Warren Buffett explains the enduring power of stock buybacks for long-term investors
- Warren Buffett, billionaire investor and chairman and CEO of Berkshire Hathaway, has long held the belief that stock buybacks can often be the best use of corporate capital.
- Berkshire and one of its biggest stock holdings, Apple, are both sitting on huge balance sheet cash reserves.
- Berkshire made its buyback policy more flexible in July and Apple bought back more stock in the first half of 2018 than any company has ever done in a six-month period.
- Goldman Sachs estimates there will be $1 trillion in U.S. stock buybacks this year, which would smash the previous record, set right before the financial crash in 2007.
Warren Buffett always has underpriced market opportunities on his mind. And while he is known for his mergers and acquisitions shrewdness, he has argued in the past that the best use of all for corporate cash is share buybacks.
At the 2004 Berkshire Hathaway annual meeting — well before the company outlined its first official buyback policy in 2011— Buffett said "When stock can be bought below a business's value it is probably the best use of cash."
Berkshire Hathaway owns many stocks that repurchase shares and pay dividends, including what is now its biggest holding, Apple,.
Buffett has long benefited from owning stocks that reward shareholders through both methods. In an interview with CNBC this week, when asked whether investors should be worried about the stock market at a record level, he said that buybacks make owning the iPhone maker a no-lose situation right now.
"I'd rather have it go down for one thing, if it goes down Apple is going to buy a lot of stock back, already buying stock back," he said. "If it goes down 10 percent it means they get to buy 10 percent more shares and my interest will go up 10 percent more for spending that money."
Buffett has always resisted a Berkshire Hathaway dividend, but continues to believe that buybacks, when done at the right prices and for the right reasons, are an effective way for executives to invest in their businesses and reward long-term holders of stock.
U.S. companies on pace for $1 trillion in buybacks this year
As the bull market nears a decade, there have been many concerns that the record-level of buybacks has created financially engineered returns. Removing shares from the market results in the remaining shares retaining a greater portion of earnings — and that can mask the true health of publicly traded businesses.
Still, U.S. companies are on track to reach $1 trillion in buybacks this year, according to Goldman Sachs. Already, companies have authorized over $750 billion in buybacks, and the overall pace of buybacks is almost double last year's. The previous annual record for buyback activity was set in 2007, at $589 billion.
In mid-July, when Berkshire was sitting on a cash pile over $100 billion and had gone three years without a major acquisition, the company announced that it was doing away with the policy of buying back shares only when the stock was trading below 1.2 times book value (which already represented an increase from a policy of only buying when shares were below 1.1 times book).
Buffett and vice chairman Charlie Munger would buy back shares when they thought Berkshire was trading below "intrinsic value," a more flexible buyback policy. Apple is currently sitting on close to $250 billion in cash.
Buffett's belief in the enduring power of buybacks, and how they should be evaluated, has been explained at Berkshire's annual meetings, and in interviews over the years. The following five buyback ideas from Buffett provide a summation of his thinking.
1. Buybacks, when done right, are a value investment
Unlike dividends, which are typically implemented with the understanding that they will always be paid to shareholders unless there is a dramatic change in a business's situation, buybacks offer management the opportunity to do what Buffett likes best: buy undervalued stocks.
In discussing why opportunistic buybacks are better than perennial dividends, Buffett told CNBC in February 2018, "The best chance to deploy capital is when things are going down."
That echoes what he said this week on CNBC about a 10 percent decline in Apple being a good thing, because it means management would likely buy more stock.
In a 2015 interview with CNBC, Buffett said, "Many management are just deciding they're gonna buy X billions over X months. That's no way to buy things. You buy when selling for less than they are worth. ... It's not a complicated equation to figure out whether it is beneficial or not to repurchase shares."
At the next year's annual meeting, in 2016, he added, "Anytime you can buy stock for less than it's worth, it's advantageous to the continuing shareholders ... but it should be by a demonstrable margin," he said.
That is important for shareholders monitoring the C-suite at a time of record stock prices and buyback activity — corporations are flush with cash not only from increased profits but the recent corporate tax cuts — and it isn't easy to offer a formula that proves a "demonstrable margin."
Even though Buffett used 1.1-1.2 times book value in the past decade as a "conservative" way to justify a buyback, he told Berkshire shareholders many years earlier that neither price-to-earnings ratio or book value alone could be used to determine the efficacy of repurchases.
In moving back to monitoring of "intrinsic value," he has opted for a buyback methodology that has also been used by JP Morgan CEO Jamie Dimon. "Jamie Dimon is very explicit about saying he's going to buy back the stock when he's buying it below what he considers intrinsic value to be," Buffett told shareholders in 2016.
"If you're repurchasing shares above a rationally calculated intrinsic value, you are harming shareholders. Just as if you issue shares beneath that figure, you are harming shareholders," the billionaire said. "The tough part is coming up with the intrinsic value. There is a lot more to intrinsic value than P/E," he added, though there is no way to work intrinsic value out to four decimal places, "or anything of the sort."
2. It is a free increase in stock ownership
Buffett's comments this week echo what he has said over the years about the powerful effect buybacks have on stock ownership. As far back as the 1996 Berkshire annual meeting, Buffett explained one of the greatest benefits of stock buybacks to shareholders: You don't need to spend a dime to increase your percentage of shares held.
Buffett said back in 1996 that he has "enormous respect for the power of a really outstanding business. And we recognize how scarce they are. And if a management wishes to further intensify our ownership by repurchasing shares, we applaud."
In 1998, when a young hedge fund manager from New York named Bill Ackman asked Buffett how he could support Coke buying back shares with a high price-to-earnings ratio, Buffett reiterated that there is no single metric by which a buyback becomes justifiable or questionable. Yet over the 100 year-plus history of Coke, there were very few times that it wouldn't have been smart to repurchase shares. "When Coke repurchases shares our interest goes up."
At that time, Buffett estimated that Berkshire's original 6.3 percent interest in Coke increased to roughly 8 percent as a result of buybacks.
He said the same about Apple at the 2018 meeting: "I'm delighted to see them repurchasing shares. ... You can say we own 5 percent of it. But I figure with, you know, with the passage of a little time we may own 6 or 7 percent simply because they repurchase shares. ... I find that if you've got an extraordinary product, and ecosystem, and there's lots to be done, I love the idea of having our 5 percent, or whatever it may be, grow to 6 or 7 percent without us laying out a dime. I mean, it's worked for us in many other situations."
3. Buybacks are better than hasty acquisitions, maybe even most acquisitions
Buffett believes that the real debate isn't acquisitions versus buybacks, but good acquisitions versus buybacks.
It is an issue that is particularly acute in technology, he noted in a May 2015 interview with CNBC, because big tech firms like Apple earn enormous amounts of money. Even with R&D spending, don't need as much money as they have for spending.
When questioned at the 2018 Berkshire annual meeting about Apple not using its huge cash pile for acquisitions, Buffett said if the tech company doesn't see an acquisition that's even more attractive, buying more shares is the right decision. Buffett also noted it is very hard for a company of Apple's size to find an acquisition that would be accretive to earnings, probably in the $50 billion to $100 billion, or even $200 billion range.
They're not going to find a $50 billion or a $100 billion acquisition that they can make at remotely a sensible price that can really become additive.Warren Buffetton Apple making a big acquisition
"And they're not going to find a $50 billion or a $100 billion acquisition that they can make at remotely a sensible price that can really become additive," he speculated. "As I look around the horizon, I don't see anything that would make a lot of sense for them in terms of what they'd have to pay and what they would get. Whereas I do see a business that they know everything about, and where they may or may not be able to buy it at an attractive price when they repurchase their shares."
Through the first two quarters of 2018, Apple repurchased $43.5 billion in shares, a record for a half-year period, according to S&P Dow Jones Indices data. Berkshire's stake in Apple shares, built in the past few years, is now valued at over $57 billion, almost twice as large as Buffett's last big acquisition, Precision Castparts, which was valued at roughly $32 billion in equity when the deal was struck in 2015.
Berkshire vice chairman Charlie Munger said mergers often lead to a decrease in value. "Generally speaking in America, when companies go out hell-bent to buy other companies, they do — they're worth less after the transaction is made than they were before. So I don't think you have a general way to wealth for American corporations to go out and buy other corporations. Averaged out, it's a way down, not up. And I think that a great many places have nothing better to do than to buy in their own stock, and nothing as advantageous to do as they can — as buying in their own stock."
Buffett has said that even if Berkshire buys back shares aggressively, it would never let the cash on hand fall below $20 billion as a result.
4. What makes for a bad buyback (and there are many of them)
Asking a senior executive whether their company's shares are undervalued is like asking an athlete whether they are going to win a game they are about to play. And that is a reason Buffett believes management must focus on valuation, and err on the side of caution, when it comes to buybacks.
"We might require a somewhat greater margin, in terms of buying Berkshire shares [versus those of other companies], simply because our view on that might be less — we probably have more knowledge on it, but we might be less objective than on some other things."
At the 2016 meeting, Buffett said that buyback plans were getting "a life of their own, and it's gotten quite common to buy back stock at very high prices that really don't do the shareholders any good at all."
Doing buybacks because they are "fashionable" is not a good reason, but Buffett said it was happening. "It's fashionable and they get sold on it by advisors."
"Can you imagine somebody going out and saying, we're going to buy a business and we don't care what the price is? You know, we're going to spend $5 billion this year buying a business, we don't care what the price is. But that's what companies do when they don't attach some kind of a metric to what they're doing on their buybacks.
Buffett added: "You will not find a lot of press releases about buybacks that say a word about valuation," but he clearly believes they should.
5. If you want a dividend, create one yourself by selling a little stock.
Berkshire has benefited from plenty of hefty dividends, even though Buffett is not a big fan of them. But if he likes a stock, he knows the chances of the company ever stopping the dividend are remote, and so the decision to own has to be made in spite of that.
"We'd rather have a company whose stock is undervalued buying back stock but the trouble is if you pay a dividend you're not going to eliminate it," Buffett said, using Apple as an example.
Buffett said for shareholders of his own company, or any stock that doesn't offer a dividend and is a big holding, there is a way to create your own dividend stream without forcing the "permanent" and taxable event on all shareholders: Sell a little stock each year. "Years ago I pointed out you can sell a little piece of Berkshire every year and still end up owning more of it. People who want to take a little bit of what they earn, each year, and turn it into cash can do it, and they don't force that policy on other people."
Back in 2004, he said, "The best use of cash, if there is not another good use for it in business, if the stock is underpriced is a repurchase."
To learn more about Warren Buffett's views on the markets, investing and stocks, consult CNBC's new Warren Buffett archive.