Why is Warren Buffet ($BRK) obsessed with treasury stock?
And by the way, what is treasury stock and how does it impact my share value?
Berkshire Hathaway ($BRK) is generally considered a good buy. Since 1965 its annual compounded growth doubles that of the S&P 500. Led by Warren Buffet, the conglomerate has led investing trends for quite some time.
Each year, Buffet’s letter to the shareholders is a must-read. Though he’s now 90 years old, he’s sharp as ever, and his ability to boil down the company’s strategy into a fairly concise message is helpful in giving investors a good idea of where the company is at and where it’s going.
For the most part, Buffet’s words need not breaking down for the “casual investor” like I intend to do in this newsletter.
But when his 2021 letter released, I noticed one element that kept coming up that may be confusing for a casual investor — Share repurchase.
What is a share repurchase?
A share repurchase is exactly what it sounds like — A company goes out into the open market and buys its own shares back, bringing them in as treasury stock.
For those interested in the accounting equation impact (ASSETS = LIABILITIES + STOCKHOLDER EQUITY) treasury stock is a contra equity account, meaning it directly reduces total stockholder equity, but it can have an overall desirable impact on an individual share basis.
What are the advantages of share repurchasing?
Buffet makes it clear many times in his article — Share repurchasing is a good thing for investors. He gave an example of Berkshire’s investment in Apple to paint a picture:
Berkshire’s investment in Apple vividly illustrates the power of repurchases. We began buying Apple stock late in 2016 and by early July 2018, owned slightly more than one billion Apple shares (split-adjusted). Saying that, I’m referencing the investment held in Berkshire’s general account and am excluding a very small and separately-managed holding of Apple shares that was subsequently sold. When we finished our purchases in mid-2018, Berkshire’s general account owned 5.2% of Apple.
Our cost for that stake was $36 billion. Since then, we have both enjoyed regular dividends, averaging about $775 million annually, and have also – in 2020 – pocketed an additional $11 billion by selling a small portion of our position.
Despite that sale – voila! – Berkshire now owns 5.4% of Apple. That increase was costless to us, coming about because Apple has continuously repurchased its shares, thereby substantially shrinking the number it now has outstanding.
Yes, despite selling a substantial $11 billion, Berkshire’s amount of equity (in terms of dollars) did not change.
Stocks, like any other tangible or intangible that you can purchase, are more valuable when there are fewer in circulation. PlayStation 5s were reselling for double the retail value in the open market in Q4 of 2020 because retailers could not feed the consumer demand. Stocks, when scarce, can and often do jump up in price.
Therefore, if a company buys back some of its own stock, less stock is out there in circulation, inherently making any shares still out there worth a bit more.
Should I be excited if a company I invest in is repurchasing shares?
Not necessarily, no. Just as you can buy a stock at the wrong time and overpay, so can companies when repurchasing their own stock.
If a company is well led with wise decision-makers, you can likely be confident that share buybacks are done with reason. But mistakes do happen, even with the smartest of leaders.
A company using funds to buy its own shares back could be done haphazardly and with poor timing.
Buffet points this out in his letter:
In no way do we think that Berkshire shares should be repurchased at simply any price. I emphasize that point because American CEOs have an embarrassing record of devoting more company funds to repurchases when prices have risen than when they have tanked. Our approach is exactly the reverse.
It’s worth keeping in mind, too, companies can also bring treasury stock to the open market. If done correctly, it can result in an influx of funds for the business and a net gain on the shares overall, but again, it can result in a negative impact as well (beyond just the fact that shares are diluted when more are taken to market).
Should I be annoyed if a company is not repurchasing stock?
Buffet seems to imply that he believes a company with strong earnings should be repurchasing stock with those earnings in order to increase the worth for investors.
In his letter, Buffet talked about how, for the purposes of Berkshire, only dividends from the company’s stock holdings are included in the accounting records. When the companies that BH has stock in (without enough owned stock to have a controlling stake in the business) retain earnings, those are not included in BH’s books (emphasis my own):
Investees use the withheld funds to expand their business, make acquisitions, pay off debt and, often, to repurchase their stock (an act that increases our share of their future earnings). As we pointed out in these pages last year, retained earnings have propelled American business throughout our country’s history.
Investors would be wise to consider whether or not the companies they invest in are treating their investments the same way.
If you aren’t (heck, even if you are) getting dividends from your stock, how are companies that you have a stake in (that are earning significant amounts) using their retained earnings? Are they becoming more solvent? Buying back shares to appreciate the market value of your ownership? Or are they standing by idly?
Warren Buffet cares about how companies he invests in are using their earnings. You owe it to yourself to make sure companies you have equity in are doing the same.