"In my early days I, too, rejoiced when the market rose. 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." -- Warren Buffett, February 25, 2012
In his most recent letter to Berkshire Hathaway shareholders (NYSE:BRK.A) (NYSE:BRK.B) , published on Saturday, Warren Buffett went into detail on his repurchases of Berkshire stock. In September, he says, the company was in the market "for only a few days - buying $67 million of stock - before the price advanced beyond our limit."
You see, he's pretty disciplined about share repurchases. He only wants to see a company do so when it has plenty of cash and its stock is selling at a material discount to the company's intrinsic business value, but he doesn't think most CEOs evaluate their share prices very well at all.
"Smart at one price, dumb at another"
You'll often see debates surface on whether cash-rich companies such as Apple (NASDAQ:AAPL) should issue a dividend or buy back shares. But it's not a matter of philosophy, or whether buybacks as opposed to dividends "work better." It's simply a function of price:
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.
Charlie and I have mixed emotions when Berkshire shares sell well below intrinsic value. We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset - our own stock - that we know to be worth at least x for less than that - for .9x, .8x or even lower. (As one of our directors says, it's like shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.)
How Berkshire Could Own A Lot More IBM
Buffett uses the topic of share repurchases to "address the irrational reaction" of investors to changing stock prices, pointing out that if he owns a company that's buying back shares, he wants the stock to underperform the market.
So in his words: "'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."
He points to IBM as an example. Berkshire now owns 63.9 million IBM shares, about 5.5% of the 1.6 billion shares outstanding. Buffett projects out that the company will be spending $50 billion to repurchase shares over 5 years:
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.
Why? Because Buffett wants the $50 billion to buy a lot more stock. If the price stays low, Berkshire could own a much higher percentage of IBM than if the stock price rises.
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.
A paid holiday for Berkshire employees?
Berkshire Hathaway owns 63.9 million shares of IBM, and of course Buffett is more concerned about future earnings than share buy backs. But there's one condition where IBM's share repurchases would give him cause to celebrate:
In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity.
And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday.
Sorry Warren. I own IBM too. You might have to settle for a float that's slightly larger than 63.9 million shares -- at least for a little while until you force me to sell. Then I'll take the day off, too.
Disclosure: I am long IBM.