Lately, I have been studying Markel Group’s annual reports.
In brief, Markel Group has its roots as a specialty insurance firm and has over time, matured and expanded into a holding company comprising controlled businesses and investments. As I write now, Markel Group has earned its reputation as a mini-Berkshire as its business model is treated and viewed to be a mini-version of Berkshire Hathaway, Inc.
Of which, in equity investments, Thomas Gayner, its CEO, reiterated the four major principles in acquiring shares of public listed companies and private businesses. They include:
1. Good return on capital and low debt;
2. Management teams with equal parts talent and integrity;
3. Reinvestment opportunities to grow and / or capital discipline;
4. All while paying a reasonable price.
My Epiphany Moment
As an investor, I understood Tom’s Point 1, Point 2 and Point 4.
I practiced and perfected the art of these points as I manage my dividend portfolio.
I documented my journey as a dividend investor in my book – Dividend Vault.
But, Point 3 did not fully register in my mind.
Because of this, I invest in stocks that are profitable and cash flow generative. But, growth from these stocks was slow (but steady). This is because these stocks pay out a larger percentage of operating cash flows generated to shareholders (like myself) in the form of dividends.
So, I am doing okay.
But, there is room for improvement.
The Priority of Utilising Cash Inflows
Then, combining with Buffett’s letter in 2012, I began to understand capital allocation strategies and how they impact returns to shareholders.
Sure, stocks that can generate increasing operating cash flows win the first half the battle.
But, the next question is the one that separates the great from the good.
That is – “What does the company do with its increasing operating cash flows?”.
Can it create and generate greater future value than when it receives the cash?
In other words, for each $1 in cash inflows, can it reinvest it to earn more than $1 in the future?
If the company can do so, it is best to not pay out dividends. Hence, ideally speaking, dividends should only be paid out only if the company runs out of ideas as to how best to utilise its cash.
So, reinvestment opportunities take priority over dividend payments.
See’s Candies
In 1972, Berkshire Hathaway acquired See’s Candies for US$25 million.
Now imagine this.
What if the above transaction did not happen?
What if See’s Candies is a listed company, focusing on selling confectionaries in the west of the United States?
Sure, it has a good brand. Definitely, it could reinvest profits to grow its candy stores until it has become a leader in confectionaries in the West. But somehow, it fails to expand to the East and thus, market growth is limited.
So, what can See’s Candies do with its profits and cash flows in this situation?
Well, since it has no reinvestment opportunity back into its business, it can invest in businesses, either related to its trade or unrelated at all.
But, what if the board of See’s Candies has no expertise in doing so?
Also, what if there are no real acquisition opportunities in that period of time?
Well, that leads us to the next option, which is share buybacks.
See’s Candies can use the cash flow to buy back its owns shares in the open market.
Again, this is only beneficial if its shares are undervalued. Then, the question is: “Does the board have a director who is experienced in equity investments?”
So, if the board of See’s Candies is one that is focused on running candy stores in a market that is established (with a cap in market growth), then, See’s Candies would be paying out dividends to its shareholders.
Berkshire Hathaway
As the owner of See’s Candies, what Berkshire Hathaway had done is to first have the cash flow from See’s Candies back to Berkshire Hathaway.
Then, with these cash inflows, Buffett and his team can reinvest them into acquiring businesses and thus, diversifying and growing Berkshire Hathaway’s sources of income. Fast forward, it has built a conglomerate that has a collection of businesses, which include Marmon, Richline, Johns Manville, Jazwares, Duracell, Shaw Industries, Brooks Sports, Fruit of the Loom, Lubrizol, IMC, H H Brown Shoe Group, IMC, W&W|AFCO Steel, Clayton Homes and so much more.
If a company has developed expertise, experience and track record for reinvesting earnings and cash flow for greater earnings and cash flow in the future, why pay dividends?
ROE & How Multi-Baggers are Achieved
Simply put, let’s assume that we have two stocks: Stock A and Stock B.
Both of them can deliver a return on equity (ROE) of 15% per annum.
In other words, for every $100 in shareholders’ equity, it can generate $15 in earnings.
Both of them are starting with $100 million in shareholders’ equity and 1 million shares in issue.
Both wish to maintain its number of shares in issue perpetually at 1 million.
Also typically, their shares are valued, on average, at P/E Ratio of 20.
But, there is one critical difference between them.
Stock A pays out 100% of its earnings in dividends, leaving nothing for reinvestment.
Stock B retains all earnings and reinvests them at a ROE of 15% per annum.
So, what would happen to their stock prices in 20 years?
Stock A
For Stock A, its stock price would remain at $300 a share after 20 years.
Typically, long-term shareholders would earn 5% yield on cost from holding onto Stock A.
Stock B
For Stock B, its stock price would rise from $300 in Year 1 to $4,270 in Year 20.
That is a 14-bagger, which is the result of attaining a CAGR of 15% in stock returns, which is the product of consistently reinvesting profits at a rate of 15% per annum (ROE) for 20 years.
Conclusion:
So, am I looking to swap dividends for growth?
Personally, I’m considering that path, but not entirely.
I may still keep some “See’s Candies” and “national champions” for dividends.
But as part of my goal to improve myself as an investor, I would challenge myself to develop my skill set in growth investing. I would like to get comfortable with earning little or no dividends at all from my subsequent stock investments as these companies reinvest them to create a higher value for the future.
At the end, it is about portfolio management and continuous learning in the art of investing.
Let’s see how it goes.
Podcast Link:
Reinvestment Opportunities: The Fuel towards Achieving Multi-Baggers
