Many great investors have cited Warren Buffett (Trades, Portfolio)'s letters as a core component of their investment education. Everyone can learn so much from reading his annual shareholder letters for Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial). There is a lot to read, so this series is designed to highlight the most interesting aspects of each letter. This discussion covers the 2011 missive.
Share repurchases
In 2011, Berkshire announced it would repurchase its shares at a price of up to 110% of book value. The conglomerate managed to get only $67 million of stock before it advanced beyond the set limit.
Charlie Munger (Trades, Portfolio) and Buffett 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.”
Many companies repurchase their own shares without considering these two rules, especially the second rule. Sometimes management just believes that its own stock is cheap, forgetting there may be better options to use the cash for. Buffett reminded readers that 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,” he wrote.
Buffett recommended reading the annual letters written by Jamie Dimon at JPMorgan Chase & Co. (JPM, Financial), as Buffett said Dimon is one CEO who always stresses the price-value factor in repurchase decisions.
The guru said he likes making money for continuing shareholders, and there is no surer way to do that than by buying an asset – Berkshire’s own stock – when he knows it to be worth at least x for less than that – for 0.9 times, 0.8 times or even lower. He likens it to “shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.”
By having a limit price of 110% of book value, Buffett stated repurchases clearly increase Berkshire’s per-share intrinsic value. However, this was not about supporting Berkshire’s stock price, and repurchases will only be done when Berkshire has ample liquidity. Buffett also said Berkshire’s bids will fade in particularly weak markets, most likely meaning in weak markets he believed he could find even more attractive investment opportunities.
Irrational investors
Buffett said many investors have an irrational reaction to changes in stock prices. Many investors and commentators customarily assume its best for stock prices to just go up. The Oracle of Omahas said that while Berkshire has the normal hope that earnings of the business will increase at a good clip for a long time to come when buying a stock, if that stock is buying back its own stock, Berkshire hopes that stock underperforms the market for a long time too. That’s because more value will be created and that’s what’s important.
Case Study: International Business Machines
Using International Business Machines Corp. (IBM, Financial) as an example, Buffett explained what he meant. First off, Buffett acknowledged CEOs Lou Gerstner and Sam Palmisano for doing a superb job in moving IBM from near-bankruptcy 20 years prior to its prominence in 2011. Their operational accomplishments were truly extraordinary. He wrote:
"But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. 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. Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. 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."
The logic goes like this: If you are going to be a net buyer of stocks in the future, either directly with your own funds or indirectly (through your ownership of a company that is repurchasing its own shares), you are hurt when stocks rise. You benefit when stocks fall as you can buy a greater amount of equity with the same dollars.
Buffett blamed the confusion on human emotion. Most people, even those who will be net buyers in the future, prefer to see 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,” he said. The guru has made this point in previous years and made it again likely because the want for stocks to go up is such a prevalent view.
Intelligent investors
Buffett acknowledged he did not expect to be able to change people’s way of thinking about this. He said, “We’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus.” He admitted that when he was younger, he did rejoice to see his stocks go up too. He continue:
"Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life."
Ultimately, the success of any investment, Buffett noted, “will be determined primarily by its future earnings.” An important secondary factor, however, will be how many shares a company purchases with any funds it is devoting to buybacks, and then lower prices are better for long-term value.
