Share Buybacks: The Anti-Buffett

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 (BRK.A) (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

Comments

[Gerry Sullivan:]

The problem with share buybacks is that most companies then go out and issue more shares via employee stock options.
Berkshire is one of the few companies that doesn't issue options.

2008 Aug 14 07:31 AM

[Wefwef:]

Share buyback=time to sell after the spike up. It's the second most terrible thing after employee stock options. IMO both should be prohibited by law (Yes I am serious!).

2008 Aug 14 08:37 AM

[Owen:]

Actually, Warren Buffet has no problem with share buybacks--at the right price. In March 2000 he said he would consider having Berkshire buy back its shares if the price dropped under $42,000. At the time, the shares were trading around $45,000, and his comments alone were probably enough to give the stock price a boost, although that certainly was not his intention. Buffet would have been happy to see the stock plummet further, giving him a convenient opportunity for a buyback.

Buffet sees nothing inherently wrong with share buybacks. He considers it an investment in a company he likes with management he trusts. As for any investment, Buffet expects to get at least as much intrinsic value as he pays. Since Berkshire stock usually trades well above what Buffet considers its intrinsic value, there haven't been many opportunities for profitable buybacks.

2008 Aug 14 09:19 AM

[Owen:]

Oops--make that _Buffett_, of course. Damn spell-checker!

2008 Aug 14 09:20 AM

[RogerScott:]

Buffett, as a board member, has encouraged several corporations to buy back shares, including Washington Post and CocaCola. It should only be done when the price is well below intrinsic value and there is still plenty of cash available to weather a downturn. Of course, many companies have violated both rules.

2008 Aug 14 12:32 PM

[Pj568:]

Buybacks are not the problem, they're only a tool. Use the tool correctly and you're ok, incorrectly and you have big problems. Those that tried to pump up share price through increased leverage during the last few years are those with the big problems today.

2008 Aug 14 01:18 PM

[swaneer:]

Syndicat and Wefwef have it right. Companies use buybacks because their year to year earnings per share comparisons would be poor without them due to stock option grants. Clearly management does not deserve the options if they can not increase earnings per share enough to offset the option grants without buying back stock. The whole process is an enormous transfer of wealth from shareholders to management. It also greatly weakens the company's balance sheet as pointed out in the article.

2008 Aug 15 05:54 PM