Ben Woodhead Deputy editor - digital

Ben Woodhead is deputy editor - digital at the Financial Review Group. He writes on business, technology, politics and the economy and can be found on BRW, The Australian Financial Review and Smart Investor.

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Warren Buffett’s five rules for increasing shareholder value

Published 02 March 2013 11:49, Updated 04 March 2013 07:15

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Warren Buffett’s five rules for increasing shareholder value

“Since the basic game is so favourable, Charlie and I believe it’s terrible mistake to try and dance in and out of it based upon the turn of the tarot cards, the predictions of ‘experts’, or the ebb and flow of business activity,” Warren Buffett says in his annual letter to Berkshire Hathaway shareholders. Photo: Gerry Images

Warren Buffett has released his annual letter to shareholders following one of the few years in which the book value of the fabled investor’s Berkshire Hathaway hasn’t risen by more than the S&P 500.

“Subpar” is the word the Oracle of Omaha used to sum up the performance, although it should be noted his letter makes him appear somewhat bemused at his own use of the term.

“When the partnership I ran took control of Berkshire in 1965, I could never have dreamed that a year in which we had a gain of $US24.1 billion would be supbar,” he writes.

“But subpar it was. For the ninth time in 48 years, Berkshire’s percentage increase in book value was less than the S&P’s percentage gain (a calculation that includes dividends as well as price appreciation. In eight of those nine years, it should be noted, the S&P had a gain of 15 per cent or more. We do better when the wind is in our face.”

Looking for more elephants

Of course, a bad year for Berkshire Hathaway isn’t your ordinary bad year. The firm still managed a 14 per cent rise in its per share book value versus a 16 per cent percentage gain for the S&P. That hasn’t stopped Buffett from lamenting more than one disappointment last year.

“The second disappointment in 2012 was my inability to make a major acquisition. I pursued a couple of acquisitions but came up empty handed,” he says.

“Our luck, however, changed early this year. In February, we agreed to buy 50 per cent of a holding company that will own all of H.J. Heinz. The other half will be owned by a small group of investors led by Jorge Paulo Lemann, a renowned Brazilian businessman and philanthropist.”

All up Berkshire will plug about $US8 billion into the deal, which he says “soaks up” much of what the firm earned in 2012.

“But we still have plenty of cash and are generating more at a good clip. So it’s back to work; Charlie [Munger, Berkshire vice president] and I have again donned our safari outfits and resumed our search for elephants.”

‘We don’t expect the US economy to tank’

As for the good news, Buffett says Berkshire’s five most profitable non-insurance businesses delivered on his prediction that they would book pretax earnings of more than $US10 billion. The figure, despite weak US growth, came in at $US10.1 billion, up $US600 million on 2011.

“Unless the US economy tanks – which we don’t expect – our powerhouse five should deliver higher earnings in 2013. The five outstanding CEOs who run them will see to that,” the billionaire writes.

As for the insurance businesses, these “shot out the lights”.

“While giving Berkshire $US73 billion of free money to invest, they also deliver a $US1.6 billion underwriting gain, the tenth consecutive year of profitable underwriting. This is truly having your cake and eating it too.”

Buffett also expects Berkshire to increase its stakes in its big four investments, Coca-Cola, American Express, Wells Fargo and IBM in the future.

No need to panic

The investor also maintained his faith in American businesses to do fine in the long run, and says any CEO who has a large, profitable project they’re considering shelving because of short-term worries should give Berkshire a ring.

“Since the basic game is so favourable, Charlie and I believe it’s a terrible mistake to try and dance in and out of it based upon the turn of the tarot cards, the predictions of ‘experts’, or the ebb and flow of business activity,” he says.

“The risks of being out of the game are huge compared to the risks of being in it.”

Guidelines for increasing shareholder value

As Berkshire continues to be a player in the game, Buffett outlined his guidelines for improving shareholder value, by:

  • “(1) Improving the earning power of our many subsidiaries;
  • “(2) further increasing their earnings through bolt-on acquisitions;
  • “(3) participating in the growth of our investees;
  • “(4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and
  • “(5) making an occasional large acquisition.”

He adds: “We will also try to maximise results for you by rarely, if ever, issuing Berkshire shares”.

Why Berkshire doesn’t pay dividends

As for the thorny question of dividends, Buffett tackles the issue with an explanation to shareholders of why he sees greater value for investors in not paying out cash.

Outlining his rationale, Buffett suggests not paying dividends works better both for shareholders and the firm, by allowing individuals the flexibility to extract the right amount of cash for them in the right circumstances, while leaving the business free to invest in itself.

So, he says investors looking to extract money should instead sell shares, leaving the company to pump all earnings back into its operations to increase the net worth of the business over time: what he calls the sell-off alternative.

Buffett runs the numbers for the two approaches on page 19 of the letter, summarising that investors using the sell-off approach have a greater chance of increasing the amount of cash they have to spend each year while gaining capital value.

He continues: “Aside from the favourable math, there are two further – and important – arguments for a sell-off policy. First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40 per cent of earnings is the policy, those who wish 30 per cent or 50 per cent will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them – perhaps most of them – are in net savings mode and logically should prefer no payment at all,” he writes.

“The sell-off alternative, on that other hand, lets each shareholder make his own choice between cash receipts and capital build-up.”

The second important argument against dividends is tax, where all the cash received by shareholders under a dividend policy is taxed, versus the sell-off approach where only a portion is tax.

To that end Berkshire expects to continue its policy of not paying dividends.

“We will stick with this policy as long as we believe our assumptions about the book-value buildup and the market-price premium seem reasonable. If the prospects of either factor change materially for the worse, we will re-examine our actions,” he says.


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