Every year I wait eagerly Warren Buffett´s letter to Berkshire shareholders to benefit from his wisdom on investment. I consider him one of the great champions of shareholder-oriented policies and usually agree with him. However, this year I fundamentally disagree with his contradictory statement on dividends. Let me explain why.
Although concluding that “We like increased dividends, and we love repurchases at appropriate prices”, he relegates the payment of dividends for last, after share repurchases (a form of earnings distribution that he opposed in the past). His view replicates the logic of the so-called pecking order theory of financing which states that firms prioritize the various sources of funds on the basis of how easily they can be accessed. Likewise, Buffett advocates that CEOs should first look to deploy the company earnings on current operations, after look for acquisitions unrelated to their current businesses, then consider repurchasing their own shares if the price-to-book value is below 1.2 and finally pay a dividend.
This use of earnings will inevitably transform CEOs into asset managers and strengthen what I call management capitalism. I define management capitalism as a system where managers may choose the investors rather than the other way around.
Management capitalism is mostly found in the regulated sectors of the economy (banking, transportation, utilities and other former state-owned companies), but also among public companies where capital has been so diluted that the former owners or their heirs no longer have a controlling interest in the business. For example, Berkshire is the single largest shareholder in Coca-Cola but owns only 8.98% of the company and appoints 2 of the 22 directors.
To simplify we may include in the management capitalism sector all public companies whose float exceeds 80% and the largest shareholder owns less than 15% of the total stock. Using these criteria, 3/4 of the 41 companies in Berkshire´s portfolio of listed companies are in the management capitalism sector. This bias in his portfolio is partly explained by the fact that he only invests in large cap stocks. Equally, his preference for CEOs with the profile of a private equity fund manager may be reasonable in his special case. Since he runs his huge portfolio with a team of only 23 people (including support staff) it is obvious that he has to rely on his CEOs as a kind of portfolio managers.
However, managerial capitalism is inferior to market capitalism because it relies on collusion with government policies (namely to inhibit the payment of dividends and distort competition), carries excessive governance costs, is highly exposed to agency problems, undermines competition and has fewer shareholder-oriented CEOs. Those that do not pay dividends often aggravate these problems.
Unfortunately, the alternative to dividends advocated by Buffett does not solve these problems. He argues that instead of receiving an annual dividend, investors pursuing an income objective would be better off by selling annually the number of shares needed to cash in an amount equivalent to the desired dividend. He gives an example assuming no-taxes and constant returns on equity and price-to-book ratios. Under such conditions the sell-off is obviously better. He adds two more advantages of sell-offs, namely that sell-offs do not impose a cash-out policy upon all shareholders and are more tax-efficient.
However, with rising capital expenditure one must expect diminishing returns on equity. For illustration, in the Buffett example, if the return on reinvested earnings after 10 years had fallen to ¼ of the starting return, the sell-off advantage over dividends (about 4%) would be halved. Given the overriding tendency to grow big at all costs there is a major danger that such returns may even turn negative.
Buffett himself, in his 1989 letter, recalling the lessons learned in his first 25 years as an investor, alerted that: “(2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops”.
There is a possibility of controlling this trend, acknowledged by Buffett in his 2012 letter as the pursuit of intrinsic value. That is, to require that net worth grows faster than investment. I checked how his current portfolio of listed stocks had performed on this count over the past four years and the result is not brilliant – less than half (17/41) had a positive elasticity of net worth in relation to capital expenditure and only two companies had an elasticity greater than one. So, if a major shareholder like Buffett cannot enforce this rule imagine how hopeless the average investor is.
Overall, the (uncertain) advantage of sell-offs over dividends is too small to compensate for the greater inefficiency of management capitalism in relation to market capitalism (the present value of his 4% estimated advantage is less than 1.6%). Moreover, it does not justify complacency with the frequent collusion between management capitalists and tax authorities to discriminate against dividends.
So, I am left wondering whether the recent softening of Buffett’s stance in relation to share repurchases and dividends has contributed for his weakening performance and if we risk losing a supporter of shareholder-oriented managers. However, I still hope that he will prove me wrong.