It’s the time of the year when investors try to decipher the outlook for equity markets by what Warren Buffett (Trades, Portfolio) has written to Berkshire Hathaway shareholders. The full has already been published (you can find it here on GuruFocus), and it’s now time to dig deep into the guru’s thinking to determine what to expect from the company and the markets in 2020.
Many important discussions, including that of the succession plan of the conglomerate, were included in the address to investors. The comments about the share buyback plan provide very valuable insights, in my opinion, which makes them a subject worthy of in-depth analysis.
The recent repurchase activities
As highlighted in the shareholder letter, Berkshire has repurchased approximately $5 billion worth of common stock during 2019, or about 1% of the total outstanding shares. The company did not buy back any shares from 2013 to 2017 but resumed the activity in 2018.
Value of buybacks
Source: Company filings
The recent spike in retiring common stock suggests that Berkshire shares might be trading at an undervalued level. However, a thorough evaluation of the prospects for the company should be conducted before reaching such a conclusion.
Buffett’s view of buybacks
The guru has discussed various types of corporate tractions, including the repurchase of common stock, in many instances. In an interview with CNBC in 2015, Buffett said:
“Many managements are just deciding they’re gonna buy X billions over X months. That’s no way to buy things. You buy when selling for less than they are worth. It’s not a complicated equation to figure out whether it is beneficial or not to repurchase shares. Anytime you can buy stock for less than it’s worth, it’s advantageous to the continuing shareholders but it should be by a demonstrable margin.”
It’s clear that he is a fan of buybacks, but only when executed at the right price, which is when shares are clearly undervalued. The key words here are "demonstrable margin," which suggest that the legendary investor wants to be absolutely sure about the presence of a margin of safety.
In the 2019 annual letter to shareholders, Buffett wrote:
“In past reports, we’ve discussed both the sense and nonsense of stock repurchases. Our thinking, boiled down: Berkshire will buy back its stock only if a) Charlie and I believe that it is selling for less than it is worth and b) the company, upon completing the repurchase, is left with ample cash.
Calculations of intrinsic value are far from precise. Consequently, neither of us feels any urgency to buy an estimated $1 of value for a very real 95 cents. In 2019, the Berkshire price/value equation was modestly favorable at times, and we spent $5 billion in repurchasing about 1% of the company. Over time, we want Berkshire’s share count to go down. If the price-to-value discount (as we estimate it) widens, we will likely become more aggressive in purchasing shares. We will not, however, prop the stock at any level.”
This explanation of the rationale behind the decision signals that Berkshire Hathaway shares might be significantly undervalued at present, and that convergence with the intrinsic value might occur in the coming years.
A bit of history
An understanding of when the conglomerate has previously repurchased shares is critical to determine whether Buffett has followed his own advice. Berkshire previously purchased its own stock in December of 2012, when the class A-shares were trading at $131,065.
At that time, the decision came on the back of a result of a policy change in the company that allowed Buffett and Charlie Munger (Trades, Portfolio) to pay up to 20% over the book value to buy shares, which was an increase from the previous limit of 10%. As illustrated in the above chart, the stock price soared right after the purchases were executed in 2012.
The company repurchased shares back in 2000 as well, which prompted investors to doubt whether this was a bid to boost the market value of the company as many small-scale, unprofitable companies were also retiring their common stock to artificially boost the share price. Buffett addressed this issue in his annual letter to shareholders in the same year and confirmed that the company would never use buybacks unless the management believed in a potential undervaluation.
“The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.”
The share price once again gained significantly in the next five years, even though markets reeled from the crash of the dotcom bubble in this period.
The empirical evidence suggests that Buffett has prudently purchased Berkshire shares at times when the company was undervalued. An investor who replicated his actions would have ended up with very attractive returns within a short time period of approximately five years.
The company that Buffett knows best
There’s one simple reason why I believe investors should trust the Oracle of Omaha when it comes to his decisions regarding Berkshire; he doesn’t know any other company better than this one.
Throughout their investing history, he and Munger have executed several investments that delivered stellar returns to shareholders, and each one of the companies bought by Berkshire was thoroughly evaluated to determine the expected future financial performance. If an investor trusts Buffett with those types of decisions, then it’s a no brainer to believe in him when he decides to buy back Berkshire shares. With all the information that he has about the company and its future plans, it’s unlikely that the guru will make a mistake.
Two conclusions can be drawn from the findings of this analysis.
- Buffett loves buybacks only when shares are trading at a significant discount to the true value of a company.
- In the last two instances when Berkshire repurchased shares, the market value of the company soared to new highs within a few years. This reiterates the fact that the guru acts on his own advice.
The share price has only moderately gained from the fourth quarter of 2019, indicating that the repurchase price is not far below the current market price. Considering that the management is seeking a considerable margin of safety, chances are that the intrinsic value of Berkshire shares according to Buffett and Munger is significantly higher. This presents a very attractive opportunity for long-term oriented investors.
Wall Street analysts have a median target price of $380,000 for class A shares, which is 13.7% higher than the market price of around $332,908 on Monday.
Source: CNN Money
Class B shares, on the other hand, are trading at a 13.5% discount to the Wall Street target price, according to data from Reuters.
Disclosure: I do not own any shares mentioned in this article.
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