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.