In his 2021 letter to investors of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), Warren Buffett (Trades, Portfolio) provides a detailed illustration for readers about the benefits of share repurchases.
Many investors overlook the impact share repurchases may have on their investments. It is not until you really dig into the data to understand how repurchases can increase one's investment in a business and the claim on the underlying earnings that the benefits of this approach become clear.
This is the reason why Buffett's commentary in his annual report is so important. It shows how repurchases can increase a shareholder's claim on the underlying profits of the business, reinforcing the principle that a stock is not just a casino chip, but a real investment in a real business.
The claim on the business
The Oracle of Omaha notes in his letter that repurchases conducted by Apple Inc. (AAPL, Financial) last year increased Berkshire's ownership in the company to 5.55%, up from 5.39% a year earlier. This might sound like "small potatoes" as the investor puts it, but each 0.1% of Apple's 2021 earnings amounted to $100 million.
As such, thanks to last year's buybacks, Berkshire's share of the company's underlying profits rose $160 million. In the letter, Buffett goes on to note:
"It's important to understand that only dividends from Apple are counted in the GAAP earnings Berkshire reports – and last year, Apple paid us $785 million of those. Yet our 'share' of Apple's earnings amounted to a staggering $5.6 billion. Much of what the company retained was used to repurchase Apple shares, an act we applaud. Tim Cook, Apple's brilliant CEO, quite properly regards users of Apple products as his first love, but all of his other constituencies benefit from Tim's managerial touch as well."
There is more to this equation than just Apple's repurchases. At the same time, Berkshire has also been repurchasing its shares. Over the past two years, the conglomerate has acquired around 10% of its outstanding shares, increasing the value of each shareholder's claim on the underlying business by 10%.
So not only have investors benefited from share repurchases conducted by the companies in the conglomerate's massive equity portfolio, which have increased their share of the underlying earnings, but they have also benefited from the conglomerate's own buybacks.
Compounding machine
Buffett explained this principle in his 2020 letter. The guru noted that when the company had finished buying Apple in July 2018, it owned 5.2% of the business. By the end of 2020, the stake had increased to 5.4%. The letter continued:
"That increase was costless to us, coming about because Apple has continuously repurchased its shares, thereby substantially shrinking the number it now has outstanding. But that's far from all of the good news. Because we also repurchased Berkshire shares during the two-and-a-half years, you now indirectly own a full 10% more of Apple's assets and future earnings than you did in July 2018."
As Buffett explained in his 2020 letter, the math of share repurchases grinds away slowly, but it can be "powerful over time." The benefits are not immediately apparent, but this process can help investors own an ever-expanding portion of an exceptional business without having to deploy any additional capital themselves.
In times when there are few other opportunities in the market, repurchases can create value for shareholders and provide an avenue for companies to deploy capital and achieve attractive rates of return.
Buffett's comments on this process in his annual report are incredibly valuable as they illustrate the process in action and the impact it can have on underlying earnings.
When analyzing the potential of any business, understanding how a company deploys capital into share repurchases and how this creates wealth is an integral part of the process.
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