Warren Buffett has always been opposed to the idea of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) issuing dividends. His thought process is that he can generate a better return on investors' money than they'd be able to if Berkshire distributed it and they invested it elsewhere.
Berkshire's track record at beating the S&P 500 for most of Buffett's career has vindicated this strategy. Over the last few years, however, Berkshire's returns have started to track the large-cap index. As Gaby Lapera and John Maxfield discuss in this week's episode of Industry Focus: Financials, this raises the question of whether Berkshire could soon change its aversion to dividends.
A full transcript follows the video.
This podcast was recorded on March 6, 2017.
Gaby Lapera: Let's talk a little bit more about the returns. One of the things you can see is that there's something going on with Berkshire's returns. They're going down over time. It looks like it's tracking the S&P 500. And Buffett explains why in the shareholder letter.
John Maxfield: Right. That 19% annualized return on their book value, what's interesting is, that's over that entire 52-year stretch. But if you actually break it down and chart out Berkshire's returns on an annualized basis, what you see is that you start super-duper high in the 1970s, way over the S&P 500, like 20% over the S&P 500, but then they come down gradually. So if you look at a five-year average difference between the S&P 500 and Berkshire's premium returns, it's actually dipped into negative territory three out of the last five years. So the question is, what's going on here? Has Buffett lost his sense of touch? The answer is no, that's not what it has to do. The answer is that Berkshire has become, because of Warren Buffett's success, because of his prudent capital allocation, has become such an enormous company that in order for him to continue generating those ridiculous returns that he did 40 years ago, he has to earn $60 billion. Let me give you the exact math. He has to earn $54 billion each year at Berkshire Hathaway in order to maintain that 19% annualized growth rate. So the returns are going down dramatically, but it's not because Buffett doesn't know what he's doing anymore by any stretch of the imagination. It's just because Berkshire has gotten to be so enormous.
Lapera: Yeah, think about it this way. Think about when you are first learning how to do a sport. Say it is soccer, which I don't really know that much about. Just minimal increases in your knowledge make you a much better player. Once you become the best player in the world, it takes a lot more knowledge to increase your performance as a player. It's the same thing with the company, except with returns. If you're a really small company, minor acquisitions or purchases or decisions can have a huge impact on how much return you get. The bigger you get, the bigger the changes you have to make to increase your performance. It's the same thing, which is something that I think a lot of people don't realize. They're like, "You're bigger, so you should be able to make more money," but it actually makes it harder to outperform what you did in the past. Sure, you are making more money as a whole, but as a percentage, it's not as much.
Maxfield: Yeah. And you know, when you see that chart, and I wrote an article about this, where you see the line comparing Berkshire's returns to the S&P 500, when you see that it's come down, it's now basically a little bit above the S&P 500 on a five-year average basis, a little bit below that or right around it, you know what this has led me to believe? Berkshire, at some point, it's going to get so big that it's just not going to be able to find enough places to invest its capital. And one of the things that Berkshire has always done, because Buffett is such a good capital allocator, is that it has retained all of its earnings. His thought process is, "If we retain our earnings, I'm going to make more on that money for our shareholders than if I returned it and they invested it elsewhere." But the situation this is putting Berkshire in is that may not be the case anymore, because it's gotten so big and it basically mimics the S&P 500 now. The S&P 500, in many cases, may even be better. I think there's an argument there. What that would lead one to believe is that there could be a point here where Berkshire pays a dividend, where that is the rational thing, and Buffett can't get around the fact that he's not going to be able to beat the S&P 500 the same that he has in the past.
Lapera: Yeah. I know he had something to say about buybacks, and I know that's where a lot of people's minds go to when they think about extra capital for companies. What did he have to say about buybacks?
Maxfield: Right. That's actually a great tie-in. There's two ways to return money. You can return it in dividends or you can return it in buybacks, by buying back stocks. And Buffett has been pretty tough on buybacks in the past. Let me give a little bit more context on this buyback conversation. Because of business confidence and consumer confidence and the slow-growth economy that we're stuck in, what a lot of businesses have been doing is, they've been taking all their earnings and, as opposed to reinvesting lot of those into business investments, because they don't see the return on those and they don't want to raise their dividend a whole bunch because then they're stuck at that rate forever more, they've been using buybacks as a pressure-release valve. The problem with that is, as you know, we're in the midst, maybe at the end, we're somewhere in this huge bull market where stocks have gone way up, so these companies are spending all this money on buybacks and buying back their shares at these really high values. The problem with doing that is, if you buy back at too high of a value, the company is actually destroying value. They're destroying value on a per-share basis. Just like if you as an individual investor paid too much for a stock. So Buffett has come out in the past and said, "Berkshire isn't going to do that. Berkshire would only buy back its stock if it trades for below 120% above its book value." But in his most recent letter, he has a really aggressive conversation about the fact that a lot of companies, while buybacks aren't necessarily good or bad as a general rule, a lot of companies in their application of the buybacks are wasting a lot of their shareholders' money.