I have heard it repeated over and over again that dividends don’t matter to Warren Buffett, and therefore, should not play any meaningful role in how other investors arrange their personal affairs. This type of conclusion is based on the superficial fact that Warren Buffett prevents Berkshire Hathaway (BRK.B) from paying a regular dividend to its shareholders.
That conclusion is a bit off because it ignores Warren Buffett’s own history, his current personal circumstances, and the current incentives that he has offered for executives of Berkshire’s subsidiaries.
To understand Buffett’s own history, check out pages 338 and 339 from Alice Schroeder’s “Snowball” biography of Buffett which contains the following quote:
“As 1974 began, stocks for which he had recently paid $50 million lost a quarter of their value. Berkshire, too, slid down to $64 per share. Some of the former partners began to fear it had been a mistake to keep the stock. Buffett saw it the opposite way. He wanted to buy more Berkshire and Blue Chip. But ‘I’d run out of gas. I had used all the $16 million of cash I got out of the partnership to buy stock in Berkshire and Blue Chip. So all of a sudden I woke up one day and had no money at all. I was getting $50,000 a year salary from Berkshire Hathaway and some fees from FMC.’ He was very, very rich but cash-poor.”
Buffett absolutely hated the idea of seeing businesses cross his desk trading at discount valuations but lacking the capital to do something about it. Being brilliant at identifying compounding machines gives you absolutely zero benefit over someone ignorant and aloof about investing if you lack the capital to transform knowledge into action.
Buffett’s subsequent behavior indicated that cash flow mattered to him a great deal. In 1978, he created an incentive structure plan that gave See’s Candies CEO Chuck Huggins bonuses tied to the amount of cash from annual chocolate sales that he transmitted to Omaha. It is a policy that he mimicked thereafter.
Likewise, though everyone covers Warren Buffett as though he was “too good for tobacco” because he didn’t participate in the RJR Nabisco takeover during the leveraged buyout craze of the late 1980s, he nevertheless willingly embraced tobacco stocks in the 1975 when he added 245,000 shares of RJ Reynolds to Berkshire’s balance sheet. This paid out $1.80 per share in dividends at the time. That $441,000 in annual income may not sound like much now, but this was during an era in which Buffett’s biggest acquisition was $25 million. On an inflation-adjusted basis, it would be analogous to collecting $2 million in annual dividend income from a tobacco stock today.
Buffett’s personal accounts are estimated to be a billion-dolllar side fortune in their own right, and he owns over $100 million in big bank stocks in his own right outside of Berkshire. This alone probably pays out around $3 million in dividends. He has got his lifestyle well supported by passive income. He has reached the point where his passive income fully surpasses anything he could theoretically need to meet his spending needs.
So what are the takeaways for us? First, passive income streams are critical to putting yourself in a position to take advantage of bargains when they materialize. I wrote yesterday that Anheuser-Busch is finally trading at an intelligent value. Well, if you agree with that, where are you going to come up with the capital to act on it? You can rely on income from your labor, but it would also be nice having 4,200 shares of BP giving you over $10,000 in annual income so that 100 shares of BUD can be purchased from a self-reinforcing cash flow pool. Then, those 100 share of BUD can mix with everything else and contribute $440 to the next annual cycle of income production.
The important caveat that the dividend critics get right is that you shouldn’t sacrifice significant capital gains in the pursuit of total income now. It is certainly alluring to lock in a 5% dividend yield with a big block of AT&T stock right now, but it will almost certainly be much lower than the aggregate wealth produced by shares of Nike that only pay out 1.4% right now. That is because the earnings per share growth rate of Nike is so much higher than what you’d get from dividends and earnings growth at AT&T.
Incidentally, that is why I have always liked stocks like Chevron that seem to fall in the sweet spot of capital gains and dividend growth. It produces high current income that can be used to make investments in other businesses year after year, but the dividend growth rate also increases at a rate of about 7% on average over the past quarter century. You get present income without the sacrifice in capital gains.
But there is a learning lesson in Warren Buffett’s 1974 investing experience. He had the investing skill to identify the bargains that lay all around him. But he didn’t have the cash flow infrastructure in place to act upon it. He certainly learned from this lesson. Between 1975 and 1985, Warren Buffett received $5.6 million in cash from Reynolds to deploy into the acquisition of other businesses. That’s why it is important to own cash generators, and ownership of reliable dividend growth stocks is a great way to remedy that dilemma.