With two huge mergers being the talk of Wall Street, which one would Warren Buffett do?
Most investors know that Buffett, chairman and CEO of Berkshire Hathaway, is full of advice for individual investors. But the Oracle of Omaha's market musings — doled out year after year across decades of annual letters to Berkshire shareholders and interviews — are also reflected in the actions of major corporations and the ways in which they leverage their balance sheets.
The two big corporate acquisitions show divergent paths when it comes to one of Buffett's strongly stated beliefs about making deals: Don't use your own stock. Use cash. Buffett's rules of the road for acquisitions have been expressed in years of shareholder letters.
His advice to CFOs, implicitly, shows up in these letters, according to the editor of "The Essays of Warren Buffett" and George Washington University professor Lawrence Cunningham. Read enough of them and the 89-year-old chief executive of Berkshire Hathaway gets around to giving his distinctively value-tinged, commonsense approaches to accounting, mergers, stock buybacks, dividends and other tricks of the trade to build value.
"Everyone sort of nods when they're reading, but then they don't listen," said Cunningham, a corporate-governance expert at George Washington University Law School. The fifth edition of the book-length distillation of Buffett's decades of shareholder letters just came out. "Then they go make the mistakes themselves."
Berkshire famously never has paid a cash dividend, for example, and has moved more slowly on stock buybacks than most companies of its size (its market capitalization is $535 billion).
Especially, Buffett sounds repeated warnings on the subject of acquisitions, though Berkshire itself has been a serial acquirer — either of whole companies like Geico and the Burlington Northern Railroad or of big stakes in public companies like Apple, IBM and American Express.
Buffett's preference for cash over stock in M&A can be summed up this way:
If a company is in a position to buy a rival, it's probably in better shape than the target is, and that means its stock is worth more of a premium, Buffett wrote in 1997. Paying cash helps the acquirer avoid giving away the appreciation of its existing business to holders of the company getting bought out, which, if you're doing it right, is larger than the gain likely to come from the acquisition, he wrote.
"For a baseball team, acquiring a player who can expected to bat .350 is almost always a wonderful event -- except when the team must trade a player hitting .380 to make the deal," Buffett wrote.
In one instance of Buffett going public with this belief about giving away shares in a deal he chastised then Kraft CEO Irene Rosenfeld in 2010 for using Kraft shares in a takeover of Cadbury. He did break his own all-cash rule once, notably, using a combination of cash and shares to buy Burlington Northern, at the time Berkshire's biggest acquisition ever.
News of the Schwab and LVMH deals hit just as a new edition of the Buffett book is hitting the stands. And the headlines underscore how timely Buffett's advice remains for corporate titans. The 89-year old has long been known in his personal life for being a bit of a miser, eating McDonald's for breakfast and living in the same modest home in Omaha for decades. When it comes to spending a company's cash or stock, in acquisitions or otherwise, his grip on his wallet is no more loose.
Analysts who cover the brokerage industry say Buffett's words are wise, but the specifics of the Schwab-TD Ameritrade deal make the decision to finance it with stock a reasonable one.
"Buffett has over $100 billion in cash. Schwab had about $20 billion at Sept. 30, so could not have financed this entire transaction with cash," wrote Argus Research analyst Stephen Biggar in an email.
Morningstar analyst Michael Wong said for Schwab shareholders the deal probably would have been more accretive if it was cash financed, but he does think that TD Ameritrade would have balked at a $26 billion valuation in cash. "Even if Schwab shareholders gave up a little bit of the value by issuing shares, both are better off from this deal."
That's because the long-term synergies that would result from the combination of the similar businesses — which should reach into billions of dollars — would have required a much higher cash premium in a deal. A stock deal allows shareholders to benefit from those synergies — albeit always uncertain in the initial estimation on deal date — that can accrue over time.
Schwab is trading at 19.5x 2020 earnings, while AMTD is at 16.5x. Both stocks have risen since news of the deal was first broken by CNBC.
"Both shares rising is an indication that investors see the merit in the expected 15%-20% cash EPS accretion by this third year," Biggar wrote. "While true that financing is currently inexpensive, keep in mind Schwab is trading at 19.5x 2020 earnings, while AMTD is at 16.5x, so Schwab is buying a similar revenue stream with a more favorable currency."
Biggar also noted that TD Ameritrade shares are 43% held by Toronto-Dominion, a large shareholder unlikely to sell.
Schwab did not respond to a request for comment.
Buffett also says to consider buying part of the business rather than all of it. Buying shares in open markets, as Berkshire often does (it has reported stakes in about 45 other public companies) lets Buffett and his team, led by vice chair Charlie Munger and investment officers Todd Combs and Ted Weschler, avoid paying takeover premiums in order to get a piece of the business, while still building value for Berkshire stockholders.
In fact, right now that is Buffett's publicly stated preference. Even as Berkshire's cash hoard has grown to near-$130 billion, Buffett has been reluctant to make big deals. Buffett wrote in last year's annual letter that he continues to hunt for the "elephant-sized" acquisition:
"In recent years, the sensible course for us to follow has been clear: Many stocks have offered far more for our money than we could obtain by purchasing businesses in their entirety. That disparity led us to buy about $43 billion of marketable equities last year, while selling only $19 billion. Charlie and I believe the companies in which we invested offered excellent value, far exceeding that available in takeover transactions. ... That disappointing reality means that 2019 will likely see us again expanding our holdings of marketable equities. We continue, nevertheless, to hope for an elephant-sized acquisition."
Here are some more of Buffett's biggest beliefs for the C-suite.
Don't fall in love with your own management skills. Too many acquirers think their kiss alone will turn a toad of a company into a prince, Buffett wrote in a witty 1981 letter. It rarely happens. That leads to Buffett's most famous rule of acquisitions: It's better to buy a good company at a fair price than a fair company at a good price, an idea he explained in 1992.
"We have occasionally tried to buy toads at bargain prices," Buffett said. "Clearly our kisses fell flat. We've done well with a couple of prices — but they were princes when purchased. At least our kisses didn't turn them into toads."
A similar combination of skepticism (about the market) and belief (in Berkshire's own business) explains why Buffett doesn't believe in cash dividends, Cunningham said.
Dividends should be paid in cash only when the company doesn't have a better place to invest the money in its own business, a point Buffett explained in 1984 with a math-dense illustration of why that's rarely so for a well-run company.
Buy more of your own stock. One place where the cash can often be put to good work is on stock buybacks, as long as management is disciplined, Buffett said, on a topic he has revisited five times in shareholder letters, as recently as 2018. Bought at the right price, the shrinking share base will boost earnings per share.
But management too often falls for the hype around their own stock and overpay, Buffett wrote in the bubble year of 1999. At Berkshire the rule had long been that the company won't pay more than 110% of shares' intrinsic value, a subjective measurement of the value of future cash flows projected by management, but it has more recently broken that rule to snag large blocks of shares when they became available.
"By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders," Buffett wrote in 1984. "Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.''
Look beyond earnings. One place where Buffett isn't all that traditional is in thinking about earnings, Cunningham said. While Berkshire follows accounting rules in reporting its results, Buffett is open about the fact that he thinks more about other measures of economic results than accounting earnings. Beginning In 1980, he has devoted parts of several letters to a concept he calls "look-through earnings,'' advocating for investors and managers to look beyond reported profits and losses under generally accepted accounting principles.
In Berkshire's case the big difference between the two is that its reported profits can fluctuate based on the value of its investment holdings. A U.S. accounting rule requires earnings to incorporate unrealized gains, including on investments such as Apple and Bank of America. Buffett said the resulting volatility can mislead investors.
And Buffett reserves particular scorn for managers who put too much emphasis on consistent yearly growth in earnings per share, Cunningham said. Berkshire doesn't issue profit guidance, unlike more than half of big companies, because he thinks "no one has any idea what next year looks like."
But the avoidance of short-term forecasts, and the emphasis on steady quarterly profit gains they induce, is only part of a good CFO's task of communicating clearly and promoting a stable financial base for their company, Cunningham said. Buffett thinks of steady financial stewardship as the center of an ongoing strategy to attract shareholders who behave like Berkshire's — they hold the shares a long time and give management running room to succeed. That's the CFO's ultimate job, he said.
"The CFO is the public face of a company's shareholder orientation," Cunningham said. "If the CFO doesn't want activist shareholders telling them what to do, speak day to day is high-quality language. That attracts high-quality investors. Ask yourself, What would Buffett like to do? And you'll get shareholders like that.''
On the long-term view, Morningstar's Wong said the Schwab deal shows concern well beyond the next quarter.
He said Schwab made this deal now because its future competitive set may not be limited to a handful of online brokers, but the Wall Street giants like Bank of America, J.P. Morgan and BlackRock, as technology allows the biggest firms to go down-market in terms of average client size, direct to investors through online arms, and across more business segments.
It is not just going to be E-Trade, TD Ameritrade, Vanguard and Fidelity in 10 years' time when it comes to online and wealth management competition, and Schwab is thinking long-term by preparing for greater competition today, even if it costs them in stock, Wong said.
Biggar said there is a "first-mover advantage" for Schwab in an industry that is fragmented today. "Future big tie-ups will necessarily mean less competition, while Schwab will have already gotten approval – i.e. regulatory scrutiny will be much higher when future partners will be trying to justify themselves as a second player with a 30-40% market share."