Re: Unique financial nuggets
Anyway, I got motivated to read Buffett's 2011 letter to shareholders. Berkshire as you know has investments in several companies such as Wells Fargo, recently IBM, Burllington Santa Fe, Coca Cola etc. Apparently, the dividends these companies pay out goes into the Berkshare earnings, but the retained earnings not given out as dividends do not flow into Berkshire's earnings in their income statement! This shows their financial staements are very conservative, and understate their true value. Here are his thoughts on share buybacks. He tells us why he wants IBM share price to remain low while IBM buys back its shares.
At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsicvalue. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets.
Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.
This discussion of repurchases offers me the chance to address the irrational reaction of many investors to changes in stock prices. When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock *underperforms *in the market for a long time as well. A corollary to this second point: “Talking our book” about a stock we own – were that to be effective – would actually be
harmful to Berkshire, not helpful as commentators customarily assume.
Let’s use IBM as an example. As all business observers know, CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary.
But their financial management was equally brilliant, particularly in recent years as the company’sfinancial flexibility improved. Indeed, I can think of no major company that has had better financial management, askill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, madevalue-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%.
Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us.
Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for theday: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won’t keep you in suspense. We should wish for IBM’s stock price to *languish *throughout the five years
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire
250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and wewould own about 7% of the company. If the stock conversely sells for an average of $300 during the five-yearperiod, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding afterfive years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100million greater under the “disappointing” scenario of a lower stock price than they would have been at the higherprice. At some later point our shares would be worth perhaps $1billion more than if the “high-price repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your ownmoney or indirectly (through your ownership of a company that is repurchasing however, too often complicate the matter: Most people, includingthose who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemblea commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Charlie and I don’t expect to win many of you over to our way of thinking – we’ve observed enoughhuman behavior to know the futility of that – but we do want you to be aware of our personal calculus. And herea confession is in order: In my early days I, too, rejoiced when the market rose. Then I read Chapter Eight of BenGraham’s The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock
prices. Immediately the scales fell from my eyes, and low prices became my friend. Picking up that book was oneof the luckiest moments in my life.
In the end, the success of our IBM investment will be determined primarily by its future earnings. Butan important secondary factor will be how many shares the company purchases with the substantial sums it islikely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I willabandon my famed frugality and give Berkshire employees a paid holiday.