If you rely on your investments for income, you may limit your portfolio to dividend-paying stocks, but this doesn't need to be the case. By using a simple strategy Warren Buffett suggests for Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders who need income, you can turn any stock you want into an income-generating investment.
Why doesn't Berkshire Hathaway pay a dividend?
In Warren Buffett's 2012 letter to Berkshire Hathaway shareholders, he offered a detailed explanation about why the company doesn't pay a dividend, and never has.
For starters, Buffett feels that his company's main priority with the capital it generates should be to make sure all the capital needs of its many subsidiary businesses are met. This is a common strategy among businesses, and even the highest-dividend-paying stocks rarely pay out more than half of their profits. It takes substantial investment to maintain your competitive advantage, and smart managers like Buffett know this.
Aside from this, Berkshire's strategy is quite different from most other well-established companies. After meeting the needs of its businesses, Berkshire typically has billions of dollars in cash left over. The company's second priority is to search for additional companies to acquire, or attractively valued stocks to buy. The goal with all of Buffett's acquisitions and stock purchases is to leave his shareholders with more intrinsic value than before.
It's tough to argue with this strategy. Given Berkshire's history, shareholders are undoubtedly better off with the company's massive portfolio of subsidiaries and stocks than they would have been had the company simply paid out some of its profits as dividends. Just to name one example, Berkshire invested $5 billion of excess capital in Bank of America in 2011. As of this writing, the investment has nearly tripled; it is now worth about $14.4 billion.
This translates to an annualized return of about 24% -- impressive by anyone's standards. It's difficult, if not impossible, to make the case that Berkshire would've been better off giving that $5 billion to shareholders instead. The same can be said about most of the company's investments over the past five decades.
Finally, when Buffett feels that Berkshire stock is trading at an attractive valuation, the company has used its excess capital to buy back shares. To do this, however, the stock must be trading at a meaningful discount to Buffett's perception of its intrinsic value, which he currently defines as 120% book value.
If these options have been considered, and there is still excess capital, the company's preferred use is to do nothing at all. As I write this, Berkshire has a cash stockpile of about $85 billion, and absolutely no plans to use it to pay dividends.
Warren Buffett's suggestion for his shareholders
Since Berkshire doesn't pay a dividend, Buffett has another suggestion for the company's shareholders who need income from their investments. Basically, he says that if you want a dividend, you should simply sell off that percentage of your shares each year. For example, if you expect a 3% dividend from your stocks, you should simply sell off 3% of your shares. Essentially, you achieve the same thing as if Berkshire had paid a 3% dividend, but with some important benefits.
Here's why this works out in your favor. Since you can sell your shares of Berkshire Hathaway for substantially more than their book value, you're technically getting more than they're worth, in terms of the value of the company's underlying assets. As of this writing, Berkshire's share price is about 1.45 times its book value. In other words, by selling your shares, you're getting $1.45 for every dollar in assets your shares represent. Meanwhile, since Berkshire has invested its profits instead of paying a dividend, the intrinsic value of your remaining shares can continue to grow at a faster pace than it otherwise would.
This approach has tax advantages as well, if your shares are held in a taxable brokerage account. Generally, the full amount of any dividend you receive is subject to tax. For qualified dividends (like those from Berkshire), this translates to a 15% tax on the entirety of the dividend for most investors.
On the other hand, when you sell shares, only the portion that represents profit is subject to tax. If you paid $100 per share and sell for $150, you'll only owe tax on the $50 gain. As long as you held the shares for more than a year, the tax rate will be the same as the qualified dividend rate, but will only be applied to a portion of the sale price. For this reason, the strategy Buffett suggests is favorable from a tax perspective for many investors.
This strategy can be applied to any stock
The strategy can be applied to any stock that doesn't pay a dividend or with a small payout. However, it's important to mention that it only makes sense for stocks trading at or above their book value. For example, Bank of America would be a bad choice for this strategy, since it trades at a substantial discount to its book value.
On the other hand, for popular stocks that don't pay a dividend like Chipotle Mexican Grill, Netflix, or Amazon.com, all of which trade for several times the value of their underlying assets, Buffett's strategy can allow you to invest in these growing companies and still generate an income stream.