Warren Buffett: Stock Repurchases Can Be Powerful

- By Robert Stephens, CFA

Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) repurchased around 5% of its shares in 2020. This contributed to an increase in the company's per-share intrinsic value versus 2019 levels.

The company's chairman, Warren Buffett (Trades, Portfolio), discussed the repurchase of stock in his annual letter to shareholders. Commenting on the principle of share repurchase programs, he said:

"The math of repurchases grinds away slowly, but can be powerful over time. The process offers a simple way for investors to own an ever-expanding portion of exceptional businesses."

In my opinion, share repurchase programs such as that followed by Berkshire could be a good idea for a few different reasons. First, buying back shares in a company that is undervalued by the stock market may represent an efficient use of capital. A repurchase increases the percentage holding of investors in the company and can have a positive impact on their long-term returns.

Second, a share repurchase program can be a productive use of capital when a company lacks opportunities elsewhere. In Berkshire's case, it did not find adequate acquisition opportunities that matched its criteria in 2020. Other companies may struggle to find capital expenditure opportunities that offer a sufficiently high rate of return. In these instances, share repurchases can be a better idea than having more cash sitting on a balance sheet earning extremely low returns.

The drawbacks of share repurchases

Of course, share repurchases can be problematic in some instances. They are sometimes made in lieu of dividend payments, which reduces the income return offered by a specific stock. This can make them less attractive for investors who require income from their capital on a regular basis.

In addition, share repurchases can be initiated by company management for the wrong reasons, which can be harmful to shareholders even if they don't realize it. Often, the upper management's pay is linked to per-share metrics such as earnings per share. As a result, share repurchases can be undertaken by management to inflate per-share metrics and their bonus payments as well as to disguise the detrimental effects of the issuance of large amounts of stock options to executives. They may be enacted when there are far more efficient uses of capital, such as acquisitions or capital expenditure, that would add to the firm's intrinsic value in the long run.

Share repurchases may also mean a company naturally invests to a lesser extent in growth opportunities than would otherwise be the case. This may harm their market position in the long run if competitors are expanding and improving their own operations. This may lead to an erosion of their competitive advantage.

A case-by-case basis

In my view, share repurchase programs can represent an efficient use of capital in some instances, but not in others. They can be a good thing if a company, such as Berkshire, has a large cash balance, undervalued shares and does not require the capital for purposes including acquisitions. However, share repurchases may be a red flag for investors if a company's valuation is rich and investment opportunities are foregone in favor of buying back stock.

Disclosure: The author has no position in any stocks mentioned.

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This article first appeared on GuruFocus.