in his or her business. For the last seven years, I have annually given away about 41⁄4% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares. Clearly my ownership percentage of the company has significantly decreased.
Yet my investment in the business has actually increased: The book value of my current interest in Berkshire considerably exceeds the book value attributable to my holdings of seven years ago. (The actual figures are $28.2 billion for 2005 and $40.2 billion for 2012.) In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased. It’s also true that my share of both Berkshire’s intrinsic business value and the company’s normal earning power is far greater than it was in 2005.
Over time, I expect this accretion of value to continue—albeit in a decidedly irregular fashion—even as I now annually give away more than 41⁄2% of my shares (the increase having occurred because I’ve recently doubled my lifetime pledges to certain foundations).
Buffett’s no dividend defense takes the long back and forth between the Graham and Dodders and the “modern” financial economists to a new stage of evolution. For here is Buffett, the greatest of all Graham and Dodders, drawing on Modigliani and Miller in his own financial defense. The move is not “irrelevance,” for dividend and reinvestment policy remain as crucial as ever for value creation. Instead Buffett employs the analytical device that MM used to make the obviously relevant turn out to be irrelevant—homemade replication.
The original MM paper achieved irrelevance for capital structure against a backdrop of heroic assumptions by making leverage a game anybody could play. Given two identical companies, one levered and the other unlevered, the levered company could not sustain a higher market value because arbitrageurs could replicate the advantages of its leverage by financing purchases of the unlevered company’s stock with borrowed money. As MM showed in their follow up paper on dividends, shareholders who want cash for present consumption can also make their own dividends, achieving perfect replication in a taxless world with complete information by selling slivers of stock.
In this year’s Annual Report, Buffett takes a step beyond mere replication to argue for superiority for homemade dividends. Given his assumptions he is quite correct. Indeed, the analysis explains a lot of what we see in the real world. These days, Berkshire isn’t the only profitable company that never pays a dividend. The no-pay ranks have grown substantially over the years and the homemade liquidity option goes a long way in explaining why tensions never erupt between savers and consumers in shareholder populations.
The problem with Buffett’s analysis lies in the assumption of steady 12 percent growth. What happens if the expected returns fall because the company no longer can access competitive investments and the S&P 500 offers a better return? Surely the 125% market premium will erode along with the company’s opportunity set. By hypothesis the company should no longer retain because it cannot create at least one dollar of market value for each retained dollar.
Let us draw on Buffett’s analysis in order to figure out what should be done. As a first expedient the company can drain its spare cash by repurchasing its own stock, thereby assisting its taxpaying shareholders by taking advantage of any rate shift between ordinary income and capital gains. But, under Buffett’s rules, no repurchases should be made unless management can see clearly that the stock is underpriced. If the stock stays overpriced even as the premium over net worth dissipates or the stock never stays down long enough to give the CFO a shot at pumping out the cash, the analytical structure implies a cash trap, just the sort of trap that sits at the top of the standard management agency cost bill of particulars formulated during the 1980s and repeated like a mantra by shareholder empowerment advocates ever since.
Is Berkshire becoming a cash trap? Return to Buffett’s last sentence above: “I expect this accretion to continue—albeit in a decidedly irregular fashion.” With each new bout of irregularity, the tension surrounding Berkshire’s no dividend policy increases commensurately. Commentators have speculated that far from signaling the policy’s further entrenchment, the discussion in this year’s Annual Report heralds the opposite, laying groundwork for a future shift, possibly by Buffett’s successor. Maybe they are on to something.
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.