Warren Buffett finds an 'elephant' in Berkshire's own backyard

  • Berkshire announced a change to its policy regarding share purchases, effectively lifting the cap at which the company would be able to purchase shares.
  • It is a bullish sign that Buffett sees Berkshire as undervalued but also recognition that it has been difficult to find companies to buy using his enormous cash hoard.
  • Buffett famously said a few years back that he was going "elephant hunting" to find big takeover targets to put Berkshire's cash to work.
Warren Buffett
David A. Grogan | CNBC
Warren Buffett

Warren Buffett has looked around for suitable ways to invest Berkshire Hathaway's $106 billion cash hoard, and he has finally come up with an idea: Berkshire Hathaway.

The move sent Berkshire shares soaring more than 5 percent on Wednesday.

Starting in August, the Omaha conglomerate may buy back more shares, joining a huge number of other American companies that have embraced share purchases as a way to use cash piles swollen by tax cuts and strong earnings.

Berkshire's board approved a change in how Buffett and his longtime lieutenant, Charlie Munger, decide whether to use the cash for share purchases. Late Tuesday, Berkshire said the decision would rest on whether Buffett and Munger both agree the trading price is below Berkshire's intrinsic value.

That sounds innocuous enough, but it's a big shift from the yardstick Berkshire has used in the last couple of years. The old policy prevented Berkshire from buying its stock if it was trading higher than 120 percent of book value. Berkshire's book value, based on its B shares, is estimated at $149 a share, while its intrinsic value is more like $236, according to calculations by J.P. Morgan Chase analysts.

The shares currently are trading at around $199.

Based on book value, Berkshire wouldn't be able to buy back shares at this level under the old policy. But it would be able to buy them back based on intrinsic value under the new policy. Berkshire said it is sticking with the old policy that it won't spend down the cash pile below $20 billion, meaning it has about $86 billion or so to use.

"The new policy provides Berkshire with more flexibility to deploy excess cash of about $86 billion that is a large drag on returns, particularly given Berkshire has not been able to find attractively valued acquisitions in an expensive market," wrote Sarah DeWitt, an analyst at J.P. Morgan, in a note on Tuesday.

Pursuing 'elephants'

Buffett has long pointed out in Berkshire's annual letters to shareholders that the gap between the company's book value and its intrinsic value has been widening in recent years. The latter is an estimate of the future cash output of a business discounted to present value. In other words, book value tells you how much money was put into a business; intrinsic value says how much money can be pulled out.

The last time Berkshire bought its own shares was in 2012. That year, Buffett told investors, was lackluster. Berkshire's book value didn't increase on pace with the gain in the S&P, and Buffett failed to make a major acquisition. "I pursued a couple of elephants, but came up empty handed," he said then. Berkshire didn't purchase any shares in 2013 because the stock didn't meet the 120 percent hurdle.

In turning to share purchases, Buffett is also signaling there isn't anything he feels comfortable buying at current values. Berkshire hasn't had good luck on the deal front in a while, backing down from an offer for Texas power transmission firm Oncor after a bidding war broke out last year and abandoning a potential deal for Unilever.

With a flood of money at private equity firms waiting to be invested and Wall Street's willingness to pile on debt to get a deal done, Berkshire's classically frugal deal style is out of favor, said David Rolfe, the chief investment officer of St. Louis-based Wedgewood Partners, a long-time holder of Berkshire B shares.

Share purchases are a bullish sign that a company sees its shares as undervalued. "It's a high-class problem," Rolfe told CNBC. Buffett famously said a few years back that he was going "elephant hunting" to find big takeover targets to put Berkshire's cash to work.

"All along, the biggest elephant has been at the Omaha zoo. In his own company," Rolfe said.

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