Warren Buffett is well known for his tips on making strategic investments. Even industry leaders such as Apple co-founder Steve Jobs and its current CEO, Tim Cook, turn to Buffett for his expert opinions.
Buffett, the CEO of Berkshire Hathaway (BRK-B) (BRK.B) has spoken openly about his stock repurchase strategy on multiple occasions. He calls share repurchasing “simple arithmetic.” Many investors grapple with this logic. However, what exactly does Warren Buffett mean? When can a policy of repurchasing your own company’s stock be a beneficial strategy?
Understanding Buffett’s “simple arithmetic”
Buffett explained his simple arithmetic with an example of a partnership firm. Assume there are three partners, each with an investment of $1 million. The total value of the partnership would be $3 million. If one partner offers the other two partners a choice to buy back their shares, there would be three scenarios:
- Case 1: The first partner quotes a premium price of $1.1 million to the other two partners. In this case, the other two partners would probably decline the offer. Why? Because it is overpriced.
- Case 2: The first partner offers their shares for buyback at par. The other two partners may very well refuse again because this buyback is a drain on funds. As a result, the other two partners wouldn’t have much to gain.
- Case 3: If the first partner offers their shares for $0.9 million, then it would be an excellent opportunity for a buyback. This way, the other stakeholders would automatically generate wealth. Their investments would increase to $1.45 million each, but the total value they hold will be $1.5 million. However, this is an elementary example. The same concept can be extrapolated to the size and scale of any company.
Buffett on buying back Berkshire Hathaway’s shares
Would you prefer to buy an overpriced stock solely because it is gaining momentum in the market? Alternatively, would you look for an undervalued stock and wait for it to gain momentum? Many investors react to the first option solely based on market sentiment and a fear of missing out.
On the other hand, a savvy investor would look for undervalued stocks and time the purchase well. Even Buffett makes investment decisions based on the same logic.
When a company repurchases its stock, it is a way of saying that the management has confidence in the company’s future. Buffett has stated that Berkshire Hathaway would be the highest investor in its own stock. However, this would happen only when the intrinsic value of the stock is higher than its market price. After all, the best way to increase shareholder wealth than to purchase your undervalued stocks from the open market.
Using idle cash reserves
In an interview with CNBC, Warren Buffett shrugged off the idea of paying a dividend. However, doesn’t it play an essential role in retaining shareholder confidence? A company could very well use the same funds for stock repurchase.
In an interview with CNBC, Buffett was asked whether he would use his $110 billion of cash reserves to purchase more stocks of Berkshire Hathaway. Buffett calmly replies, “We will only buy Berkshire if we think that the shareholder the next day is—or that same day—is wealthier after we bought the stock.”
This strategy makes sense only if the stock is underpriced and the buyback is timed wisely. As a result, the company can be a significant investor in its shares, manage market price volatility, and create an opportunity for stakeholders to generate wealth.
Quantity of shares a company should buy back
Buffett encountered a question from Jay Gelb of Barclays Capital during Berkshire Hathaway’s annual general meeting held on May 4, 2019. Gelb inquired about Buffett’s statement in the Financial Times that he wouldn’t mind deploying $100 billion for Berkshire Hathaway’s stock repurchase: “How did you arrive at that $100 billion figure? And over what time frame would you expect this to occur?”
Buffett replied, “We’ve got the money to buy in $100 billion worth of stock. And bear in mind, if we’re buying in $100 billion stock, it probably would be that the company wasn’t selling at 500 billion. So, it might buy well over 20 percent.”
If such a situation arises, the company wouldn’t be able to buy stocks in huge numbers within a short time. However, he would take the first step by fixing an upper cap to the value of shares to be repurchased, instead of the number of shares to be purchased.
Stock buybacks can have many positive effects on a company, not just in the form of holding the majority of shares. Buybacks can also affect other aspects like increasing investor wealth, generating investor confidence, and exhibiting management confidence. Another benefit of a stock repurchase is the advantage when it comes to tax planning and maintaining healthy financial ratios.
Apple has been repurchasing its stocks for a long time. In Q2 2019, Apple repurchased shares valued at $24 billion. This record buyback includes shares purchased from the open market as well as an accelerated share repurchase.
Apple stock was priced at $157.92 at the beginning of 2019. Since then, the stock has been on an uptrend. AAPL traded at $218.75 on September 13, 2019.