Wednesday, September 28, 2011

Thinking about Buffett's decision to repurchase

Well, the recent announcement by Berkshire Hathaway that it would initiate an open-ended buyback at prices up to 1.1x book value has raised quite some stir in the investment community, about BRK stock, the company's future, equity prices in general and the future direction of the stock markets.

Opinions range from the idea that this is a shrewd PR move to boost the stock price, by essentially setting a price floor at 10% of a (rising) book value, to the opposite idea, that the action will set a ceiling on the price, since if Buffett is unwilling to purchase the stock above 1.1x book, why should any other investor?

The International Business Times has a very thoughtful quote from Thomas Russo, of the asset management firm Gardner, Russo and Gardner - arguing that the buyback is part of planning for life after Warren, because with Buffett "cash had such a high value", but that under another manager, the value of the "cash option" will be lower.  This is almost certainly right, as Buffett regularly gets to make investments on "only for Warren" terms - e.g. his investments in Goldman Sachs and Bank of America, which both were willing to pay up to get his imprimatur and prevent a confidence crisis that could have caused a (liquidation-forcing) run.  With lowered expectations for cash deployment, it is time to begin returning cash to shareholders.

Finally, there are a host of arguments about what the buyback means for equity valuation and market direction, typically these span the gamut of arguing that the buyback is a bearish signal, and that it is a bullish signal.

Taking the arguments, I think the last one can be dismissed out of hand - the author makes some tortured arguments about the relatively low premium of the S&P500 to book value, to argue that if Buffett is wiling to purchase at 1.1x book, then why not the whole market at 2+ times.  Indeed the author acknowledges that only 20% of companies actually trade at or below the price at which Buffett is willing to buy BRK.  Unsaid is that many of them carry far more risk, a company that certainly meets the first three Buffett criteria for a business - good trustworthy management, simple understandable businesses, possessing wide moats with reasonable growth prospects.  These, he obviously now feels he is getting a reasonable price.  Given the arguments of the Bullish writer, it appears that BRK is now trading at quite a discount to the market (this is my own view, which is why, prior to this announcement, I have considered purchasing "B" shares).

The bearish argument makes more sense, as it rightly argues that were valuations cheap, Buffett would take the opportunity to deploy cash scooping up assets at a discount.  The fact is, large cap value stocks - the kind that produce stable cashflows, strong returns on equity and allow for higher leverage are among the least expensive, as measured by PE (and adjusted PE, since most of these firms did not sustain huge losses in 2008/2009).  The fact is, a buyback is indicative of the lack of attractive investments relative to the cash generation of the company.  (Buffett and Munger have repeatedly argued that buybacks and dividends are symbols of failure - an indication of an inabilty to put the cashflows of BRK businesses to work making yet more money).

The argument about the relative valuation of cash is particualrly an interesting one.  In Buffett's hands, liquidity is incredibly powerful.  My only argument against this is to point out that Buffett is hardly out of the picture, so presumably, there has been no loss of the value of the cash - only that BRK is now generating too much.  This is not a new situation, actually.  Over time, Buffett has migrated from purchasing businesses that produced huge amounts of float (cash to invest) such as Blue Chip stamps and his insurance businesses to purchasing businesses that needed little increase in capital to grow the business (See's Candies - Buffett's favorite investment, I think), to purchasing large capital intensive businesses, such as Burlington Northern and Lubrizol.  This is no accident.  Buffett's traditional businesses produce so much cash, he can no longer acquire enough businesses, so he has instead looked to businesses that require large capital injections, but which can then earn acceptable rates of return on that capital.  Buffett is essentially providing internal financing to these large industrial companies so that they can avoid the difficulty of raising funds on the open markets in difficult times.  But even these cannot absorb all of the cash Berkshire now generates.

As to the value of BRK stock, well, Buffett has always maintained that the intrinsic value is high above book value, (but that change in book value is a good proxy for the change in intrinsic value).  There is good reason to believe that the stock's intrinsic value is well above the price at which Buffett is willing to purchase.  As we know, Buffett is a student of Ben Graham, and is particularly influenced by the idea that investing requires a margin of safety, and to always purchase when you are assured that there is one.  We also know that Buffett never breaks discipline.  Nevertheless, there is a chance that by trying to set a floor, Buffett may limit the upside to the stock price.  But if intrinsic value is truly greater than 1.1x book, there would still be significant money to be made purchasing above Buffett's price, but below intrinsic value, so the likelihood is that ultimately, the price will rise well above that Buffett is offering.

My own view is the Buffett has made yet another shrewd calculation in offering to buy back stock.  He is, in fact, taking advantage of Mr. Market's preference for growth, which has companies like trading at triple digit multiples (or nearly), while allowing companies like Microsoft to trade in single digit multiples.  Moreover, BRK may be suffering from a discount related to the expected change in leadership - management changes are risky for investors, since new mangement may not act in shareholder friendly ways (or even with good business sense).  Finally, BRK is more than anything else an insurance company, and financial firms are also quite out of Mr. Market's favor, so Buffett will be happy to take shares off his hands.   Buffett gets a diversified conglomerate trading at a significant discount to both the market and his own estimate of intrinsic value, and will be able to put the money to work in large sums (provided the stock doesn't rise above his bid).  Ultimately, I am not even sure that he will actually repurchase any shares, as the market will likely keep the stock at a premium to his bid.

Please note that there are arguements to be made that the performance of Buffett's businesses is deteriorating, and that perhaps the stock should not trade at such a premium to book.  But this article is too long already to debate that issue.

Returing to the rationale for the buyback, I believe the decision to repurchase shares is serving Buffett - and his shareholders - in three other ways.

First - it is allowing Buffett to make a statement about how management returns cash to shareholders.  Buffett has actually named his price for shares, which is highly unusual.  Most managements declare a willingness to repurchase a certain number of shares, or a certain dollar value of shares, but do not specify at what price they are buyers or at what price they are sellers.

Most company managers use buybacks as a means of deploying excess cash - that means, however, that they are usually buying when business is good (and stock prices are high), because that is when the business is generating surplus cash, and are hoarding cash and not buying when stock prices are low.  Thus firms set a record for buyback in 2007 at the market top, but were at a multi-decade low in spring of 2009, when stocks were at their nadir.  Buffett has instead argued that buybacks should be based on valuation - management should initiate buybacks ONLY WHEN the stock trades at a discount to intrinsic value, otherwise, they should just return excess cash to shareholders (via dividends).

Moreover, Buffett is telling his shareholders that he thinks he is getting a very good price.  Buffett has effectively said, "At 1.1x book, I think I'm getting a good deal.  Now, if you still want to sell, then ok, but just be aware, I think I'm getting the better end of this trade".  Buffett in his interview with Becky Quick earlier this year, explained that when buying back stock, you have to recognize that you are ultimately trading with your shareholders, and that the agents of shareholders, management has a duty to advise shareholders of the economics of the deal prior to making it (which is why BRK has never repurchased shares).  Once you tell someone, "hey, just so you know you're getting screwed," they usually decide not to deal.

Second - I believe Buffett is trying to counteract the effect of the rapid expansion of BRK float resulting from long term, octogenarian, holders finally liquidating positions that have not traded in decades.  While this should not really have a signficant impact on the stock price (which should reflect intrinsic value), the fact is that markets also respond to short term differences in supply and demand, and that at the moment, supply is being increased rapidly as the Gates foundation liquidates the shares Buffett is donating to them.  This is potentially weighing on the price (even though this is an extended process), and Buffett has an opportunity to mop up some of the excess supply (at a nice gain).

Third, and most important, is what BRK did not do: issue a dividend.  Overlooked by every commentator I have read, is the fact that buying back the shares doesn't limit Buffett's ability to acquire other businesses - it may change the currency, however.  Repurchased shares become treasury shares and are then available for acquisitions.  Indeed, if the stock returns to intrinsic value (or even a premium), Buffett may be able to use the currency of treasury shares to acquire a company for less than if he had paid all cash (there are some tax advantages that often mean a stock deal can be had at a discount).  Thus, the money allocated to treasury purchases is not really "gone" (though of course, reissuance of treasury shares increases shares outstanding, with implications for book value and for EPS). 

Had Buffett instead issued a dividend, the money would truly be no longer available and a new deal would have to be done by issuing new stock.  Of course, if the stock continues to trade a discount to intrinsic value (it could fall further, even), then treasury stock is not an attractive currency, so in that sense, there is risk in comparison to keeping the cash.

All in all, I believe that Buffett is deploying BRK cash quite wisely in making this purchase.  I would that more CEOs would focus on valuation when repurchasing stock.

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