Tuesday, January 25, 2011

Beware the Buyback Craze

In this recent post (and several others), I've highlighted how much Buffett likes buybacks when a company comfortably has the financial resources and a stock selling clearly below intrinsic value.

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. - Warren Buffett in the 1984 Berkshire Hathaway (BRKa) Shareholder Letter

While Buffett has articulated on many occasions how much he likes buybacks under the right circumstances, historically Buffett has not felt it necessary to allocate any of Berkshire Hathaway's capital toward buybacks.

Here's where it gets a bit tricky. Consider this Barron's article. The evidence seems to show that companies have a tendency to buy high.

Some highlights of points made in the article:

- Buybacks are often done during the good times when company's have lots of cash and stocks are expensive. The article also points out that the biggest buyback year ever was 2007 at $ 863 billion (according to research firm Biryini) when stocks were peaking.

- Buffett called most buybacks in recent times "foolish"; companies were paying too much.

- Buybacks were only $ 125 billion in 2009. If a company has the funds a buyback only makes sense, as Buffett says, if shares are selling below "intrinsic value, conservatively calculated."

A business with durable competitive advantages (wide economic moat) selling below intrinsic value (margin of safety) isn't enough.

Investors need more than that: Management that allocates capital wisely and knows how to widen the moat.

Adam

Long BRKb

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