Monday, February 27, 2012

Why Buffett Wants IBM's Shares "To Languish"

In this previous post back in 2009 and later in some others, I've covered why it makes little sense for a long-term investor to hope a stock will perform well just after it has been purchased.

In fact, unless someone is primarily involved in trading near-term stock price action (all too many market participants these days), those with a long horizon should hope the shares they buy underperform in the days, weeks, and even years that follow while the business itself does well.*

Warren Buffett wrote some excellent material on this subject in the 2011 Berkshire Hathaway (BRKa) shareholder letter that was released over this past weekend.

It's the best explanation I've read yet.

Now, it's understandable that an investor will feel pretty unlucky for having bought shares at a price higher than what becomes available soon after. Yet, while that stock price drop after purchase may seem annoying, it obviously allows the long-term investor to accumulate more shares. The key is that the shares are bought at a discount to per share intrinsic value in the first place.

If shares are actually purchased at a discount, there should be no complaints if they temporarily sell at an even greater discount. In other words, a discount can be a very good thing -- even if it lasts for many years -- for long-term owners provided that business value was judged reasonably well in the first place.

The lower price naturally also benefits long-term owners if free cash flow (in combination with cash on the balance sheet and, in some cases, debt issuance) is persistent and used intelligently to buy back cheap shares over time.

If done in a smart way the compounded benefits for continuing long-term shareholders is not at all small.

This generally only works if the buybacks are done comfortably below (ideally, well below) a conservative estimate of intrinsic value -- too often with buybacks this is not the case -- and the investor has a long time horizon.

A price that offers an appropriate margin of safety protects the investor from the unforeseen and, maybe, the unforeseeable -- what cannot necessarily be known beforehand -- as well as the inevitable mistakes.

This applies whether the investor is accumulating shares or the company is repurchasing stock.

Uncertainty is a given. The price paid should reflect this reality.

Overconfidence in future outcomes can destroy returns.

Of course, the business itself must have a strong balance sheet and plenty of free cash flow that's at least sustainable and, ideally, increasing somewhat over time; it must also have enough financial flexibility to carry out the buyback without damaging the moat, adversely affecting operations, and making other important investments.**

Here's how Buffett explained it in the letter:

"When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: 'Talking our book' about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume."

Buffett continues by focusing in on IBM's financial management (some might call it "financial engineering"):

"Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock."

He later added...

"Naturally, what happens to the company's earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won't keep you in suspense. We should wish for IBM's stock price to languish throughout the five years."

Buffett then walks through some of the math:

"If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. 

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the 'disappointing' scenario..."

He concludes by saying:

"The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Charlie and I don't expect to win many of you over to our way of thinking – we've observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus."

Many buyers of stock like to see it go up after purchase but the high price actually does reduce long-term returns. I understand that seeing a stock sell below the price paid, especially if it is for an extended period, is difficult for most investors to tolerate. Quite a few end up bailing out before the compounded benefits of shares bought at cheap prices has really had an impact.

Loss aversion is a powerful force but it's possible to develop a more rational response. The long-term investor should hope the stock performs poorly in the near-term and, in fact, for even much longer.
(It's not at all hard to see why this way of thinking might not be particularly popular. That is especially true in an environment where the focus is on profiting from near-term price action instead of long run investment outcomes. What's popular is often very different from what's sensible.)

If shares of a good business are bought consistently below intrinsic value it has powerful long-term effects (especially in terms of risk-reward). This can work whether it is the individual investor -- through additional share purchases or dividend reinvestments -- or the company itself that is doing the buying.
(Other than the tax considerations, share repurchases and dividend reinvestments -- implemented when shares are selling at reasonable or, better yet, cheap valuation levels -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned. Repurchases, depending on the type of account, are generally more tax efficient.)

One of the keys, again, is a truly long-term investing horizon.

Here's another important thing to consider: the business itself can (and likely will) experience difficulties from time to time. Even the best of them usually do.
(Some might, as a result, be tempted to jump in and out at just the right time. That's usually a better idea in theory than in reality.)

Despite the inevitable business challenges, what really matters is whether the core business economics remain mostly intact once most of the problems are solved. Well, whether IBM's competitive position in the longer run will remain strong seems, at the very least, not the easiest thing to figure out. That's just the nature of technology businesses. To me, at a minimum, this means a larger margin of safety is required.

I'd add that businesses with the most exciting growth will often get their fair share of attention (along with a premium market price). Well, while it's crucial that returns on capital are both durable and attractive, growth actually need not be all that impressive if the price is right.

So growth can be a fine thing, of course, it's just not inevitably a wonderful thing. The price that's paid and whether a business will still be producing attractive returns on capital in 20-30 years (or longer) is what's all-important.***

The fact is, while growth can be an important contributor to long-term returns, it need not be.

I write this because some seem to assume (and behave as if) all growth is good growth.

It's just not.

Buffett's thinking on share repurchases begins at the bottom of page 6 of the letter.

Well worth reading.

As is the rest of the letter.


Long position in BRKb established at lower than recent prices. No position in IBM at this time.

Related posts:
Buffett on IBM: Berkshire Buys "Big Blue"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Technology Stocks
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* Naturally, in the longer run, an investor will wants the stock price to at least roughly track the increases to per share intrinsic value.
** The business must have plentiful funds available for operational liquidity needs while not underinvesting in crucial assets that widen the economic moat and provide competitive advantages. So, in general, a long-term investor logically should not want shares of a sound business to go up in the near-term or even longer. What's an exception to this? Here's one scenario to consider. Unfortunately, at least for some businesses, there's the very real risk that a buyout offer comes in at a premium to market value but a discount to intrinsic value. If enough short-term oriented owners are okay with the gain (and, of course, enough board members) that will have occurred compared to the recent price action, the deal may be approved. Also, if too few have conviction about longer run prospects, the deal may get approved. When a large proportion of owners of shares are in it for the short-term or, at least, primarily to profit from price action, the chance of this happening increases. Well, those that became owners because of the plain discount to intrinsic value and the company's long run prospects will likely get hurt in this scenario. It's worth mentioning that, considering its market capitalization, IBM is not exactly a likely candidate but it can and does happen to public companies of lesser size. So picking co-owners wisely matters (as much as that is possible). Some public companies certainly have more long-term oriented owners than others. 
*** What a business will look like many years from now is, in most cases, not at all easy to figure out. Neither is whether the expected exciting growth will be sustained and the high return variety (in order to justify what is often a premium price).
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