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By Jeremy Glaser and Josh Peters, CFA | 03-19-2013 02:00 PM

Companies Can't Be Like Berkshire When It Comes to Dividends

Buffett has the discipline to guide capital back into his firm rather than use it for dividend payouts, but most companies are better off distributing excess cash to shareholders, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. In Warren Buffett’s annual letter to shareholders, he explained why Berkshire doesn't pay a dividend and why he doesn't expect it to pay dividend anytime soon. But is this advice good for other companies, as well? I'm here with Josh Peters. He is the editor of Morningstar DividendInvestor. He is also the director of equity-income strategies at Morningstar.

Josh, thanks for joining me.

Josh Peters: Good to be here.

Glaser: So, what was Buffett's case for not paying a dividend?

Peters: Well, he talked about dividends in the framework of capital allocation for Berkshire as a whole, which is definitely the right way to characterize it. And he talked about having four basic sets of opportunities to deploy the company's earnings and cash flow. The first is internal reinvestment opportunities, the opportunities to add on to, say, MidAmerican Energy assets, or the rail lines and railcars at Burlington Northern, or open more shops for See's Candies, all the classic, sort of, Buffett names. Those tend to be very high-return opportunities because they are inside those companies existing circles of competence and competitive advantages. You might get very high returns on tangible capital, certainly double digits or maybe even better. The problem is that you can only shove so much money into that area. There is really finite amounts of growth there.

So, the second in his capital-allocation priority list is acquisitions. Now, it's the number two priority for lots of other companies, too, but you got to remember, this is Warren Buffett we're talking about here. He doesn't buy companies because he's looking to build an empire or consolidate an industry. He is looking at it from the standpoint of an investor. He is only going to pay what a company is worth or less than what he thinks a company can be worth to Berkshire in the long run, whereas a lot of other companies, when they make acquisitions, most of them destroy shareholder value in the process. I would rather prefer companies put dividends ahead of acquisitions.

The same thing with share buybacks; Buffett lists that third. And again, he is very, very disciplined; he is only going to pay up to 1.2 times book value. If the stock trades above that, he says he is not going to buy back shares. Most companies, they buy back shares when they have lots of cash. When do they have lots of cash? When times are good. What happens when times are good? The stock price is high, and then the stock price comes back down because earnings dry up and the share buybacks shut off. You can just kind of trace the trend of share buybacks in the market against stock prices. They are high when prices are high, and then they fall off a cliff when stock prices fall off a cliff.

Again, Buffett has got the discipline, I think, to do well with a share-repurchase plan. Other companies just don't really have that track record. Then, in this process, Buffett still feels like he can deploy all of the company's earnings into internal reinvestment, acquisitions, or buybacks, and he doesn't need to pay a dividend. Most companies, I think they need to put that dividend ahead of acquisitions and share repurchases.

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