On July 17, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) announced a change to its share repurchase program:
The earlier share repurchase program provided that the price paid for repurchases would not exceed a 20% premium over the then-current book value of such shares. Under the amendment adopted by the Board of Directors, share repurchases can be made at any time that both Warren Buffett, Berkshire's Chairman and CEO, and Charlie Munger, a Berkshire Vice Chairman, believe that the repurchase price is below Berkshire's intrinsic value, conservatively determined.
Of course, Berkshire didn't report any repurchases in its recent second quarter report, since the quarter ended two weeks prior to the announcement. So, did Buffett and Munger decide to loosen the purse strings on Berkshire's cash pile randomly, or did the announcement signal they want to start buying shares right now? Though the stock sits near all-time highs, I think it's entirely possible Berkshire is repurchasing its shares at this very moment.
Image source: The Motley Fool.
1.2 times book is too stingy after the tax cut
The first reason Berkshire might be repurchasing stock now is due to pure math. Businesses that earn high capital returns should be valued with a higher price-to-book ratio, since it takes less capital to produce $1 of earnings. Fortunately for Berkshire, the new U.S. tax law lowered Berkshire's Q2 tax rate by almost one-third, from 28.9% in the second quarter 2017 to just 20% last quarter.
But will lower taxes automatically lead to higher returns? Skeptics might believe most businesses will merely compete away their tax break by cutting prices and accepting lower pre-tax margins on a permanent basis.
But that's where Berkshire's special sauce comes in. Throughout Berkshire's corporate life, Buffett has adhered to the principle of only purchasing businesses with sustainable competitive advantages, or "moats" against competition. Thus, Berkshire's stable of wide-moat businesses should ensure it preserves most of the tax cut benefits. These sustainable higher returns should lead to a higher intrinsic value on a price-to-book basis.
As of this writing, Berkshire trades at roughly 1.4 times book value. That's not meaningfully above 1.2, and it's not unreasonable to think 1.4 might be an appropriate new threshold based on this tax math alone.
Not swimming but drowning... in cash
Berkshire noted in its earnings release that its insurance float has reached roughly $116 billion, a huge amount compared to the $20 billion Buffett has said he likes to keep on hand. This cash pile has swelled due to Berkshire's highly profitable businesses and the lack of meaningful acquisitions in recent years. In fact, the company's last large purchase -- the $32 billion acquisition of Precision Castparts -- was completed back in early 2016.
Buffett himself recently vented his frustration to CNBC, saying cash is, "just about the world's worst investment except doing something dumb that you're doing for a longer term." When asked, Buffett even admitted that deploying cash into an index fund, "wouldn't be the dumbest thing in the world."
Since Buffett likely believes Berkshire will outperform an index in the future, why not invest in Berkshire's stock at reasonable levels?
The seller's market could continue
Why have meaningful acquisitions been so elusive? The current environment of relatively high valuations and low interest rates have made things very challenging for buyers. In his 2017 annual shareholder letter, Buffett described the current state of the acquisition market:
"[A sensible purchase price] proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers."
Berkshire actually had been able to reach a deal last year for Oncor, a Texas utility, but was subsequently outbid by Elliott Management, an activist hedge fund which owned Oncor bonds and pushed for a higher price.
With whole acquisitions seemingly out of reach, Buffett could instead buy a large minority stake in a publicly traded company, but Berkshire doesn't like to buy more than 10% of any public company it doesn't control due to regulatory concerns. That means only the largest companies are viable targets.
Since today's largest companies are highly valued tech names, that puts most meaningful public market investments out of reach, as Buffett is famously stingy with purchases and cautious on technology investments. Moreover, Buffett has already taken out the largest of targets, increasing his stake in Apple (AAPL +4.44%) to around 5% of the company earlier this year.
Then just buy Berkshire
Given the lower corporate tax rate, an ever-growing float, and lack of meaningful alternatives, I wouldn't be surprised to learn Berkshire began buying back shares this quarter. That means Berkshire could very well be repurchasing shares at this very moment, even with the stock near all-time highs.
