Sunday, February 27, 2011

Warren Buffett Is Tap Dancing in Omaha Again

CEO Warren Buffett was tap dancing with gusto Saturday as he reported estimate-busting earnings for Berkshire Hathaway (BRK/A).  The results were far above Wall Street estimates and 43% higher than last year.  Importantly book value (net assets per share divided by total shares) exceeded $95,000 for the Class A shares. 
As many of you know, BRK is the only non-dividend paying stock we own in our models (it's in our Capital Builder Model). We have made this dispensation for Mr. Buffett because in studying him over the years we learned of Benjamin Graham, and in getting to know Mr. Graham's theories, we came to know about the dividend meister John Burr Williams.  We have been convinced for years that Mr. Buffett is really a follower of Williams as much as Graham because of the types of companies he has acquired over the last 30 years.
The common denominator of most Buffett acquisitions, especially his publicly traded purchases, is that they have tremendous free cash flows, powerful brands or competitive advantages, and they pay generous and growing dividends.  Thus Mr. Buffett's non-dividend paying company breaks all our rules, but the underlying companies he owns fulfill them.  There is probably a good analogy here, but I can't grasp it at the moment. 
Berkshire's impressive results are good for the company but are also a great leading indicator for the US economy because of the breadth of industries in its portfolio.  Burlington Northern's results (purchased by Berkshire in 2009) were simply outstanding and make its purchase price look cheap.  But then again, hasn't Buffett always had an uncanny ability to buy the cream of the crop on the cheap?  We are convinced that his greatest legacy will be this: His courage to go on shopping sprees when everyone else is convinced that pillows and tin cans are the best place to put money. 
Another reason we have been buyers and holders of Berkshire Hathaway is that in listening to Buffett's annual lectures to the investing public, he has given many clues as to how to value his company.  We are primarily dividend investors because we believe dividend growth is a great indicator of value.  In listening to Buffett some years ago we realized that for Berkshire Hathaway, book value was the key indicator of value.
The chart above in a multiple regression of book value and United States GDP versus the price of BRK/A over the last 15 years.   As you know, the red line is the actual price and the blue bars are the model's predicted prices for each of the last 15 years.  The checkered bar at the far right is the projected value of BRK/A one year from today based on estimates of the model's inputs.
The model shows the the stock is currently modestly undervalued, and significantly undervalued based on next year's estimates.  In particular, the model is suggesting if historical patterns hold true that BRK/A's price will grow about 16% in the coming year.  Remember this is not a guarantee; it is a mathematical guess.  That would put the stock near $150,000 per share a year from now, a big climb from its current value near $128,000.
You'll note that the model's blue bars have given a good account of themselves in estimating BRK/A's value over the years.  In fact the R2 is over .85.  I'll leave it to you to Google R2 if you want an explanation of what it means.
In trying to provide an order of magnitude for how impressive BRK's 2010 earning data are, it would be like Michael Jordan scoring 60 points in his last year of play.  It is remarkable, it is out of the box, it is a testament to the nerdy kid who grew up in Omaha, Nebraska and never left.  
From an investment perspective nobody has ever done it better.  We congratulate you Mr. Buffett and all your employees.
We own Berkshire Hathaway Cl  B.  Please do use this information for investment decisions.  Please consult your investment advisor.

Monday, February 21, 2011

An Open Letter to American Corporations About Your Dividend Policies

As major American corporations you employ a multitude of psychological and scientific analytical tools to plumb the hearts and minds of your customers.  In short, your quest is to find out what your customers want and give it to them.  By contrast,  most companies pay very little attention to what their shareholders want, other than price growth. Doing this you falsely assume that your only constituencies are the Wall Street analysts and money gunners who live or die on each quarter's earnings release.  You forget about the millions of individual investors and asset managers who could care less if you beat, meet, or miss your quarterly earnings estimates by a few pennies, yet do care about your dividend payout policies.

Most companies believe dividend investors occupy the fringe of their stakeholders and are not worthy of much attention.  In short, most American corporations care more about what their customers think than what their shareholders think.  In doing so, you miss a wonderful opportunity to attract and retain an incredibly loyal set of shareholders who take a much longer view of their holdings than do the hedge fund or money gunners.

Oddly enough, you will find that if you talked more about your long-term dividend growth goals you would catch the ears of millions of Americans who are trying to figure out where to put their money where it will give them a living income.

Yet quarter after quarter you invite in only the Wall Street crowd for a discussion of what happened in the last 90 days and offer a glimpse of what may be happening in the next 90 days.  I would think these quarterly dog and pony shows for the Wall Street circus crowd would leave you scratching your collective heads as to whether you are running a business for the ages, or a carnival show that will be packing up and heading for the next town at weeks end.  

For many years in this blog, I have been saying that the lack of attention to the income needs of your shareholders was going to change.  I have long believed that the catalyst for a new emphasis on dividends would manifest itself when the baby boomers reached retirement age.  My reasons for saying this are simple.  In retirement people need reliable and growing income, and Wall Street's computerized predictions of how much income a person "ought" to be able to take out of a body of capital just scares the dickens out of most people.  They don't like the idea of trying to live off of the capital appreciation of their assets, when doing so may mean they are selling in down markets. 

Down markets are very tough on retiree's psyche's.  At a minimum, they realize they are selling securities at the wrong time to fund their daily bread, and at the worst they know they may be taking loses to do it. 

Our approach at DCM is to build each client's portfolio, when possible, so that it produces sufficient income for their living expenses.  In this way, even in bear markets, they are never forced to sell securities to fund living expenses.  They just live off of the monthly income their portfolio generates.

Yet, in assembling a portfolio of dividend paying stocks, I am constantly frustrated by companies with very high free cash flows that pay only a modest dividend.  In most cases these are great companies, but they choose to keep the extra cash in the company rather than paying it out to their shareholders.

I would like to remind these companies of some very important demographics:  Seventy-nine million Americans of the baby boomer generation will soon be retiring.  Judging from the the new clients that come to our firm, I would say only a fraction of them are now focused on dividends for their retirement incomes.  As we explain how important rising dividends can be to them in their retirement, we often hear the words:  "This is what I have been looking for.  I can live with this."

From the 1920s through 1993, the average annual dividend payout ratio of the S&P 500 was near 50%.  The concept of Modern Portfolio Theory took over in the 1990s, during which time academia convinced most major American corporations that share buy backs were a more tax efficient means of rewarding shareholders than cash dividends. Corporations liked this idea because it took a lot of pressure off of them by allowing them to keep most of the money they made instead of distributing it to their shareholders as they had for the 70 prior years.  That switch to a share buyback strategy for free cash flow led to dividend payout ratios falling under 30% by 2001.

Dividend payout ratios began to climb again after the Bush dividend tax cuts of 2003 and nudged above 40% in 2006.  The subprime crisis, which had its genesis beginning in the middle of this decade, again took a toll on dividend payout ratios, and as of year end 2010, major American corporations are now paying out only about 29% of earnings.

This week Met Life (MET) CFO,  William Wheeler, said in the Wall Street Journal that his "'bias has changed' to favor an annual dividend over share buybacks as a means of the return of capital to shareholders."   I have read similar statements from Eaton Corporation (ETN) and Parker Hannifin (PH).

We don't think these companies will be the last to come to this conclusion.  There is an income crisis in this country.  Short-term bonds and CDs yield almost nothing and inflation worries pose impediments to higher yielding, longer term bonds.  The time is ripe for companies to begin a persistent and consistent surge to higher dividend payments.  Your balance sheets can handle significantly higher payouts, and the strong free cash flows you are generating would suggest that many companies can afford as much as a 50% dividend payout ratio again.  If that were the case, the average dividend yield of the S&P 500 would be near 3% and growing between 6%-8% a year. 

Listen to the voices of investors who are looking for rising incomes and want to own companies they can count on for the long-term.  Better yet, listen to your own heart.  If a dear friend said they were looking for a great company with a great dividend, how would your stock stack up?  Stop playing the shell game of stock buy backs and whack-a-mole quarterly earnings, and start playing the game where everybody wins:  pay out as much of your free cash flows as you can in dividends.  Seventy-nine million Americans will thank you, as will countless foundations, churches, colleges, and retirement plans.

The author owns Eaton.  He is looking hard at Met Life and Parker Hannifin.