Monday, March 17, 2014

Warren Buffett: Dividends and Acquisitions

Warren Buffett’s Berkshire Hathaway BRK is facing a dividend challenge from a small investor. The investor is seeking a resolution to be voted upon at BRK’s annual May meeting. The resolution calls for a regular dividend. BRK argues against the resolution on technical grounds stating the board already decides each year on shareholder distributions. To date BRK has not paid a dividend, although it has engaged in share repurchases when it considers its shares undervalued (defined as share price< 120% of intrinsic value).  Initially, it appears the investor may be right. Essentially, he argues as follows:
  1.  BRK’s share price has lagged the S&P 500 index for 5 years
  2.  Buffett admits having difficulty investing BRK’s huge cash flow and cash balances
  3.  BRK is “elephant hunting”-looking for big deals
  4.  The elephant hunting may result in forced errors
  5.  Investors could better use the funds if they were return to them via dividends as repurchases would be ill advised at BRK’s current share price
Sounds like an approach used by activists like Carl Icahn against similar large firms with excess cash (e.g. Apple).

Buffett correctly points out dividends do not directly affect shareholder value. Dividends merely distribute value-they do not create value. What matters is who can invest the funds better-the firm or the shareholder. If the firm can do so thru organic or acquisition investments then it should retain the funds and make the appropriate capital allocations. Otherwise, the funds should be returned to shareholders. The decision rule is to retain and invest provided the expected returns exceed the cost of capital. The Dividend Discount Model shows Share Price=Dividend/ (Cost of Equity-Growth) where Growth= (1-Dividend Payout Ratio) x Return on New Investment. If investors need cash, then a better alternative, which may be more tax efficient, is for them to create homemade dividends by selling some of their shares.

Buffett’s record demonstrates good long term capital allocation decisions-albeit the last 5 years have been more problematic. Buffett, unlike the firms Icahn targets, eats his own cooking. Thus, the risks of value destructive capital misallocations from Agency Costs are reduced. BRK is more like long only hedge fund than a traditional maturing firm continuing to invest in declining projects. BRK can chose from a number of undervalued opportunities. I remember the last time Buffett was attacked as losing his touch in the 1990s with the tech boom. He was subsequently proven right.

I would trust Buffett for now to continue make good investment decisions. The dividend decision can be reconsidered should that trust turn out to be misplaced. For now, advantage Buffett.


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