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.

STICKING TO WHAT YOU KNOW

CORE BUSINESSES

Warren Buffett likes to invest in companies where management focuses on activities that are within the expertise of the company and not wander off and spend shareholders’ money in going into areas that they know little about.

Keeping a company on track is obviously an attribute of sound company management and is a sound investment principle.

UNDERSTANDING THE BUSINESS

This is really just an extension of Warren Buffett’s investment principle that one should not invest in a company whose business one does not understand. If it applies to direct investment, it also applies to indirect investment and an investor is better off investing in a company that uses its capital in areas of its own expertise.

Investors should Stay with What They Know

KNOWING A COMPANY

Knowing a company involves research as well as personal experience and successful investors approach share investment the way that they would the purchase of a business.

They buy a business in an industry area that they know or that they have learned about, they investigate the financials, they look at how the business operated in the past, they weigh up future potential, and they then make a reasoned decision to buy at the price offered or not buy.

Just as the cobbler should stick to his last, investors should stay with what they know. They should not stray into areas beyond their expertise. As Warren Buffett said in 1992:

‘What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.’

Robert Hagstrom has looked extensively at Warren Buffett’s investments over the years and agrees that Buffett has made it his business to understand the business of the companies where he puts the money of Berkshire Hathaway. According to Hagstrom, Buffett:

‘understands the revenues, expenses, cash flow, labor relations flexibility and capital-allocation needs of each of Berkshire’s holdings.’

Hagstrom argues that the prudent individual investor should do no less.

Why Warren Buffet does not Invest in Companies he does NOT Understand

COMPLEX COMPANIES

Take however, a company like Unilever NV. This is a corporation that has been around a long time, has a worldwide reputation and market, and is successful. But how easy is it to understand the way it operates?

According to Value Line, it has two parent holding companies, one in Great Britain, and one in The Netherlands. It operates as one company but each of the two holding companies owns shares in operating subsidiaries. The director component of both holding companies is the same and there are agreements that equalise dividends and set trading ratios for their respective shares. The business may be good but this complex structure is just too difficult for the average person to understand.

WHY WARREN BUFFETT DOES NOT INVEST IN MICROSOFT

As Warren Buffett has said, he knows and admires Bill Gates and the Microsoft Corporation but has never invested in it because he does not understand the way that the company works.

Warren Buffett and Keynes

WARREN BUFFETT AND KEYNES

In Warren Buffett’s own words, he did not invest in these companies, and many other successful investments, without acquiring as full a knowledge as possible about the company, its business, its management, and its financial position. He has advised individual investors to do the same, as did the great economist and successful investor John Maynard Keynes.

‘As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about …’ - Jim Keynes

What Warren Buffett says about Buying a Business

BUYING THE BUSINESS

Warren Buffett believes, as did Benjamin Graham, that investors should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, or a partnership in the business, they are only buying a tiny share.

A prudent investor never buys a business that they do not understand. Similarly, a prudent share investor should never buy shares in a company, whose business they do not understand.

WHAT WARREN BUFFET SAYS ABOUT BUYING A BUSINESS

In 1977, Warren Buffett told shareholders in Berkshire Hathaway that their company would only invest in a business that the directors could understand.. He has repeated this message many times since. In 1992, he expanded on this theme:

‘[W]e try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.’

What Warren Buffett says about Non-Commodity (Franchise) Companies

NON-COMMODITY COMPANIES

Warren Buffett prefers to invest in non-commodity companies - companies whose products or services are unique or special in some way.

Here customers either need the product, or there is no real competitor, or the reputation of the product is such that people will keep buying it. Suppliers and distributors have no choice but to stock the product or people will go elsewhere.

Generally, but not always, either the product will be a brand name (eg Coke, Gillette), the company will be a brand name (H & R Block) or the company will be in a monopoly situation or monopolistic cartel.

WHAT WARREN BUFFETT SAYS ABOUT NON-COMMODITY COMPANIES

Warren Buffett illustrated this difference in 1982:

‘[There is the] constant struggle of every vendor to establish special qualities of product or services. This works with candy bars (customers buy by brand name, not by asking for a "two-ounce candy bar") but doesn't work with sugar (how often do you hear, "I’ll have a cup of coffee with cream and C & H sugar, please").’

What Warren Buffett says about Commodity Companies

COMMODITY COMPANIES

Warren Buffett does not like to invest in what he calls commodity companies - companies whose product does not differ from that of competitors in any significant way.

A company like this can be vulnerable to the actions of competitors and have limited power to raise prices to retain their profit position in the light of inflation.

WHAT WARREN BUFFETT SAYS ABOUT COMMODITY COMPANIES

Warren Buffett said this in 1982:

‘[Where] costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.’

WHAT WARREN BUFFETT SAYS ABOUT GOOD BUSINESSES

Good businesses with that ‘protective moat’ that Warren Buffett likes have the ability to cope with inflation by raising prices. As he said in 1993:

‘The might of their brand names, the attributes of their products and the strength of their distribution systems gives them an enormous competitive advantage, setting up a protective moat around their economic activities. The average company, in contrast, does battle daily without any means of protection.’

BERKSHIRE HATHAWAY HOLDINGS

Stocks held by Berkshire Hathaway in 2002, as stated by Buffett in his letter to stockholders include:

• The Coca Cola Company
• American Express
• The Gillette Company
• H and R Block Inc
• Moody’s Corporation
• The Washington Post Company
• Wells Fargo and Company

These are all companies with a unique or special product, or with a company brand name, or in a market domination position. They or their products have a loyalty (voluntary or otherwise) that means customers want or must come back.

Another desirable quality in non-commodity companies is repeat business. Customers drink their Coke, wear out their razor blades, or finish reading their Washington Post, and then, eventually have to replace it.

WHAT WARREN BUFFETT SAYS ABOUT DEBT

Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

‘Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.'

'It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.’

WARREN BUFFETT DOES NOT LIKE DEBT

Warren Buffett does not like debt and does not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

• In 1982, Warren Buffett noted that Berkshire Hathaway preferred to buy companies with little or no debt and has repeated this mantra on many occasions. 
• He adopts the same philosophy for his company, preferring to avoid debt but where necessary going into it on a long-term basis only with fixed rates of interest and to obtain the finance before they need it.

Warren Buffett and Long-Term Debt

WARREN BUFFETT AND LONG-TERM DEBT

Warren Buffett speaks only generally of his approach to debt. Mary Buffett and David Clark have concluded that he focuses on long-term debt, a conclusion that is supported by his public comments. They believe that his concern lies with the company’s ability to repay its debts, should the need arise, from its profits; the longer the time period, the more vulnerable is the company to external changes and the less predictable are its future earnings.

The formula for such a calculation is:

Number of years to pay out debt = Long term debt
                                                 Current annual profit

COMPANY EXAMPLES

If we apply this formula to Johnson and Johnson, for example, we find, using Value Line, that for 2002, the long-term debt of the company was $2022 million and the profit for that year was $6610 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 0.3 of a year.

If we apply the same formula to McDonald’s Corporation, we find, using Value Line, that for 2002, the long-term debt of that company was $9703 million and the profit for that year was $ 1692 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 5.73 years.

Charlie Munger - A Short Biography

CHARLIE MUNGER AND WARREN BUFFETT

Charlie T Munger works alongside Warren Buffett, as Vice-Chairman ofBerkshire Hathaway and Warren invariably refers to him as his partner and right hand man, generously giving Charlie credit for much of his success and that of the company.

Charlie Munger was a practising lawyer, having got into Harvard Law School without then having an existing Bachelor degree, not an easy thing to do.Roger Lowenstein recounts that Charlie was somewhat assertive as a student; when challenged by a professor in the Harvard Socratic fashion to analyze a case, Charlie, who had not prepared for the lesson, is reputed to have told the professor to give him the facts of the case and he, Charlie, would give him the law.

Charlie was practising law in Omaha Nebraska when he met Warren Buffett and Buffett eventually persuaded him to give up the law and get into financial investment. Charlie did so, a decision that one suspects neither man has regretted. Certainly, long time shareholders of Berkshire Hathaway would not.

Munger is chief executive officer of Wesco, an associate of Berkshire Hathaway, and like Buffet, his annual letters to shareholders can give good clues as to the investment secrets of this brilliant duo.

Charlie Munger is not only a brilliant investor; he is also a deep thinker with strong views on society, education and the philosophy of life. Go here to read an example of Charlie Munger’s frank discission of investment philosophy.

In 1995, Charlie Munger addressed students at the Harvard Law School on the issue of psychology of human misjudgement.

Charlie Munger is an interesting man and the recent subject of a book on investment philosophy, Investing: The Last Liberal Art

FURTHER RESOURCES

Our review of Investing: The Last Liberal Art, by Robert Hagstrom

EXTERNAL RESOURCES

The philosophy of Charlie Munger

http://www.buffettsecrets.com/charlie-munger.htm