Berkshire Hathaway chairman Warren Buffett has pushed back at critics who he says come close to calling share buybacks ‘un-American.’Nati Harnik/The Associated Press
John Reese is CEO of Validea.com and Validea Capital, the manager of an actively managed ETF. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it today – Globe and Mail readers get an exclusive 25-per-cent discount.
Warren Buffett's Berkshire Hathaway currently has $86-billion (U.S.) cash at its disposal to acquire companies or take bigger stakes in existing stock holdings, as it did with Apple shares in the final three months of 2016.
Shareholders and followers of Mr. Buffett have come to expect big moves from the billionaire, who is known for focusing on the long term. But in his annual letter to shareholders last month he spent some time trying to talk readers into accepting a practice that has been vilified for encouraging short-term thinking: share buybacks.
Critics – including some of the biggest U.S. money managers – have complained that buybacks take a company's focus off investing its resources in activities that can produce long-term gains. American companies bought $2.1-trillion of their own shares from 2010 to 2015, according to a report by HSBC last year.
But they are a useful way for companies to return money to shareholders without making a huge, costly commitment to a merger that has the potential to go awry. And they are a way for management to signal that it believes its stock is not being recognized for its true value.
Companies such as IBM – one of Berkshire's biggest holdings – have bought back a significant number of shares in recent years while their stock prices were depressed. In a previous shareholder letter, Mr. Buffett explained that this only stood to benefit Berkshire shareholders by boosting its economic interest in IBM, thus increasing its share of IBM's future earnings.
In his latest letter, Mr. Buffett pushes back at critics. Buybacks have their place, as long as the buying is done at a price that makes sense, he says.
"Some people have come close to calling them un-American – characterizing them as corporate misdeeds that divert funds needed for productive endeavours," Mr. Buffett writes, urging people to take a deep breath and think about it. "Both American corporations and private investors are today awash in funds looking to be sensibly deployed. I am not aware of any enticing project that in recent years has died for lack of capital."
Where it becomes a problem is where boards are authorizing buybacks for shares that are already trading at prices above the company's actual value. This matters, especially, for shareholders who intend to hold their shares long term. Boards and managers "all too often seem oblivious to price."
One of the reasons Berkshire hasn't been buying back stock is that conditions don't warrant it. The board authorized management to buy shares at 120 per cent or less of Berkshire's book value, but Mr. Buffett said he believes he and his management team have been good at signalling to the market they believe the company's intrinsic value is significantly greater than 120 per cent of book value.
In any event, the lesson is that a chief executive should have a target price in mind above which he or she won't buy back the stock but save that cash for acquisitions or other long-term activities.
Acquisitions are one of those activities, assuming, as with share buybacks, that they are well-priced and solidly executed. They are a way to deliver instant revenue growth. Of course, they are a terrific way to lose a lot of money, too.
For years, Mr. Buffett has said he wanted to use Berkshire's sizable cash pile to go hunting for "elephants" – big corporate acquisitions. Berkshire has already transformed from making most of its money from investment activities to one that makes money owning businesses, and Mr. Buffett said in his letter that he learned a few lessons on the way.
Overpaying, and using company stock to do so, was one of those lessons.
"I made one egregious error," he wrote in the shareholder letter last month, "acquiring Dexter Shoe for $434-million in 1993. Dexter's value promptly went to zero. The story gets worse: I used stock for the purchase."
He would repeat this error in 1998, with the purchase of General Re, for which he says he "foolishly" overpaid using Berkshire stock.
Subsequent deals, such as the MidAmerican Energy acquisition in 2000 and more recently the $32-billion deal for Precision Castparts last year have been done in cash.
Mr. Buffett sits on the board of Kraft Heinz, a company he helped cobble together with a team of billionaire Brazilian investors. Kraft Heinz recently backed out of a potential $143-billion blockbuster bid for Unilever. Time will tell what Mr. Buffett's next elephant will be. Maybe if Berkshire itself gets cheap enough, Mr. Buffett won't have to look too far to go big-game hunting.
John Reese