Warren Buffett wrote in his 2012 Annual Report that, "We relish the dividends we receive from most of the stocks that Berkshire owns, but pay nothing ourselves."
The Oracle of Omaha, who is hosting some 40,000 investors this weekend at his famed annual meeting in Omaha, clearly likes receiving dividends -- nearly 90% of his portfolio is in dividend stocks. So why exactly does he refrain from paying them? The answer lies in understanding optimal capital allocation.
Capital Allocation at Berkshire Hathaway
The primary job of the owners and managers of a business is to allocate capital in a way that maximizes shareholder value. At Berkshire Hathaway, Warren Buffett is very clear where the company wants to allocate capital.
The best use of capital for the company is to invest in widening "moats," as Buffett calls them, in current business units. This is his way of describing the advantages businesses have, like a strong brand, having expertise in an industry with high barriers to entry, and more. This means cash outlays on better employees, more efficient production methods, better advertising, or other strategic initiatives. In addition to these, small bolt-on acquisitions are also considered moat-widening endeavors at Berkshire Hathaway. That Buffett would rather spend money on continuing to build his businesses rather than paying out cash to investors speaks volumes about how important investing in businesses with strong competitive advantages is.
The second most-preferred use of cash for Buffett is large acquisitions of businesses he likes. Buffett has a very simple test he uses to determine if Berkshire Hathaway should engage in an acquisition, as he explains, "Do Charlie [Munger, his long-time business partner] and I think we can effect a transaction that is likely to leave our shareholders wealthier on a per-share basis than they were prior to the acquisition?"
The third most-preferred use of cash at Berkshire Hathaway is share repurchases. Warren Buffett has very specific guidelines about when to repurchase shares. When the company's stock falls below 120% of book value, Warren Buffett will use available cash to repurchase shares. The 120% of book value number is not arbitrary. Warren Buffett will only spend money on share repurchases when he believes Berkshire Hathaway is trading below fair value and 120% of book value is his definition of fair value at Berkshire Hathaway.
Why Warren Buffett Doesn't Pay Dividends
None of Warren Buffett's preferred uses of cash are to reward shareholders with dividend payments. Paying dividends means taking money out of the business and giving it to shareholders. If the manager of a company has better investment opportunities or abilities than shareholders, shareholders will be better off when management reinvests earnings themselves instead of paying it out as dividends.
There are few investors as respected as Buffett. In addition, Berkshire Hathaway's size and connections give it access to certain investment opportunities that others simply don't have access to. Examples include his famous Goldman Sachs (GS - Get Report) trade and the Bank of America (BAC - Get Report) bailout. Simply put, shareholder cash is best utilized in the hands of super-investor Buffett rather than paid out to shareholders in the form of dividends. Berkshire Hathaway is the exception to the rule that dividends are beneficial for shareholders due to Buffett's excellence in capital allocation.
Why Warren Buffett Loves Dividend Stocks
While he doesn't like paying dividends, Buffett clearly loves dividend stocks. His largest seven holdings all pay dividends. In total, nearly 90% of the market value of Bershire Hathaway's portfolio is in dividend paying stocks. Buffett loves dividend stocks for a very simple reason: They pay him to own them. Dividend payments to Berkshire Hathaway give Buffett even more money to work with and acquire new businesses with strong competitive advantages.
Any investor can follow Buffett's formula for successful dividend investing: Businesses that pay consistently rising dividends provide stable and increasing cash flows for investors. Investors can use these cash flows to buy additional businesses with strong competitive advantages or reinvest the dividends in the company that paid the dividend. Over time, investors can build their own dividend growth portfolio of businesses with strong competitive advantages -- similar to what Buffett has done but on a smaller scale.