Berkshire Hathaway announced yesterday that the board had authorized a share buyback. The PR was obviously written by Buffett, and is so short and sweet I’ll repost it here in full (omitting the boilerplate legal disclosure):
Omaha, NE — Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest. Berkshire plans to use cash on hand to fund repurchases, and repurchases will not be made if they would reduce Berkshire’s consolidated cash equivalent holdings below $20 billion. Financial strength and redundant liquidity will always be of paramount importance at Berkshire. Berkshire may repurchase shares in open market purchases or through privately negotiated transactions, at management’s discretion. The repurchase program is expected to continue indefinitely and the amount of purchases will depend entirely upon the levels of cash available, the attractiveness of investment and business opportunities either at hand or on the horizon, and the degree of discount from management’s estimate of intrinsic value. The repurchase program does not obligate Berkshire to repurchase any dollar amount or number of Class A or Class B shares.
Now this will surely be analyzed, written, reported, and blogged about to death, as most Berkshire news items are, so this post suffers from redundancy risk. However, there are a couple of important implications and answers that this announcement causes that I haven’t seen covered in full well enough.
First of all, as Whitney Tilson notes, Buffett’s got a heck of a lot of cash, but still to do a buyback he surely believes the stock is deeply undervalued. Buffett notes that he does not want the cash hoard to ever fall below $20 billion, and as I type this Berkshire most likely has over $80 billion in cash and short-term debt investments, so he has over $60 billion to invest. While it’s extremely unlikely Buffett would ever use the entire hoard of free cash on buybacks, even if he uses a fraction of it, the reduction in share count and effect of the buying on the stock price should be large, relative to what the market does (i.e., if a loose floor should occur under the stock).
Buffett thinks BRK is undervalued, but by how much? It’s impossible to know, but suffice it to say he wouldn’t be doing a buyback if he thought it was 10 or 20 percent undervalued. I would bet he thinks the true value of Berkshire is somewhere between $150,000 and $200,000 per A share.
The question should come up of "why now?" Berkshire was surely cheaper on an absolute basis in 2008 and 2009, but no buyback occurred. I think the only reason buyback makes sense now in Buffett’s mind is that Berkshire is relatively very undervalued in comparison to large cap stocks (and probably small cap stocks generally, but they are irrelevant, because they don’t move the needle). It is Berkshire’s goal, capital allocation-wise, to first acquire high-quality businesses in whole at good prices, second acquire shares in high quality-businesses at good prices, and third buy back Berkshire stock at good prices.
Berkshire is liquidity-rich, too much so, and the operating subs are pouring cash into Berkshire’s coffers. This buyback is a testament to two facts, that Berkshire has too much idle cash, and not enough cheap elephants to shoot (or undervalued stocks to invest in). In 2008 you could practically throw a dart at a stock dartboard and hit an undervalued stock (the Jim Cramer method). There is no need to buy back Berkshire stock when Goldman Sachs (GS) and GE (GE) are offering you a sweetheart deal because they need liquidity and a Buffett credit rating seal of approval. There is no need to buy back shares when Wells Fargo (WFC) is selling in the single digits.
But now Berkshire is drowning in cash, and despite the recent stock market turmoil, stocks and whole businesses aren’t cheap enough. Sure, there is the Bank of America (BAC) preferred deal, but that barely makes a dent in the excess $60 billion hoard. This isn’t just Buffett screaming "Berkshire is cheap!," this is really Buffett saying, "We have a lot of cash; there aren't enough large, cheap securities out there; thus BRK is cheap enough to warrant a buyback as an allocation of some of our cash."
Stock Buybacks: Superior Capital Allocation Method For the Capable
There is a lot of confusion over the effectiveness of buybacks. Many see a multitude of companies buy back stock just to see the prices fall further, and conclude they are wasting money. They are usually right about this, and some companies also use buybacks as less of a capital allocation strategy and more of an attempt to cloak the diluting effects of generous management stock options. They argue we should demand only dividends.
I even came across an amusing eight-minute CNBC piece on Mad Money via the usually clearer-headed Herb Greenberg (who has recently been infused with a little too much CNBC-ness), where Cramer argued that buybacks at three popular large cap stocks destroyed a lot of value. He operated under the premise that the stocks would have the same stock price currently had they paid dividends rather than buybacks, and then he calculated the total return had they paid dividends, and ignored taxes, naturally. Of course since the companies bought back shares their share count is lower now, and thus the stock price would have to be lower had they paid dividends instead, to achieve the same market cap currently. The assumption that the stock price would be the same despite what would be a higher share count is shockingly ignorant. This confusion -- by a professed expert on a highly watched time slot of the “best” financial news networks -- would be hilarious if it wasn’t so sad.
Really, dividends are nothing special, they are truly just a liquidation of book value, and a tax-inefficient one. Share buybacks are a more tax-efficient liquidation of book, with the kicker that shareholder value can be added (or subtracted) if the buyback is done below (or above) intrinsic value. Buffett is the king of capital allocators, and in his hands a buyback is 10 times as valuable as a dividend. Buffett and his partner Charlie Munger know this, which is why they both have said on multiple occasions that they hope they are dead before they have to pay a dividend, but have no problem buying back shares if the conditions are right -- like they are now.
Buybacks are clearly a higher rung of value creation than dividends, given the right management. And this says nothing about tax effects. Skeptics will say this buyback signals that Berkshire is getting too big and the cash hoard is too much to handle. That it can no longer effectively operate under its past strategy of acquisitions and stock purchases. In more docile and expensive market times, this may be true in part, but the buyback proves there are sometimes other ways of creating value. At today’s prices, with the quality of the insurance operations and non-financial operating subs, Berkshire isn’t valued for much value creation anymore.
Disclosure: I am long BRK.B.