No. of Recommendations: 32
I am unsure how buybacks affect future returns. Is there an equation that shows the long term expected value of buying back shares?
A buyback done at fair value does not change the value of the continuing shares at all.
Any buyback done above fair value reduces the value of a continuing share.
Any buyback done below fair value increases the value of a continuing share.
So much, so obvious: it's the same with buying any other stock. Bad if you overpay, good if you underpay.
So, simple math:
If a company buys back 15% of its stock at at 20% discount to fair value, the value of each continuing share rises around 20%*15% = 3%.
That's why a few billion spend on buybacks at modest discounts to fair value is not really as big a deal as many people make it out to be.
It's a little bit more nuanced when you consider that sometimes a buyback is the best available idea. Buying in shares at fair value doesn't really do anything by itself, but it's very much better than overpaying for an acquisition or branching out into a line of business with poor economics. Often it is the best of a lot of not really great alternatives.
The other thing about buybacks is this: say it's a really good company, with great capital allocation skills and a high return on incrementally allocated capital. You want to own lots of it, and buybacks (not above fair value) make tremendous sense. You want to buy as much as you can, and so does management.
But as the price paid rises, not only does each buyback make less sense because it's more expensive, but it also makes each buyback worth less because it is now a worse quality business: their capital allocation is not as good, and their return on incrementally allocated capital is worse. So there is a weird counteracting effect going on: the more buybacks you do (i.e., the less discerning you are about the price at which you buy), the less the business is worth at any given price because it's not as good at capital allocation.
If a great business only does buybacks when the shares are REALLY cheap, it's a great firm so you want them to do tons of buybacks.
But if they do those more buybacks when the shares aren't so cheap, it isn't as good a firm, so you want them to do fewer buybacks because the firm isn't as attractive at any given price...and round and round. What the wise man does at the start, the fool does in the end.
This touches on why it interests me very much that Berkshire has been doing buybacks at considerably higher levels lately. Not because I think it's a worse firm as a result per the reasoning above, but because Mr Buffett clearly *doesn't* think it's a worse firm. Yet valuations of those buybacks seems quite high, not just on simple book, but on other fancier value metrics like multiples of operating earnings or look through earnings. I read into this fact that Mr Buffett thinks the serious weakness in operating earnings in the last few years, especially in the utilities, is transient. I would say that the buybacks at recent levels make sense only if the trajectory of business value (per unit of assets or sales) returns to the old trend. As approximated by trend price/sales within the utilities and rails divisions. i.e., net margin reversion to old norms.
I think he is pretty sure it's going to get fixed.
Jim
