Home > Economics, Idle Speculation > Something doesn’t add up about Warren Buffett

Something doesn’t add up about Warren Buffett

WARNING: I have completely changed my view on this topic, and intend to write more on in in he future. Below I suggest you can’t perform a fundamental value analysis on Berkshire stock, when of course you can on all its underlying income streams. I leave it up as a shining example of how applying a useful framework inexpertly (in this case, the distinction between value-investing and speculation) can lead to bad results

A bit of a bold title for a first post, but I was absolutely astounded to find out today that Warren Buffett’s phenomenally successful company Berkshire Hathaway – a single share of which would currently set you back $115,325* – hasn’t paid out a dividend to shareholders since 1967.

Think about this for a second.

Buffett is famous not only for being an incredibly skilled allocator of capital, but for his philosophy of investing for expected future returns rather than on speculation. You find a company whose future returns are undervalued, buy that company and hold it. Maybe you’ll have to rejig it a little to get those expected future returns, but as I recall Buffett saying himself on the BBC special he was the subject of last year: he bought a company once that required turning around and making some tough decisions, and it wasn’t much fun. So he made sure he never had to do it again.

Would Warren Buffett invest in Berkshire Hathaway, if he was following his own philosophy? I can hardly see how. What is the value of owning an expensive piece of stock unless you expect it to pay dividends, or unless you plan to sell it at a higher price in the future? The former is nonsensical if the dividends are zero, and the latter goes entirely against the letter (let alone the spirit!) of Buffett’s investment philosophy.

Consider the following, from CNNMoney.com in 2004:

A shareholder asked what it would take for Berkshire to change its longstanding opposition to paying a dividend or conducting share repurchases. Buffett used the question to teach a mini-clinic on corporate finance, pointing out that the managers of a company have a fiduciary duty to put the company’s cash to optimal use…

Later, Buffett made a striking observation. Imagine that Berkshire decided that it could no longer wisely invest its $30 billion-plus worth of cash and decided to distribute all that cash to shareholders in a special dividend. Buffett himself, as the largest shareholder, would get more than $7 billion.

Then, he pointed out, he would have to try to find good investment opportunities to put all that money to work for his own account. “I would be in competition with Berkshire’s shareholders, and I don’t think that would be good for them,” Buffett said.”

This response doesn’t make any sense, because the whole point of a fiduciary duty is that management act in the interest of the shareholders. But I can’t see what the interest of the shareholders is here, unless it is simply to increase the share price (and Lord knows that in many cases such a policy can have terrible consequences for shareholders). They never actually get any of the money!

And furthermore, the shareholders might not want to use the dividends to find good investment opportunities. Maybe – and this might come as a shock to the famously frugal Buffett – they might want to spend the money. Money doesn’t just exist for its own sake – it is a medium of exchange. It exists so we can get stuff. Why on earth would anyone invest except to have more money to spend?

Something doesn’t add up. I’m not going so far as to brand one of the richest men in the world a hypocrite.. or maybe I am, I’m not sure. The annual shareholder meeting for Berkshire Hathaway is often referred to as ‘Woodstock for Capitalists’. And that’s the only possible rational reason you could have for owning stock in Berkshire Hathaway – to be part of an elite club that get to go hang with a bunch of cool kids every year (or, at least, with a bunch of kids who all think another kid is really cool). Perhaps this is the way that Berkshire shareholders see themselves. We can test this hypothesis. If it is the case – as I strongly suspect – that one gets as much benefit from holding one share as any other number if we think about it as a private club, then we should expect almost all the shareholders to own one share. If this is correct, anyone who has more than one share is either  a) incompetent at calculating the value of a simple investment (in this case, the marginal utility of a second share in Berkshire Hathaway) or b) engaging in speculation. Either way, they can hardly be said to be following the philosophy of the man they so admire. And Buffett’s justifications about not paying a dividend strike me as if it is supposed to be something more than an elite club.

Almost like its supposed to be a publicly traded business or something.

*UPDATE (3/5/10): This price reflects the ‘Class A’ shares – there are also ‘Class B’ shares which have 1/150th of the claim of Class A.

However, what this serves is to prove the point that Berkshire Hathaway stock holders are engaged in speculation. Class B shares trade at pretty much exactly 1/150th of the price of Class A shares, therefore the value is (unsurprisingly) based on the claim to the company, rather than the right to go to the meeting and be part of the club (which is exactly the same for both Class A and Class B). It remains, then, an utter mystery to me how one can consistently adhere to Buffett’s value-investing philosophy and be a Berkshire Hathaway shareholder.

To drive home this point once and for all: value-investing is based on the idea of a so-called ‘fundamental analysis’ – and essentially if the fundamental analysis churns out a number that is greater than the current market price, then you buy. But if Berkshire never pays dividends (and it never has while Buffett has been running it full time), you can’t carry out a fundamental analysis. Even the price-earnings ratio for Berkshire is pretty high already (about 22), despite the fact as a stockholder you get to see no more of those earnings than I do.

Pure speculation…

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