Friday, December 14, 2012

Buffett on Buybacks, Book Value, and Intrinsic Value

Looks like any recent purchases of Berkshire Hathaway's (BRKa) stock was a smart move as far as Warren Buffett and Charlie Munger are concerned.

News Release: Berkshire Repurchases 9,200 Class A shares

On Wednesday, the company bought back $ 1.2 billion in stock at $ 131,000 per Class A share (~ $ 87 per Class B share). More interestingly, they raised the buyback threshold to 120% of book value, up from 110% of book value. So, if nothing else, Buffett has made it easy to know when he thinks the shares are selling at an attractive discount to intrinsic value.

Berkshire's book value as of last quarter was ~ $ 111,700.

That means, based on the $ 111,700 book value, they are willing to buy the stock at or below ~ $ 134,000 per Class A share (~ $ 89 per Class B share). Buffett and the Board of Directors have said before that Berkshire is intrinsically worth quite a bit more than its book value in the past.
(And, of course, it would make no sense to buyback the stock if that weren't the case.)

Below, I've collected some relevant buyback-related excerpts from Buffett's shareholder letters over the years. It's a quick tour of what he has said on the subject though far from comprehensive. I'll begin with a couple excerpts from the latest Berkshire Hathaway shareholder letter:

Charlie and I measure our performance by the rate of gain in Berkshire's per-share intrinsic business value. If our gain over time outstrips the performance of the S&P 500, we have earned our paychecks. If it doesn't, we are overpaid at any price.

We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values. - 2011 Berkshire Hathaway Shareholder Letter

The reason is straightforward enough. The publicly traded investment portfolio is carried at market value. While market prices are frequently not equal to per-share intrinsic value (in fact, often far from it), that's not the main source of the discrepancy long-term. The real discrepancy comes from the wholly owned operating companies that Berkshire controls. These businesses are often intrinsically worth far more than their carrying value on the books.*

Even if far from being a perfect reflection of value, the appreciation of the marketable securities owned by Berkshire, over the long haul, is largely taken into account. That's will continue to be far from the case with the operating businesses Berkshire controls. More from the latest letter:

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn't suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. - 2011 Berkshire Hathaway Shareholder Letter

Buffett has covered the subject of share repurchases and intrinsic value in many of his letters. Here are some of the noteworthy excerpts:

...if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? - 1980 Berkshire Hathaway Shareholder Letter

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases. - 1984 Berkshire Hathaway Shareholder Letter

...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. - 1984 Berkshire Hathaway Shareholder Letter

When Coca-Cola (KO) uses retained earnings to repurchase its shares, the company increases our percentage ownership in what I regard to be the most valuable franchise in the world. (Coke also, of course, uses retained earnings in many other value-enhancing ways.) Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares. That would be a less efficient scenario: Because of taxes we would pay on dividend income, we would not be able to increase our proportionate ownership to the degree that Coke can, acting for us. - 1990 Berkshire Hathaway Shareholder Letter

Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases. - 1992 Berkshire Hathaway Shareholder Letter

Understanding intrinsic value is as important for managers as it is for investors. When managers are making capital allocation decisions - including decisions to repurchase shares - it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. This principle may seem obvious but we constantly see it violated. - 1994 Berkshire Hathaway Shareholder Letter

The 1999 letter provides probably the most comprehensive explanation of when Buffett thinks stock should and should not be repurchased.

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

The business "needs" that I speak of are of two kinds: First, expenditures that a company must make to maintain its competitive position (e.g., the remodeling of stores at Helzberg's) and, second, optional outlays, aimed at business growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey's expansion into Idaho).** - 1999 Berkshire Hathaway Shareholder Letter

In the 1999 letter, he also admits to missing the chance on prior occasions to repurchase Berkshire's stock when it was a good buy.

The latest letter has a couple of good sections that are well worth reading. Check out the Intrinsic Business Value and Share Repurchases sections.

In addition, pages 99-100 of the 2011 annual report and the owner's manual have useful explanations of intrinsic value.

Maybe a very large and attractive acquisition will come along that uses a good chunk of Berkshire's cash.

If not, the best case for long-term Berkshire shareholders is for the shares to remain cheap so Buffett can use some of Berkshire's capital for repurchases. Those who want to sell Berkshire's shares near-term will rightfully want the market price to be as high as possible. Otherwise, those that have a longer term horizon should be hoping for just the opposite.

Berkshire's book value should increase at a nice clip -- not every quarter or even every year but over time -- so the maximum price for repurchasing shares is generally a moving target to the upside.


Long position in BRKb established at much lower than recent prices

Some related posts:
Stock as a Currency
Buffett on Teledyne's Henry Singleton
Berkshire's Book Value, & Intrinsic Value
Buffett: Intrinsic Value vs Book Value - Part II
Buffett: Intrinsic Value vs Book Value
Why Buffett Want IBM's Shares "To Languish"
Buffett: The Berkshire Hathaway Buybacks Have Begun
Berkshire Hathaway Authorizes Share Repurchase
Buffett: When it's Advisable for a Company to Repurchase Shares
Should Berkshire Repurchase Its Own Stock?
Buffett & Munger on Berkshire's Stock
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Discount Rate
Buy a Stock...Hope the Price Drops?

Some related articles:
Wall Street Journal

* In the short run or even longer, the market price is not the same as per share intrinsic value, of course, but the "weighing machine" doesn't work too badly in the long run. Eventually, the market prices will adjust upward to at least mostly reflect the appreciation in intrinsic value. Certainly it's a better reflection of economic value than the way businesses Berkshire controls are carried on its books. Most of the wholly owned businesses are given a value on the books that's equal to what the company paid (and maybe less since some assets are adjusted downward in book value over time via amortization or depreciation). So value isn't generally adjusted upward to reflect the current economics until something is sold. Well, since Berkshire doesn't like to sell the businesses (see Business Principle # 11 in the owner's manual) it owns, the divergence is destined to be persistent. Purely a limitation of accounting but, with a little work, easily adjusted into something economically meaningful.
** The expenditures at Helzberg and R.C. Willey are explained in more detail earlier in the 1999 letter.
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