Every February investors wait with anxiousness, like children waiting for Santa Claus, for Mr. Buffett’s annual letter to shareholders of Berkshire Hathaway to be released – myself included.
Investors wait with anticipation and like many things, over analyze seemingly every word and punctuation mark to try to sort out clues as to what Mr. Buffett and team plan to do with their ever growing stock pile of cash, future succession plan, and overall views of the economy. The annual report is so revered because of Mr. Buffett’s ability to communicate some of the most complex items in the simplest terms.
This year one area specifically stood out to me, which were his comments around retained earnings.
Why this area in particular?
Well, in development of our investment strategy over the years, one area we focus in on is dividends and earnings. So it is not uncommon for someone to bring to our attention ‘What about X stock they have a good yield’….only to find out that their dividend payout ratio is basically taking all of their free cash flow to maintain (General Electric was the most recent example of this).
So what are retained earnings and the dividend payout ratio?
Retained earnings are just what they sound like – earnings left over after dividends have been paid to shareholders.
The dividend payout ratio is the percentage of earnings paid out to shareholders as dividends.
So simply put, for a company that is in a capital-intensive industry, it would be best to not have a dividend payout ratio near the top as they would have little money to put towards improving their business.
That being said, below is the section from the annual letter:
The Power of Retained Earnings
In 1924, Edgar Lawrence Smith, an obscure economist and financial advisor, wrote Common Stocks as Long Term Investments, a slim book that changed the investment world. Indeed, writing the book changed Smith himself, forcing him to reassess his own investment beliefs. Going in, he planned to argue that stocks would perform better than bonds during inflationary periods and that bonds would deliver superior returns during deflationary times. That seemed sensible enough. But Smith was in for a shock.
His book began, therefore, with a confession: “These studies are the record of a failure – the failure of facts to sustain a preconceived theory.” Luckily for investors, that failure led Smith to think more deeply about how stocks should be evaluated.
For the crux of Smith’s insight, I will quote an early reviewer of his book, none other than John Maynard Keynes: “I have kept until last what is perhaps Mr. Smith’s most important, and is certainly his most novel, point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus there is an element of compound interest (Keynes’ italics) operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”
And with that sprinkling of holy water, Smith was no longer obscure.
It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was published. After all, it was no secret that mind-boggling wealth had earlier been amassed by such titans as Carnegie, Rockefeller and Ford, all of whom had retained a huge portion of their business earnings to fund growth and produce ever-greater profits. Throughout America, also, there had long been small-time capitalists who became rich following the same playbook. Nevertheless, when business ownership was sliced into small pieces – “stocks” – buyers in the pre-Smith years usually thought of their shares as a short-term gamble on market movements. Even at their best, stocks were considered speculations. Gentlemen preferred bonds. Though investors were slow to wise up, the math of retaining and reinvesting earnings is now well understood. Today, school children learn what Keynes termed “novel”: combining savings with compound interest works wonders.
After reading this, it leads me to believe that Mr. Buffett is warning all of us about the dangers that lurk in companies with seemingly unsustainable dividends and that the payout ratios need to be carefully scrutinized.
I would relate it to a conversation I had with my daughter late last year when I asked her if she wanted to participate in a soccer camp near our house. She kind seemed disinterested and said ‘no, not really’. I mentioned to her that I know her goal is that she wants to get better, but if she didn’t invest the time in working to get better, eventually those whom she was currently outplaying would catch up and then pass her.’ She went to camp.
Same can be said for business, except at the end of the day, it’s lost revenue, not just not making a team.
The full text of Mr. Buffett’s letter can be read here.