Returning value through share repurchases rather than dividends

[twacowfca]

Also, remember that share prices generally fall my the amount of the dividend, so it's questionable how much value you are really gaining from dividend payouts.

 

You're right about taxes.  However, in a world without taxation the benefit is that you get the dividend paid at full intrinsic value.  It doesn't matter that the share price drops -- it's supposed to drop after a dividend is paid. 

 

I will provide now an example where the dividend adds value:

 

Let's say for example that you want to withdraw 3% annually from your investment account, but everything in your account is trading as a 50 cent dollar.  You have nothing trading at intrinsic value.  And we're in difficult economic times and this discount exists for years on end.  Your account is fully invested.  Do you sell shares for 50% below what they're worth?  Or let's say instead that you own dividend payers and your yield on your portfolio is at least 3% -- you can just extract the cash from your account at full intrinsic value, without needing to sell anything.

 

So dividends allow you to regularly extract full intrinsic value from your investments like clockwork.  A value investor should enjoy that aspect of it.  Isn't the whole point to purchase shares below intrinsic value and then realize full intrinsic value from your investments?  That's my understanding.  Selling shares for intrinsic value is very lumpy and it might never happen as for some companies the fair value at where they should trade could very welll be far below intrinsic value (prices take risk into account) -- when you need cash on a more consistent basis the dividend is the answer.  How long might you have been holding onto Fairfax shares waiting for full intrinsic value?  I like their dividend -- every January I get full intrinsic value on a portion of my investment.

 

 

An excellent rationale for paying dividends.  Kudos, Eric.  :)

[Rabbitisrich]

If we are assuming financially savvy management, then, as a small investor, I would prefer buybacks.

 

The company can act as a source of liquidity to draw out less savvy sellers and pass the value proportionally to the holders. In a dividend situation, the extra value will concentrate on the most liquid holders, as everyone else can only apply their dividend plus small reserve to purchasing stock.

 

Ericopoly, I definitely appreciate your arguments, especially considering the prices I've seen for actual buybacks. However, regular dividends seem to have a stultifying effect on shareholders. If the company needs cash and wants to cut dividends to issue equities, you get massive selling. If the management wants to divert attention from operations, it increases dividends. There is something about giving out cash that seems to placate people.

[bargainman]

Do you sell shares for 50% below what they're worth?  Or let's say instead that you own dividend payers and your yield on your portfolio is at least 3% -- you can just extract the cash from your account at full intrinsic value, without needing to sell anything.

 

So dividends allow you to regularly extract full intrinsic value from your investments like clockwork.  A value investor should enjoy that aspect of it.  Isn't the whole point to purchase shares below intrinsic value and then realize full intrinsic value from your investments?  That's my understanding. 

 

This is the same rationale I've heard for closed-ended funds which pay out managed 'dividends'.  Often they trade for a discount to their NAV, and this way they are able to return capital at full value.

[Guest Bronco]

twacowfca,

 

You didn't really post the whole thing...

 

Recently, a number of shareholders have suggested to us that Berkshire repurchase its shares. Usually the requests

were rationally based, but a few leaned on spurious logic.

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the

company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business

and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add

a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise,

insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We

have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down.

The business “needs” that I speak of are of two kinds: First, expenditures that a company must make to maintain

its competitive position (e.g., the remodeling of stores at Helzberg’s) and, second, optional outlays, aimed at business

growth, that management expects will produce more than a dollar of value for each dollar spent (R. C. Willey’s

expansion into Idaho).

When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can

buy new businesses or repurchase shares. If a company’s stock is selling well below intrinsic value, repurchases usually

make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few

responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been

17

pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were

large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a

shareholder-oriented management.

That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view,

ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted

by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic

value. Buying dollar bills for $1.10 is not good business for those who stick around.

Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and

then only when we employ a range of values, rather than some pseudo-precise figure. Nevertheless, it appears to us that

many companies now making repurchases are overpaying departing shareholders at the expense of those who stay. In

defense of those companies, I would say that it is natural for CEOs to be optimistic about their own businesses. They

also know a whole lot more about them than I do. However, I can’t help but feel that too often today’s repurchases are

dictated by management’s desire to “show confidence” or be in fashion rather than by a desire to enhance per-share

value.

Sometimes, too, companies say they are repurchasing shares to offset the shares issued when stock options granted

at much lower prices are exercised. This “buy high, sell low” strategy is one many unfortunate investors have employed

— but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.

Of course, both option grants and repurchases may make sense — but if that’s the case, it’s not because the two

activities are logically related. Rationally, a company’s decision to repurchase shares or to issue them should stand on

its own feet. Just because stock has been issued to satisfy options — or for any other reason — does not mean that stock

should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value

should be repurchased whether or not stock has previously been issued (or may be because of outstanding options).

You should be aware that, at certain times in the past, I have erred in not making repurchases. My appraisal of

Berkshire’s value was then too conservative or I was too enthused about some alternative use of funds. We have

therefore missed some opportunities — though Berkshire’s trading volume at these points was too light for us to have

done much buying, which means that the gain in our per-share value would have been minimal. (A repurchase of, say,

2% of a company’s shares at a 25% discount from per-share intrinsic value produces only a ½% gain in that value at

most — and even less if the funds could alternatively have been deployed in value-building moves.)

Some of the letters we’ve received clearly imply that the writer is unconcerned about intrinsic value considerations

but instead wants us to trumpet an intention to repurchase so that the stock will rise (or quit going down). If the writer

wants to sell tomorrow, his thinking makes sense — for him! — but if he intends to hold, he should instead hope the

stock falls and trades in enough volume for us to buy a lot of it. That’s the only way a repurchase program can have

any real benefit for a continuing shareholder.

We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value,

conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever

told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders — and potential shareholders — the

same valuation-related information we would wish to have if our positions were reversed.

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to

delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find

that repurchases make sense, we will only rarely place bids on the New York Stock Exchange (“NYSE”). Instead, we

will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call

Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the “third market” or on the

NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not

engage in transactions involving fewer than 10 shares of A or 50 shares of B.

Please be clear about one point: We will never make purchases with the intention of stemming a decline in

Berkshire’s price. Rather we will make them if and when we believe that they represent an attractive use of the

Company’s money. At best, repurchases are likely to have only a very minor effect on the future rate of gain in our

stock’s intrinsic value.

 

I can't find evidence on the F/S (statement of cash flows) that anything was done.  Regardless (or as my colleagues say, irregardless..)

 

Also, to the person that wrote about Washington Post - you think investing long term in the newspaper business was a great idea?  If anything, Washington Post is better off because it invested in a business outside of newspapers.  But in hindsight, my suggestion is the capital would have been left better to Buffett.

 

I feel that taking capital away from Buffett in any way shape or form is like taking the ball away from Jordan at the end of  the game. 

 

Nuff said on this topic - too hard to change people's opinions either way (myself included).

[Myth465]

Great Post Bronco / Ericology. I think sometimes people can get a bit too academic with these sorts of things. I think when repurchases make sense it will be extremely obvious to both Owners and Managers (both would be buying with their own cash). 

[twacowfca]

Thanks for serving up "the whole pizza", Bronco.  You're right.  WEB didn't buy back any shares then because BRK popped up in price after he made his offer.  Contrary to what WEB said, my personal opinion is that the knowledge that some of his biggest fans like Andy were getting margin calls played a large role in his decision to buy back shares.  When the offer was made BRK was selling below IV, but not dramatically below IV as was sometimes the case many years ago.

 

Interestingly, WEB actually did buy back BRK shares once when his partnership was being dissolved.  :)

 

 

Five

[Guest Bronco]

I think we all agree that share buybacks can work if a stock is trading well below its intrisic value, but the majority of the time these programs are overused.  I think we also all agree that tax policy is a driving factor, and at least in the U.S., I think the tax and cporporate policy is a disgrace.  I base this on the following: 1) owners should be treated like owners 2) corporate earnings don't need to be taxed to the owners at a 45% - 50% clip (and they are) and 3) you should want capital moving into your country, not out.  This last one is where Obama really gets an F. 

 

It is my belief that there are great managers of business, and then there are great allocators of capital.  Very rarely do you see both.  Even Buffett is more the latter than the former, although I believe he is a fantastic insurance and risk management mind.  And with board of directors, things get worse.  It is my belief that Wall Street has fallen in love with buybacks because they will always, without question, drive EPS up (assuming there are earnings and not losses).  We all know this is pathetic.  Capital should find a home to its greatest use - whether it is in investments, paying debt, paying a dividend, staying put to strengthen balance sheets, or even the buyback if it is the BEST alternative.  That is always my argument - let capital find a home where it will grow the best.  I believe Buffett has made a career of this philosophy, but he is so rarely imitated.  Mind boggling.

[twacowfca]

Great Post Bronco / Ericology. I think sometimes people can get a bit too academic with these sorts of things. I think when repurchases make sense it will be extremely obvious to both Owners and Managers (both would be buying with their own cash).  

 

 

Not necessarily.  In the 1970's BRK sometimes sold way below BV and for an even greater discount to IV, yet WEB didn't buy back shares even though that was the ideal time to repurchase.  Why?  Because other great companies were selling for even greater discounts to IV!

[alwaysinvert]

Great Post Bronco / Ericology. I think sometimes people can get a bit too academic with these sorts of things. I think when repurchases make sense it will be extremely obvious to both Owners and Managers (both would be buying with their own cash).  

 

 

Not necessarily.  In the 1970's BRK sometimes sold way below BV and for an even greater discount to IV, yet WEB didn't buy back shares even though that was the ideal time to repurchase.  Why?  Because other great companies were selling for even greater discounts to IV!

 

Most companies do not and should not operate that way, though. I wouldn't like to see a random retailer or whatever company that I own go on an acquisition spree just because valuations were low.

[Myth465]

Still extremely obvious though. If there were other companies at better prices then good Managers / Owners would be buying those instead. If I am buying a stock, it typically means I think it’s one of the better risk adjusted values available. Depending on the situation (maybe they have to pay a dividend for tax reasons, or they have too much debt and need to delever, or they have capital allocation skills and should be buying something else), I would want Management doing the same.