Time for Warren Buffett to Heed Benjamin Graham

Every value investor is familiar with the name Benjamin Graham. Every investor is familiar with the name Warren Buffett. The two, you may or may not know, are interconnected: Graham was Buffett’s first mentor and set the foundation on which a multi-billion-dollar fortune was constructed.
Buffett was mentored by Graham, but he is no clone of Graham. Buffett long ago deviated from Graham’s clinical value approach to investing, where the numbers – P/E multiple, current ratio, debt-to-equity ratio, dividend yield – told the story.
Buffett has evolved over the decades into something of an amalgam of Graham and Philip Fisher, whose book “Common Stocks and Uncommon Profits” emphasized a more qualitative approach. Fisher liked value, to be sure, but it must come tethered to a strong management team and a sustainable growth model.
You can detect Fisher’s influence on Buffett in this popular Buffett quote: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Graham might object. Graham would frequently opt for the fair company at a wonderful price.
I’ve long argued that Buffett should revisit his Grahamsian roots, particularly in regards to one number – a per-share dividend payout. Benjamin Graham was a big fan of dividends. Berkshire Hathaway (NYSE: BRK-B) should be paying one.
When I argue for a Berkshire dividend, I’m frequently rebuked with some iteration of the following sentiment: “I’d rather have Buffett reinvest Berkshire earnings than receive a dividend. Buffett is the world’s greatest investor.” Fair enough, but upon closer observation, you find the rebuke is anchored in soft ground.
Berkshire return numbers hardly stand out. For the past five years, return on equity has averaged roughly 9%, return on assets has averaged 4%, and return on invested capital has averaged 9%. The same returns on Apple (NASDAQ: AAPL) are 40%, 20% and 48%, respectively. And Apple pays a dividend.
Berkshire’s low return on invested capital is the reason Buffett should revisit Graham. Graham reasoned that a dividend was important, because a dividend removes excess capital from the books, thus preventing empire building and ensuring capital is allocated to the highest-return investments. I look at Berkshire today and I see empire building and capital being allocated to lower-return investments.
Yes, we’re all familiar with Buffett’s long and storied investment history. No point in belaboring the obvious. Investments of late, though, are somewhat less storied: Kinder Morgan (NYSE: KMI), Phillips 66 (NYSE: PSX), International Business Machines (NYSE: IBM), General Motors (NYSE: GM), Deere & Co. (NYSE: DE). These are names you’ll find copiously represented at Vanguard, T. Rowe Price (NASDAQ: TROW), American Century, Janus, and every other mutual fund with a billion dollars to put to work.
As for the “forever holding period” meme, it’s never been true. It certainly wasn’t true for Berkshire last year: Positions in National Oilwell Varco (NYSE: NOV), Cable One (NYSE: CABO), Viacom (NYSE: VIAB), Chicago Bridge & Iron (NYSE: CBI) and DirecTV were all closed in 2015. Many other holdings were reduced. If you think back to 2014, Exxon Mobil (NYSE: XOM) was sold within a year after it was bought. Exxon Mobil was a $3.6 billion initial investment.
Buffett simply has too much money to play with, because Berkshire has too much money on its books. Even after spending $32.7 billion to buy Precision Castparts, a maker of specialty metal components, Berkshire still has $64 billion in cash and cash equivalents.
Buffett has said that he would be willing to return cash to shareholders by purchasing Berkshire shares for up 1.2 times book value. The book value on the Class B shares is $104. This means that Buffett would be willing to buy the shares at $125 each. That’s unlikely to happen. The B shares trade at $137 each.
The S&P 500 is up 54% over the past 10 years; Berkshire shares are up 134%. Over the past five years, the S&P is up 50%; Berkshire is up 60%. Over the past year, the S&P is down 6%; Berkshire is down 6.5%. The gap has certainly narrowed over time. This tells me that it’s time to remove excess capital off Berkshire’s books and deliver it to the shareholders as dividends. Ben Graham would be pleased, and so would I.

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