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Share buybacks vs Distributing dividends

Berkshire Hathaway annual meeting was just concluded on 1 May. As usual, one of the biggest spotlights on Berkshire Hathaway is on the issue of a large cash position and the amount of share buybacks it does.

In 2020, Berkshire Hathaway spent a whopping $24.7 billion in share buybacks. During the first quarter this year, Berkshire Hathaway spent another $6.6 billion in share buybacks. Meanwhile, the amount of cash piles grew 5% during the first quarter to more than $145.4 billion.

One of the biggest questions raised about Berkshire Hathaway is its persistent stance towards not paying any dividends despite the large cash position. Instead, Berkshire Hathaway focuses heavily on share buybacks and believes that distributing dividends to shareholders is a second-rate solution.

Before we go deep into whether this is indeed true for Berkshire Hathaway, let's go through some of the pros and cons of share buybacks vs distributing dividends.

Let's first talk about share buybacks.

Here's the pros and cons of share buybacks.

  • Does not incur tax like distributing dividends (a pro for the company)

  • Affects share count and hence a positive effect on EPS (usually a pro)

  • Flexible in execution (a pro for the company)

  • Might not have the same positive effect for all shareholders (con to retail investors)

Here's the pros and cons of distributing dividends.

  • All shareholders receive rewards in the forms of dividends (pro)

  • Less tax efficient due to tax incurred from receiving dividend (con)

  • Less flexible in execution (a con for the company)

  • Potential market backlash if dividend is to reduce one day (a con for the company)

As retail investors, some of us might prefer to receive dividends instead as it is always good to have cash in the pocket. In some ways, it's also a fairer way to treat all shareholders as share buybacks have the effect of benefiting a minority of the shareholders (when the company purchases back the shares from a few individuals) rather than everyone. On the flip side though, shareholders will have to pay tax (eg. US withholding tax) when they receive the dividends.

However, I'm of the opinion that share buybacks will generate greater shareholder value if it's done properly. Now, let me just elaborate a bit more on what I mean by properly.

Doing share buybacks is generally not the most ideal situation as it means that you are not putting your cash to use in the most ideal way. In the best situations, you should be using this cash to make certain acquisitions so that it generates more profits for the company in the longer run. If we look back in history, we often wish that companies which did share buybacks in the past have used the cash to make some meaningful acquisitions instead. For instance, if Microsoft has not spent more than $100 billion to do share buybacks and perhaps successfully used some of them to buy companies like Salesforce, the company might be even bigger than what it is today. While that might sound really optimal, reality is that there is also a good chance that companies used this cash on equally value-destructive stuff that could put them in a worse situation now. Imagine if Microsoft were to spend more of these $100 billion on Zunes. You probably will not want that. Hence, doing share buyback might not be the most ideal way of using the cash pile but for sure it's a better way than putting this cash into meaningless business operations or acquisitions.

The manner of how the share buyback is conducted is also equally important. If a company is to raise debt to do share buyback, it is usually very much not favoured as that will take a toll on the financial balance sheet with a higher net debt ratio. Raising debt to make meaningful acquisitions is a very different story as compared to raising debt to buyback your own shares.

And that is why my personal preference is still for Berkshire Hathaway to make meaningful acquisitions with the large pile of excess cash it has. That will still take precedence over share buybacks. It's just that when it becomes a situation of either doing share buybacks or distributing dividends, perhaps doing share buybacks make more sense.

Here is a quick example to demonstrate why. Let's say you have a stock which has a book value of $1000 and is currently trading at its book value which is $1000. Suppose the business produces a 10% return and has a payout ratio of 50%. In this case, investors who bought the stock will enjoy dividends of $50 from an investment of $1000 by buying the stock at its book value. Now, if the stock is consistently trading at a book value of $1500, the story will be very different. Investors will still receive the same $50, but that will only represent as 3.33% return in terms of dividends. Because of a payout ratio of 50%, the stock will still appreciate at 5% (half of 10% return) in terms of book value. However, investors will only enjoy 8.33% (5% of the appreciation plus 3.33% return in terms of dividends) return this way instead of the full 10% they should be enjoying. Hence, dividends can be value destroyers in this case and share buybacks at the right price by the companies might be a better idea.

A good example of it will be Apple. Apple has been consistently buying back 5% of its shares every year from 2015 to 2020. Total share count now is 75% of what it is in 2015. This greatly increases the earnings per share, which in turns bring forth more shareholder value.

Similar to Apple which has a large cash position, Berkshire Hathaway is also potentially generating shareholder value via these share buybacks. In the long run, the share price of Berkshire Hathaway should enjoy a good ride up due to these share buybacks like what you are seeing in Apple. As a retail investor, you simply just need to buy and not do anything, and your ownership of the company will still increase. If you are really hard up for the dividends, you can always sell away a certain percentage of your holdings (at the same rate as Berkshire Hathaway does it share buybacks) and your ownership of the company still remains the same.

If all goes well, we should be seeing good growth in Berkshire Hathaway share prices in the coming years.

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