BRK - Buffett 2005 Letter to Shareholders

[buffett]

Link goes live at approximately 9am EST Saturday

Mr. Buffett speaks.

[FatOtt]

If there is no mention of dividends or buybacks, I will be irritated.

[Sniper]

Buff's letters are a must read! Always useful info in there.

[MatthewRyan]

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If there is no mention of dividends or buybacks, I will be irritated.

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Any predictions? Mine is no dividend or buyback.

[DesertCat]

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If there is no mention of dividends or buybacks, I will be irritated.

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Don't worry, I'm sure he'll explain why both dividends and buybacks don't make sense for the vast majority of BRK shareholders.

[FatOtt]

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If there is no mention of dividends or buybacks, I will be irritated.



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Don't worry, I'm sure he'll explain why both dividends and buybacks don't make sense for the vast majority of BRK shareholders.

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Umm, ok. Assume that I understand, generally, the merits of retaining funds for Berkshire. While I understand the benefits of WEB retaining cash, I also observe the ever-growing cash hoard earning treasury rates. I believe that BRK is coming very close to failing the 5-year retained earnings test that Buffett lays out in the owner's manual - the one that acts as a guideline for whether dividend payouts are maybe a good idea.

As far as repurchases go, the stock is arguably as cheap now as it was when Buffett made the $45k repurchase offer in 2000.

So maybe you could address the dividend/repurchase issue with more substance? Or is it just too obvious for words?

As to an earlier question, my prediction is that he will make no mention of dividends or repurchases and I will be disappointed.

[DesertCat]

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As far as repurchases go, the stock is arguably as cheap now as it was when Buffett made the $45k repurchase offer in 2000.

So maybe you could address the dividend/repurchase issue with more substance? Or is it just too obvious for words?


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Sorry, it's a topic that's just gotten old for me. Not your fault, it's others who've harped on it for years on end.

First, I'm not sure it's as cheap as it was in 2000 (and wasn't his threshold lower than $45?). Price to book was substantially lower in 2000, so I'm not sure BRK is that cheap at all. But if WEB thinks it is, your question will soon be answered, he'd likely make another offer.

Repurchases are great because you (the shareholder) don't have to participate and still benefit by increasing your percentage ownership in a tax free transaction.

Dividends are not so great. For the vast majority of shareholders, Buffett is going to earn higher returns on that money than they will. Most will want to keep their investment working under Buffett's control. A dividend would force those shareholders to take part of their investment back in cash, and pay taxes on it. Then, if they want to keep the dividend working in BRK, they'd have taken a 15% haircut on it before rebuying more shares.

Shareholders who need cash, either for higher return opportunities or just personal needs, can simply sell shares. They not only pay the same tax rate as dividends (15% on long term cap gains) but also don't pay it on their basis, so their effective tax rate is much lower this way.

The only time there is a need to dividend is if WEB can't beat the returns from the S&P 500. Right now he's still beating the S&P 500 regularly (as measured by growth in book value), so BRK fails the dividend test. This is the same basic test every company should use. If you can't re-invest internally at a high rate of return, use excess cash to rebuy stock if it's cheap and offers a high return, otherwise, dividend it out.

My personal feeling is that 15% returns and higher definitely supports re-investment, less than 10% demands dividending or stock repurchase. In between lies gray area.

[FatOtt]

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First, I'm not sure it's as cheap as it was in 2000 (and wasn't his threshold lower than $45?). Price to book was substantially lower in 2000, so I'm not sure BRK is that cheap at all. But if WEB thinks it is, your question will soon be answered, he'd likely make another offer.

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Price/Book is going to be flawed because part of that book (represented by investments in marketable securities) was super-inflated at that point in time, relative to what it is now. If you were able to calculate something like "Book value assuming all equity holdings were valued fairly", the Price/Book ratio in late 1999/early 2000 would be much higher. I don't know if you subscribe to The Motley Fool, but if you do, you should read this extremely thorough discussion of current valuation vs. 2000 valuation by one of the smartest money managers I know:
http://boards.fool.com/Message.asp?mid=23678339


As far as the repurchase cutoff point, here's the quote from the 1999 letter:

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange ("NYSE"). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the "third market" or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.

It may not be conclusive, but I've not met anyone that argued Buffett wouldn't actually buy any shares at <$45k.

As far as the dividend test goes, I think you've got it wrong when you say:
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The only time there is a need to dividend is if WEB can't beat the returns from the S&P 500. Right now he's still beating the S&P 500 regularly (as measured by growth in book value), so BRK fails the dividend test. This is the same basic test every company should use. If you can't re-invest internally at a high rate of return, use excess cash to rebuy stock if it's cheap and offers a high return, otherwise, dividend it out.

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The dividend test (or the retained earnings test) says that every dollar of dividends retained should result in a dollar increase in market value. The Berkshire owner's manual says this test is performed on a five-year rolling basis, which means that if the firm earned $15 billion in a five-year period, but the market value only increased by $10 billion in that period, the test was failed and the firm should have paid out dividends or repurchased stock.

Your comment regarding growth in book value isn't really on point because book value is going to grow primarily from the assets in place, not because retained earnings were invetested at that rate. The Buffett comparison on the first page of the letter looks at overall growth in book value. What we care about is the return on incremental (reinvested) capital. Here's a concrete example:

Firm makes $100 of investments that yield, in aggregate $20 per year. Great investment, right? The problem is that there's no room for incremental investment (much like See's Candy, which just hasn't been able to soak up much incremental capital). So the owner of that investment has to invest the income in 2.5% treasuries. In year 1, the firm's book value grows from $100 to $120, or 20%. In year 2, the book value grows from $120 to $140.5, or 17.1%. In year 3, the book value grows from $140.5 to $161.51, or 15%. Your comparison would say "Hey, the firm grew book value by at least 15% each year, so retaining those earnings was a good idea." The appropriate analysis would say that retaining the earnings was a bad idea because the return on those retained earnings was 2.5%, which is less than what an equity investor is likely to require.

That's the situation that Berkshire is in - by virtue of all previous investments made at attractive prices, book value is likely to grow at a very nice rate. However, the latest balance sheet (3rd Quarter 2005) has over $40 billion in cash, representing money that's earnings (most likely) <4% pre-tax. That's money that could be paid out in dividends or used for repurchases.

Buffett is certainly a better investor than I am, but the size of BRK is handcuffing him so that he's working in a very confined space. Quite frankly, with shares of WMT and KO (as examples) trading at multi-year lows yet still not attractive enough for BRK to add in meaningful amounts, it's hard for me to understand what that $40 billion is going to be used for.

So, yes, if there's not some significant discussion about issuing cash to shareholders in tomorrow's report, I'll be irritated. Note that I'll be happy if it says, "We are coming close to failing the retained earnings test, but we continue to believe that attractive investments opportunities will present themselves in the next 12-24 months, so we continue to retain earnings even though we have no investment opportunities at present."

Basically, I understand Buffett and Berkshire pretty well, but I definitely don't accept the fact that dividends/repurchases are obviously a sub-optimal idea. Berkshire is at a point where the money coming in is far greater than the investment opportunity set (as evidenced by cash in versus cash out over the past several years), which means that I, as a shareholder, want to hear something about plans for getting capital back to shareholders.

[Sniper]

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which means that I, as a shareholder, want to hear something about plans for getting capital back to shareholders.

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[buffett]

Well, Mr. Ott, I guess you are going to be irritated/disappointed. Sorry.

I just finished my first slog through the letter. I'll probably take another go at it once more before work on Monday. I highly recommend it to anyone on this board. Even if you don't have the ability to understand all the financial stuff, just read it anyway. He peppers it with occasional jokes (I laughed out loud at two of them this year), and after enough practice it'll start to seep in.

By the way, I don't have a subscription to the Fool's boards. Who was the author of the piece that you referred to as one of the smartest money managers you know?