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Why Warren Buffett Is Wrong on Dividends

warren-buffett-dividendsI’m in the 1%.

No, not the 1% that controls an inordinate amount of wealth and, therefore, draws and an inordinate amount of invective from grandstanding demagogues. I refer to the 1% that believes Warren Buffett is wrong for eschewing dividends in favor of total reinvestment in Berkshire Hathaway (BRK.a).

Even within the chambers and halls of Wyatt Research, most of my colleagues consider me daft for tackling the subject. After all, can you persuasively argue when success is so obvious?  Why tilt at windmills?

But argue and tilt I will.

Yes, the success is obvious. It’s also possible that there could have been more of it, and that’s less obvious. On a higher philosophical plane – no one is above questioning, nor should anyone be. Infallibility is an impossible human achievement.

Nevertheless, a sense of fair play is in order. The master should be given his due.

In his 2012 annual letter to shareholders, Buffett addresses one-percenters like me. He readily acknowledges some investors are flummoxed by the apparent paradox: “It puzzles them [investors like me] that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves,” muses Buffett.

Indeed, Berkshire listed 15 common stock investment valued at more than a $1 billion in 2012.  Only one, DirectTV (NASDAQ: DTV), failed to pay a dividend.

Buffett eschews dividends because he believes Berkshire investors are better off with him reinvesting all earnings. Buffett declares as much: “Overall, however, our record [reinvesting earnings] is satisfactory, which means that our shareholders are far wealthier today than they would be if the funds we used for acquisitions had instead been devoted to share repurchases or dividends.”

Of course, what Buffett declares is a counterfactual. There is no way to prove it right or wrong.

There are no parallel universes.

That’s said, parse the past 50 years and you could rationally concede Buffett is right.  On the other hand, parse the past five years and Buffett is on shakier ground.  Berkshire shares are up roughly 127% compared to 124% for the S&P 500. Factor in reinvested dividends, and the S&P and Berkshire are on equal footing.

In the same 2012 letter, Buffett offers his most cogent, and I believe most persuasive, argument for retaining all earnings. He refers to it as the “sell-off” scenario.

Under this scenario, investors basically “manufacture” dividends by selling a set percentage of their ownership value each year. It appears a win-win for all involved: Investors demanding annual cash flow get it; investors preferring reinvested earnings get that; a dividend isn’t thrust upon them.

Buffett’s example focuses on a small operation – with $2 million of net worth. Here, you and Buffett are equal owners. The enterprise generates 12% earnings annually on its annual net worth. So after the first year, $2 million would generate $240,000 in earnings. Buffett also assumes any outside investor would pay 125% of the company’s net worth.

To buttress his case, Buffett juxtaposes two options: one where the company pays one-third of annual earnings to you and to him as dividends; the other where each of you sells 3.2% of your portion of the company’s net worth annually.

Under Buffett’s “sell-off” scenario, both of you are indeed better off if the company issues no dividends.

At the end of 10 years, you’ll receive $79,960 in annual dividends compared to $82,775 in annual cash flow by using Buffett’s “sell-off” strategy.  What’s more, your portion of net worth in the enterprise would still be worth roughly 4% more – $2.8 million compared to $2.7 million – by adhering to his method.

In the real world, Buffett offers another reason for eschewing dividends: Berkshire’s 600,000 shareholders have differing cash needs. Buffett surmises that most are in a net-savings mode and logically would prefer no dividends.

To be sure, Buffett offers persuasive reasons why Berkshire is a non-dividend payer. That said, his reasons aren’t persuasive enough.

Stay tuned, because in Friday’s edition of Income & Prosperity, I’ll offer my own reasons  – based on Buffett’s own scenario – for why Berkshire should pay a dividend.

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  • jg2222

    I have a question. I am new to investing.

  • jg2222

    I am really not sure if I am doing something good or bad. It seems good, maybe to good to be true. But Why couldnt someone like me , a small investor, simply buy and sell stocks for the dividends, put the money away in an safe thing for taxes next year? And maybe hold a stock a day, a week, 10 days, to make a little capital gaines as well as the dividend? Sell and buy, like shooting fish in a barrel? In desperation, and with luck, I think I can make cash. And taxes are taxes, but if I am mindful of it, and live a modest way like a do,….. isnt it possible to trade like this? Sure one needs to look at the charts, history, news on the company, be mindful and pick a stock or etf to buy that you think is best for that couple of days or a week?
    Wyatt got me started when , again out of desperation I bought the dividend calander and news letter from them. I picked PSEC as my first investment, putting half my money into it. We all know what happened, the stock tanked due to SEC filing concerns (but has since bounced bacK). I doubled up on PSEC putting the 2nd half of my money into it when it was fairly low in the tanking, albiet not at the bottom. I wound up losing 3000 in capital losses but got 3000 in dividends,by the time I sold it. So Ilose, the taxes on the dividends I guess. I then went outside of Wyatts sugestions and bought Windstream., Held it for about 3 weeks maybe selling yesterday, I made about 4500 in the dividend and another 3500 or so in capital gaines. This is my only income for the year, and in many years for a matter of fact. If at this point it is treated as regular tax bracket I’ll be no worse than the 15% tax level.
    Why can’t I do this every week?, Maybe sometimes twice a week,….. If the stock maintain s value and no capital losses occur and the dividend comes in, How can I lose?
    Am I missing something here?
    I already have a list of about 15-20 companies to choose from the buy this coming week where I can earn anywhere from 1200-3600 in dividends, and hopefuly some capital gains as well.
    I know it is risky, being done out of desperation,.but if I am willing to take the risk, do the homework, and keep my finger on the trading button in case I panic,….. WHY COULDNT THIS WORK?
    Am I making a mistake and doing something bad?

  • Crystal E. Sackett

    The discussion would need to be evaluated by the beholders/readers income or investment bracket and thus would not be true all the way thru the spectrum, I’m sure. Those trying to learn by reading, will have no history to make an opinion on, thus cannot learn. I suppose a strategy to explore and understand at some future time, with the myriad of other things to explore and learn, not possible in a life without money. So perhaps these things should have some kind of grading when delivering.
    Evaluate level of expertise or experience when playing with retirements incomes, cover ones karma butt. I note in BC, Canada we have a University for learning the basics…. only got to the door of the intro, but had I $7K I could have played. I think they had an 8 year old showing how easy it was in the classroom. Wonder who gave him the $7K.


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