There are only three ways a company can generate returns for its shareholders: capital gains, dividends and share repurchases. It is known that the father of value investing, Ben Graham, supported some dividend stocks. Now, what is the view of his most famous student, Warren Buffett (Trades, Portfolio)? These were some of his comments during the 2008 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting.
Q: Why do you not believe in dividends when Benjamin Graham believed in them?
Buffett: "I had to show a little individuality. I do believe in dividends, including dividends at companies where we own stock. The test on dividends is, ‘can you create more than one dollar of value with the one you retain?’ It would be a mistake for See’s to retain money because they have no ability to use the cash they make to generate a high return internally. We hope to move the capital to a place where it will be worth $1.20. If we do that, taxable or not, they are better off if we retain money. But when the time comes that we don’t think we can use money effectively, we will pay it out. But because we have the ability to redistribute money in a tax-efficient way within the company, we have more reason to retain earnings in the company. We like companies where we have investments to pay to us the money they can’t use effectively."
Buffett's answer makes us think about three main points:
Opportunity costs: What Buffett questions is why should a dollar be distributed if it can generate more money internally? The more we think about the second-best alternative, retaining the cash and reinvesting it, the decision to avoid paying a dividend is quite obvious.
If, on the contrary, the cash is unlikely to to be allocated into attractive projects with good rates of return, then dividends are the way to go. To have this clear concept of opportunity costs deeply ingrained in our minds is critical to achieve optimal results.
Taxes: Generally, there are different tax rates for capital gains and dividends. We could start bringing fancy theories, such as the Modigliani and Miller ones, to discuss which one is more beneficial. I believe that common sense is critical; if my dividend tax rate is very high, then it would make no sense even if the yield seems attractive. Management should also have this in mind in order for their investors to maximize return, as Buffett said.
Capital allocation: Buffett has repeatedly said his job is not investing, but allocating capital. To minimize the burden of taxes, commisions and transactions, it is important to look constantly for businesses whose return is greater than our cost of capital. As long as we find alternatives that satisfy this axiom, on a risk-adjusted basis, we are very likely to reinvest our earnings instead of distributing them. In the long run via compounding, this would translate into outstanding results.
What do you think?
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