Wednesday, December 29, 2010

Buffett on Stock Buybacks - Part II: Berkshire Shareholder Letter Highlights

As a follow up to this post on stock buybacks. Here's a more complete explanation by Warren Buffett of his views on buying back stock.

From the 1984 Berkshire Hathaway (BRKa) shareholder letter:

"The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons - one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.

The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer."

Buffett later added...

"The key word is 'demonstrated'. A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as 'maximizing shareholder wealth' (this season's favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth - and, after a while, neither will the market."

Even though written more than 25 years ago we've no doubt this past decade seen more than our fair share of shareholder wealth destroying, as Buffett says, "actions that expand management's domain but that do nothing for (or even harm) shareholders."

We've also seen many stock buybacks happen when a company's stock price was clearly above intrinsic value. In fact, if you look at a chart of S&P 500 stock repurchases over the past five years you'll notice most of the buying was being done when the market peaked* in 2007. Evidence of management competence in this regard among public companies is rather spotty to say the least. While this type of mistake may not be caused by a "self-interested manager marching to a different drummer", it is a mistake in judgment that can be just as destructive to shareholder wealth. The quantity of purchases and amount that the stock sells above intrinsic value when those repurchases occur obviously determines the extent of the damage that is done.

From an investors perspective the best type of manager: 1) understands the stock price/intrinsic value relationship, 2) consistently displays good judgment in the use of excess capital for dividends/share repurchases/acquisitions, and 3) does not pursue expansion of management's domain or growth for growth's sake (at shareholders expense) under the guise of "strategic opportunity" or some similar phrase.

Adam

Long BRKb

Related posts:
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* Buyback activity was also at or near the lowest levels when the market bottomed in 2009.
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