February 27, 2015

The Contracts Are Being Drawn Up for the Buyout and the Ghost of Dividend Stocks Past Keep Showing Up

As we approach the home stretch of negotiations, I spent yesterday selling off some of our Berkshire Hathaway hoard, which I still think is significantly undervalued for long-term owners even though we generated some very nice taxable capital gains on the portion we liquidated, to come up with the cash necessary to buy out all of the shareholders of one of my retail companies.  

The plan is to merge the business under Kennon Green Enterprises as a wholly owned subsidiary, though I may hold off on that until next fiscal year.  The deal looks like it will be structured so that the departing shareholders will receive a distribution of property, privately issued bonds, and a significant up-front cash check that is, in my opinion, more than fair.

I’m also thinking of doing several more case studies of dividend paying companies over the past 25 to 50 years like the one I just published of The Clorox Company.  I had the idea when going through the checks that came into one of the limited liability companies I own.  I love dividends.  I really do.  Capital gains are great, but collecting cash from a decision you made years ago, and watching it grow so that it is at least a 10% or 20% yield-on-cost is emotionally satisfying.  

Come to think of it, it is somewhat ironic that growing up, it was Berkshire Hathaway I collected (though, back then, the Class B shares were not split yet and traded at $1,800 each.)  If Warren Buffett ever does pay a dividend, or upon his death if the Board of Directors decides the best way to protect capital is to distribute it so there is less to allocate, my dividend income will skyrocket.  It is still, by far, my biggest holding in terms of public securities.

Calculating Dividend Checks

The ghost of my early startup days still show up from quarter to quarter …

Anyway, these are a relic of my younger, less experienced days.  One of the first things I did when I started my first company back in my early twenties was use the profit to buy 1 share of stock in 100+ businesses, have them framed, and keep them on the wall.  Then, I had the company enroll in the direct stock purchase plans of a dozen or so of the firms, with dividends plowed back to buy more shares and regular contributions withdrawn, like bills, from the company checking account.  The stocks I chose were McDonald’s, PepsiCo, General Electric, Johnson & Johnson, and a few others of comparable quality.  

We amassed a good deal of surplus capital doing that, and never thought about it because the money was treated as if we were paying a bill to a vendor.  I don’t remember exactly, but I am almost certain that I had $250 per stock, per month withdrawn, or $3,000 per year into each company for a total of $36,000 annually.  I thought of it as hiring an employee that never showed up for work but who went out in the world and made money for me.  On the books,  it was referred to as the “Blue Chip Reserve Portfolio”, while the rest of the profits went into an account I managed actively to either expand the company, buy public stocks, or pay dividends to the members.

It became unwieldy from a management perspective.  Like I said, I was young and excited.  It took several years, but I came to my senses.  Now, we have corporate brokerage relationships, stocks are only bought in round lots, dividends are paid and pooled in a cash account, and then reinvested whenever I decide to buy more shares of something. It keeps it so much cleaner.  The stocks we bought were transferred in and sold down or bought up to reach round lots, but I still get around $20 to $100 in checks from various companies every quarter for the firms I haven’t yet shut down.  

They have come in handy, helping teach the youngest members of my family about ownership and how you can get money sent to you in the mail if you own a productive asset.  I really need to get on this and at least have them direct deposited because I do not want to have to un-frame all of those stock certificates and deal with the paperwork.

My grandma told me I should give her the checks because they are a nuisance to me.  She wouldn’t mind tallying them up and depositing them in the bank.  It might mean a few more QVC or an extra trip to the casino.  Maybe I will.  They just sit on my desk until I do something with them, sometimes for months.

That’s it.  Just work today.  It is beautiful around here.  Everything is starting to burst into oranges and reds.

The Leaves Are Starting to Change Autumn 2012

The leaves on the trees have started changing …

I think I’ll go get pancakes for breakfast / lunch (at 2 p.m., mind you) from iHop or something.  That sounds good.  I have a case study of The Walt Disney Company almost finished.  I am running into trouble finding their historical dividend records back to 1957.

  • http://www.facebook.com/jason.s.snodgrass Jason Scott Snodgrass

    Thanks for providing insight into your initial drip investing approach. I may be thinking too much between the lines, but when you mentioned you treated the portfolio as an “invisible employee” and captured it on the books as the “Blue Chip Reserve Portfolio”…were you able to expense the $36,000 annually as a business expense (the money was treated as if we were paying a bill to a vendor)? I am just getting to where I can start investing this much or more annually, but I’m doing it from individual savings and wondering if I could form a holding company now (while accumulating) and expense the investments or something…or convert my individual portfolio’s into a holding company once I’ve built up some compoundable wealth ($500k – $1M). I look forward to your response and I always enjoy reading your real life experiences and approach on investing.

    • Joshua Kennon

      No, you couldn’t do that. I wish you could! It was just the way I thought about the money going out of the check register. It’s amazing how you will adjust if you think of something as a non-negotiable cost. The shares were treated for tax purposes just like any other stock you bought; capital gains or losses were taxed either short-term or long-term and dividend distributions were taxed on a qualified or non-qualified basis.

      Economically speaking, there is a type of investment that, in the right circumstances, can kind of work like that. If you were to buy a master limited partnership (never buy them through a tax-advantaged account or you will get hit with the UBTI filings, but that is its own post), the dividend distributions can often be sheltered from taxes and, instead, the cost basis written down over time. It’s really complex and far too much to get into here, but I’ll try and write about it some day. You’ll end up paying more when you liquidate the limited partnership interests but for someone who held on for 25+ years, it can work out much better that way.

  • Anon

    I would just switch them all to direct deposit, if there is a way.

    • Joshua Kennon

      That’s what I’ll end up doing.

  • FratMan

    Hey Joshua, is Philip Morris still in the KRIP? If not, did you sell it for moral reasons or because of a perceived deterioration in its long-term viability?

    • Joshua Kennon

      No and neither. Eight months after I acquired it, it had generated an 18% capital gain and 3.3% dividend return on cost for a combined 21.3%. It happened to (fortunately) all be in a tax-sheltered account. In July of 2011, Berkshire Hathaway hit the lowest valuation I had ever seen in my lifetime, and I began buying heavily. Fresh cash wasn’t enough to satisfy the additional stock I wanted to purchase so I sold off some positions that were at or above intrinsic value, Philip Morris International being among them. The proceeds were rolled over into additional shares of Berkshire Hathaway Class B for maximum liquidity at a few pennies above $76 per share.

      Those are now up to around $90 per share, or 18.4% over cost, in a little over a year. I hope they stay cheap. I’d like to buy a lot more.

      So, all of the Philip Morris stock is now in Berkshire Hathaway.

      My thoughts on Philip Morris International of late are … conflicted. Partly on valuation relative to some of its European peers, and partly on the morality. I know people are going to do what they are going to do but all of the other businesses I own help people. There is nothing redeeming about tobacco. But, I’ve made a lot of money on it over the years. I’m not sure how I feel about it.

      • Gilvus

        “There’s nothing redeeming about tobacco.” I disagree here. It’s hard to claim that tobacco “helps” people with a straight face, but what about alcohol, marijuana, and fast food? People smoke for the same reasons they drink, hit the bong, or order a triple-bypass bacon lardburger: to relax, socialize, and enjoy themselves. I don’t indulge in any of the above, but I can understand why people do: they’d rather live shorter lives and be happier during that time. While I’m ಠ_ಠ toward second-hand smoke and increased healthcare costs due to COPD, emphysema, and lung cancer, I’m more terrified of drunk drivers and the healthcare costs associated with obesity. As for marijuana…if it were ever legalized I can see Papa John’s stock skyrocketing. Plus you could levy sin taxes on weed sales!

        TL;DR: Saying that tobacco doesn’t help anyone is like saying the companies/dealers that sell alcohol, marijuana, or fast food don’t provide value to people.

        • Joshua Kennon

          Other than the first time someone picks up a cigarette, people don’t smoke because they want to smoke, they smoke because the nicotine overwhelms the brains chemistry and creates insatiable cravings that are nearly impossible for most people to deny without incredible discomfort.

          I’ve collected a good size stream of cash from tobacco dividends in my lifetime but I don’t pretend to believe I’m doing God’s work. Firms like Johnson & Johnson, Clorox, Apple, and Compass Mineral do far more good for humanity, making a profit and improving standards of living and safety.

        • Gilvus

          I have a history with non-chemical addiction that I’d rather not talk about publicly, but it’s made me interpret the word “addiction” very liberally. Basically anything that stimulates the pleasure center of the brain is addictive. And like so many things in life, the level of addictiveness varies from person to person and falls on a spectrum without discrete units. So things like gambling, TV series, and video gaming are addictive in my book, but are on the opposite end of the spectrum from ultra-hard drugs like speedball.

          My argument is that everything has value. If they didn’t, there wouldn’t be a market for them. Even scheduled drugs have value, but they are (rightfully) illegal because they do far more harm than good. On the other end, activities with minor addictiveness also provide value, but are (rightfully) legal because on average, they don’t harm as much as the joy and utility they provide. That’s why I don’t have a problem with gambling, video games, and fast food, even though they’ve occasionally ruined lives and fortunes, and (in extreme cases) people have died because of all of them.

          For things in the middle of the spectrum, alcohol is about as damaging as tobacco. Herein lies my argument: tobacco DOES provide joy (euphoria) and utility (nicotine is a stimulant and bolsters mental dexterity), albeit with increased deleterious consequences.

          TL;DR I strongly disagree with your assertion that tobacco has no redeeming qualities, because it provides joy and utility (at least in the short term) to its users. However, I fully acknowledge that unlike respectable companies, there’s a far greater cost in tobacco use, both to personal health and society drain.

          If you’d like to know more details of my past experiences have colored my insights, we can discuss that through email. It’s a very interesting topic, because investing can stimulate the pleasure center as well, so it falls under the “addictive” category.

        • Joshua Kennon

          Stated that way, I don’t disagree with you. I’m not talking about economic utility, I’m talking about societal good. They are not the same thing in all cases, though they do often overlap.

          To be clear, it would be accurate to summarize my position that all else being equal, I feel better about $1 made selling someone bleach that will help prevent disease or heart pills that will keep them alive longer than I do a box of rolled tobacco leaves that they are going to smoke, especially if those tobacco leaves are in the form of cigarettes (a non-rational double standard, I know).

          I will still own the tobacco stocks. I could see myself, under the right circumstances, owning (not running) an expensive cigar shop. I have no problem with an adult walking into a store and buying a pack cigarettes if they are aware of the risks and choose to spend their money on the product. I love the scent of tobacco leaves in Creed’s Tabarome fragrance. The scent of burning cigars is one of my favorite things in the world, probably because of my grandfather. But I will never feel – which is an emotional response based on personal values – as good about it as I would selling people heating oil for their homes or safe, nutritious baby formula for their newborns.

          Case in point: When I owned Philip Morris stock, a small part of me winced inside whenever I saw someone buying the product at the register. Sure, they may enjoy it. I may be giving them utility. But, in the long-run, I’m harming them. Yes, we are both free agents. Yes, it is legal. Yes, they are deriving enjoyment out of the product. But that doesn’t satisfy my conscience. In contrast, a few hours ago, when my grandmother stopped by to watch The Best Exotic Marigold Hotel, I literally “whooped” outloud in a scene where the General Electric logo was plastered on a pillar in the middle of a street in India, knowing I was collecting dividends off the products and services provided there.

        • Gilvus

          I see it completely differently; I’m happy for people who can find solace in a Marlboro, because they may lack the discipline, foresight, or fortitude to draw happiness from other sources. Likewise, I don’t feel bad for people who diligently keep up with the Joneses; I’m happy for them because their lives may not have much purpose or meaning beyond that, and temporarily filling that hole in their lives with material possessions makes them temporarily happy.

          Yes, tobacco companies are selling slow poisons to their customers. But their customers may prefer the slow poison over rejection from a social group (peer pressure is a big reason why people start smoking).

        • Gilvus

          Also, I should add that I’m happy for them on a good day. On a grumpy day, I’m annoyed that their decisions lead to increased taxes for healthcare, social security and other forms of welfare. But my point is, it would never stir my conscience to own shares of a tobacco company.

  • FratMan

    Joshua, obviously this question relates to Buffett’s mortality which is not something I really wanted to discuss, but–if you had to guess, when do you think Berkshire will pay a dividend?

    • Joshua Kennon

      I think he’s a builder and there is a lot of room left to go so the bigger trigger is likely mortality. If you compare Berkshire Hathaway to ExxonMobil, the former has after-tax profits of $10.25 billion, whereas the latter has after-tax profits of $41.06 billion. If ExxonMobil wanted to, it could buy Berkshire Hathaway for cash and then rebuild its war chest using the combined after-tax company profits in barely 4 years.

      That means there is a lot of room for Berkshire left to expand, despite its size. The test that has always been laid out is the creation of $1 in intrinsic value for every $1 retained. If the world doesn’t fall apart, it wouldn’t be unreasonable to see a 10-year period of 12% compounded internal growth, resulting in shareholder equity of $500 to $600 billion producing $35 billion to $40 billion in annual profits. That would put it, in a decade, at the same size Apple, Inc. is today. It is clear that the #1 agenda at Berkshire Hathaway is the conversion of an investment company into an operating company, which has been underway for more than a decade.

      However, if Warren dies, one way to very quickly solve the capital allocation risk is to put in place a dividend policy that sends 25% or 50% of earnings out to stockholders in cash. The announcement of a dividend corresponding with his demise would also likely ease fears of some long-term holders who wouldn’t want to sell if checks were just around the corner. With a decent size payout, the dividend would be 2% to 3% of current market value.

      The dividend timed with his death would also create a safety floor for the stockholders at a time when the Bill & Melinda Gates Foundation was receiving massive blocks of Berkshire Hathaway stock from Warren’s estate, which they are required to sell on the market very quickly, which could otherwise depress the price.

      Of course, there is always the oft-overlooked alternative: The Gates Foundation could swing a deal with Berkshire Hathaway for a privately placed, massive share buyback that would reduce the share count by 1/3rd. At today’s valuation, I would gladly support that proposal.

      TL;DR: No clue. It depends entirely on what Buffett feels like doing, both in life and in death. The rest of us owners are along for the ride. As long as Berkshire can retain earnings profitably, I’m happy to have it do it. When it can’t, I want the cash dividend, which will then go into my hands to redeploy as it is mixed with cash streams from other investments. I don’t know when it will be, but someday, at some point in the future – could be twelve months, could be twelve years – I imagine that dividend income from my personal and business portfolios will suddenly get a massive influx as Berkshire Hathaway starts mailing out checks.

      I also imagine the day is coming, 30 years hence, when the entire company is broken up or at least involves a few spin-offs. It won’t happen until long after the current board of directors is gone.