Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) recently announced that it is modifying its current buyback authorization, and shares popped by 4%. The prospect of increased stock repurchases is often welcomed by investors, but Berkshire shareholders are more excited by the possibility than most.
Simply put, the company has been sitting on a big stockpile of cash for some time now without any attractive ways to put it to work for investors, and this could give Chairman and CEO Warren Buffett the solution he's been looking for.
Warren Buffett. Image source: The Motley Fool.
Berkshire's newly modified buyback plan
Previously, Berkshire Hathaway's board had authorized Buffett to buy back Berkshire Hathaway's stock whenever it fell below 1.2 times its book value, a level that the board felt clearly undervalued the company.
The problem is that even in turbulent market times, Berkshire's stock price hasn't fallen below that valuation in the past five years. So the rule effectively prohibited any buybacks from occurring.
Under the amended buyback plan, the board has thrown the 1.2 times book threshold in the trash. Instead, shares can now be repurchased any time Buffett and Vice Chairman Charlie Munger agree that the stock price is below its intrinsic value as "conservatively determined" by the two men.
Now, Buffett's valuation method isn't public knowledge, but it's fair to say that this gives him a lot more room to buy back shares, especially since he has repeatedly said that Berkshire's stock is worth considerably more than its book value.
There are a couple of other important points to know. First, the buybacks cannot reduce Berkshire's cash position below $20 billion, a cushion Buffett has mentioned many times. And second, no buybacks can be made under this modified authorization until after Friday, Aug. 3, the day Berkshire is scheduled to report its second-quarter earnings.
Why it matters to investors
Berkshire Hathaway has a ton of cash in the bank and hasn't been able to figure out what to do with it. As of the company's first-quarter earnings report, Berkshire had more than $108 billion in cash and equivalents on its balance sheet, well in excess of the $20 billion or so Buffett likes to keep on hand.
Berkshire's first choice when it comes to putting its capital to work is to acquire entire businesses, an area where it hasn't had much success lately. Aside from a medium-sized acquisition of a stake in Pilot Flying J, Berkshire hasn't made any big purchases since agreeing to buy Precision Castparts in 2015.
The company's second choice is to invest in common stocks. Buffett and his team have found some recent success in this area. For example, the company successfully reduced its cash hoard for the first time in years during the first quarter by adding significantly to its Apple investment.
However, for the most part, Berkshire hasn't been able to find many attractive acquisition or stock opportunities. And, since the former buyback threshold prohibited Berkshire from using its cash for buybacks, the only other option was to pay a dividend. To put it mildly, Buffett isn't a big fan of that idea.
To be fair, a 12-figure cash stockpile is a good problem to have, but it is a problem. This is a massive sum of money sitting in the bank and earning little or no returns, instead of being invested in return-generating opportunities. So removing the buyback threshold gives Buffett a new way to put some of this money to work.
Here's what Berkshire is signaling to investors
If you follow Berkshire Hathaway's earnings reports, annual meetings, or Buffett's letters to shareholders, it's no big secret that Berkshire's team thinks that stocks and acquisition targets are generally expensive right now. After all, it's a lack of acquisition opportunities that caused the company's cash hoard to balloon in the first place, and Buffett has specifically cited valuations as the main obstacle to getting deals done.
While we don't know for sure that Buffett and Munger will actually use these modified rules to buy back any stock, if they do, it is a signal that they believe Berkshire's stock is the best possible use of the company's excess capital. In other words, it would look like Buffett and Munger might think Berkshire shares are cheap.
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Matthew Frankel owns shares of AAPL and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends AAPL. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.