In a recent article on The Street, Jim Cramer wrote about why Apple (NASDAQ:AAPL) does not need to pay a dividend, but Berkshire Hathaway should. Cramer's article is pretty intriguing, but along the way, I think he makes several misguided assumptions about Buffett's relationship with share buybacks and dividends. Here's what Cramer had to say on the matter:
I think there are three comments in particular that demonstrate Cramer's misunderstanding of the Berkshire Hathaway (NYSE:BRK.A) business model.
1. "Instead, Buffett focuses on book value. That's all well and good if the company is willing to buy back stock to take advantage of its discount, a discount that Warren Buffett chatters about throughout his letter."
What is interesting about this bit of Cramer's criticism is that Buffett currently has a share buyback program in place at Berkshire. Anytime Berkshire trades at 110% or less of book value, Buffett says that, "we will likely repurchase stock aggressively at our price limit or lower." Cramer, on the other hand, seems to be suggesting that anytime Berkshire is trading in an undervalued range, Buffett should automatically buy back shares until the share price comes close to representing the firm's fair value.
This would probably not be bad advice for most companies, but Cramer's approach sells Buffett's capital allocation abilities short. The primary reason why Berkshire Hathaway has delivered such outsized returns with Buffett at the helm is because Buffett has been able to take profits and dividends from ongoing operations and divert them to other avenues that offer the greatest profit-making potential (on a risk-adjusted basis). When Berkshire is trading at 110% or less than book value, the stock is very undervalued, and there are probably few better investment opportunities out there for Buffett to pour billions of dollars into. But if the company is moderately undervalued (like it appears to be now), Buffett is most likely making the bet that he can put his money to better use by searching for investment opportunities in the overall stock market that provide more value than the repurchase of Berkshire shares at a moderate discount.
2. Further, even more oddly, Buffett highlights the IBM (NYSE:IBM) buyback as being a terrific one, even though IBM is clearly overvalued compared with Berkshire when it comes to book value.
First of all, Buffett mentions in the 2011 Shareholder letter that book value is a good proxy for Berkshire, but is probably not the best metric at most companies. Buffett writes,
"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. That's because the amount by which Berkshire's intrinsic value exceeds book value does not swing wildly from year to year, though it increases in most years."
Book value is traditionally the measuring stick with financial companies that are in the insurance industry, the banking industry, etc., and I find it odd that Cramer tries to force a book value comparison with IBM when earnings growth is probably a more telling metric to use.
Buffett makes it explicitly clear in his shareholder letter that the success of IBM's share buyback will be more successful with lower prices. Here's what Buffett had to say about IBM's share repurchase program (excerpt is from page 6):
"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. Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%. If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the "disappointing" scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the "high-price" repurchase scenario had taken place."
Buffett recognizes that the repurchasing undervalued shares is much better than repurchasing overvalued shares, and I suspect that Buffett's satisfaction with IBM's buyback going forward will directly correspond to whether or not IBM can buy back its own shares at lower prices.
3. I have suggested here that if Berkshire wants to bring out its value and give shareholders a decent return, Buffett should give us a dividend.
Buffett has repeatedly said that he applies a test to determine whether or not Berkshire should pay out a dividend. If Buffett believes that he can turn each dollar paid out as dividends into something worth more than a dollar of value, then the shareholders are best served by Buffett making the capital allocation decisions. And if he doesn't believe that he can increase that last dollar of profit's value, then he will pay out part of Berkshire's profits as a dividend to shareholders.
While this attitude may not work at most companies (just about every management team thinks they can pass this Buffett test), the difference here is that Buffett's record actually proves that he can do it. He has almost a half-century long record of proving that he knows how to allocate capital very well, and this track record earns him the benefit of the doubt in the eyes of many Berkshire shareholders.
When Cramer dips into the language of "decent return" and "bring out its value", he is co-opting the mentality of a short-term investor. Long-term investors are not best served by measures aimed at inflating the company's stock price, but rather, decisions that increase Berkshire's profit stream by the greatest amount on a risk-adjusted basis. Cramer devotes most of his recommendations to measures that can increase what the market is willing to pay for Berkshire's profit stream, whereas Buffett is most likely focusing on increasing Berkshire's profit stream (rather than finding ways to get market participants to pay more for a share of that company's profits).