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Manufacturing Dividends: Choose Your Own Payout


Published on March 26th, 2021

This is a guest contribution by Adam J. Mead.  Adam Mead is CEO and Chief Investment Officer at Mead Capital Management, and founder of WatchlistInvesting.comAdam’s views are his own and do not necessarily reflect those of Sure Dividend.

Many investors restrict the cash flow from their equity investments to the periodic dividends they receive. They are content to let the company’s board of directors decide the payout ratio (how much of current earnings to pay out as a dividend) and trust the remainder to be reinvested back into the business.

There is another way, and you might not be surprised to learn that Warren Buffett has weighed in on the topic. The answer: “manufacture” your own dividend, as you see fit, by selling shares. Though perfectly rational, this is easier said than done.

At the tail end of his 2012 annual letter to Berkshire Hathaway (BRK.A, BRK.B) shareholders, Warren Buffett laid out his case for why Berkshire’s shareholders were better off with their company not paying a dividend. His rationale was simple:

  1. More opportunities for wealth creation were available within Berkshire;
  2. Not all shareholders wanted a dividend, and if they did, their preferences for the payout ratio quite likely spanned a wide range;
  3. Shares could be sold at a premium to book value; and
  4. Selling shares instead of paying a dividend would be more tax efficient for many shareholders.

Why Don’t More Investors Choose Their Own Dividend?

So why don’t more investors choose their own dividend?  It’s probably a combination of psychology, inertia, and not knowing such an option is available.

Psychology
It’s hard to see the share count shrink. Even in the case of a modest 2.5% ‘manufactured dividend’ for Berkshire an investor would have seen their share count shrink meaningfully over time. For many this is hard to stomach. Another pitfall is the fact that (most) people aren’t machines. MMost people would have a hard time following a sell-down program without trying to time the market in some way (‘Should I hold off selling in a down market or try to wait to sell higher?’).

But, just as the share price is irrelevant on its own – you need the number of shares outstanding to determine the market capitalization – share count in a portfolio is meaningless in isolation. What matters is the dollar value of the investment, which could go down, remain the same, or increase, all while the share count is in a continual state of decline.

Inertia
The board-chosen dividend policy is probably what most investors follow as a default. This can be hard to overcome, especially if one doesn’t know there’s another option.

Ignorance
This is not questioning investors’ intelligence. Rather, I would venture to guess that most simply don’t know a dividend-on-demand strategy is an option. Yes, many investors sell part of their equity portfolios as part of a re-balancing strategy, or as they shift from stocks to bonds heading into retirement. This type of selling, however, is based on an allocation strategy and (I’d guess) not tied to monetizing the underlying earnings of their investments.

Add these up and you get what Charlie Munger calls a “lollapalooza” – a confluence of factors all working in the same direction. That is, against selling off shares to augment board-declared dividends. What is interesting, though certainly not surprising, is that investors regularly do the opposite.

DRIPs Are The Reverse Of ManufacturingDividends

Investors regularly choose to turn a dividend yielding stock into one that pays nothing. How?

Through common DRIP, or dividend reinvestment plans. By taking their dividends and using that money to purchase shares, these investors are in effect saying they’d prefer the company retain the earnings for future growth. Yet since they cannot do this, they must instead purchase shares from other owners (or newly issued shares from the company). Unfortunately, since a dividend was paid (and immediately reinvested), a portion of the dividend goes to taxes in non tax-advantaged accounts.  The company pays a dividend, the investor’s share count goes up, but he/she outlays some cash to Uncle Sam for the tax bill.

In terms of implementing this strategy it would be wise to remember taxes and opportunity cost. In another article, I explained the awesome power of deferred taxes. Selling shares to create a dividend goes against this strategy, though that is not to say it isn’t sometimes the best course.

Opportunity cost is another major consideration. What will the funds be used for? If they are being ‘recycled’ into the portfolio, is that new opportunity better than the existing investment? Would it be better not to pay taxes on any gains and instead leave your share of earnings in the company to be redeployed by its managers?

Warren Buffett’s Gradual Philanthropic Share Selling

Far from simply opining on theory, Buffett, by structuring his annual philanthropic donations as a percentage of his current shares, has demonstrated this sell-off approach works. From the same 2012 Chairman’s Letter:

For the last seven years, I have annually given away about 4.25% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares. Clearly my ownership percentage of the company has significantly decreased. Yet my investment in the business has actually increased: The book value of my current interest in Berkshire considerably exceeds the book value attributable to my holdings of seven years ago. (The actual figures are $28.2 billion for 2005 and $40.2 billion for 2012.) In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased. It’s also true that my share of both Berkshire’s intrinsic business value and the company’s normal earning power is far greater than it was in 2005.

Update: As of the beginning of 2021 when Berkshire filed its proxy statement, Buffett’s B-equivalent share count had declined to 373,111,188 – representing a book value of $71.8 billion and with a market value of $92.8 billion. The share count of Buffett’s Berkshire ownership stake declined by 48%, yet the value of his stake – despite selling hundreds of millions of shares – rose by over 120%.

Final Thoughts

All of this leads to an unsurprising conclusion: An investor should treat public companies just like private businesses. If a larger dividend is desired from any stock in a portfolio, selling shares to “manufacture” a dividend is possible. This also opens up non-dividend-paying companies to the dividend investor.

It is the mindset that an investor has a claim on the underlying earnings of a business, and therefore should only expect to receive as much in cash, over time, which is powerful. It focuses not only the selection of which companies to purchase, but expectations as well. Owners of private businesses only expect to earn what the underlying enterprise earns; why should owners of public companies expect any different? As Charlie Munger would say, “How could it be otherwise?”.

For more from Adam Mead, see his book The Complete Financial History of Berkshire Hathaway: A Chronological Financial Analysis of Warren Buffett and Charlie Munger’s Conglomerate Masterpiece

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