Share buybacks have been all the rage throughout this bull market. Warren Buffett has opined on the efficacy of such repurchases routinely over the years. His latest discussion is in Berkshire’s year-old 2016 shareholder letter:
In the investment world, discussions about share repurchases often become heated. But I’d suggest that participants in this debate take a deep breath: Assessing the desirability of repurchases isn’t that complicated.
From the standpoint of exiting shareholders, repurchases are always a plus. Though the day-to-day impact of these purchases is usually minuscule, it’s always better for a seller to have an additional buyer in the market.
For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent. (Italics added.)
It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn’t be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision.
When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price. Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not.
It is important to remember that there are two occasions in which repurchases should not take place, even if the company’s shares are underpriced. One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made… [Second occasion not germane to this post.]
My suggestion: Before even discussing repurchases, a CEO and his or her Board should stand, join hands and in unison declare, “What is smart at one price is stupid at another.”
His 2017 annual report shows he continues to follow his own advice.
First, Buffett lamented Berkshire’s difficulty in consummating sizable standalone acquisitions in 2017. The pinch point was “a sensible purchase price,” even for “decent, but far from spectacular, businesses, whose prices hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.” He attributed the inflated prices to avaricious CEOs and the parasitic bankers who feed at their trough and the ample availability of extraordinarily cheap debt in 2017 that enabled overpriced deals to be immediately accretive to per share results.
Second, on page K-94 Berkshire announced that it made no purchases under its authorized share repurchase program which restricts buybacks to prices no higher than a 20% premium over book value.
So, with Berkshire shares too expensive to repurchase and Buffett finding even mediocre companies selling at record high prices, his default response, is to hoard cash, which has grown to 18% of total assets. Berkshire, a broadly diversified conglomerate, has also elected not to pay a dividend until it runs out of ideas to redeploy capital internally that are advantageously for its shareholders.
That is not the case for S&P companies, on average, as the chart from Ed Yardeni illustrates below. They are expending an amount nearly equal to operating income on dividends and share buybacks. Why do the S&P 500 companies eschew Buffet’s admonition, particularly in regard to buybacks?
See Yardeni’s work here.
It is in part because of chronically slow growth. The U.S. economy did not significantly deleverage following the financial crisis. High debt ratios retard growth, particularly when the debt incurred has only marginal economic impact, a dynamic which I have discussed at length elsewhere. Should interest rates continue to rise, this burden will be even more oppressive. In the face of slow economic growth as well as low productivity of labor, there are few options left to firms seeking to maintain the favor of Wall Street.
Two decades ago, I first wrote on the subject of stock buybacks in an essay primarily concerned with the relaxing of accounting standards.
Many, if not most, programs evince a prudent use of shareholder cash. Boards that authorize share-repurchase initiatives at market prices below what the businesses are intrinsically worth per share (without forgoing investment in even more compelling growth opportunities and with due regard for the financial security of remaining shareholders) are clearly putting the shareholders’ interests high on their priority list.
While trying not to cast unnecessary aspersions on the purity of motives, we nonetheless find a curious circularity to the reasoning behind the calculation of the worth of the business. If the higher-earnings-per-share growth rate that results from the share buyback program in turn causes the board’s determination of the worth of the business to be ratcheted up accordingly, where does one get off the merry-go-round?
Furthermore, and of no pressing concern, it also has occurred to us that share-repurchase programs are subject to finite limits. There is conceivably no ceiling on company growth, but a company can retire no more shares than are outstanding. If there are enough shareholders who don’t comprehend the value of the business and are willing therefore to part with stock at prices well below intrinsic worth, someday there will be but one shareholder group remaining. That’s what we call an MBO (management buyout)—on the installment plan.
Depending on how they’re financed, stock buybacks have the effect of increasing earnings per share. If the numerator (after-tax earnings adjusted downward to account for additional interest expense when money is borrowed to finance the purchase) falls less than the denominator (reduced by virtue of the shares acquired and retired), earnings per share will rise. In a catch-22 scenario, once a stock-repurchase program is instituted, discontinuing it becomes problematic. If the stock price surges in part because of the presumed higher rate of earnings growth, terminating the buyback plan will remove the growth catalyst that financial engineering provided, and the share price will likely register Wall Street’s displeasure. Letting the air out of stock prices, as noted elsewhere, is anathema in modern-day boardrooms. To the extent that this section addresses techniques by which executives can “manage” earnings, share repurchases must be included. Such programs—many of which we applaud, and a few of which we think are blatant, flagrant, and systematic squanderings of shareholder assets—are nothing more than another arrow in the financial-engineering quiver. Their only income-statement appearances are through an increase in interest expense or a decrease in interest income, relating to the means by which they are financed—and a reduction in the denominator in the earnings-per-share calculation. They have no effect on operating profits.
That buybacks are in vogue, then, should not surprise us. As I have noted before, physical capacity in the U.S. is underutilized. Therefore, cash flow otherwise used for capital spending is redirected toward activities that give only the illusion of growing prosperity. “Inflation of per-share earnings through stock repurchases and rising dividends, ultimately leading to higher stock prices, create no system-wide gain in prosperity.” The lack of such prosperity does not bode well for those higher prices.
 Frank Martin, Decade of Delusions ( Hoboken: John Wiley & Sons, 2011), 40.
 Frank Martin, “The Tail Risks Optimizer’s Dilemma: Taleb vs Spitznagel,” Blog post, October 6, 2017.
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FKM: Did you ever get a reply from Jerome? Regards, One T no S