The Power of Retained Earnings

Article #632 by Edward Rizzo - Published Weekly

While most active investors and financial analysts were undoubtedly glued to their screens last week as global equity markets sank due to the economic impact from the coronavirus, another important event took place – the publication of the annual letter by Warren Buffett to shareholders of Berkshire Hathaway Inc.

This is widely followed by many investors worldwide since it is considered as one of the best reviews on the US stockmarket and the global economy. In the letter published on 22 February, Warren Buffett dedicated a section to the importance of retained earnings within a company. I thought this would be an important topic to highlight due to the philosophy of many Maltese investors.

In the letter, Warren Buffett quoted a review by John Maynard Keynes of an influential book written in 1924 by author Edgar Lawrence Smith ‘Common Stocks as Long Term Investments’, which promoted the idea almost a century ago that shares outperform bonds in the long-term. John Maynard Keynes was a renowned British economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments.

In this review John Maynard Keynes stated that “Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back into the business. Thus, there is an element of compound interest operating in favour of a sound industrial investment. Over a period of years, the real value of the property of a sound industrial is increasing at compound interest, quite apart from the dividends paid out to the shareholders.”

Warren Buffett has long been a promoter of the significance of compound interest and stated in the recent letter that he always focused “on using retained earnings advantageously”. In fact, Berkshire Hathaway does not pay any dividends to shareholders and uses all accumulated profit to continue to invest in their current business and seek to acquire businesses in their entirety or minority shareholdings in others based on three criteria – (i) they must earn good returns on the net tangible capital required in their operation; (ii) they must be run by able and honest managers; (iii) they must be available at a sensible price.

The lack of dividend distributions by Berkshire Hathaway and the concept of the importance of retained earnings may be surprising to many Maltese investors who are obsessed about viewing companies positively mainly based on their dividend distribution and the resultant yield.

While dividends may be an important source of income for several investors, the concept of equity investing goes beyond the annual income that may be distributed to shareholders.

In fact, on an annual basis, I publish the ‘return on equity’ league table ranking those companies listed on the MSE which generate the highest return on equity. Effectively, this shows a company’s ability in generating added wealth for shareholders on the original share capital invested as well as the retained earnings accumulated over the years.

BMIT Technologies plc, Malta International Airport plc and PG plc were highlighted in my article last year as being those generating the highest returns on equity as these all exceeded 20% per annum. Several other companies also manage to generate double-digit returns on equity which is a positive signal for the investing public.

As the reporting season for companies listed on the Malta Stock Exchange continues in the coming days, the ability of a company to generate strong returns is an important aspect for investors to keep in mind when judging decisions by a company’s board of directors on the extent of any dividend distributions and the amount retained in the company for future investment.

Meanwhile, the significant declines across most international equities last week would have caused increased anxiety and concern for investors. It is therefore timely to remind investors about the concept of value investing consistently promoted by Warren Buffett and a reference to his long-term outlook once again in his recent letter to shareholders. The Chairman of Berkshire Hathaway argued that although “anything can happen to stock prices tomorrow” and “occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater”, the combination of positive economic growth over the long-term and the impact of compound interest “will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions”. Warren Buffett once again re-iterated that “if something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments”. This is a very reassuring statement to many investors following the events that quickly unfolded across international equity markets last week.

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This article was produced by Edward Rizzo, Director at Rizzo Farrugia, which is a company licensed to undertake investment services in Malta by the MFSA under the Investment Services Act, Cap. 370 of the Laws of Malta and a member of the Malta Stock Exchange. The company’s registered address is at Airways House, Fourth Floor, High Street, Sliema SLM 1551, Malta.