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Warren Buffett once told us that avoiding dividends during the early years of Berkshire Hathaway gave him the ability to refocus the company’s money on better businesses, just like a person would overcome “a misspent youth.”

The billionaire Warren Buffett, now 82 years old, is focusing on his legacy as he prepares Berkshire Hathaway for new management as his time with the company winds down to a close. Using the annual letter being published on March 1 as a way to outline a dividend plan could show shareholders a way for the next leaders of the company to look at the challenge of allocating profits.

“It may ease the burden on the successors” if they have the ability to pay a dividend, Richard Cook tells us, co manager of the Cook & Bynum Fund, which has Berkshire Hathaway as one of its largest holdings. Berkshire and its subsidiaries “generate a lot of cash.”

Buffett’s annual letter is there to teach Berkshire Hathaway shareholders about corporate governance, investing and business, as well as the annual meetings in Omaha, Nebraska, where the company is located. As Berkshire grew through acquisitions and investment gains, so did its rather large pile of cash, which by the end of September 2012 amounted $47.8 billion. This large sum has made it very difficult to allocate the funds, since it is often difficult to find large investments that are worthwhile, we learned from Buffett himself.

The CEO and Chairman started buying back Berkshire shares in 2011 and used part of the most recent annual letter to explain when share repurchasing made sense. Last May, while on CNBC, he said that he would probably discuss the makings of a logical dividend policy in the upcoming annual letter.

Buffett’s Blessing

“It’s a very sensible move” to discuss when the company should begin paying a dividend, so the next CEO of Berkshire Hathaway will appear to have a Buffett’s blessing, we learned from Tom Russo, currently a partner at Gardner Russo & Gardener, overseer of more than US$5 billion, and that includes Berkshire Hathaway shares. After Warren Buffett is gone, many will have “a tendency to second-guess,” said Russo.

In 1965, Warren Buffett took over Berkshire Hathaway and changed it from a company that made men’s suit linings and textiles, and turned it into a $251 billion company that currently has retail businesses, lots of manufacturing companies, subsidiaries that generate electricity, they sell insurance and haul freight among many other things. His opinions about investments, due to his excellent record of accomplishment, make his annual letters a must read on Wall Street.

In his 1985 letter, Warren Buffett said that dividends make sense when a company’s managers cannot generate adequate returns when keeping the money inside the business. Berkshire Hathaway never paid a dividend because it’s always been able to earn better rates on retained profits, he told us at the time.

Averting Disaster

Buffett once wrote that paying a significant amount of money to his investors could have actually been “disastrous” in the beginning because the three businesses that he and Charlie Munger oversaw in the beginning had very little money. They also incurred losses and were only a fraction of their original size just 20 years later.

“It’s been like overcoming a misspent youth,” said Buffett of the Berkshire Hathaway effort to expand their chocolate making, newspaper publishing and insurance businesses. “Clearly, diversification has served us well.”

Buffett continually finds the best ways to invest the extra cash that Berkshire Hathaway has on hand. Over the last 30 years, he’s amassed tremendous stakes in large companies including IBM, Coca-Cola and Wells Fargo & Co. He even buys whole companies such as General Re reinsurer and Burlington Northern Santa Fe railroad.

Just this month, he teamed up with Jorge Paulo Lehman’s 3G Capital in a deal worth $23 billion to purchase H.J. Heinz Co. and make it a private company. The deal will provide Berkshire Hathaway with $4.1 billion worth of equity and $8 billion in preferred stock that pays a dividend of 9%, we learned from the regulatory filing.

Charles Munger’s Wish

Warren Buffett points out his own mistakes in his annual letters, and he also uses them to praise his managers like Ajit Jain, his reinsurance chief, and the CEO of Burlington Northern Santa Fe Matt Rose. Warren Buffett relies heavily upon the subsidiary heads to oversee the day-to-day operations of these businesses. This leaves him and Charlie Munger the time they need to allocate the profits properly.

I believe that some of the people reading this article will live to see the day when Berkshire Hathaway pays a dividend. But hopefully it isn’t in the very near future.

The enormous size of Berkshire Hathaway could very well make a dividend a necessity at some point in the future since they may not have a better way to invest the accumulated funds, we heard from Munger at a meeting during 2011 in Pasadena, California.

“I think that some of you will live to see Berkshire pay a dividend, but I hope I don’t,” said Munger, 87 years old at the time, responding to the question of a member of the audience. “You’re saying, ‘Do you predict failure?’ And I suppose I do.”

During last year’s annual letter, Warren Buffett told us that the board chose a manager to take over as the next CEO, but they chose not to identify this individual. For a while now, Mr. Buffett has been allowing his investment managers Ted Weschler and Todd Combs to oversee more of the company’s $88 billion worth of stock.

Stock Rally

As of this morning, Berkshire Class A shares gained 0.5% to reach the amount of $152,650 at the opening around 9:35 AM in New York. Over the last 12 months, Berkshire has rallied for a 29% gain due to the gains in their operating units, a buy back in stock and Bank of America Corp. investment. In the same period of time, the S&P 500 index only gained 10%.

One roadblock to potentially paying a dividend now is that Warren Buffett, as the largest shareholder of Berkshire Hathaway, would have to do something with the payments he earns, said Russo. You probably know that he has pledged the majority of his wealth to charity, but he still has stock in Berkshire Hathaway worth more than $50 billion.

“Warren doesn’t want cash. He doesn’t need it. He doesn’t want the burden of investing it,” said Russo.

Paying a dividend could certainly makes sense once Buffett is no longer leading the firm, and more of the current shares he has passed over to the Bill & Melinda Gates Foundation as well as his children’s philanthropic endeavors, Russo said. These charitable organizations are obligated to spend the money generated by a dividend, Russo also said.

The mutual fund manager, Cook, said he’d rather Berkshire skip paying a dividend and hold onto the cash for the time being.

“You’ve got a 50 year track record of being the best capital allocator in the world,” said Cook of Buffett. “As long as he’s alive, we think we’re generally better off with him” handling the money.

The bank stock investors definitely have some choices that they are going to need to make since the largest banks in the nation have just reported their quarterly earnings.

Do these investors want to take a risk and chase the earnings rebound that is bound to happen at the major banks like Citigroup, Bank of America, and J.P. Morgan Chase Bank? There’s the potential for their shares rising well above single digit price-to-earnings multiples. Or better yet, would it be a better idea to invest in the safer premium priced lenders like U.S. Bancorp, BB&T, M&T Bank and Wells Fargo?

The one thing I can say for sure is that if you followed Warren Buffett’s lead, and invested in the traditional lenders such as Wells Fargo, then you would have implemented a very effective yet simple strategy. This industry is normally marked by high risk and earnings numbers that are very hard to understand.

To put it quite simply, Warren Buffett who is also known as the Oracle of Omaha, made the choice to invest his money in banks that were growing earnings through mortgage lending rebounding a bit, as well as low-cost share repurchases that are now going up in value.

On the flip side, Warren Buffett has hesitated when it comes to putting more money behind the players more oriented toward the capital markets such as J.P. Morgan, and he’s even backed off of the Wall Street investment banks such as Morgan Stanley and Goldman Sachs since they are at risk from the malaise on Wall Street, as well as the European debt crisis and new regulations that are coming into play each and every day.

Buffett has been sticking with the mid-teen price multiples of U.S. Bancorp, M&T bank, and Wells Fargo, as opposed to going after the single digit P/E ratios of some of the previous banks mentioned in the paragraph above.

Buffett chose to avoid making common stock bets in investing banks, which is why the investments Buffett made in the financial sector are outperforming those of his peers by a wide margin. The second quarter earnings of the bank stocks that he owns definitely reaffirmed that his way of investing is certainly the smart way to go. Wells Fargo and J.P. Morgan Chase Bank both started off this earnings season with much stronger than expected numbers, and Wells Fargo even outperformed expectations, which I learned according to data released by Bloomberg.

When you take a close look at Buffett’s portfolio of bank stocks, the outperformance is a marked improvement which you will certainly notice.

The top performers in the banking sector of the Standard & Poor’s 500 index, since earning season began are both M&T Bank and U.S. Bancorp. And the laggards in the banking sector are Bank of America, Goldman Sachs and Morgan Stanley.

That doesn’t mean that Buffett doesn’t have any investments in either Goldman Sachs or Bank of America. But he made preferred share investments which are extremely safe loans that will guarantee him a return on his investment. This has nothing to do with the regular trading of the common stock, and it’s a totally different type of investment opportunity which is paying off for Berkshire Hathaway.

It’s probably not a great idea to base your investment strategy off of the bank stock gains that have been taking place since the second week of July. But I’d like to point out that the performance of shares is actually reinforcing trends over the last few years which you also see reflected in earnings statements.

Buffett and company are continuing to hold their bank stocks because they believe in the investment in the US economy and recovery, but he did it wisely by smartly placing his money in banks like Wells Fargo (they are projected to be the most profitable bank in 2012 according to computations and analyst estimates from Bloomberg.) There are many other investors who are being lured into subpar investments by placing their money into the large financial banks that have troubled balance sheets and uneven earnings.

The Wall Street crash in 2008 hammered most of the bank stocks, but then in March 2009 the bottom of the stock market crash is where the bank shares began to triple in value for Bank of America and Citigroup, and Goldman Sachs and J.P. Morgan all doubled in value in a one-month period. There are lots of analysts and investors in the financial sector who believe that those mega gains could be duplicated once again in the very near future.

But the truth is that our nation’s biggest investment banks have totally underperformed, but that didn’t stop their shares from rising higher due to some deal making and misplaced optimism.

Between the months of March 2009 through May 2009, the nation’s biggest investment banks were actually the top performers at the time. But things have changed, and since that three-month period, Citigroup, Goldman Sachs, Morgan Stanley and Bank of America have all lost more than 15% of their share value. All of these stocks are part of 10 bank stocks on the S&P 500, out of a total of 85 bank stocks in all, that have taken double-digit losses since May 2009. This information was obtained through Bloomberg data.

J.P. Morgan on the other hand has gained about 20% since that time. But Bloomberg data also shows us that the financial stock picks that Buffett made in M&T, U.S. Bancorp and Wells Fargo have all gained much better returns, and outperformed Chase by a wide margin during that same time.

If anything, I hope this market data will show investors that these large banks with volatile earnings aren’t necessarily the smart play, no matter what the big financial media reports show you. If you were to follow the less glamorous bank stocks that Warren Buffett chose, then you would’ve been much better off and gained some great exposure to consumer and mortgage lender growth.

The strategy is definitely confirmed by the earnings reports that have recently come out in the financial sector. The truth is that the strength in the lending gains are the reason why these earnings have propelled at Wells Fargo, and the reason why they outperformed expectations. The same holds true for J.P. Morgan.

When the second quarter earnings were released, it was learned that Wells Fargo beat the street because of a 35% increase in their quarterly profits. This number was bolstered by housing related activity and mortgage lending. J.P. Morgan, on the other hand, showed major growth in the area of new and existing homes, and they had a 30% year-over-year growth in the mortgage loan origination revenue department. The growth was also 14% sequentially which rose to $43.9 billion. But they showed a sharp drop in profits in the investment bank area.

The fact that J.P. Morgan had a major boost in their home lending earnings was actually a major bright spot throughout the entire second quarter. This was an earnings season that showed a sharp drop in revenue from the investment banks, and the $4.4 billion “London Whale” trading loss. Traditional revenues in investment banking fell a great deal on Wall Street, and in Morgan Stanley’s case they dropped about 50%, and the large bank earnings were unfortunately clouded by a lot of accounting items that only represent a onetime situation. There’s also the possibility that the rate fixing scandal going on at Barclays is going to spread and that will negatively affect the large banking conglomerates.

“With roughly 80% of the banking industry by assets having reported 2Q12 results, the overarching theme of earnings has been continued impressive mortgage banking revenues, surprising [net interest margin] resilience, and modest loan growth,” said Paul Miller who is an FBR Capital Markets analyst in a July 23 earnings wrap. “Given a sustained low rate environment, government mortgage programs, and constrained market capacity, we believe that mortgage banking will continue to be a dominant earnings driver through the end of 2012,” he added.

Banks such as Wells Fargo, Fifth Third, PNC Financial, J.P. Morgan and U.S. Bancorp, who all have large mortgage banking platforms, will all continue to be supported by home buying activity and refinancing, mentioned Miller.

As a matter of fact, the recent earnings numbers actually reinforce some of the things that Warren Buffett forecasted about the housing market in an interview that he gave on CNBC on July 12. He mentions that our economic growth in this country has basically stopped dead in its tracks, but he’s noticing that there is a pickup in the residential housing area, which was a comment that he made in regards to bank earnings.

“The general economy in the United States has been more or less flat, and so the growth has tempered down. But the residential housing, we’re seeing a pickup. It’s noticeable. It’s from a very low base,” Buffett said, who stated that he recognizes that he sort of flip-flopped with his optimism when he was very bullish on this topic of housing in 2011.

There are lots of housing sector analysts and banks that also agree with him. The analysts from Goldman Sachs actually raised their earnings estimates on two of the homebuilders which included MDC Holdings and KB Home, because the analyst believes in a “strong US housing recovery.”

If you are a stock investor that trusts in the fundamentals, you should also consider following Buffett. According to the results of the stress test of the Federal Reserve in March, Buffett led the way with his investments in such areas as U.S. Bancorp and Wells Fargo, and this also pushed forward some share buyback plans and dividend boosts. The Wells Fargo dividend was raised by 83%, and this was followed by an accelerated buyback program which began in the year 2011. U.S. Bancorp, on the other hand, also boosted their dividend by a total of 56%, and they even plan to buy back $3.3 billion worth of shares.