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I have noticed an interesting trend over the last several years. When times are good, companies have a higher level of profitability and higher cash flows. As a result, the higher profits lead to higher share prices. This is pretty much common sense.

The higher cash flows cause management to make some decisions. With excess cash flows, companies have the following options:

  • Keep the cash – maintain capital
  • Pay down debt
  • Pay out more cash in the form of dividends (distributions)
  • Invest the capital into the business
  • Invest the capital into other investments (i.e. Warren Buffett)
  • Do a share buyback
  1. Let’s look quickly at option #1. How many banks wish they chose this option over the past five years? Is it so wrong for a company to stay liquid? How much cash does Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) have on its books? Perhaps in order for board of directors to earn their “deserved fees”, they feel pressured into other options.
  2. Option #2 – pay down debt. I know the whole theory of WACC (Weighted Average Cost of Capital). But to me, option #2 is similar to option #1. Paying down debt lets a company stay more liquid – no crime.
  3. Option #3 – dividend payouts. Nothing wrong with giving the owners of the company a share of the profits. If shareholders want to reinvest their money in the stock, they are free to do so (although they will take a 15% haircut based on the tax on dividends).
  4. Option #4 – invest capital into the business. This is a management decision – needs to be analyzed on a case by cash basis.
  5. Option #5 - invest capital in other investments. Clearly, this has been the strategy for Warren Buffett for decades. He treats capital very seriously. He always attempts to find the best possible use for capital that he sees fit. The combination of allocating capital to the best investments at the best possible times (low prices for great businesses) is a formula few have been able to replicate.
  6. Option #6 – the share buyback. In my opinion, this has been a disastrous option for many companies. As mentioned in the beginning of the article, companies will often have excess cash when times are good, and their share price is high. Therefore, the share buybacks allow companies to buy back shares at high prices – is this the best possible use of capital? I can think of hundreds of companies that have done share buybacks at much higher prices – again, think of the banks. In general (and I am in a minority) – I hate share buybacks. To me, it makes the following statement – “the best use of capital at this possible time is an investment in our company’s stock”. Huh?! In other words, management feels that of the thousands of worldwide investments, the best use of capital is to buy back stock in their company at the exact moment that excess capital is available.

This is not the strategy that Warren Buffett used to evolve Berkshire Hathaway from a $40 stock to a $115,000 stock. In fact, it is almost the exact opposite strategy.

As anyone reading this article can tell, I am a fan of Warren Buffett and what he has accomplished (but then again, who isn’t). I am just amazed that more management teams haven’t adopted some of his basic principles.

By the way, when was the last share buyback at Berkshire?

Disclosure: None

Source: Share Buybacks: The Anti-Buffett