Berkshire’s Repurchase Policy: Too Little, Too Late?

Berkshire Hathaway acquired $928 million of its own stock during the third quarter of 2018 through a series of purchases of Class A and Class B shares from August 7 to 24.  A repurchase of this size, relative to the company’s cash flow and market capitalization, would normally attract relatively little attention.  However, Berkshire has maintained an unusual policy with respect to return of shareholder capital in general and stock repurchases in particular.

Rational capital allocation is a problem that many companies never adequately resolve because the skill set of management is often more attuned to solving operational problems rather than allocating free cash flow.  However, Berkshire shareholders have benefitted from Warren Buffett’s superior operational and capital allocation skills for decades.  For almost all of Berkshire’s history, there was never any question regarding whether capital should be retained within the company.  Few shareholders would have been better off receiving dividends or selling their shares back to the company and reinvesting the after-tax proceeds elsewhere.  Mr. Buffett’s investment prowess fully justified full retention of all free cash flow generated by the business.

In 2015, Berkshire marked its 50th anniversary of Mr. Buffett taking full control of the company.  This was a natural time to look back on the history of Berkshire and, more importantly, to take a look at where the company might be a decade in the future:

The implications of Berkshire continuing to retain all earnings over the next decade while growing book value per share at a compound rate of approximately 10 percent are staggering.  If we take Berkshire’s 2015 net earnings of $24 billion as a baseline, reinvestment of all earnings would need to result in enough incremental earnings power to generate approximately $62 billion of net income for Berkshire by 2025.  We would expect retained earnings to increase by about $420 billion over the next decade.  Berkshire’s shareholders’ equity would approximate $675 billion by the end of 2025 based on these assumptions.  With this kind of track record, the market would most likely value Berkshire in excess of $1 trillion.

The idea of a trillion dollar company is no longer as novel today as it was a few years ago, but the numbers are still staggering.  We also pointed out in the article that Berkshire’s repurchase policy may well need to be changed in order to allocate a portion of the massive free cash flow likely to accrue over the coming decade and noted that the novel repurchase policy adopted by Berkshire could make it difficult to deploy cash via repurchases.  Berkshire had, for several years, limited repurchases to times when shares could be repurchased under a fixed price-to-book ratio which had been set at 120% since late 2012 after being established at 110% in 2011.

For critics of Berkshire’s repurchase policy, Berkshire’s updated repurchase policy announced on July 17, 2018 was welcome news.  A fixed price-to-book ratio limit was eliminated in favor of allowing repurchases anytime both Warren Buffett and Charlie Munger believe that the stock is trading “below Berkshire’s intrinsic value, conservatively determined” and when doing so would not reduce Berkshire’s holdings of cash and equivalents below $20 billion.  The news was very surprising to the market with shares closing up over 5 percent on July 18.  One caveat was that repurchases under the new policy would not be permitted until after Berkshire released second quarter earnings.  As a result, the first day that repurchases were permitted under the new policy was August 6.

Let’s take a look at Berkshire’s repurchase activity under the new policy.  Here is an excerpt from the recently released 10-Q report showing repurchase activity during the quarter:

It helps to put these repurchases into proper context by looking at Berkshire’s trading activity during that time.  The charts below, presented separately for Class A and Class B shares, were derived using data from Yahoo Finance:


We can see from the charts that there were two significant bumps in Berkshire’s trading price following the revision to the repurchase policy on July 17.  On July 18, the stock price rose significantly due to market expectations that repurchases were more likely to occur and, on August 6, the stock rose again in response to the release of second quarter earnings.  These price increases did not deter Mr. Buffett from repurchasing close to 9 percent of the company’s trading volume, in aggregate, over the period from August 7 to 24.  This is not to say that he regularly purchased some fixed percentage of volume, although perhaps he did, and repurchases could have been concentrated on specific days.  However, the average price paid of $312,807/A and $207.09/B is pretty typical for that range of dates.

After August 24, the stock price rose to a level where Mr. Buffett decided to halt repurchase activity.  We know that no further shares were repurchased between August 25 and September 30.  However, we can infer that additional shares were repurchased between October 1 and October 25.  We know this because Berkshire is required to release a recent share count along with its 10-Q report.  On the first page of the recently released 10-Q, we see the following:

Given the conversion ratio of 1,500 Class B shares per Class A share, the Class A equivalent share count on October 25 was 1,641,681 shares whereas the Class A equivalent share count was 1,642,269 shares on September 30.  Berkshire typically issues a very small number of shares every year so we cannot simply subtract the October 25 share count from the September 30 share count.  However, we can infer that at least the difference of 588 A equivalents were repurchased between October 1 and October 25.  This is a relatively small deployment of capital – probably around $185 million.  Obviously shares were available during this timeframe well under the levels paid during the August repurchases.

What can we infer from these repurchases regarding what Mr. Buffett and Mr. Munger think of Berkshire’s intrinsic value, “conservatively calculated”?  Since Berkshire’s repurchase policy was based on book value for several years, it is logical to start by considering what price-to-book ratio was paid for the August repurchases.  Mr. Buffett made a point to wait until after second quarter results were released prior to initiating any repurchases.  June 30, 2018 book value per share was $217,677/A and $145.12/B.  The average price paid for the August repurchases was 1.437x book value for the A shares and 1.427x book value for the B shares.  This is substantially higher than the prior 1.2x book value limit and quite surprising.

We do not know the price or timing of the repurchases that took place from October 1 to 25, and there are sometimes “quiet periods” that limit companies from freely repurchasing stock prior to releasing earnings.  However, we know that Berkshire traded below the average level of the August repurchases from October 11 to 25.  Additionally, we know that Berkshire’s book value rose to $228,712/A and $152.47/B as of September 30.  Berkshire’s A class stock price on Friday, November 2 closed at $308,411 which is slightly under 1.35x book value.  With the caveat that the recent stock market correction has put pressure on Berkshire’s book value due to its large holding of marketable securities, it seems like we can still infer that Mr. Buffett and Mr. Munger view Berkshire’s stock to be trading below conservatively calculated intrinsic value.

Although we are still awaiting the release of Berkshire’s 13-F report which will reveal the company’s U.S. equity portfolio as of September 30, astute observers have already inferred from the 10-Q that Berkshire was a heavy buyer of common stocks during the second quarter.  Although an analysis of what Berkshire may have been doing in its equity portfolio during the quarter is beyond the immediate scope of this article, it is worth pointing out that the scale of Berkshire’s repurchases are quite small compared to its overall free cash flow and its allocation of capital into the stock of other companies.  This could be due to a variety of factors.  Mr. Buffett and Mr. Munger could believe that Berkshire is undervalued but not as undervalued as other opportunities in public markets.  It could also be due to the relative lack of trading volume in Berkshire’s stock which could put a cap on how much Berkshire can repurchase without pushing up the price dramatically.

Shareholders who were hoping for very large repurchases relative to Berkshire’s market capitalization or free cash flow will probably be disappointed with the magnitude of actual repurchase activity in the third quarter.  It could be that the peculiarities of Berkshire’s shareholder base and trading volume will make it difficult to execute large repurchases and that activity will be more modest.  However, over long periods of time, a significant reduction of the share count is still a possibility.

One cannot help but wonder how much lower Berkshire’s share count might be today had the present repurchase policy been adopted in 2011 rather than the policy that imposed the 110 percent of book value limit.  We now know that Mr. Buffett and Mr. Munger view a price below 140 percent of book value as a definite bargain.  Although we must note that the ratio between intrinsic value and book value can change over time, we can see that the price-to-book has been below 140 percent for substantial periods since 2011:


Would Berkshire shareholders have been better off with aggressive repurchase activity at various times since 2011 given that the stock price has traded below management’s view of intrinsic value for much of this time?  This is a complicated question to answer because obviously Berkshire has utilized its resources for other purposes during the past several years.  However, the presence of a large amount of undeployed cash on the balance sheet for a long period of time has signaled a dearth of opportunities and, for much of this time, management was unable to capitalize on an undervalued bargain in the form of the company’s own stock due to the constraints imposed by the 2011 and 2012 repurchase authorizations.

The updated repurchase policy is well overdue and hopefully will not be “too little, too late” when it comes to Berkshire’s overall capital allocation over the next decade.  We should, however, note that this new repurchase policy places no more of a “floor” on the stock price than the old policy.  Markets can and will do crazy things and Berkshire’s stock will certainly trade at depressed levels at times in the future.  Now, management has full flexibility to take advantage of such times.  Despite occasional criticism by the uniformed and/or politically motivated, repurchases can be a very intelligent way to deploy capital under the right circumstances.  The key issue is to avoid overpaying and there seems to be little risk of that happening at Berkshire.

It is also worth noting that for many longtime shareholders with a low cost basis, Berkshire represents a particularly tax advantaged way of compounding wealth.  Allocating capital to repurchases rather than dividends, as long as repurchases are below intrinsic value, will have the effect of increasing unrealized capital gains and continue tax efficient compounding for continuing shareholders.  The alternative of receiving dividends would result in immediate tax consequences and interrupt the snowballing tax deferred compounding machine known as Berkshire Hathaway.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

The Pitfalls of Early Success – A Personal History

“Success makes people think they’re smart.  That’s fine as far as it goes, but there can also be negative ramifications.”

— Howard Marks 

The investing profession tends to attract individuals who, to put it politely, have a healthy sense of self esteem.  After all, anyone who actively invests is essentially saying that their views regarding investments are superior to the collective wisdom of the rest of the market.  Without this underlying belief, it would not be possible to think that one can outperform a passive index and it would make no sense to spend a career pursuing superior performance.  However, investors often get into trouble when they permit a healthy self esteem to evolve into arrogance and hubris that allows no intellectual room for the possibility of being wrong.  There is a huge difference between conviction in one’s skills and delusions of infallibility.

Contrary to what many may wish to believe, random luck plays a major role in one’s life experiences and prospects for overall success.  As Warren Buffett often says, he won the “ovarian lottery” by being born into a successful and prominent family in the United States in 1930.  His unusual numeracy at a young age served him extremely well whereas it would have been of limited value had he been born into a small hunting and gathering tribe in Africa in 3000 BC.  His success is a combination of the circumstances and timing of his birth, his innate intelligence, and hard work.  Only the hard work was under his direct control.

Howard Marks makes many important observations in his latest book, Mastering the Market Cyclebut perhaps the most intriguing points have to do with the role of human nature and emotion.  Chapter 16 deals with the cycle in success, much of which has to do with human nature.  The seeds of failure are often planted during periods of success due to the extent to which our mentality changes when we are doing well.  To the extent that success makes us arrogant, we are more likely to tune out evidence contrary to our own beliefs without a thorough examination of the facts.  We always need to remember that when we make the decision to buy or sell an investment, we are making an affirmative statement that we know more than the market and that even though the market often seems “crazy”, it is made up of thousands of investors just like us who are trying to achieve the same objective – outperformance.  We must always be thinking about what makes our views better than the market consensus – in other words, what is our edge?

Warren Buffett was born in 1930 and came of age during the post World War II boom and inflation and the subsequent economic expansion of the 1950s.  These early experiences shaped his outlook and also presented him with a set of opportunities.  Would his career have been different if he had been born in 1910 rather than 1930?  He would have come of age right at the tail end of the 1920s boom and his formative experiences would have been in the context of the Great Depression rather than the post-war economic boom.  What if he had been born in 1950 rather than 1930?  He would have come of age during the turbulent late 1960s, possibly have been drafted into the Vietnam War and, from an investing perspective, would have started out in the Nifty Fifty era followed by the dismal 1973-74 bear market.  It is likely that Mr. Buffett would have joined the ranks of the super rich no matter which era in the 20th century he was born into, but being born in 1930 probably was an advantage over being born 20 years earlier or later.  Of course, we will never know for certain.

Clearly, the timing of one’s career plays a big role in the type of opportunities available.  However, the experiences of a particular era probably have an even greater impact on how we see the world.  In the context of the stock market, if we start out in a bull market, we are likely to see the world much differently than starting out in a bear market.  Furthermore, if we have early success in any type of market that was really the product of luck rather than skill, we are almost certain to attribute this success to skill anyway and draw the wrong conclusions from the experience.  Those incorrect conclusions could very well lead to extremely negative consequences.  As Mr. Marks says, “success isn’t good for most people”, especially if that success is due to luck rather than skill.

Would you rather have a string of successful outcomes early in your career, or is it better to be tested with various types of adversity?  Obviously, early success can be much more pleasant.  And certain individuals will just give up if there is too much early failure.  However, we need to keep in mind that from an investing perspective, most individuals have much less to work with early in their career.  Granted, small amounts of money early in life can potentially compound into huge sums later on so decisions at an early age are important.  However, there is also something to be said for making a major mistake with $10,000 of capital rather than $10 million at stake.

As a member of Generation X who was interested in making money from a very early age, I was clearly impacted by the economic boom of the 1980s and, although I had no money invested in stocks during the 1987 crash, I still remember watching Wall Street Week on the Friday after the crash.  Louis Rukeyser’s opening is still worth watching today.  Having no real understanding of stocks, my natural reaction was amazement that so much money could be lost in the blink of an eye and I had no desire to lose my morning paper route and after school job earnings.  However, the crash was fascinating enough to get me to follow stocks and eventually major in finance in college.

My first venture into investing was the Vanguard Wellington fund sometime in the early 1990s.  Wellington was one of the oldest mutual funds in existence which, along with its “balanced” portfolio seemed like an appealing place to put some money.  However, it was boringly conservative by the time I graduated in 1995 armed with what seemed like “all the answers” that I needed to outperform.  I decided to take higher paying work in software with the idea that I would live frugally and invest my savings.  By the mid 1990s, the technology boom was well established but had not yet reached the insanity of the late 1990s, and I was immersed in the technology world since I worked in software in the Silicon Valley.  I sold my mutual funds and went to the library to read Value Line on Saturday mornings, but 60-80 hour weeks in software limited my free time.  Eventually I purchased Intel stock and let it ride for a number of years.  I also purchased real estate and benefited from the late 1990s housing boom in the Silicon Valley.

Having the good fortune to read The Intelligent Investor and Buffett: The Making of an American Capitalist in 1995 made a lasting impression and allowed me to see the bubble of the late 1990s for the insanity that it was.  I was not tempted to purchase dot com stocks and when the value of my Intel stock rose spectacularly, I was not blinded by that success and kept an eye on the valuation.  Through a combination of luck and thanks to Benjamin Graham, I sold my shares of Intel in early 2000.  My reading about Warren Buffett’s career as well as the decline in Berkshire Hathaway stock led me to put the proceeds of my Intel sale into Berkshire in February and March 2000.  My second purchase of Berkshire stock, on March 9, 2000, represented perfect timing.  I had come very close to nailing the bottom tick and had substantial paper gains after the annual report was released shortly after my purchase.  Although I’ve made plenty of subsequent mistakes, I still hold those original shares of Berkshire that were purchased with nearly perfect timing.  I did not nail the timing of the Intel sale quite as well but a year later I felt like a genius for sidestepping the large decline in Intel shares.  The combination of avoiding loss by selling Intel and achieving gains in Berkshire was the mental equivalent of taking drugs:  I viewed myself as an investing genius for many years thereafter.

A heavier workload in my software career put me on the investing sidelines for the most part for several years but I continued to save the majority of my income and opportunistically purchased Berkshire Hathaway shares when they looked attractive, and also sometimes when the shares were not that attractive.  Nevertheless, I posted a respectable overall record during the period leading up to the 2008-09 market crash.  The combination of returns on my investments, new savings and the sale of another real estate property caused my portfolio size to be far larger as I approached the 2008 crash than it had been in 2000.  My success in early 2000 was real, but partly due to luck and only partly due to my insights from reading Graham and Buffett.  But whether due to skill or luck, my capital base was tiny in 2000 compared to 2008.  The “genius” of my moves in 2000 on a small capital base made me feel invincible with a much larger capital base in 2008.

My results in 2008 were horrific but I still managed to beat the S&P 500 by 8 percent.  Although the magnitude of my losses were great, I was still “winning” relative to the market averages and I finally went into investing full time almost exactly at the early 2009 market lows (which is also the time when I launched The Rational Walk).  I had every reason to believe that I had substantial skill due to my track record and while I was not oblivious to the role of luck, I viewed skill to be the paramount factor in my historical success.

In retrospect, it seems obvious that early 2009 was a time to buy, and it also seems obvious that at that type of inflection point in a market cycle the biggest gains would accrue to those who aggressively purchased leveraged companies that were viewed as being at risk of bankruptcy but subsequently pulled through.  In other words, it paid to be very aggressive at that time.  My decision was to become increasingly conservative.  Part of the reason had to do with becoming a full time investor.  I knew that I would have to live off my investments so my level of risk aversion increased at precisely the time that I should have become more aggressive.  However, I also believed that greater bargains would likely be available later.  I thought that the market had further to fall.

The short story is that I underperformed the S&P 500 by nearly 21 percent in 2009.  I missed one of the greatest buying opportunities of my lifetime and did so with a capital base far greater than I had in 1999-2000.  The experience of 2009 forced me to reassess my strengths and weaknesses and to be more introspective regarding my abilities.  I did not reflexively lose all of my confidence but I had more humility at the end of 2009 than I did at the beginning.  I went back to the basics and re-read Graham, studied Buffett and his letters to shareholders, and fundamentally sought to learn from my experience.  I went on to post respectable performance in subsequent years, but I will never have 2009 back and the drag from the underperformance of that year cannot be undone.

In retrospect, my early success with a small capital base in 1999-2000 resulted in a level of overconfidence and hubris that made me think that I had the ability to time the market in 2008-09.  After all, I had almost perfectly timed my purchase of Berkshire in 2000 so I must have had a “knack” for these things.  The early success on a small capital base played an important role in a major failure in 2009 on a much larger capital base.  Earning returns in 2009 of less than 6 percent when the S&P 500 rose more than 26 percent is a mistake that cannot be undone but one can learn from such experiences and seek to improve in the future.  Ultimately, we are products of our experiences as well as luck.  Sometimes what seems like good fortune, in the form of early success, can actually be worse than the reverse.  Had I encountered more adversity in 1999-2000 with a small capital base, perhaps my results with much more capital in 2009 would have been better.

Book Review: Sapiens – A Brief History of Humankind

There are many aspects of life where the link between cause and effect is very clear.  Humans, as well as many other animals, quickly learn that taking a certain action invariably leads to a predictable and reliable result.  For example, just as other animals, we respond to bodily sensations such as hunger or thirst by finding food and water and consuming it.  We also learn to interpret all sorts of environmental factors in ways that have been conditioned into our minds.  We respond to such stimuli almost automatically.

Daniel Kahneman, in Thinking, Fast and Slow, refers to “system one” thinking as an automatic, fast, and unconscious way of thinking.  When we are crossing the street and we hear the sound of screeching tires behind us, adrenaline and cortisol hormones surge in our bodies to alert us to impending danger and we take action automatically in response.  This response is not that different from the reaction that a squirrel might have when it sees a large bird flying above the telephone wire that it is using to get from one tree to another.  System one thinking has served us well in myriad settings for all of human history but it also can lead us astray in an increasingly complex society.  Human beings, to be successful in our modern world, must increasingly utilize “system two” thinking which is characterized by slow, effortful, conscious, and calculating thought.  Danger awaits humans who respond to situations requiring system two thinking with simplistic “gut responses” driven by system one thinking.  (For more on Daniel Kahneman, see this review of The Undoing Project by Michael Lewis.)


Economics is the study of how human beings produce, distribute, and consume goods and services.  It is considered a social science because the key elements of how an economy works depend on the actions of economic actors rather than laws of nature or the output of a computer algorithm.  The study of how financial markets work is, fundamentally, a subset of the study of economics.  However, academics have long attempted to reduce the study of financial markets to overly precise equations more appropriate for a “hard science” like physics.  In reality, those who are interested in finance would be better off if they devote considerable attention to human psychology.  Popular books on psychology such as Thinking, Fast and Slowhave improved our understanding of human cognitive mistakes.  However, to really understand human beings, we might want to take a step back and survey the fields of evolution and anthropology.  It is in these areas of study that Yuval Noah Harari’s recent book, Sapiens:  A Brief History of Humankind, has made a meaningful contribution to our understanding of what makes humans tick.

It is useful to take a step back and consider human history in the context of some very large numbers (the following is a condensed re-statement of the “Timeline of History” included in the book):

Years Before Present    Event                                                    
13,500,000,000          Matter and energy appear
 4,500,000,000          Formation of Earth
 3,800,000,000          Emergence of organisms
     6,000,000          Last common ancestor of humans and chimpanzees
     2,500,000          Evolution of the genus Homo in Africa
       500,000          Neanderthals evolve in Europe and Middle East
       300,000          Daily usage of fire
       200,000          Homo sapiens evolves in East Africa
        70,000          Cognitive revolution and emergence of fictive language
        30,000          Extinction of Neanderthals
        13,000          Extinction of Homo floresiensis
        12,000          Agricultural revolution
         5,000          First kingdoms, money, and polytheistic religions
         2,000          Christianity
         1,400          Islam
           500          Scientific revolution
           200          Industrial revolution

What we often perceive to be “long periods of time” are, in fact, nothing but tiny blips on the radar when it comes to overall history.  Until 70,000 years ago, human beings were “animals of no significance” according to the author.  It isn’t that human beings did not exist prior to 70,000 years ago.  Creatures that were very similar to modern humans first appeared about 2,500,000 years ago but they did not stand out from the other animals that shared their habitat.  Humans went along, generation after generation, without distinguishing themselves in any particular way and were just part of the overall food chain.  However, humans did many of the same things they do today.  While humans played, formed various relationships and competed within their social groups, the same was true for other primates such as chimpanzees and baboons, as well as elephants and many other creatures.

Amazing advances took place about 70,000 years ago that allowed Homo sapiens to shoot ahead of other human species and other animals.  Prior to that point, sapiens did not have a capability called fictive language.  Humans, as well as other animals, had long had the ability to communicate factual information about the here and now.  Studies have been done that show that certain monkeys have specific calls that warn about various dangers in surprising detail.  For example, there are specific calls that warn about lions and eagles since the necessary response is different in each case.  Humans had the capability to communicate about the present but could not conceive of the concept of fiction.

Fictive language involves the ability to use imagination to describe things that are entirely abstract.  The concept of religion*, for example, describes a set of beliefs that cannot be observed by ordinary human beings but, nonetheless, allows humans to form a common set of beliefs and customs.  Without fictive language, it is difficult for groups larger than about 150 individuals to form a cohesive society because they lack the ability to develop “fictions” that bind together larger populations.  The development of the notion of religion and nationality allowed much larger groups of humans to form social bonds.  Two humans who meet each other for the first time cannot know how to interact without a common set of underlying beliefs.  Just as two Roman Catholics or two Germans meeting for the first time today will already share a lot in common, humans after the cognitive revolution had the ability to understand each other much more fully after the emergence of fictive language.

Until the agricultural revolution, which took place about 12,000 years ago, humans were primarily hunters and gatherers who lived a nomadic lifestyle and did not generally settle in permanent villages or cities.  The development and use of “system one” thinking and “fight or flight” instinct was necessary for survival.  You and your family or tribe would eat, or not eat, based on the success of your hunting and gathering activities in the very near term.  The development of agriculture fundamentally changed human society by making it possible to settle in permanent villages and for some members of a society to engage in activities other than those needed for immediate survival.  Agriculture also made it necessary to analyze and plan for the future.  In other words, the development of agriculture made it necessary to utilize “system two” thinking – slow, effortful, calculating, and long range in nature.

Take another look at the table above showing key developments in history.  12,000 years seems like a long time to us, but it is less than one-half of one percent of the time since the first humans appeared in Africa 2.5 million years ago and only six percent of the time since Homo sapiens first appeared 200,000 years ago.  The vast majority of our time as a species has been spent in hunter/gathered mode where “system one” thinking was paramount for survival.  Not only was a refinement of “system two” thinking unnecessary for survival but it would have been a liability.  When you see a predator on the horizon, taking immediate action is required and analysis is a liability.

A major problem with the way that most of our minds work is that, in evolutionary terms, we are still basically designed to optimize for conditions that our hunter/gatherer ancestors faced but are largely irrelevant to our modern lives.  The acceleration of human advancement through the scientific and industrial revolutions has been remarkable for such a short period of time and change seems to be accelerating even more rapidly than ever before.

Charlie Munger often talks about the psychology of human misjudgment.  The study of psychology can help us better understand how human beings think which, in turn, helps us understand how complex social systems operate.  The study of economics and financial markets, if done without an underlying understanding of psychology, is destined to be superficial and prone to misunderstanding.  As Mr. Munger might say, without an understanding of psychology, you would be like a “one legged man in an ass kicking competition”, compared to those who do have a better understanding.

By reading books such as Sapiensthe reader comes away with an enhanced understanding of how humanity developed over a very long period of time, puts that development into an evolutionary context, and can help to answer why humans tend to think the way they do.  It would be folly, however, to think that we ourselves have somehow ascended to a higher intellectual plane simply by understanding these topics.  The best we can do is to understand where we came from, what we have evolved to do well, and how we might be prone to making errors.  Immunity from such errors is beyond our reach.  Some think that we can develop artificial intelligence that is super-rational and reaches an intellectual and decision making plane that surpasses our own.  If this ends up being the case, artificial intelligence may end up surpassing humanity and result in our extinction. The author’s new book, Homo Deus, apparently delves further into the question of where we go from here.

~~~~~

* The author comes across as somewhat insensitive to religious people when repeatedly describing their beliefs as “fictional”.  It seems unnecessary since we can arrive at similar conclusions regarding the development of humanity without dismissing the possibility of humans who had special insights or divine inspiration.  Rather than “fictional”, one might prefer to think of language capable of describing abstract, or unobservable, things that cannot be perceived by ordinary humans.  The conclusions drawn by the author need not preclude the possibility of religion. 

Book Review: Mastering the Market Cycle

“Imagine how much harder physics would be if electrons had feelings!”

— Richard Feynman

The goal of many websites is to create “evergreen” content — that is, content that stands the test of time and will prove to be relevant not only to today’s reader but to someone coming across the same content in several years.  The logic behind this strategy is simple, at least for sites that hope to monetize their content in some way.  If one writes articles that are irrelevant shortly after publication, the writer will always be on a treadmill of having to create brand new articles to generate any revenue.  On the other hand, “evergreen” articles generate clicks years into the future and revenue from such a website is likely to grow over time as new content is added.  In the early years of this nearly ten year old website, a majority of articles were related to current “news” and became stale shortly after publication.  In later years, articles such as this one on how to read a 10-K proved to be “evergreen”.  Since there are hardly any ads on this site, the topic of evergreen content is somewhat academic, but even aside from revenue generation, most writers gain satisfaction by creating content that stands the test of time.

Normally, I would steer clear of any book that seems to imply that investors should pay attention to market cycles, not to mention Mastering the Market Cycle which is the title of the latest book written by legendary investor Howard Marks.  Perhaps my aversion to reading about cycles is due to years of listening to Warren Buffett state that he pays no heed to macroeconomic factors.  Investors who have long followed Mr. Buffett and Charlie Munger seem to take it as an article of faith that they should diligently study companies, read primary sources such as annual reports, and stay true to traditional valuation metrics that have stood the test of time.  We are not supposed to pay attention to market cycles and certainly not supposed to attempt to benefit from them.  However, longtime students of Mr. Buffett cannot help but notice that as Chairman of Berkshire Hathaway, he has access to a wealth of information about the economy that could rival the data at the disposal of the Federal Reserve.  Berkshire’s collection of subsidiaries collectively provide Mr. Buffett with something close to the pulse of the economy.

Mr. Marks is very well known in the value investing community and his previous book, The Most Important Thinghas been incorporated in many lists of “must read” resources.  Both of his books draw heavily from the author’s collection of memos to Oaktree Clients.  These memos are certainly “evergreen” in terms of covering important topics using current and historical examples.  One of the principles Mr. Marks discusses very often is the idea of “second level thinking”.  A simplistic “first level” thinker draws only the most immediate and obvious conclusion from a new piece of data.  For such individuals, any discussion of market cycles is likely to be dominated by gut reactions to a piece of data.  For example, if the ten year treasury note yield rises rapidly over a short period of time, a first level thinker is likely to simplistically update his models to reflect a higher risk free rate which, in turn, would depress the valuation of stocks in his portfolio.  A second level thinker might attempt to understand the impact of rising rates on real economic activity relevant to the companies in his portfolio and think about whether the myriad economic fundamentals impacting the cash flows of his companies will be impacted by higher interest rates.  To be sure, the risk free rate has gone up and all things being equal, stock valuations should decline.  But all things aren’t always equal for all companies and anyone hoping to beat the market needs to look deeper through second level thinking.  The question “and then what?” must always be asked.

Mr. Marks provides a comprehensive outline of the nature of cycles, the impact on the economy, and the regularity of these cycles.  The question is not one of “prediction” in terms of being able to forecast what will happen next week, next month, or even next year.  An intelligent investor should instead focus on being an observer of the investment environment and overall climate and to simply be aware of where we are likely to be in the cycle.  Mr. Marks points out that the economic cycle, in terms of changes to Gross Domestic Product (GDP), is actually relatively tame when you consider that a recession might imply a decline in GDP of a percent or two over a period of a few quarters while a boom might imply a rise of three to four percent annually.  The variation in corporate profits, however, is far greater than the variation in GDP due to the presence of operating and financial leverage.  This varies greatly based on the type of business one is invested in and how it is financed.  A business that sells items that have relatively constant demand in good times and bad and is funded without much, if any, debt, will have more stable profits than a business selling highly discretionary products that is funded predominantly with debt.

While the variability in corporate profits will be far greater than the economic cycle, as measured by GDP, we all know that the swings of the stock market far exceed swings in earnings.  What accounts for this?  Mr. Marks spends a great deal of time examining the cycle of investor psychology, which he compares to the swing of a pendulum.  Economics is not a science in the way that physics is science.  Why?  Human beings are inherently emotional beings who have psychological impulses that cause massive overreactions in many facets of life.  This is certainly true in the stock market and this creates massive swings totally disconnected from economic fundamentals.  Those who are reading this article shortly after it was written will probably be nodding their heads because the last several days have featured large swings in stocks that seem divorced from economic fundamentals.  The broad market decline was blamed on “higher interest rates” but could have been due to a variety of psychological factors.  Human beings like to create narratives to explain what is often unexplainable.  The decline of the past week had much more to do with human emotion than with Excel spreadsheets, discount rates, and profit projections.

The last paragraph probably won’t be very salient to anyone reading this article a few years from now.  Why?  Because the market action of the past week will have receded into distant memory.  It is possible that the past week was the start of a major downward move in the stock market, but it is more probable that it was just one of many random moves driven by psychology.  Mr. Marks does provide the reader with some guidance regarding how to tell where we are in a cycle from a psychological perspective.  Based on his ideas, it does seem clear that we are in a period where investors generally are optimistic, care more about missing out on gains than increasing downside protection, and seem credulous when it comes to “story” stocks where the valuation is built entirely on fanciful future projections.  Those of us who have been investing for a long time have seen such cycles come and go and today’s environment certainly dictates a cautious approach.

Returning to the question of whether a “Buffett follower” should be concerned with market cycles, one must consider whether we are really looking at two sides of the same coin.  Those who explicitly consider market cycles seek to be aware of where we are in the cycle and position themselves accordingly.  But the rest of us might be doing the sample thing implicitly because in times of extreme enthusiasm, we are unlikely to find investments that meet our investment criteria and existing investments may reach valuations that dictate that they should be sold.  Therefore, in boom times, disciplined value investors are implicitly responding to the market cycle through their actions with respect to individual holdings.  The same would hold true in bear markets.  One might start finding more and more investments that meet their criteria and this would naturally serve to increase exposure to stocks.  Whether done explicitly at the macro level or implicitly through signals emanating from the valuation of individual securities, an awareness of where we are in the cycle is indispensable for anyone seeking to outperform a broad index.

The key caveat for those who receive our signals from the availability or scarcity of individual investments is that we cannot arbitrarily change our criteria due to psychological factors as market cycles progress.  Lately, it is hard to not notice that many who consider themselves value investors have started to invest in companies like Google, Facebook, and Amazon.  These companies have long had valuations that made them too expensive for traditional value investors, and it is worth noting that we have all been wrong by not having invested in these “growth stories”.  However, we must guard against hindsight and survivorship bias and understand that this isn’t “our game” and be content to stay in sandboxes that we understand.  Many value investors seem to be changing their valuation criteria due to a desire to participate in growth stories that they missed and, in so doing, they are taking the risk that they themselves are driving the market cycle rather than observing it and seeking to profit from it.

Speaking of Amazon, I was recently in Washington D.C. where Amazon has a storefront location in Georgetown.  After years of “disrupting” the traditional bookstore model, Amazon has entered the bricks-and-mortar bookselling business and has done so in a spectacular fashion by providing online prices to anyone with a Prime membership.  This means that one can browse in a bookstore and benefit from online pricing immediately.  While browsing the selection, I came across Sapiens by Yuval Noah Harari, a book that I have intended to read for some time and I purchased it.  I read this book immediately before Mastering the Market Cycle and, of course, Sapiens has nothing to do with investing.  It is a book that provides a “brief history of humankind” and falls somewhere in the category of evolutionary science and sociology.  Nevertheless, Sapiens reinforced one aspect of human psychology that helps us understand why market cycles occur.

Until very recently, in evolutionary terms, human beings were hunter/gatherers and we are still wired for such a lifestyle even though humans have gone through massive cognitive revolutions over the past several thousand years.  Evolution is measured in tens and hundreds of thousands of years and the “fight or flight” instinct is still very much among us.  Although a gross simplification, humans react to economic stimuli much as our ancestors 50,000 years ago would have reacted to seeing prey or a predator 100 feet away.  We must train our minds to react intelligently to the modern world in which we find ourselves and to suppress instincts that hurt us.  In doing so, as investors we can seek to benefit from the folly of others rather than be members of the herd generating that folly.  Howard Marks has made an important contribution to our understanding of human psychology and market cycles and all investors would benefit from absorbing these lessons.

 

Thoughts on Share Repurchases and Capital Allocation

The concept of share repurchases is not particularly complicated.  Repurchase programs allow companies to allocate capital toward purchasing its own shares either on public marketplaces or through privately negotiated transactions.  Capital allocation is one of the most important recurring functions of management, at least for companies that regularly generate positive free cash flow.  Share repurchases represent one of many options for allocating free cash flow.  This week, Berkshire Hathaway surprised many investors by amending its share repurchase program in a way that dramatically increases the odds of repurchase activity in the years to come.  Berkshire’s program is relatively unusual and worth considering in some detail, but first it might be useful to step back in order to review the overall concept of share repurchases and various stigmas that have come to be associated with the practice.

Capital Allocation 101

From a financial standpoint, the purpose of any enterprise is to generate positive free cash flow that justifies the level of capital that investors have allocated to the business.  Despite many creative approaches to value companies that grow more popular toward the conclusion of every bull market, the only conservative way to look at business valuation is to consider the power of the business to generate free cash flow and its prospects for deploying that cash flow over time.  Free cash flow is simply defined as cash generated by the business in excess of reinvestment required to allow the business to maintain its competitive position and earnings power.  Although there are a number of approaches used to calculate free cash flow, which does not have a firm definition under generally accepted accounting principles (GAAP), most investors use some variation of taking cash flow from operations and subtracting maintenance capital expenditures.  Some judgment on the part of investors is required to determine what percentage of overall capital expenditures are for “maintenance” versus “growth” and few managements explicitly report this figure.

For purposes of this discussion, assume that you are confident in your assessment of free cash flow.  As an owner or potential owner of a business, the question becomes how management should allocate this free cash flow in a manner that maximizes your wealth in the long run.  There are only a few options for management to allocate free cash flow:

  1. Expand current business operations.  If there are growth opportunities within the company’s current line of business that can be pursued by allocating additional capital, and if those opportunities promise to yield an acceptable return on incremental invested capital, most management teams will opt to pursue expansion.  After all, doing so continues to leverage management’s core skill set and incremental expansion is something most managers will feel comfortable pursuing.
  2. Pursue business opportunities in adjacent or unrelated areas.  Management may find limited growth opportunities within the company’s current line of business but see opportunities for expansion in related adjacent markets or even in unrelated areas.  The level of risk involved in this type of investment is generally higher than reinvesting in the current line of business and expected returns on capital would need to be commensurately higher to justify investment.
  3. Pursue acquisitions.  Management may pursue acquisitions either within the company’s current line of business, in adjacent businesses, or in totally unrelated areas.  In the latter case, management would be pursuing a conglomerate strategy if they enter into multiple lines of unrelated businesses.  Obviously, the expected return on acquisitions must justify the investment and management should not be pursuing this merely to expand the size of the company for the sake of size itself, which is not an uncommon motive since compensation generally rises with the size of a CEO’s “empire”.  Pursuing a conglomerate strategy is risky and would require a versatile and talented management team.
  4. Accumulate cash.  If management cannot find current opportunities to deploy free cash flow through internal or external expansion, they can accumulate this cash flow on the balance sheet until such time that opportunities emerge that warrant investment.  However, accumulation of excess cash suffers from many problems including minuscule returns and the risk that management will feel like that cash is burning a hole in their pocket which can often lead to poor decision making.  The cash can also be misallocated toward unjustifiable executive compensation.
  5. Return capital to shareholders.  Lacking viable investment opportunities logically leads shareholder oriented management teams toward looking for ways to return that capital to shareholders.  Shareholders will then reallocate this cash themselves by investing in other businesses or using the cash for consumption, both of which have the potential to generate productive uses of the capital.  Capital can be returned to shareholders through dividends or share repurchases.

Return of Capital

The best businesses are those that generate massive amounts of free cash flow relative to capital invested and managers have ample opportunities to allocate that cash flow toward investment opportunities that also generate massive cash flow relative to that incremental capital.  In reality, this type of business is extremely rare.  More common and still attractive are businesses that generate significant free cash flow but have trouble expanding at attractive rates of return.  Examples abound but one that comes immediately to mind is See’s Candies, one of Berkshire Hathaway’s longest held subsidiaries.  See’s is capable of generating extremely high returns on invested capital but it has been very hard for See’s management to expand the business beyond the markets in the western United States that it already dominates and it has also been difficult to expand the overall market for boxed chocolates.  See’s cannot redeploy all of its cash flow internally so it remits the cash to its controlling shareholder which is the parent company, Berkshire Hathaway.

Returning capital to owners is not admitting failure, nor should it be any kind of stigma against the management team.  Some businesses are cash cows and should be treated accordingly.  The stigma should arise from allocating cash from a cash cow in a manner that destroys value.  And it is not difficult to destroy value by allocating incremental capital toward sub-par projects while the evidence of the folly is somewhat disguised since the company’s overall return on capital will still be attractive.

To repeat, capital allocation of free cash flow must generate an attractive incremental rate of return on that reinvested capital.  If this is not possible, it should be returned to owners.

Taxes, Taxes, Taxes

Why are the best businesses those that can generate massive free cash flow and profitably redeploy that cash flow internally?  Well, although they will not escape the corporate layer of taxation, such companies can grow internally and avoid paying dividends to shareholders which means that individual shareholders will not have to pay a second layer of taxation.  This is incredibly valuable.  It is the duty of managers who do not have the ability to reinvest internally to return capital to shareholders in a way that minimizes tax consequences.

Payment of a cash dividend is the most straight forward way for a company to return capital to shareholders but it is also the least flexible and most impactful when it comes to tax consequences.  All shareholders of the company will receive a pro-rata share of the cash dividend (putting aside cases where there are multiple share classes with different entitlements to distributions).  Shareholders holding stock in taxable accounts will have to pay income taxes on the proceeds.  Many companies establish regular cash dividends which they attempt increase over time.  This tends to attract a shareholder base that appreciates regular payment of dividends and is presumably less sensitive to the fact that the dividends incur taxes.  Whether used for investment in other companies or for consumption, the tax drag makes the payment of cash dividends inherently inefficient.

Regular cash dividends also promote potentially suboptimal management behavior.  Once established, a regular dividend typically cannot be reduced or eliminated without sending negative “signals” to the market regarding management’s view of the company’s future prospects.  As a result, all kinds of irrational behavior can occur to continue paying dividends at times when there is no free cash flow to pay out.  This can lead a company to take on debt to continue paying dividends or even to issue new shares for that purpose (which, in extreme cases, can resemble a Ponzi scheme).  Special dividends can alleviate part of this problem.  A special dividend is one that is not expected to recur and managers are more free to use this approach only at times when it makes sense.  However, special dividends, or dividends set based on some predefined formula such as the one Progressive uses, are quite rare.

Repurchases:  A Tax Efficient Return of Capital

If executed properly, a share repurchase program can be a very efficient means of returning capital to shareholders.  Unlike cash dividends, the only shareholders who have tax consequences as a result of a repurchase are those who voluntarily sell their shares back to the company, either in open market transactions or through a negotiated private sale.  Share repurchases, unlike dividends, are not presumed to occur on a regular schedule and there is generally no stigma associated with ceasing a repurchase program at times when there is no free cash flow to deploy or if attractive investment opportunities emerge in the future.  In contrast, cutting a regular dividend to make an attractive investment is almost never done because of the stigma associated with such a move.

Despite the advantages, share repurchases can be pursued for sub-optimal or even nefarious purposes.  Executives can use share repurchases to temporarily prop up the stock price by acting as a means of “support” – purchasing shares at times where there are few other buyers.  For executives who are compensated based on stock price movements, it can be tempting to attempt to manipulate the market for shares through repurchase activity that is not economically attractive to shareholders.  Managers can also repurchase shares in an attempt to artificially boost earnings per share since this is a common metric used to set compensation and one that is fixated upon by analysts and shareholders during quarterly earnings releases.  Executives who succumb to these poor reasons for repurchasing stock are doing a disservice to the owners of the company who they work for.

Even when executives are pursuing repurchases for all the right reasons, they could overpay for the shares if they are too optimistic regarding the company’s future prospects.  Share repurchases only add value for continuing shareholders when the price paid for the shares is below the company’s intrinsic value.  The notion of intrinsic value is necessarily subjective and managers are going to tend to be naturally optimistic regarding the prospects for the business they run.  This can lead to repurchases at times of elevated stock prices which will destroy value for ongoing shareholders.  If the value destruction is severe enough, shareholders would have been better off receiving cash dividends and paying the income taxes.

Share repurchases have also been subject to various political stigmas over the years, many of which have been reported in the financial media particularly since the corporate tax cut went into effect this year.  The one time effect of the corporate tax law change with respect to repatriation of cash long held in foreign countries and the recurring effect of the lower tax rate has led to concern among politicians that companies will use this cash to repurchase shares rather than reinvesting in their business.  This concern is misguided on many levels, particularly because it seems to presume that cash used for repurchases is somehow “lost” to the economy rather than reinvested in other businesses or used for consumption, both of which will have positive feedback effects in aggregate.  As stated earlier, reinvestment is not viable in cases where opportunities do not exist.  Value would be destroyed economy-wide if companies insisted on internally reinvesting capital that could be paid out to shareholders and reinvested elsewhere.

Despite the various objections to share repurchases, it is clear that buying back shares represents the most efficient means of distributing excess cash to shareholders when reinvestment opportunities do not exist and shares can be purchased at or below a conservative assessment of the company’s intrinsic value.

Berkshire’s Evolving Repurchase Program

Berkshire Hathaway has long been relatively unique among mega-cap companies because the company has not returned significant capital to shareholders and has managed to redeploy capital efficiently.  Berkshire is a conglomerate with dozens of large companies with varying levels of reinvestment opportunities relative to free cash flow generation.  Chairman Warren Buffett has been able to reallocate capital within Berkshire as a whole, taking free cash flow from cash cows like See’s Candies and directing that cash flow toward other existing subsidiaries that have reinvestment opportunities, purchasing new wholly owned subsidiaries, or investing the cash in publicly traded securities.

Warren Buffett and Vice Chairman Charlie Munger have the vast majority of their net worths invested in Berkshire and, as a result, think like owners when it comes to distributing cash to shareholders.  Reinvestment of substantially all of Berkshire’s free cash flow has eliminated personal tax consequences over the years.  The last thing Mr. Buffett presumably would want to do is declare large cash dividends and subject all shareholders, most notably himself, to the resulting massive tax consequences.  While he clearly prefers to reinvest cash flow within Berkshire, it also seems obvious that he would prefer to repurchase shares if faced with a situation where Berkshire cannot redeploy cash internally.

Berkshire first introduced a share repurchase program in 2011 that limited management to repurchasing shares only when they traded at or below 110 percent of book value.  The program was later amended to allow repurchases at or below 120 percent of book value to facilitate the repurchase of a large block of shares from the estate of a longtime shareholder.  However, repurchases in the open market have not taken place in any meaningful quantities because most observers have presumed that the repurchase limit of 120 percent of book value represents a floor or a “Buffett Put”.  Although this perception is likely not accurate, it has kept Berkshire shares stubbornly above the level at which management is permitted to repurchase shares.

Berkshire’s recent amendment to the program allows for share repurchases without specifying a particular limit relative to book value.  The repurchase of shares must only be at a level where both Mr. Buffett and Mr. Munger believe is below intrinsic value and the repurchase cannot reduce Berkshire’s overall cash holdings below $20 billion.  No repurchases will take place at least until Berkshire’s second quarter results are released in early August.

Flexibility Adds Value

Berkshire shareholders have often considered how long cash could be successfully redeployed internally.  Indeed, looking forward a number of years, it is difficult to see how the massive free cash flow the company is likely to generate can be deployed internally or through acquisitions.  Up to this week’s announcement, it appeared likely that Berkshire would eventually have to return cash primarily through cash dividends because the shares rarely trade below the level where repurchases would be allowed.  However, the amended plan makes it far more likely that excess cash will be returned via repurchases.  This development means that the “risk” of significant tax consequences for Berkshire shareholders in the coming years is reduced.  It seems reasonable to expect cash dividends from Berkshire only at times when the share price is clearly trading above intrinsic value.

From the perspective of a longtime Berkshire Hathaway shareholder, the news is very welcome primarily because tax consequences would be significant in the event of cash dividends and there is no recourse to avoid those dividends other than selling highly appreciated shares which also would incur significant tax consequences.  Berkshire’s amended program increases the probability that the company will continue serving as a means of compounding wealth with minimal tax consequences for years to come.  Longtime shareholders benefit from the “float” represented by their personal deferred tax liability.  As long as they avoid selling shares, the deferred tax liability “works” on their behalf and continues compounding.  The beauty of being able to compound wealth using not only your capital but deferred tax liabilities cannot be overstated.

The amendment to the plan also increases the flexibility of Berkshire’s future CEOs to return capital via repurchases without being second guessed constantly. If Mr. Buffett had left the 120 percent of book value limitation in place until his death or retirement, the next CEO would have faced tough questions if he wished to relax or eliminate the restriction.  Now that Mr. Buffett has eliminated the restriction himself, the next CEO will be more free to return capital through repurchases than he otherwise would have been.  With Mr. Buffett approaching his 88th birthday next month, he is clearly positioning the company to act in an optimal manner beyond his tenure.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

X

Forgot Password?

Join Us

Password Reset
Please enter your e-mail address. You will receive a new password via e-mail.