In Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) 2011 annual shareholder letter, Warren Buffet put out some thoughts on share repurchases. The first portion related to Berkshire's own share repurchase policy, with a specific emphasis on when this sort of activity may or may not make sense. The second portion laid out a hypothetical five-year illustration using Berkshire's then newly acquired partial stake in IBM (NYSE:IBM) as an example.
Although it should be underscored that this was merely a theoretical exercise, it can still be useful to see what's happened in the last five years. I'll start from the beginning of the illustration and work through the demonstration as we go. Buffett begins:
This discussion of repurchases offers me the chance to address the irrational reaction of many investors to changes in stock prices. When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: "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.
This strikes true to the long-term investor mindset. If you're a trader looking for a quick buck, the last thing that you'd hope for is a declining, stagnant or even market trailing stock price. On the other hand, as we're about to see, this is the exact thing that the long-term owner ought to be rooting for. There's an immediate disconnect between trader and investor when you're talking about what's most beneficial on the share repurchase front.
We'll move on to Buffett's demonstration:
Let's use IBM as an example … 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 1⁄2 billion more than if the "high-price" repurchase scenario had taken place.
Now let's look at the components individually.
In the 2011 shareholder report Berkshire reported owning 63,905,931 shares of International Business Machines at a cost of $10,856 million or just under $170 per share. According to IBM's fourth-quarter 2011 report there were 1,172.2 million weighted common shares during the quarter, but 1.16 billion (as Buffett notes) actually outstanding at year-end.
The first prediction (and keep in mind the hypothetical nature) in the above scenario was for $50 billion in share repurchases over the next five years. Here's what the actual amounts totaled in millions:
- 2012 = $11,995
- 2013 = $13,859
- 2014 = $13,679
- 2015 = $4,609
- 2016 = $3,502
That's a total of $47,644 -- very close to the $50 billion mark. Now a couple of notes should be made. For one thing, the prediction appeared conservative for many years. Indeed, in the five years preceding 2012 IBM spent in excess of $60 billion retiring shares. And from 2012 to 2014, IBM was well ahead of the pace. It was only in the last two years that share repurchases trailed off dramatically.
The other note is that you should "net out" the share repurchases. Companies are notorious for highlighting the total amount used in retiring shares without also mentioning the corresponding dilution. In IBM's case the "net" share repurchase number (less issuance and stock compensation) was closer to $41 billion.
So IBM spent a considerable amount of funds retiring shares, but not quite as much as anticipated.
The next part is "rooting" for a languishing share price. This portion delivered in spades. The above example talks about $200 or $300 as scenarios, but the reality was a whole lot lower. Here's a look at the year-end share prices over the period:
- 2011 = $183.88
- 2012 = $191.55
- 2013 = $187.57
- 2014 = $160.44
- 2015 = $137.62
- 2016 = $165.99
Naturally share repurchases happen all throughout the year and not just at year-end, but the above numbers give you some context. The long-term owner's hope for lower share prices was certainly answered.
According to IBM's 2016 annual report the actual number of common shares outstanding at year-end stood at 945.9 million. This represents a reduction of roughly 214.1 million shares over the period. Based on a "net" repurchase number of roughly $41 billion, that equals an effective cost of approximately $191 per share.
That's an interesting number. As you can glean from above the average share price was often much lower this mark throughout the last five years. I'd chalk up the difference to two items. For one, IBM was purchasing a good amount of shares in 2012 and 2013 when the share price was frequently at $190 or even $200+. Then, when the share price was at its lowest marks in 2015 and 2016, this was also the precise time when IBM took its foot off the gas on the share repurchase front.
And just as important, remember that shares outstanding are a net number. Announcing a big share buyback program and then reporting those purchases each year is commonplace. What's often skimmed past is the opposite effect of stock dilution that offsets this activity.
Still, we can see the share repurchase influence in full force. Those same 63.9 million shares that Berkshire owned went from representing 5.5% of the company up to 6.8%. (Incidentally, today Berkshire's stake is closer to 8.5% of IBM as a result of more purchases in the following years, but for our example we'll stick with the original numbers.)
Buffett's scenarios of owning between 6.5% and 7% of IBM after five years was right on par -- at 6.8% (prior to considering new purchases). That's an important takeaway on its own - even if you don't invest another dime and decide to spend every dividend payment, your ownership claim in a profitable business is often growing anyway.
And the share price at which IBM bought back shares is important. I won't create another illustration, but had the company retired fewer shares due to a higher average purchase price, Berkshire's claim (and indeed any long-term owner's claim) in the business would have been a lower.
The last hypothetical in the above illustration is sure to be a sticking point: earning $20 billion in the fifth year. Last year IBM reported net income of $11,872 million -- less than 60% of the expectation.
For a while, IBM was rolling when it came to profitability. The firm generated $10.4 billion in 2007 and grew this number nicely in the years to come: $12.3, $13.4, $14.8, $15.9, $16.6 and $16.5 billion by 2013. Thereafter earnings began to shrink: $12, $13.2 and $11.9 billion last year. Here again the prediction rang true to start, but in the last few years the business has not performed as expected.
The results for IBM's share repurchase program have not come about as anticipated. Instead of $50 billion in repurchases (perhaps a cautious view at the time) the net number was closer to $41 billion. And instead of the earnings machine humming along, it's begun to stall a bit (although to be sure the company still pumps out enormous profits).
The interesting thing is that this program still might work out all right for Berkshire and long-term shareholders. Take Berkshire's starting 5.5% stake. Had the company instead received "extra" payouts instead of IBM repurchasing shares over the years the total nominal value to Berkshire might have been about $2.25 billion. (You could argue for a higher real number if reinvested profitably over the years, but you'd also have to discount taxes to be paid.)
That sounds like a large number, but Berkshire's repurchase benefit as it stands hasn't been all that poor either. The "extra" 1.3% of the business that the company now owns due to share repurchases currently equates to an additional earnings claim of roughly $150 million. At say 13 times earnings, that's a current value of nearly $2 billion (and the tax burden on that is at Berkshire's discretion). And things could get better. If IBM starts earning a bit more and trades at a slightly higher multiple in the future, Berkshire's benefit could start increasing towards $3 billion and beyond.
Buffett concludes his illustration:
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.
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.
There's a theoretical framework here that makes a lot of sense. It's no different than shopping for your favorite grocery item or a rental unit - the lower the price, the better the value. The same is true for the long-term owner who happens to be a net buyer through share repurchases.
With IBM in particular the example didn't quite work out as expected. As noted, IBM's success over the period was primarily determined by its future earnings, which have thus far been lackluster. Still, the capital allocation program allowed for a benefit along the line -- a benefit, while not as robust as previously anticipated, that could continue to add value through time.
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.