Warren Buffett has always been opposed to the idea ofBerkshire 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.
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Gaby Lapera: Let's talk a little bit more about the returns. One of the things you can see is that there'ssomething going on with Berkshire'sreturns. They're going down over time. It looks like it's tracking the S&P 500. And Buffettexplains why in the shareholder letter.
John Maxfield:Right. That19% annualized return on their book value,what's interesting is, that's over that entire 52-year stretch. Butif you actually break it down and chart outBerkshire'sreturns on an annualized basis,what you see is that you startsuper-duper high in the 1970s, wayover the S&P 500, like 20% over the S&P 500, but then theycome down gradually. So if you look at a five-year average differencebetween the S&P 500 and Berkshire's premium returns, it'sactually dipped into negative territory threeout 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 thatBerkshire has become,because of Warren Buffett's success, becauseof his prudent capital allocation, hasbecome such an enormous companythat in order for him to continuegenerating those ridiculous returns that he did 40 years ago,he has to earn $60 billion. Let me give you the exact math. Hehas to earn $54 billion each year atBerkshire 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 anymoreby 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 arefirst learning how to do a sport. Say it issoccer, which I don't really know that much about. Justminimal increases in your knowledge make you a much better player. Onceyou become the best player in the world, ittakes a lot more knowledge toincrease your performance as a player. It's the same thing with the company,except with returns. If you're a really small company, minoracquisitions or purchases or decisions can have a hugeimpact on how much return you get. The bigger you get,the bigger the changes you have to make to increase your performance. It'sthe same thing,which is something that I think a lot of people don't realize. They'relike, "You'rebigger, so you should be able to make more money," butit 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, whenyou see that chart, and I wrote an article about this, where you see the linecomparing Berkshire's returns to the S&P 500, when you see that it's come down, it's now basicallya little bit above the S&P 500 on a five-yearaverage basis, a little bit below that or right around it, you know what this has led me to believe? Berkshire, at some point, it'sgoing to get so big that it's just not going to be able to find enough places to invest its capital. Andone of the things that Berkshire has always done, because Buffett is such a goodcapital 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 ifI returned it and they invested it elsewhere." Butthe situation this is putting Berkshire in is that may not be the case anymore,because it's gotten so bigand it basically mimics the S&P 500 now. TheS&P 500, in many cases,may even be better. I think there's anargument there. What that would lead one to believe is that there could be a point here whereBerkshire pays a dividend, wherethat is the rational thing, and Buffett can't get around the fact that he'snot going to be able to beat the S&P 500the same that he hasin 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 towhen they think about extra capitalfor companies. What did he have to say about buybacks?
Maxfield:Right. That'sactually a great tie-in. There'stwo ways to return money. You can return it in dividends or you can return it in buybacks, by buying back stocks. And Buffetthas been pretty tough on buybacks in the past. Let me givea little bit more context on this buyback conversation. Because of business confidenceand consumer confidence and the slow-growtheconomy that we're stuck in,what a lot of businesses have been doing is,they've been taking all their earnings and, asopposed to reinvesting lot of those into business investments,because they don't see the return on thoseand 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 apressure-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 bullmarket 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. Theproblem with doing that is,if you buy back at too high of a value,the company is actually destroying value. They'redestroying 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 stockif it trades for below 120% above its book value." Butin his most recent letter, he has a reallyaggressive conversation about the fact that a lot of companies, while buybacks aren'tnecessarily good or bad as a general rule,a lot of companies in their application of the buybacks arewasting a lot of their shareholders' money.
Gaby Lapera has no position in any stocks mentioned. John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.