Buffett: In my early days I, too, rejoiced when the market rose. Now, low prices became my friend.

Buffett highlights the irrational reaction of many investors to changes in stock prices.


Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.  Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us.  Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?

I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

----



The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter:

• Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. 
• These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enough human behavior to know the futility of that – but we do want you to be aware of our personal calculus. And here
a confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of Ben Graham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was one of the luckiest moments in my life.

In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million,  I will abandon my famed frugality and give Berkshire employees a paid holiday. 

-----


When Berkshire buys stock in a company that is repurchasing shares, we hope for two events:

• First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and 
• second, we also hope that the stock underperforms in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be harmful to Berkshire, not helpful as commentators customarily assume.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

Share Buybacks: Mixed Emotions evoked when Berkshire shares sell well below Intrinsic Value

Share Repurchases


Last September, we announced that Berkshire would repurchase its shares at a price of up to 110% of book value. We were in the market for only a few days – buying $67 million of stock – before the price advanced beyond our limit. Nonetheless, the general importance of share repurchases suggests I should focus for a bit on the subject.

Charlie and I favor repurchases when two conditions are met: 

• first, a company has ample funds to take care of the operational and liquidity needs of its business; 
• second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. 

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted.

• It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. 
• Continuing shareholders are hurt unless shares are purchased below intrinsic value. 

The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)

Charlie and I have mixed emotions when Berkshire shares sell well below intrinsic value. We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset – our
own stock – that we know to be worth at least x for less than that – for .9x, .8x or even lower. (As one of our directors says, it’s like shooting fish in a barrel, after the barrel has been drained and the fish have quit flopping.)

Nevertheless, we don’t enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. 

• When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling. 
• At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. 
• And the more and the cheaper we buy, the greater the gain for continuing shareholders. 

Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower.

You should know, however, that

• we have no interest in supporting the stock and that our bids will fade in particularly weak markets.
• Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

When a company should buy back shares

So, according to Warren Buffett, a company can add value to its shares by buying some of them back:

1. where it has surplus funds;
2. where it can buy them back at a price below intrinsic value.

Warren Buffett has said on several occasions, in relation to Berkshire Hathaway, that the company will never buy back shares merely to bolster the share price or to stop a fall in the price.

Warren Buffett on Share Buybacks

BUYING BACK SHARES FOR THE RIGHT REASONS

Warren Buffett likes companies that buy back their shares if they do so for the right reasons, and if they pay less than the intrinsic value of the share. . A share buy back that is designed simply to inflate or support the value of the shares is not a good reason.

WARREN BUFFETT ON BUYBACKS

In 1999, Warren Buffett said this:

‘Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.’

Share Buy-Back

BUYING BACK SHARES

Sometimes a company has surplus funds that it does not need for its operations. It can use those funds to expand its operations (eg buy new businesses) or it can distribute them to stockholders. One way of distributing funds to shareholders is to have a share buy back, wherein the company buys back some of its shares from existing stockholders.

EXAMPLE OF A SHARE BUY-BACK

Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $7.50.

Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.

Stock Buybacks

What is a stock buyback?

A stock buyback occurs when a company repurchases outstanding shares from the marketplace, reducing the total number of shares that it has out. It helps indicate that a company thinks that its shares are undervalued, and the removal of shares from the marketplace increases the value of the remaining shares.

Why is this important?

The share repurchase increases the Earnings per Share (EPS) because the number of shares has been reduced. In addition, one important thing to note is that companies have a pool of savings that they utilize. They can choose to invest in research and development, build a new factory, etc. Since they choose to reinvest in their company by buying back shares, they show confidence that their company will do well, which is definitely a good sign for investors.

Example

Let's say that company A did not grow this year, but the management still wants to provide value to shareholders. They have one million outstanding shares at a price of $100 a share, so their market capitalization is $100 million. In addition, this year they made a profit of $10 million, which is the same as last year, so there is no profit growth. If a stock buyback is approved, they could use the $10 million to buy back shares in their own company and take them off the market, so that the number of oustanding shares are reduced. The $10 million dollars can buy 100,000 shares, so now there are 900,000 outstanding shares worth $100 million. Under this simple analysis, that means that each share is now worth $111. If you were a lucky shareholder in this company, you would have made $11 even though the company did not grow at all from last year!

When does it Occur?

Since buybacks are generally a good thing, it would be nice to know which companies are starting to buy back stock soon so that you could purchase a stock position in the company. Although they are relatively unpredictable, when a company's stockpile of savings keeps on increasing even after paying their R&D and operating costs, it is more likely they will buy back stock. For example, in the following picture from the Seattle Post-Intelligencer in 2004, you can see that Microsoft's cash reserves were rapidly increasing, and soon after they instituted a stock buyback and a special dividend for shareholders.

 

 http://www.stanford.edu/~mikefan/stocks/stockbuybacks.html

SEPTEMBER 26, 2011, 10:12 AMMERGERS & ACQUISITIONS

Berkshire Hathaway to Buy Back Shares

BY DEALBOOK

Charles Dharapak/Associated PressWarren E. Buffett, chief of Berkshire Hathaway.

It looks as if Berkshire Hathaway’s “elephant gun” of $43 billion in cash will also be pointed at itself.

Warren E. Buffett’s company announced on Monday that its board had authorized the repurchase of the company’s class A and class B shares at premium of as much as 10 percent over the current book value.

The company did not disclose how big the buyback would be, but said the repurchases would not be made if they reduced Berkshire’s cash holdings below $20 billion.

The cash war chest was highlighted in February, when Mr. Buffett told investors he was on the hunt for acquisitions. “Our elephant gun has been reloaded, and my trigger finger is itchy,” he wrote.As of June 30, Berkshire had more than $43 billion in cash.

The use of cash for share buybacks is unusual for Berkshire, which has preferred to use it for acquisitions.

Berkshire Hathaway’s class A and class B shares.

In its 2000 annual letter, the company said “we will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value,conservatively calculated.”

Shares of Berkshire, however, have slumped this year. The class A shares are down 12.2 percent, while the class B shares are down nearly 10 percent.

Bursa Malaysia: Follow the 'smart money'

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It is probably wise to follow the "smart money" in investment. When smart money buys, we buy. When smart money sells, we sell.  What is smart money? How do we know which is smart money? When do we know smart money has started buying? Also, how do we know that the smart money is really "smart"?

What is smart money?

Smart money is a fund that is supposed to be influential and has a strong impact on stock prices. It is supposed to be well informed and know exactly when and what to invest.

Its actions may also move prices. Because of its reputation as a market mover, it is able to attract many followers who also join in the purchases, causing stock prices to move further. If smart money can make money most of the time, then tracking the investments of smart money and following its footsteps can be a profitable strategy.

In this article, we will discuss several types of smart money, some of which are really "smart" but some may have limited impact on the market.

Accumulation by owners

Purchases by owners of listed companies are deemed to be influential. As owners, they are required to make disclosures to the exchange after each purchase, and their transactions are regularly monitored by the market players.

Owners are supposed to know what happens in their companies. They know the prospects of the company. The future direction of the company is literally in their hands. There are many plans that they have for the company, which may not have been brought to the board for consideration. In many instances, preliminary discussions on deals are engaged by the owners privately.

Many dealmakers prefer to talk to owners who can make immediate decision on a deal, as getting the board's approval is probably just a formality if the owners have already agreed to the deal.

On the other hand, if there are troubles ahead, owners are definitely the first to sense them. If the company is not doing well or if its earnings are not improving, it is unlikely that the owners will buy the stock. They will probably wait for a better time to buy. At least, this is the perception of investors.

Investors will also feel more confident to participate in the stock if the owners have the confidence to buy the stock. Even if the stock price does not go up after a series of purchases by the owners, there is no pressure for other shareholders to sell.
On the other hand, if the market comes to know that an owner has been disposing of his stock in the market regularly or in large quantities, they may become very uncomfortable and wonder what's going wrong. Is there something that the owner knows that the public is not aware of? As such, disposals by owners will have more impact than their purchases.

However, owners of listed companies may have multiple objectives and it could be difficult to read their minds.

? First, the owners may own a big percentage of the company and what they are buying could just be a small fraction of what they own. They may just want to support the share price to instil confidence in the market.

? Second, if the owners pledged their shares to banks (owners' shares under nominees are likely to be pledged), they may need to support the share price to prevent force-selling by banks if the share price falls below a certain level.

? Third, owners prefer to invest in their own shares. Even if their stock is undervalued, there is no guarantee that it will go up, as there could be other stocks that are more attractive to fund managers.

? Lastly, owners may also give a false impression of their action, as they may buy smaller quantities under their names but at the same time sell larger amount using nominee names, which is not uncommon in this part of the world.

As such, following this type of "smart money" may not be very reliable. Therefore, we need to know the character of the owners and whether they are credible or not.

Purchases by the EPF

The Employees Provident Fund (EPF) is the largest local equity investor in our stock market. It was reported that the EPF accounted for as much as 50% of the total traded volume during certain periods. Since the EPF is a large player, its actions have far-reaching impact on prices of many stocks.

Since most of its investments exceed 5% of the stock's paid-up capital, the EPF make regular disclosures on their purchases and disposals. Sometimes, investors are puzzled why the EPF trades regularly between buy and sell.

The presumably unclear direction of trades is because the provident fund also appoints external fund managers (EFMs) who have the full discretion to buy or sell. As such, sometimes the EPF could be buying a stock but their EFMs could be selling the same stock on the same day.

In certain cases, one EFM buys but another EFM could be selling at the same time or a few days later. Hence, the disclosure by the EPF is a combination of trades by its internal fund managers as well as that of EFMs.

Due to the difference in opinion between the EPF and its EFMs, there is no clear signal of the direction of this powerful domestic fund. The fund could be big, but they are not "united" and they are in fact competing with each other. This is also a way to generate liquidity in the market. As such, relying on the trades of this "smart money" for direction may not be very reliable.

Even if the fund is buying a particular stock persistently, we observe that the stock price may not seem to rise substantially. This may be linked to the way the orders are placed - that is, they tend to buy lower after a completed trade. This is different from the trading style of foreign fund managers, which we shall discuss later in this article.

Actions of local institutions

Although other local institutions are smaller in size than the the EPF, they could be more focused when it comes to buying a stock. Generally, purchases on big-cap stocks by local institutions may not have much impact on the stock price.

Since big-cap stocks are widely owned by most local funds, such as mutual funds, insurance companies and asset management companies, for every purchase to lift the stock price, there could be several funds waiting to sell to the buyer. Local institutions are competing with each other to achieve maximum returns as they have their own stakeholders to answer to.

As the market continues to rise, more and more local institutions are seeking investment opportunities in undiscovered stocks and unpolished gems. Research houses are competing with each other to identify growth stocks with good earnings prospects and "good story" to satisfy the appetite of local funds and entice them to buy.

Most of these stocks are the tightly held mid- to small-cap stocks, where the valuation is generally much cheaper than that of the big-cap stocks. If the "story" is compelling, more funds are likely to participate in the purchases. If there are also private placements from the owners or by the company, a stock may attract even more interest and can move quite fast.
A stock may be attractive from various angles, but if there is no liquidity, most funds are hesitant to participate due to the lack of liquidity to get out when the need arises. When funds started to buy a stock, the rise in the share price is likely to bring out some sellers, which will lead to improved liquidity. The subsequent improvement in liquidity will in turn attract even more funds to partake in the "game". If there are sufficient "followers" the stock price will continue to climb; otherwise, it may just fizzle out a short jerk.

As such, local institutions could be a useful "smart money" to follow if they start to have position in smaller cap stocks. A neglected stock may turn out to be a star performer if the stock has been successfully promoted. There are a number of such well-promoted stocks which have performed very well this year.

Share buyback 

In the case of share buyback schemes by certain listed companies, this provides yet another hint to investors that the management believes the stocks are undervalued. Although share buybacks may not be very popular among listed companies in Malaysia, there are a number of listed companies that buy back their own shares regularly. The impact on the stock price will depend on how aggressive the share buyback is conducted. The degree of "aggressiveness" depends on the percentage of shares being bought back and the proportion of the share buyback against the daily traded volume.

From our observation, share buybacks seldom have much impact on stock price. Such repurchase of own share will definitely reduce the free-float of the stock in the market, but moving the stock price to a higher level is another issue. Share buyback may clear off some of the weak holders and place the stock in a good position to run if other strong buyers emerge. But for the stock to attract strong buyers, it must deliver results and show growth potential.

Buying by insiders 

Insiders are those who hold key positions in a company or those who have access to information not known to the public. Insiders include directors of the company, company secretary, senior management, corporate lawyer, auditors, merchant bankers who handle important corporate information for the company.

Because key personnel have unfair advantage over the public, it is illegal to trade on insider information, which unfortunately is very difficult to prove. To reduce the incidence of insider trading, blackout periods for the trading of stock are imposed before the release of important announcements and these include the announcement of quarterly results, right/bonus/split issues and other material announcements, which may have a strong impact on the share price.

The purchases made by insiders are difficult to detect. A sudden share price movement of a stock is usually suspected to be related to insiders who may use nominees to avoid detection. The only way to detect possible insider trading is through technical charts, which may reveal such activities from price movement as well as changes in volume. Otherwise, it is difficult to identify this type of "smart money".

Syndicate buying

A syndicate is also another influential force, as it normally focuses on a handful of stocks. The objective of such a syndicate is to make money. They may act independently or with the help of the owners or top management. They may or may not play based on insider information. If there is a stock worth buying with the intention to sell at a higher level, they will be interested. Stocks selected by a syndicate could be purely because of cheap valuation or some impending news, which could be entirely conceptual.

Although syndicated play could be powerful, their movement is very secretive and hard to predict. As a syndicate is out there to make money, they will use all sorts of tactics to achieve their objectives. The tricks may include dissemination of untimely rumours just to lure in other punters to help them to stir the market. Unknowing speculators could be drawn in by their own greed.

Going along with a syndicate is a risky game, as they will not disclose their game plan. They can play one game on the surface but at the same time be selling quietly at the back.

Inflow of foreign funds

Perhaps the most influential smart money is foreign funds. Foreign funds come in droves, which is more powerful than if they act individually. The movement of foreign funds, or simply hot money, follows certain investment themes for investment purposes. Their investment duration is normally fairly long to achieve maximum profit. One of the factors driving the flow of foreign funds is the direction of the US dollar. When the US dollar weakens, this hot money will flow to emerging markets and to Asia, causing market here to rise (See charts).

There is a number of reasons why following the footsteps of foreign fund managers are more reliable:

? Purchases by foreign fund managers are more dynamic, as they normally push up the share price when buying. In this way, not only can they obtain the quantity of shares required, they can also record immediate price appreciation.

? The quantity allocated to each stock is normally larger, as foreign funds are normally bigger in size and hence have bigger allocations.

? Unlike local funds, which probably have two dozen or more stocks, foreign funds normally select a handful of local stocks to invest.

Summary
The strategy of investing by following the "smart money" must be very selective, as many of them are either not very effective or not reliable. It is better to follow foreign funds, which are more powerful and less deceitful.

Source: The EdgeDaily

Written by Ang Kok Heng

Monday, 20 December 2010 11:01

Ang has 20 years' experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.

Genting M’sia pays RM15.7m in share buy-back

Tuesday August 24, 2010

Genting M’sia pays RM15.7m in share buy-back

KUALA LUMPUR: Genting Malaysia Bhd spent RM15.71mil to buy five million of its own shares yesterday and announced that it intends to acquire more within the next 10 months.

The shares represented just below a quarter of the 20.527 million Genting Malaysia shares traded yesterday.

Genting Malaysia closed five sen higher at RM3.14.

In a filing with Bursa Malaysia, the company said it intended to purchase up to a further 362.207 million of its shares (representing 6.13% of the issued and paid-up share capital) within the next 10 months.

Its cumulative net outstanding treasury shares now comprised 228.501 million or 3.87% of its issued and paid-up capital of 5.907 billion shares as at Aug 23.

The share buy-back was part of continuing efforts under its capital management programme, which the company constantly monitored together with its strategies of business expansion (through organic growth or acquisitions) and capital distribution, Genting Malaysia said.

The company said it would continue to pursue share buy-back efforts when opportunities presented themselves, pursuant to the mandate approved by its shareholders on June 9. — Bernama

What makes a stock attractive for shareholders?

http://msnmoney.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?ID=5595340&SessionID=vAirWMxMf1z0nY9

That a company earns a lot of money doesn't necessarily mean the stockholders will benefit.

That a company earns a lot of money doesn't necessarily mean the stockholders will benefit.  The next big question is:

• What does the company plan to do with this money? 

Basically, it has 4 choices.

1.  It can plow the money back into the business, in effect investing in itself.

• It uses this money to open more stores or build new factories and grow its earnings even faster than before. 
• In the long run, this is highly beneficial to the stockholders. 
• A fast growing company can take every dollar and make a 20% return on it. 
• That's far more than you and I could get by putting that dollar in the bank.

2.  Or it can waste the money.

• It can waste on corporate jets, teak-paneled offices, marble in the executive bathrooms, executive salaries that are double the going rate, or buying other companies and paying too much for them. 
• Such unnecessary purchases are bad for stockholders and can ruin what otherwise would be a very good investment.

3.  Or a company can buy back its own shares and take them off the market. 

• Why would any company want to do such a thing? 
• Because with fewer shares on the market, the remaining shares become more valuable. 
• Share buybacks can be very good for the stockholders, especially if the company is buying its own shares at a cheap price.

4.  Finally, the company can pay dividend. 

• A majority of companies do this. 
• Dividends are not entirely a positive thing - a company that pays one is giving up the chance to invest that money in itself. 
• Nevertheless, dividends are very beneficial to shareholders.

A dividend is a company's way of paying you to own the stock.  The money gets sent to you directly on a regular basis - it's the only one of the above 4 options in which the company's profits go directly into your pocket. 

• If you need income while you're holding on to the stock, the dividend does the trick. 
• Or you can use the dividend to buy more shares.

Dividend also have a psychological benefit. 

• In a bear market or a correction, no matter what happens to the price of the stock, you're still collecting the dividend. 
• This gives you an extra reason not to sell in a panic.

Millions of investors buy dividend-paying stocks and nothing else. 

• Compile a list of companies that have raised their dividends for many years in a row. 
• In Wall Stree, one company has been doing it for 50 years, and more than 300 have been doing it for 10. 

Repurchases of Shares by Companies

Convincing evidence that many companies do in fact accumulate more capital than they need is seen in the prevalence of repurchases of stock in the open market.

A check in 1951 of companies listed on the New York Stock Exchange showed 430 (or 40.3%) holding shares of their own previously issued common and preferred stocks. A compilation by the Exchange in 1934 indicated 250 (or 32%) of the corporations held such stock in the treasury.

It is appropriate to mention that there are legitimate reasons (other than possession of surplus cash) for reacquiring stock, such as

• for retirement under sinking-fund provisions,
• to acquire assets which cannot be purchased for cash, and
• for distribution to employees as awards or
• for sale under company stock-purchase plans.

These repurchases as a whole present ethical questions which have not been thoroughly considered either by managements or stockholders.

It is assumed to be a "smart" thing to buy in stock at the lowest possible price, just as a smart buyer would purchase anything else.

For some reason, managements consider their duty lies only to those stockholders who do NOT sell, and that they have no obligation to deal considerately with anyone so disloyal or so speculatively minded as to want to dispose of his shares.

Furthermore, the argument runs, the company could refrain from buying shares at all, in which case those selling out would receive a still lower price. Hence, there can be no unfairness in paying a price, however small, as long as the seller could not do better elsewhere.


Ref: Security Analysis by Graham and Dodd

Cash Flow from Financing Activities

Investing activities tell what a firm does with cash to increase or decrease fixed assets and assets not directly related to operations.

Financing activities tell where a firm has obtained capital in the form of cash to fund the business.

Source of cash for financing: Proceeds from the:

• sale of company shares or
• sale of bonds (long-term debt).

Use of cash for financing: If a company:

• pays off a bond issue,
• pays a dividend, or
• buys back its own stock.

A consistent cash flow from financing activities indicates excessive dependence on credit or equity markets. Typically, this figure oscillates between negative and positive.

A big positive spike reflects a big bond issue or stock sale. In such a case, check to see whether the resulting cash is used:

• for investments in the business (probably okay) or
• to make up for a shortfall in operating cash flow (probably not okay), or,
• if the generated cash flows straight to the cash balance, you should wonder why a company is selling shares or debt just to increase cash, although often the reasons are difficult to know. Perhaps an acquisition?
  

An illustration:

Company X's statement shows a happy story for investors:

• $15.4 m paid to investors as dividends
• $8.2 m paid out in "Sale Purchase of Stock" (- this is most likely for a share buyback. In fact, the company X actually repurchased $17.2 million in its own stock on the market; then issued $8.9 million in stock, most likely for employee stock options ESOS, and compensation.)

Still, this isn't bad - shareholders benefited from both the dividend and the repurchase.

Bottom line: Company X is using surplus cash generated from operations to give something back to shareholders. That's a good thing.

Sources of Shareholder Value

Sources of Shareholder Value

For the equity holder, the source of future cash flows is the earnings of firms.

Earnings create value for shareholders by the :

• Payment of cash dividends
• Repurchase of shares
• Retirement of debt
• Investment in securities, capital projects, or other firms.

If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.

If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.

Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.

Which creates more value?

Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.

Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.

Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.

Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.

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Fear of misusing retained earnings

If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.

Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.

Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.

In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.

Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.

Ref: Stocks for the Long Run, Jeremy Siegel

Buffett attacks buyback strategy as 'foolish'

Buffett attacks buyback strategy as 'foolish'

Legendary investor Warren Buffett has attacked the strategy of companies buying back their own shares, arguing that it almost always destroys value.

By Garry White
Last Updated: 9:09PM BST 03 May 2009

Warren Buffett thinks most buybacks do not create value
Speaking at Berkshire Hathaway's annual meeting in Omaha, Nebraska, Mr Buffett said: "Most of the repurchasing in recent years was foolish." He added that companies invariably paid too much.

Mr Buffett said that only once in the last decade had he considered buying back Berkshire stock as its shares were trading "demonstrably lower than intrinsic value".

However, he stressed: "I don't think that situation exists now."

Many companies that bought back shares over the last two years are licking their wounds, particularly in the financial sector.

RBS launched a £1bn share buyback in 2006, paying an average of £18.38 for the shares, which now stand at just 44p. In January 2008, Lehman Brothers unveiled plans to buy back 19pc of its equity – just nine months before the investment bank went bust.

When a company has spare cash on its balance sheet that it does not need to invest in its business, it can use share buybacks to boost its earnings per share – in expectation that it receives a higher stock market rating.

Mr Buffett is not alone in having doubts over the practice. The UK Shareholders' Association (UKSA) has also argued that buybacks are often contrary to shareholders' interests, especially private investors. UKSA prefers the dividend route as a way of returning cash.

Buybacks have also come under criticism because they are regarded as a way to improve management benefits under share option or other remuneration schemes that relate to an improvement in earnings per share.

Mr Buffett also dismissed the US government's stress tests on bank balance sheets.

"I think I know their future, frankly, better than somebody that comes in to take a look," Mr Buffett said. "They may be using more of a checklist-type approach." He said he had applied his own stress test to Wells Fargo and it had passed with flying colours.

When Mr Buffett retires his role will be split, with his son Howard becoming chairman and a new chief executive appointed from within the group. However, he said all the internal candidates failed to beat the S&P 500 in 2008.

Following the biggest annual drop in profits since Mr Buffett began running the company in 1965, Berkshire Hathaway will report its first-quarter results on Friday. Mr Buffett said that operating profits would fall by around 10pc year-on-year to $1.7bn (£1.1bn). Operating profits do not include the changes in valuation of the company's investments and derivatives.

Book value per share, a key measure of investment companies, will be down another 6pc from the end of 2008, as the value of Berkshire's share investments fell and losses on derivatives contracts mounted. This is added to book value losses of 9.6pc in 2008.

Berkshire Hathaway lost around $7.5bn in the value of its investments and derivatives last year, the majority of which were unrealised. Profits last year slid by 62pc to $3,224 per Class A share.

Berkshire Hathaway shares have fallen from a peak of $147,000 in September 2008 to $92,005 now.

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5269092/Buffett-attacks-buyback-strategy-as-foolish.html

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Capital-intensive and Capital-hungry companies

CAPITAL SUFFICIENCY

Capital-hungry companies are sometimes hard to detect, but there are a few obvious signs.

Companies in capital-intensive industries, such as manufacturing, transportation, or telecommunications, are likely suspects.

Here are a few indicators.

1. Share buybacks

The number of shares outstanding can be a real simple indicator of a capital hungry company. A company using cash to retire shares - if acting sensibly - is telling you that it generates more capital than it needs. On the other hand, if you look at a company like IBM, ROE has grown substantially, and massive share buybacks are a major reason.

Warning! : When evaluating share buybacks, make sure to look at actual shares outstanding. Relying on company news releases alone can be misleading. Companies also buy back shares to support employee incentive programs or to accumulate shares for an acquisition. Such repurchases may be okay but aren't the kind of repurchases that increase return on equity for remaining owners. (Comment: to take a look at HaiO share buyback.)

2. Cash flow ratio

Is cash flow from operations enough to meet investing requirements (capital assets being the main form of investment) and financing requirements (in this case, the repayment of debt)?

If not, it's back to the capital markets. This figure is pretty elusive unless you have - and study - statements of cash flow.

3. Lengthening asset cycles

If accounts receivable collection periods and inventory holding periods are lengthening (number of days' sales in accounts receivable and inventory), that forewarns the need for more capital.

4. Working capital

A company requiring steady increases in workng capital to support sales requires, naturally, capital. Working capital is capital.