This past weekend I had the pleasure of attending the annual shareholder meeting of Berkshire Hathaway. Seeing Warren Buffett and Charlie Munger dish investing wisdom in person was on my bucket list. They didn’t disappoint.
The flight to Omaha gave me an opportunity to read Berkshire’s annual report, including Buffett’s famous letter to shareholders. I highly recommend the letter to any investor, regardless of whether you own Berkshire stock. Buffett’s discussion of dividends (pages 19 to 21) was especially interesting. In three pages Buffett gives investors everything they need to know about dividends. He begins his discussion with a question that has puzzled many: “A number of Berkshire shareholders – including some of my good friends – would like Berkshire to pay a cash dividend. It puzzles them that we relish the dividends we receive from most of the stocks that Berkshire owns, but pay out nothing ourselves.”
It’s a fair question, and one that Buffett handles deftly. Through the use of a hypothetical company, he demonstrates that investors are better off if a company keeps all of its earnings rather than pay dividends, so long as it can and will put those earnings to good and profitable use. Buffett compares two hypothetical companies, one that retains all its earnings and one that pays a dividend. Spoiler Alert: the hypothetical company that retained its earnings proved a better option for investors than the one paying dividends.
While I’ll spare you the details of Buffett’s calculations, the conclusion he draws is important for those nearing or in retirement. As a retiree with equity investments, you can generate income in one of two ways. First, you can invest in stocks that pay dividends. Second, you can sell shares of the companies you own. And, of course, a retiree could generate income from a combination of the two.
At first glance, dividends seem like an attractive way to generate income. You’ll receive quarterly dividend checks to fund retirement without having to sell any of your shares. There are, however, several advantages to selling shares rather than relying on dividends.
First, with dividends, company management decides how much you’ll receive each quarter. The dividend payments may prove to be more than you need or not enough. If you rely on selling shares, you determine how many shares to sell based on your cash needs.
Second, taxes generally favor stock sales over dividends. The long-term capital gains tax on the sale of stock held for more than one year is typically less than the ordinary income tax paid on dividends. Further, 100 percent of dividend payments are typically taxable. With the sale of stock, only the portion of the sale representing a gain is subject to capital gains tax.
Finally, shares typically sell for a premium over a company’s book value. In Buffett’s example, he assumes that a company’s stock trades at 125 percent of net worth, a very conservative assumption in today’s market. That means that for every $1 of retained earnings per share, a stockholder could net $1.25 per share on a sale.
I’m not suggesting you should avoid investing in dividend paying stocks, whether for retirement or otherwise. I invest in many, including Apple, Ford, Verizon and Pepsi. (Sorry Warren, Pepsi tastes better than Coke.) The point is to invest in great companies. Many great companies pay dividends, but as a retiree, those quarterly checks may be less desirable than popular opinion would have us believe.