In the 2011 Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A) annual letter Warren Buffett laid out the case for why you should wish for IBM's (NYSE:IBM) stock to languish over the years. The idea was simple: as a long-term owner you're apt to be a long-term net buyer as well. You're likely to be buying either through new capital, by reinvesting dividends or the company would do so on your behalf via share repurchases. When you're buying it's at lower prices, not higher ones, which provide the ultimate benefit.
So far the languishing and decreasing price share price has become a reality. Of course there's a follow-up to hoping for lower share prices: you want the business to continue performing and eventually grow as well. To this point, it's fair to suggest that the profitability of the firm has been stagnating and decreasing, although the share price decline has fallen even further.
As it stands today you have a firm generating $13 billion in annual profits, paying out 40% or so of those profits in the form of dividends, to go along with a robust and ongoing share repurchase program. The earnings multiple now sits under 10, assuredly reflecting the cautious approach toward future growth expectations.
What's interesting to me is what the current valuation implies in a "no growth" scenario. And this applies for both the individual investor and for much larger stakeholders such as Buffett's Berkshire Hathaway. I'll work through an example to illustrate what I mean.
Last year the company reported $13.4 billion in net income (or $14.7 billion in operating income). During the last six years the company has earned about $89 billion in net income. From that, roughly $24 billion has been paid out in the form of dividends, with another $65 billion going toward net share repurchases. That's effectively a 100% payout ratio when it comes to returning profits to shareholders.
Moving forward you might suspect that this sort of activity would continue, but you could bake some prudence into the equation. We'll keep the $13 billion in annual profits and use a payout ratio of say 80% for dividends and share repurchases. The current dividend requires a total payout of about $5 billion. That leaves another $5.4 billion for share repurchases each year, which we'll use for a base line.
So we have exactly zero company-wide profit growth to go along with the same $5 billion in dividend payments and $5.4 billion in share repurchases for the indefinite future. Just as a point of reference, the company has averaged twice that amount of share repurchases per year recently.
Here's what that could look like on a per share basis:
Note that I'm not predicting a $0.0125 quarterly dividend cut this year, that's just the way the round numbers ($5 billion) worked out. (Indeed, with a declining share count the two items could be congruous.) The second column shows the number of shares outstanding (in millions) followed by earnings-per-share, dividends-per-share and an assumption of a future share price based on an earnings multiple of 10. Naturally this can vary widely, but it doesn't have as large as an effect on the total return as you might imagine.
This is the sort of thing that is not intuitively obvious when people are constantly talking about "stagnant" sales and revenues. The company can still grow its per share metrics as the share repurchase program continues.
In spite of the lack of company-wide growth you could see EPS and dividends per share both growing by over 4% annually. In this scenario today's investor might anticipate annualized returns on the magnitude of 6.4% per year. A $10,000 starting investment could be worth $47,000 in two and a half decades prior to thinking about reinvesting dividends.
Conceivably this is the type of low "investment bar" that Buffett has been drawn to - the company doesn't have to do any spectacular (no growth) in order to provide reasonable results. From there, if a bit of growth does formulate, it's easy to see that solid returns could be had rather quickly.
This sort of view is interesting for another reason. Check out the ending share count in this example: 350 million or thereabouts. For the average investor, that means that your ownership claim in the business would increase nearly three times over. In fact you can see this quite clearly with the EPS numbers: despite a lack of company-wide growth, you could see earnings-per-share move from about $13 to $37.
For an investor like Berkshire Hathaway, this sort of thing would dramatically increase the company's ownership stake. Berkshire Hathaway currently holds 81 million shares of IBM or thereabouts. Based on today's share count that means Buffett's firm has about 8.4% of the outstanding shares. Should the share count be reduced to 350 million, and Berkshire's stake remains steady, the ownership claim would jump up to 23%. The number of shares would be the same, but Berkshire would now be collecting over $700 million more in annual dividends to go along with a $1.9 billion larger ownership claim.
The stats become more impressive if you started to think about reinvestment. Based on a $1.30 quarterly dividend, Berkshire receives $105 million from IBM every 90 days ($800 a minute). That's $420 million on an annual basis, prior to thinking about a dividend increase. If the company chose to reinvest these funds, call it $375 million after the dividends received deduction, Berkshire might be able to add 2.8 million shares or so of IBM to its stake.
If Berkshire were to continue to reinvest, using the above assumptions, you might suspect that the company could amass 180 million shares after 25 years. In other words, based on 350 million total outstanding shares, Berkshire Hathaway would own more than 50% of the company. And that's a controlling stake just based on reinvestment. If new capital was deployed it's conceivable that IBM could become a Berkshire Hathaway subsidiary a few decades down the line.
Naturally a variety of simplifying assumptions have been made. On the share count reduction front, a good deal of the reduction is a result of the hefty buyback program and low current valuation. Should this program dwindle or shares trade at a loftier valuation its effectiveness would be significantly less. Yet even in this scenario, investors could still see solid returns due to an expanding earnings multiple.
On the Berkshire Hathaway front the assumption of consistently reinvesting is unlikely as there hasn't been much precedent for that. A more likely scenario would be periodically adding new blocks of shares, depending on whether or not the company feels that is an adequate place to continue allocating capital.
Yet the takeaway, in my view, is still interesting. First, you have the idea that your average shareholder could still see reasonable returns even if the business stagnates for decades. This isn't inherently obvious, but it makes a lot of sense when you think about a high starting yield coupled with repurchasing shares at a comparatively low valuation.
With regard to larger shareholders, it's also interesting to note that Berkshire's stake is apt to get much larger over the years. As long as the company maintains its current shares, its ownership claim could increase significantly. And if Buffett and Berkshire decided to periodically reinvest or add new capital it's conceivable that Berkshire would have a majority stake in the next couple of decades. It should be interesting to see how IBM's business and repurchase program progress in the coming years.
Disclosure: I am/we are long IBM, BRK.B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.