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@finweek finweek finweekmagazine finweek^ 19 March 2020^17COMPANIES
The power of retained earnings
b
erkshire Hathaway’s annual
letter from Warren Buffett is
available online and worth a
read for its many gems.
The first one for me was a mention
of a book I’d never heard of: Common
Stocks as Long Term Investments by
Edgar Lawrence Smith. It was published
in 1924 and is still available.
For Buffett the key thesis is the power
of retained earnings. A company makes
a profit and the board gets to decide
what to do with that profit. Most often
a portion is paid to shareholders as a
dividend. Depending on several factors,
the dividend could be a small portion of
the profit or a significant portion thereof.
The portion which is kept back by the
company is then ‘retained earnings’.
These are used to continue growing the
company and it is the power of these
retained earnings that Smith discovered.
Retained earnings not only help
to grow the business, but they’re also
compounded over time, thus becoming
even more ‘earnings enhancing’. This
compounding effect could be used to
make an argument for smaller dividend
payouts, assuming management doesn’t
bungle the compounding.
But, personally, I think the board
needs to find the balance between
retained earnings and dividends to
shareholders. That said, a company such
as Berkshire Hathaway has never paid a
dividend, with Buffett saying if you want
income from an investment then you
should sell some of your holding. He’s not
wrong, but I like the cash flow and, as I
have mentioned before, management
can destroy value, resulting in no future
retained earnings or dividends. So, give
me some of that profit now.
However, an important argument is
that those retained earnings continue
to work for shareholders, growing the
company from within.
Buffett also writes about how, when
buying shares in companies, some of
them simply don’t live up to expectations.
This is partly remedied, according to him,by the fact that over time the successful
companies will grow, and the disappointing
ones will stagnate (or shrink), thus
reducing their overall importance.
He’s not wrong, but I’d hate to
continue holding a share in a company
that I no longer have trust in (whether it’s
management or the growth potential).
Thus, I am happy to exit those stagnating
stocks and, because I only hold listed
assets, selling them is easy.
Buffett likes to buy entire companies
and, as such, exiting is harder. But I still
ideally want an entire portfolio of winners,
even if in the short to medium term
they may not be winning. The long-term
potential is what I really monitor.
Another big takeaway in Buffett’s
letter looks at corporate deals and
directors’ desire for deals. He notes that
boards seldom, if ever, have a detractor
director to the deal to present an
opposite view to the board. Buffett drily
writes, “don’t ask the barber whether you
need a haircut”.
This ties into the use of retained
earnings, which I mentioned earlier
in this column. A board manages the
shareholders’ company and really needs
to do so with the best interests of the
company front of mind. But a powerful
CEO will often put a dazzling proposal
on the table and the bright lights will
convince the board. Therefore, proper
independent directors are so very
important and that is also why they need
to have term limits of a decade at most.
Lastly, the Berkshire Hathaway
annual general meeting will take place on
2 May and will be webcast via Yahoo; it’s
well worth spending the couple of hours
it runs to watch and learn.
This year Ajit Jain and Greg Abel, “two
key operating managers” at Berkshire
Hathaway, will also be answering
questions, indicating the continued
slow shift away from Buffett, chairman
of the company, and Charlie Munger,
vice chairman, as their combined age is
approaching 200. ■
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In his annual letter to shareholders, Warren Buffett mentions how undistributed profits can boost a company in the
long term. Simon Brown engages with this notion.By Simon BrownWarren Buffett
Chairman and CEO of
Berkshire HathawayAn important argument
is that those retained
earnings continue to work
for shareholders, growing
the company from within.