At an unguarded moment at a Berkshire Hathaway (BRK.B 0.38%) (BRK.A 0.46%) shareholder meeting in 1967, then CEO Warren Buffett did something he immediately regretted: He agreed to pay a dividend.
The $0.10 per share payout might not sound like much, but it meant shelling out $101,733 to shareholders that he felt he could have turned into millions by reinvesting in the company's operations. To remedy the mistake, he offered shareholders a 7.5% debenture in return for their stock, an offer that 32,000 investors took him up on.
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This weeded out the income-hungry shareholders, leaving investors who were happy with just capital appreciation. Though it would return millions of percent in the following decades, the conglomerate would never mail another dividend again.
Given Buffett's hesitancy to issue Berkshire dividends, it might be surprising, then, to learn that Buffett loves dividends from the companies Berkshire invests in. In his 2023 letter to shareholders, he called serial dividend growers "the secret sauce" to Berkshire's massive returns. But he says there's one scenario in which management shouldn't pay them.
When buybacks are better
Taxation laws favor long-term holding periods. Both dividends and capital gains are taxed at a 0% to 20% rate for investors who hold for the long term (61 days before a stock goes ex-dividend for dividend income, and over 365 days for long-term capital gains.)
This favoring of long-term investors is important because share buybacks work their magic over the long term. Shareholders pay tax only once, if they sell for a capital gain, for a rate capped at 20%. If you're single and earning between $49,450 to $545,500, you'll pay a long-term capital gains tax of just 15%. For spouses filing jointly, the long-term capital gains tax rate is 15% if taxable income is under $613,700.
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Key Data Points
For companies with excess cash, management can either grow value through buybacks, dividends, or acquisitions that grow the company's reach. In 2004, Warren Buffett said that share buybacks are "probably the best use of cash" -- but only if shares can be bought below the business's value. This is why Buffett cheered Apple's historic $100 billion buyback program in 2018, saying that management was unlikely to find an acquisition target that would be a better use of its cash.
On the other hand, ill-advised share buybacks can leave investors rightfully wishing they had received dividends instead. Take the now-defunct former retail titan Sears. In 2005, management decided to spend $6 billion on share repurchases. Unfortunately, shares plunged by over 99% in the years ahead.
We'll never know if spending that $6 billion on research and development or other capital expenditures might have saved the company. One thing is for sure: Shareholders would have been better off receiving that $6 billion in dividends.
Share buybacks are generally the more shareholder-friendly move IF management is repurchasing shares below book value, or a firm's total assets, minus liabilities, divided by shares outstanding. It's a bit like calculating an individual's net worth, only you want to calculate a company's net worth per share.
Buffett's rule of thumb is to buy back shares when a company is trading at below 1.2 times book value. If that's the case, buybacks are "probably the best use of cash."
