There is nothing terribly complicated or nefarious about stock buybacks, though shareholders are often hurt when they are mistimed or are not executed correctly. The recently announced Berkshire Hathaway buyback demonstrates the right way to do it. I hold the following propositions about stock buybacks to be self-evident (and I hope that you do as well):
1. Buybacks should never be considered unless the stock is undervalued.
Buybacks should be considered when the firm's stock is undervalued and when the present value of investing $1 in the firm's existing operations is greater than the present value of investing the same dollar in discretionary capital expenditures or acquisitions. If the firm's stock is not undervalued, then paying the $1 directly to shareholders in the form of a cash dividend is always preferable to using it to buy back stock.
As Buffett stated at the 2004 Berkshire Hathaway annual meeting: "If the stock is underpriced, buy it back with excess cash; if it’s overvalued, don’t buy a single share."
2. Managers should establish a maximum on the price per share that they will pay to buy back stock, and should not establish a minimum on the amount that they will spend on a buyback.
The Berkshire press release reads: "Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares." This drastically reduces the probability of overpaying for shares. In contrast, countless firms in recent years have announced to great fanfare that they will spend X billions of dollars on buybacks over a period that sometimes stretches for years into the future, without naming a maximum price. This is the only example that I know of in which managers and boards profess to believe that they can fix capital allocation decisions years ahead of time.
3. Management should be upfront with all shareholders about their estimate of the firm's intrinsic value.
I don't understand the heavy philosophical discussions about what management's responsibilities are in this situation. It seems clear to me that management has a duty to look out for the interests of all shareholders, up to the moment that they decide to dispose of their shares. If some shareholders still wish to sell after being apprised of all relevant information, then management has done its duty with respect to those shareholders. Continuing with the Berkshire press release mentioned above:
"In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."
4. Management must never sell into a buyback.
Enough said, right? Well, incredibly, it happens. Buffett, of course, doesn't trade in Berkshire shares, especially not against his own shareholders.
5. When the financial implications of a proposed buyback for management or board members differs from the implications for a shareholder who plans to retain his shares,....well, they really shouldn't, but if they do then at the very minimum this fact should be widely publicized when the buyback is announced.
I'm not keen on proscribing new regulations, but stock options and bonus compensation based on targets like earnings per share (EPS) clearly create a misalignment of incentives between management and shareholders when it comes to buybacks. Dividends are sometimes a better alternative for shareholders, but management and board members with options might avoid them because dividends reduce option values. Similarly, managers who are compensated on per share measures like EPS will prefer buybacks to dividends because they take shares out of circulation. Berkshire avoids these problems by paying executives salaries and performance bonuses that are not directly tied to specific, "gameable" metrics. Buffett has worked hard to instill a culture that will hopefully allow Berkshire to continue to avoid these types of blatant conflicts of interest long after he steps down.
Disclosure: I am long Berkshire Hathaway common stock (BRK-B). Positions can change at any time without notice.
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I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.
1. Buybacks should never be considered unless the stock is undervalued.
Buybacks should be considered when the firm's stock is undervalued and when the present value of investing $1 in the firm's existing operations is greater than the present value of investing the same dollar in discretionary capital expenditures or acquisitions. If the firm's stock is not undervalued, then paying the $1 directly to shareholders in the form of a cash dividend is always preferable to using it to buy back stock.
As Buffett stated at the 2004 Berkshire Hathaway annual meeting: "If the stock is underpriced, buy it back with excess cash; if it’s overvalued, don’t buy a single share."
2. Managers should establish a maximum on the price per share that they will pay to buy back stock, and should not establish a minimum on the amount that they will spend on a buyback.
The Berkshire press release reads: "Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10% premium over the then-current book value of the shares." This drastically reduces the probability of overpaying for shares. In contrast, countless firms in recent years have announced to great fanfare that they will spend X billions of dollars on buybacks over a period that sometimes stretches for years into the future, without naming a maximum price. This is the only example that I know of in which managers and boards profess to believe that they can fix capital allocation decisions years ahead of time.
3. Management should be upfront with all shareholders about their estimate of the firm's intrinsic value.
I don't understand the heavy philosophical discussions about what management's responsibilities are in this situation. It seems clear to me that management has a duty to look out for the interests of all shareholders, up to the moment that they decide to dispose of their shares. If some shareholders still wish to sell after being apprised of all relevant information, then management has done its duty with respect to those shareholders. Continuing with the Berkshire press release mentioned above:
"In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest."
4. Management must never sell into a buyback.
Enough said, right? Well, incredibly, it happens. Buffett, of course, doesn't trade in Berkshire shares, especially not against his own shareholders.
5. When the financial implications of a proposed buyback for management or board members differs from the implications for a shareholder who plans to retain his shares,....well, they really shouldn't, but if they do then at the very minimum this fact should be widely publicized when the buyback is announced.
I'm not keen on proscribing new regulations, but stock options and bonus compensation based on targets like earnings per share (EPS) clearly create a misalignment of incentives between management and shareholders when it comes to buybacks. Dividends are sometimes a better alternative for shareholders, but management and board members with options might avoid them because dividends reduce option values. Similarly, managers who are compensated on per share measures like EPS will prefer buybacks to dividends because they take shares out of circulation. Berkshire avoids these problems by paying executives salaries and performance bonuses that are not directly tied to specific, "gameable" metrics. Buffett has worked hard to instill a culture that will hopefully allow Berkshire to continue to avoid these types of blatant conflicts of interest long after he steps down.
Disclosure: I am long Berkshire Hathaway common stock (BRK-B). Positions can change at any time without notice.
******************************************************************************************************************
I am an individual investor who occasionally shares opinions about investments and other matters on the internet. I am not a registered investment adviser or investment adviser representative. I did pass the series 65 exam in 2011, but I have never been registered as an investment adviser or investment adviser representative in any jurisdiction. I will not respond to any inquiries about investment management services. Nothing posted on this blog should be interpreted as actionable investment advice, financial planning advice, tax advice, or legal advice. I do not derive or seek to derive any income from my blogging activities. This blog is intended solely for the entertainment of the reader, and the author.
