Earlier this week, shares in Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) jumped nearly 5% in a single day after it was revealed that the Oracle of Omaha had been granted permission by the rest of the board to make stock repurchases when both Buffett and Charlie Munger (Trades, Portfolio) believe the price is below Berkshire’s “intrinsic value,” a determination that would be made “conservatively.”
The shares jumped after this announcement because the market took it to mean that Buffett, who is currently sitting on more than $100 billion in cash, is just itching to redistribute some of this income to investors. He has previously ruled out a dividend as a method of returning cash.
Previously, Berkshire Hathaway was restricted from buying back stock when the stock price exceeded 1.2 times book value per share.
To me, it seems as if Buffett's decision to make this change has been fueled not by his desire to invest Berkshire's cash, but more out of a change in how it has evolved over the past few years, and new accounting rules.
Berkshire's book value
Today, valuing Berkshire Hathaway on a book-value basis does not make much sense for several different reasons. First off, the recent cutting of the U.S. corporate tax rate materially boosted Berkshire's book value by reducing deferred tax liabilities, but this had almost no impact on intrinsic value.
So, you could argue that before the tax changes came into force, book value substantially undervalued the company. As deferred tax liabilities have grown over the past four decades, the impact of these accounting rules have on book value have only increased.
The recent change in the way investments are accounted for has also had a detrimental impact on Berkshire Hathaway accounting. Warren Buffett (Trades, Portfolio) has called these new rules a "nightmare" because they distort a company's true earnings.
The accounting change I'm talking about is the rules that require all companies to report unrealized gains or losses on equity investments in net income. These rules helped fuel a $1.14 billion loss at Berkshire Hathaway in the first quarter of this year -- the first quarter of mandated use.
With a stock portfolio of more than $170 billion, even a small 1% quarterly change can have a considerable impact on the bottom line. In February, Buffett wrote in his letter to investors that this “requirement will produce some truly wild and capricious swings in our GAAP bottom line," and will "severely distort Berkshire’s net income figures and very often mislead commentators and investors.”
Accounting changes are just part of the reason why I believe Buffett's buyback policy change was made out of necessity rather than choice.
Over the past 40 years, Berkshire Hathaway has changed significantly.
Book value no longer relevant
Today the conglomerate is one of the largest businesses in the world with operations stretching all over the globe. Many of the companies Buffett has brought to add to the Berkshire empire have significant amounts of intellectual property, property that will never be correctly reflected on a balance sheet. Therefore, these businesses do not deserve to trade at book value.
The intrinsic value of companies under the Berkshire Hathaway umbrella such as GEICO, NetJets and See's Candies he's always going to be significantly higher than book value, so why should the group as a whole be valued at book?
Looking at assets such as BNSF, its balance sheet is likely to understate the replacement cost of the railroads it operates significantly. Replacing a nationwide railroad operation today would cost many times more than it would have done to build the same network over the past century (the origins of the company date back to 1849).
There is another element I believe is worth considering here, and that is the element of surprise. Ever since Buffett announced that he would be buying back stock when it traded below 1.2 times book, the market has viewed this so-called "Buffett put" as a safety net and the stock has not dropped below this level. In recent weeks, the shares have fallen to around 1.4 to 1.3 times book, and Buffett has not been able to buy.
Even if he raised the buyback threshold to 1.4 times book, it is likely the market would just push the stock higher to this level, limiting Buffett's buyback ability.
With the new policy, Buffett can buy back whenever he believes the stock is undervalued. This means there is an air of uncertainty to consider. He can act when he sees fit without alerting the market of his intentions and having to pay a higher price, thus getting better value for shareholders.
Disclosure: The author owns shares in Berkshire Hathaway.
