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:

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.

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