Every year starting in around late December and continuing until around this time, I found myself at the end of each day hoping that the S&P had gone down. Rooting against GS, of course, made obvious sense, but I was also keenly aware that I was soon going to be buying a whole lot – relatively! – of equities and it would be nice to get them at a discount. This guy knows what I’m taking about:
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
Like everyone in my former industry, I had no emotions, so I simply counted my expected-value gains when stocks went down. And because I dealt in derivatives, I spent some time thinking about the inflection point: when, in expectation, do you stop being a net buyer and become a net seller? For a profitable and growing P&C insurer is the answer never? For a banker … well for me at least it was in March of every year as my bonus-time discount rate of future bonuses was extremely high for reasons you can probably guess. (Hint: Now I blog.) For Warren Buffett … I mean … what should you take away from this long letter explaining why BRK is undervalued? (Also: does this change your discount rate?)
The quote above is of course from Warren Buffett’s annual letter to shareholders, and comes in the context of his discussion of share buybacks, which won’t necessarily blow your mind but which is entirely sensible Graham-and-Doddery and I have no problem with it. The letter as a whole is a good read; I straight-up enjoyed the newspaper tossing contest and the cube-fondling callback, though I had a rough time with the claim that people will always “be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle” because boy does that make you ponder your mortality and the poor choices you’ve made and will continue to make along the way. But you’re not here for peanut brittle. You’re here for share buybacks, and it’s hard to fault Buffett’s choices there too much.
But he’s actually talking about IBM’s share repurchases, which he considers even more faultless:
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’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.
You can sort of generalize Buffett’s quote above and say: outstanding financial management is great if you’re a net … let’s say “holder,” it sounds nicer than “seller.” It’s less great if you’re looking to buy in, since IBM is doing things like buying when the stock is underpriced and not issuing loads of stock for no reasons. If you’re looking to put Berkshire’s zillions to work, what you really like is actually indiscipline: a company that, for whatever reason of desperation or Buffett-halo or just plain bad financial management, wants to sell you securities with a much higher cost of capital than would otherwise be justified.
Coincidentally guess who Buffett really likes:
At Bank of America, some huge mistakes were made by prior management. Brian Moynihan has made excellent progress in cleaning these up, though the completion of that process will take a number of years. Concurrently, he is nurturing a huge and attractive underlying business that will endure long after today’s problems are forgotten. Our warrants to buy 700 million Bank of America shares will likely be of great value before they expire.
And he has only nice things to say about his “large and very attractive” investments in GS and GE, who both bought back their Buffett preferreds this year. The cost of capital of GS’s preferred-and-warrants, from issuance to the preferred redemption, was something like 25% a year (vs. about an 8% annualized return on GS’s common stock); GE’s cost of capital was around 14% vs. a negative return on its common stock. Awesome trades for the buyer; less great in hindsight if you were a shareholder at the time. (Yeah, yeah, what would have happened to them had he not invested, entirely fair.) Don’t let the folksy fool you: the value of the Buffett brand is obtaining capital discipline from the companies where you’re an owner – and capital indiscipline from companies where you’re a net buyer.
Berkshire Hathaway shareholder letter