Share Buybacks: Buffett Backs Me Up

On Feb. 23, I wrote that U.S. companies were embarking on another historic misallocation by announcing share buybacks at a rate unequaled since the fall of Lehman Brothers. Several readers criticized me in no uncertain terms; didn't I know that stocks are cheap? Well, in an interview with CNBC just last week, Berkshire Hathaway (NYSE: BRK-B  ) CEO Warren Buffett -- arguably the greatest capital allocator of all time -- highlighted this very problem.

Buffett on buybacks
Responding to a question regarding the possibility of a Berkshire Hathaway share repurchase, Buffett said:

[Buying back shares] is a great thing to do if your stock is selling well below intrinsic value. Now, 40 years ago, when Henry Singleton was buying back Teledyne, when Paul Getty was buying back Tidewater Oil, they were buying them because they were cheap. They were buying dollar bills for 60 cents. I would say that my experience with managements in the last 20 years is that they like buying their stocks when they're high. Just look at the buybacks that took place in 2006 and 2007 and then look at what those companies were doing in 2008 and '9. They were not buying back their stocks at a small fraction of what they'd been selling for earlier. Many managements just like the idea of having their stocks sell as high as they can... my attitude is entirely different.

A graph that paints a sorry picture
Henry Singleton is the same person that I said present-day managements should seek to emulate. The following graph shows that America's leading companies are very far from that goal:

The problem is flagrant: During the cyclical bull market that began at the end of 2002 and peaked with the market's all-time high in October 2007 -- as shares were becoming increasingly overpriced -- S&P 500 companies were plowing increasing amounts of their shareholders' cash into buybacks. Indeed, between 2003 and 2007, the dollar amount of repurchases more than quadrupled, an annualized growth rate of 46%, far outpacing the gains in the index.

Buying high and selling low
Conversely, once the financial crisis had ushered in a brutal bear market, the rate of buybacks fell even faster than it had risen, bottoming out during the second quarter of 2009 below the level of 2003. Finally, incorrigible, corporates have ramped up buybacks even faster than the massive increase in share prices since the March 2009 low. This isn't an area in which America's most respected companies set a good example, either. Take a look at the following table:

Company

Bull Market:

2007 Total Share Repurchases

Bear Market:

Q3 '08 – Q2 '09 Total Share Repurchases

General Electric (NYSE: GE  )

$15.0 billion

$1.8 billion

Pfizer (NYSE: PFE  )

$7.5 billion

$33 million

3M (NYSE: MMM  )

$3.2 billion

$0.6 billion

Verizon (NYSE: VZ  )

$2.8 billion

$0.3 billion

JPMorgan Chase (NYSE: JPM  )

$8.2 billion

$0

Cisco Systems (Nasdaq: CSCO  )

$10.0 billion

$3.6 billion

Source: Capital IQ, a division of Standard & Poor's.

Note that Pfizer, 3M, and Verizon announced new share repurchase programs in February. Last July, General Electric extended its program through 2013.

Zombie buybacks
The problem is that companies appear to give no thought to the price paid in share repurchases, which are implemented as a matter of course instead of being the product of opportunity. If anything, companies -- like many investors -- prefer to buy shares when sentiment is expansive and shares are expensive. Meanwhile, when the shares go on sale, that appetite wanes. As a value investor, no wonder Buffett prefers the opposite attitude.

As far as the attractiveness of buybacks today, Buffett stopped short of calling the current market overvalued. However, I thought it was telling that when Buffett was asked about the level of the stock market, he was careful to couch his answer in relative terms (emphasis mine): "Compared to other assets, [stocks] look attractive." In a world in which Treasury bonds are significantly overpriced, that's hardly a ringing endorsement.

Even slightly undervalued won't do the trick
Furthermore, even if stocks are fairly valued or slightly undervalued, they would not meet Buffett's "well below intrinsic value" standard for an intelligent repurchase. That was no throwaway line; in Berkshire Hathaway's 1984 Shareholder Letter, Buffett used virtually identical words in discussing share buybacks:

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.

Don't give them the benefit of the doubt!
Is every company that is repurchasing shares now making a mistake? Of course not. Nonetheless, companies' historical record is, on average, poor, so the current acceleration in buybacks should be a red flag. On the other hand, managements that have a record of doing buybacks that genuinely create substantial value for shareholders merit favorable attention: They are exceedingly rare, and they tend to create shareholder wealth in more ways than one. In the third and final article in this series, I'll identify several of these value champions.

Click on Berkshire Hathaway, General Electric, or Cisco Systems to add them to your free watchlist, or start a new watchlist and add any company you want. You'll get valuable updates as well as immediate access to a new special report, "Six Stocks to Watch from David and Tom Gardner." Click here to get started.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Berkshire Hathaway, 3M, and Pfizer are Motley Fool Inside Value picks. Berkshire Hathaway is a Motley Fool Stock Advisor selection. The Fool has created a bull call spread position on Cisco Systems. The Fool owns shares of Berkshire Hathaway, and JPMorgan Chase &. Motley Fool Alpha owns shares of Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (41)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 07, 2011, at 3:04 PM, ilovesumm wrote:

    good article

    perhaps the management is inflating the price

    to sell their shares higher ?

  • Report this Comment On March 07, 2011, at 3:33 PM, jimmy4040 wrote:

    Try telling this to a MSFT fan! LOL

  • Report this Comment On March 07, 2011, at 4:06 PM, willmccaa wrote:

    agree with the article that management goes about share buy backs completely wrong.

    however - there are other factors for share repurchase programs that the article fails to address: Many companies use share repurchase programs as a tax-efficient way of giving money to shareholders instead of through starting or increasing a dividend.

    This is especially important due to the impact on share price if a dividend is ever cut or suspended. Unlike a dividend, there is no market penalty to end a share repurchase program.

  • Report this Comment On March 07, 2011, at 6:54 PM, SJLATTY wrote:

    Buyback Shares=B.S.

    No existing shareholder makes any $ with a buyback program unless they sell; with a tax rate that is higher than a dividend tax rate, they will loose $. Only dividends are a direct benefit to shareholders.

    Buybacks should be treated as though they are "instider trader" events. The "buys" are done in secret. They should be announced and no corporate insider should be allowed to trade a stock within 1 year of a buyback event. Buybacks are done in secret, except for the insiders that order the "buy" orders.

    iF YOU DO NOT ALREADY OWN SHARES, YOU ARE COMPETEING AGAINST YOURSELF IF YOU BUY SHARES WHEN THE COMPANY ITSELF IS THE COUNTER PARTY.

    Most executive bonus plans will benefit by a buyback program...look at the calculation of bonus pool $; the share price is part of the calculation. Could be called self dealing, except it is being done by manipulating the share price with the shareholders money.

    In my opinion, no one should buy shares of a compny that is itself buying shares in the open market.

  • Report this Comment On March 07, 2011, at 8:34 PM, efbeau wrote:

    A thought came to me,is this stock buy back not the same as QE2?

    The companies hope to inflate their stock price, just as the FED hopes to inflate Treasuries and also drop interest rates(less to pay the Chinese and Middle East).

  • Report this Comment On March 08, 2011, at 11:37 AM, frank3773 wrote:

    Someone please educate me: when a company buys back its own stock does the total number of shares (market capitalization) then decline? If not, then the rest of us shareholders don't gain or lose any $ value. It's as if the company itself is no different than any other investor/institution/individual. So, whether I be buyer or seller, the "other side" of any trade is unknown to me, whether they be another (or group of) individuals, a large institution (or fund) or the company itself........ seems to me my decision to buy or sell is based on mostly other factors than whether the company is/isn't in a share buyback mode.

    Again, someone please inform-what have I been missing?

    Not saying buyback is good or bad - just that "a company holding some of its own shares", per se, doesn't increase or decrease the value of the rest of the shares that we individual shareholders hold, nor the percentage of company ownership that OUR shares represent..........

    Been doing this for 15 yrs but still not clear on differing comments I've heard on this subject - TIA, anyone.

    Frank

  • Report this Comment On March 08, 2011, at 2:14 PM, TMFAleph1 wrote:

    @Frank

    This document from Michael Mauboussin should help you understand share buybacks and the way in which they create or destroy value:

    http://www.lmcm.com/pdf/ClearThinkingAboutShareRepurchase.pd...

    Alex Dumortier

  • Report this Comment On March 08, 2011, at 8:45 PM, frank3773 wrote:

    Thanks, Alex

    Have read enough to not feel so bad about being confused - I think I'll print it out......

    Frank

  • Report this Comment On March 08, 2011, at 11:58 PM, wrenchbender57 wrote:

    My top of the head guess is that the companies buy back shares when they have the extra cash. That situation probably arises more often in a bull market type of scenario. However, I think the author makes a good point that there may be better places to put that money than in shares that are overpriced.

  • Report this Comment On March 09, 2011, at 11:05 AM, Fliujniligui wrote:

    CSCO and PWRD are timely with repurchases near lows.

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