The power of retained earnings

Berkshire 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.

This article originally appeared in the 19 March edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.