A few weeks ago, it was announced that Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), the conglomerate run by Warren Buffett (Trades, Portfolio), had changed its stock buyback policy.
Under the terms of the new policy, rather than buying back stock when it traded down to 1.2 times book, Berkshire can repurchase stock when both Buffett and Charlie Munger (Trades, Portfolio) believe the price is below Berkshire’s “intrinsic value,” a determination that would be made “conservatively.”
Since this change was announced, the market has been rife with speculation. When is Buffett going to start buying? How much is he going to buy? How fast is he going to buy?
As I have said before, I believe this changing strategy is a natural progression of the business and is not a change in Buffett's mentality about buybacks and returning cash to investors.
A changing business
Over the past several decades, Berkshire Hathaway has changed significantly. Today, it's probably better to evaluate the business using an intrinsic value method rather than book value.
The company's second-quarter results reveal just how difficult it has become for Buffett to invest his money, while at the same time show how profitable Berkshire Hathaway has become, especially over the last 12 months due to tax reform and the rapidly expanding U.S. economy.
The conglomerate's cash pile increased to $129.6 billion, despite $12 billion in new investments and traded securities in the second quarter.
According to data from Moody's Analytics, the global value of mergers and acquisitions hit $2.6 trillion during the first half of 2018, just below a record set in 2007. In other words, while Buffett's holding on to his money, other allocators and managers are rushing to splash the cash on acquisitions.
Moving against the market
Buffett's deal-making activity has historically been a contrarian indicator. His cash pile grew between 1998 and 1999, just ahead of the tech stock bubble, and then again in 2005 to 2007. On both occasions, the market peaked soon after and Buffett went shopping. The years 2000 to 2003 and 2007 to 2009 were some of the most active deal-making periods in Buffett's lifetime.
If the next bear market is just around the corner, it is more than likely that Buffett will use the same playbook as the last two. He will open his checkbook and write substantial checks; being greedy in an environment where others are fearful. However, $130 billion is a lot of cash to spend, so buybacks will also be on the cards. After deducting the $20 billion Berkshire needs to keep its insurance operations solvent, there's $110 billion (and growing) of capital left to invest.
The problem as I see it is it is going to become increasingly difficult for Buffett to deploy this cash. He can (and most likely will) engage in buybacks, but he will only be able to deploy so much capital using this method. When the market knows Buffett is buying, I'm willing to bet Berkshire's stock price will shoot higher, just as it did on the day of the announcement.
In some respects, the "Oracle of Omaha" has become his own worst enemy. With thousands of investors watching his every move, Berkshire's shares are unlikely to trade down to a level where Buffett can deploy a meaningful amount of capital. At the same time, the bigger Buffett's cash pile becomes, the harder it's going to be to find takeover targets that really move the needle for Berkshire. It's a Catch-22 situation. Although it's a good problem to have, you could argue Buffett's biggest problem today is his ballooning cash pile.
Disclosure: The author owns shares of Berkshire Hathaway.
