Last month, Fortune magazine published its annual "Fortune 500" list, with Apple (NASDAQ:AAPL) ranking sixth, making a big jump from last year's spot in 17th place. Fortune offered a closer look at Apple in that issue, centering on what the company might do with its massive pile of cash. One of the biggest takeaways for investors in the article might have gone unnoticed by many, though: Why Warren Buffett recommended that the company repurchase Apple stock.
As veteran financial journalist Carol Loomis recounted, around early 2010, Steve Jobs picked Buffett's brain about what Apple might do with its pile of cash. Regarding the option of repurchasing Apple stock, Buffett offered a simple guideline: If you believe your stock is cheap, "then the best thing you can do with your cash is buy in shares." Apple stock was trading in the $200s at the time, and Jobs did think it was cheap. It went on to top $700 within a few years, though it has since pulled back to the $400s. Jobs, long averse to buybacks because they can squander money if the stock later falls, chose not to initiate a buyback. (Loomis noted that he had also seen some hard times at Apple, when cash was in short supply -- thus, the idea of letting it pile up was attractive to him.) But Jobs' successor, Tim Cook, did decide to buy back Apple stock.
When asked by Buffett if he thought Apple stock was cheap, Jobs had answered with a definitive yes. To understand why he might have thought so, it's instructive to look back at where Apple was in early 2010. Then, as now, opinions were divided on the stock's valuation and the company's future. As 2009 drew to a close, my colleague Rick Munarriz named the company a "Best Stock" for 2010, citing strong iPhone sales (more than 7 million in a single quarter!) and anticipating the debut of Apple's new tablet, as yet unnamed, and the many apps that would be created for it. But others viewed it as one of the worst stocks, seeing an unattractive risk-reward ratio, looming competition, the threat of commoditization, and inevitable slowing growth. Looking back, the bulls were right, and a stock buyback would have rewarded shareholders. But management was averse to buybacks, with the CFO stressing the company's focus on "preservation of capital" when it comes to cash. Buffett, too, seeks preservation of capital, but he also welcomes compelling value propositions. Indeed, he recently bought back shares of his own company.
The price matters
Buffett's advice is often forgotten by investors when they hear about a stock repurchase plan. It's not just CEOs who should heed it -- investors need to keep valuation in mind, too, regarding buybacks. Buybacks have appeal for shareholders because they reduce the number of shares outstanding, and thereby boost the value of remaining shares. (Imagine, for example, a pizza that is cut into six equal slices instead of eight – each slice will be bigger.) But all buybacks are not created equal. Since a company has many options for its excess cash, it should choose the most productive ones. Alternatives include buying another company, paying down debt, hiring more people, buying more advertising, paying a dividend, and letting the money accumulate further. If stock is bought back when it's at inflated levels, that can destroy shareholder value. Simply paying that money out as dividends could permit shareholders to redeploy it into more compelling investments.
It might seem that by the time that Cook started repurchasing Apple stock, it was a terrible idea, as the stock soared. But per an April filing with the SEC, the first 4 million shares of Apple stock that were bought back were bought at an average price of $478, not too far from recent levels (and well below Apple stock's high above $700). Management seems pleased with the idea of buybacks, too, as plans to buy back Apple stock have been boosted from a spending cap of $10 billion to $60 billion. If you, too, think that Apple stock is cheap (as many, but not all, do), this bodes very well for shareholders.
Next time you hear of a stock buyback plan, don't let yourself get too excited before thinking of Warren Buffett, Steve Jobs, Tim Cook, and the importance of a stock's valuation.
Longtime Fool contributor Selena Maranjian, whom you can follow on Twitter, owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. 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.