Warren Buffett doesn’t hate share repurchases.
In 2016, US corporates likely used $1 trillion repurchasing their own shares on the open market. This use of cash has become increasingly controversial as buybacks have been the favored use of cash by corporates during the ongoing, sluggish post-crisis economic recovery.
“In the investment world, discussions about share repurchases often become heated,” Buffett writes in his latest letter to Berkshire Hathaway (BRK-A, BRK-B) shareholders.
“But I’d suggest that participants in this debate take a deep breath: Assessing the desirability of repurchases isn’t that complicated.”
For example, Larry Fink, the CEO of BlackRock, the world’s largest asset manager, wrote in a recent letter to corporate leaders around the world, that, “Companies have begun to devote greater attention to these issues of long-term sustainability, but despite increased rhetorical commitment, they have continued to engage in buybacks at a furious pace… Companies should engage in buybacks only when they are confident that the return on those buybacks will ultimately exceed the cost of capital and the long-term returns of investing in future growth.”
Fink’s second sentence, however, is the assumption that underwrites Buffett’s defense of the practice. If a company is trading on the open market at price below its intrinsic value, then the decision to buyback some of its shares is easy: do it. For Berkshire, that level is 120% of book value.
Here’s the example Buffett lays out:
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.
However, Buffett thinks that many executives do make a mistake when deciding to repurchase shares, and one that gives the entire practice a bad name: they don’t consider price.
“It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed,” Buffett writes. “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.”
Buffett continues:
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.
The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser. Long ago, Berkshire itself often had to choose between these alternatives. At our present size, the issue is far less likely to arise.
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.”
In recent years, most of the controversy around stock buybacks is that payouts to shareholders — dividends plus buybacks — were exceeding earnings for the S&P 500.
Companies, of course, argue this is because they’d found no better uses for their cash. Critics argue that companies simply weren’t trying to find productive investments (like, for example, giving employees raises). Even more cynically, some view increased buybacks as shareholding-managers and executives simply enriching themselves.
But to Buffett, the idea that payouts exceeding earnings indicates some grand malfeasance on the part of executives is a misread of the situation.
“As the subject of repurchases has come to a boil, some people have come close to calling them un-American — characterizing them as corporate misdeeds that divert funds needed for productive endeavors,” Buffett writes.
“That simply isn’t the case: Both American corporations and private investors are today awash in funds looking to be sensibly deployed. I’m not aware of any enticing project that in recent years has died for lack of capital. (Call us if you have a candidate.)”
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Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland
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