In today’s Barron’s, Andrew Bary presents the bullish case for Berkshire Hathaway and speculates that Warren Buffett may soon be willing to part with some of Berkshire’s growing cash hoard by paying a dividend to shareholders, perhaps as soon as later this year. Mr. Bary believes that Berkshire may be sitting on close to $50 billion in the core insurance operation by the end of the year driven by rising cash flows from operations as well as the repayment of several investments Berkshire made during the financial crisis. Without a major “elephant” acquisition, low returns on cash could become a headwind for the company.
For a number of reasons, it appears quite unlikely that Berkshire Hathaway will introduce a dividend anytime soon. Berkshire shareholders have been in a similar situation at many points in the past when tens of billions piled up without any immediate use for the funds and questions of whether a dividend would be declared have surfaced periodically over the past decade.
Cash Provides Advantages
We have been critical of executives who hoard cash, particularly in the technology sector, because often a growing cash pile burns a hole in a CEO’s pocket and makes value destroying acquisitions more likely. However, in the case of Berkshire, the risk is not so much that a value destroying acquisition will occur than that cash will build up and earn suboptimal returns for several years. With Warren Buffett in charge, many Berkshire shareholders view this “cash penalty” as the option premium that must be paid in order to enable Mr. Buffett to opportunistically pursue investment opportunities in times of distress.
If Berkshire had distributed cash to shareholders during the middle of the last decade, Mr. Buffett would have been more constrained in his investment operations during 2008 and may have been unable to fully fund very profitable deals such as the Swiss Re, Goldman Sachs, and General Electric investments. The Burlington Northern Santa Fe acquisition may have been possible only through the issuance of a greater number of Berkshire shares or by leveraging the balance sheet by more than the $8 billion in debt that was issued to fund part of the deal.
Would Shareholders Want to Compete With Buffett?
One other obstacle to a dividend involves taxes that Warren Buffett would incur upon any cash distribution. If we assume that a dividend would be introduced at a modest level of around $2,000 per Class A share annually (a yield of about 1.7 percent), Mr. Buffett would receive approximately $750 million in taxable dividend income annually which would create a significant tax liability.
Some shareholders may correctly point out that Mr. Buffett’s personal tax situation should not dictate optimal capital allocation for Berkshire and this argument has merit. However, one problem that would potentially impact Berkshire shareholders is the prospect of Mr. Buffett having to find places to invest perhaps $600 million in after tax proceeds he would receive annually from a Berkshire dividend. Essentially, Berkshire shareholders would find themselves in competition with Mr. Buffett himself in terms of finding appropriate investment opportunities for large amounts of cash.
Dividends Will Come — But Hopefully Not Soon
At some point in the future, Berkshire Hathaway is nearly certain to pay a dividend, and perhaps a very sizable one at that. Doing so would create a number of benefits for shareholders seeking income as well as reduce the pressure on future managements to intelligently invest the growing amount of cash Berkshire’s operations generate each year. However, while Warren Buffett is running the company, shareholders appear to be better off with the current policy in place both due to the optionality created by allowing Mr. Buffett to retain ample “dry powder” for opportunistic investments and to avoid creating a conflict of interest in which Mr. Buffett is forced to invest large sums of money annually in competition with Berkshire due to annual dividend distributions.
Update– 1/22/2011 4:30 pm
A reader commented on a version of this article syndicated to GuruFocus.com asking whether Warren Buffett could mitigate the tax liability associated with a dividend by giving away the proceeds to a charity. While this would eliminate part of the tax liability, limits on charitable deductions are normally capped at 50 percent of adjusted gross income (see this link on the IRS website for more details). Accordingly, we can safely conclude that Mr. Buffett could offset at least part of his tax liability through such a donation of cash, but it would be suboptimal in many ways compared to donations of appreciated stock which has been Mr. Buffett’s vehicle of choice for his large donations to the Gates Foundation in recent years.
The author of this article owns shares of Berkshire Hathaway. The Rational Walk will publish Berkshire Hathaway: In Search of the Buffett Premium in early March. The report will cover all facets of Berkshire Hathaway’s business with a focus on the succession planning process.