Berkshire’s Repurchase Level is not a “Floor”

“You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets.” –Warren Buffett on repurchases, 2011 annual report

After posting a 12.5 percent decline in 2015, Berkshire Hathaway’s common stock entered the new year only modestly above the company’s repurchase threshold of 120 percent of book value.  As a result, many commentators have been speculating on the possibility of repurchases in the near future.  Due to recent market volatility, many investors are seeking “safe havens” in the short run and have noticed that Berkshire has limited downside before reaching the repurchase threshold.  It is not uncommon to see references to a “floor” for Berkshire’s stock price roughly corresponding to 120 percent of book value.  Based on the last reported book value figure of $151,083 as of September 30, 2015, the repurchase threshold currently stands at $181,300 which is slightly more than 8 percent below Berkshire’s closing price on January 6.

The exhibit below displays Berkshire’s Class A share price and book value per share since 2000 along with Berkshire’s “buyback threshold” since Warren Buffett introduced the first such threshold in September 2011.  The threshold was originally set at 110 percent of book value and was subsequently raised to 120 percent of book value in December 2012.  It is unusual for a public company to telegraph its intentions in this manner.  However, Mr. Buffett feels strongly that if the company repurchases stock, departing shareholders should be fully aware of the possibility that the company may be buying and that management views the shares as undervalued.

Berkshire's Price and BV History

Anyone looking at this chart might be forgiven for thinking that the repurchase threshold represents a “floor”.  Indeed, the stock has rarely traded below the prevailing repurchase level since it was first introduced in September 2011.  However, there are a number of reasons to be very cautious when thinking about the repurchase threshold.

Repurchases and Intrinsic Value

The main motivation for Berkshire to repurchase stock has nothing to do with maintaining a short term “floor” in the stock price.  It has everything to do with purchasing shares at a level that is clearly below intrinsic value, conservatively calculated.  Here is what Mr. Buffett had to say in the 2011 annual report regarding the newly introduced repurchase authorization.  (Note that the repurchase threshold was subsequently raised to 120 percent of book value in December 2012):

At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower. You should know, however, that we have no interest in supporting the stock and that our bids will fade in particularly weak markets. Nor will we buy shares if our cash-equivalent holdings are below $20 billion. At Berkshire, financial strength that is unquestionable takes precedence over all else.

It appears that many investors are focusing on part of Mr. Buffett’s statement rather than looking at it in full.  He clearly states that Berkshire will only repurchase shares well below intrinsic value and that he will likely repurchase aggressively if that opportunity arises.  However, it is also clear that repurchases will not occur simply to support the stock price and that Berkshire could very well pursue opportunities other than repurchases in particularly weak markets.

A Thought Experiment

We make no attempt to predict stock prices in the short run and have no particular opinion regarding the possibility of a major bear market in the near term.  However, it is worth pondering a scenario where stocks fall sharply in the near term and how that might impact Berkshire’s book value and propensity to repurchase shares.

If the equity markets enter a severe bear market in 2016, perhaps falling 30 to 40 percent, Berkshire’s large holdings in publicly traded securities will almost certainly participate in the decline as well which will have a negative impact on reported book value.  Additionally, Berkshire’s equity derivative investments will also show mark-to-market declines which will negatively impact book value in the short run.  Exerting a pull in the opposite direction, it is almost certain that Berkshire would still report substantial operating earnings which would increase book value.

Where will the dust settle?  It is certainly possible that a declining stock market could result in Berkshire’s book value falling in any given quarter or even in a full year despite the effect of substantial operating earnings.  Such a decline in book value would obviously reduce the repurchase threshold commensurately.  Therefore, even if the repurchase level could be considered a “floor”, that floor could be moving downward in the short run.

However, the situation is even more complex.  If equity markets decline severely, that will present major opportunities for Mr. Buffett to deploy Berkshire’s cash.  Not only will publicly traded equities be cheaper but the market for private businesses would probably soften as well.  If the market decline is also accompanied by real or perceived systemic risks to the overall financial system, as was the case in 2008-2009, Mr. Buffett’s phone will be ringing off the hook with offers for unusual investment opportunities at attractive terms because Berkshire will have cash and the “Buffett stamp of approval” is worth a great deal in crisis conditions.

Faced with a rich set of investment opportunities brought about by a market panic, there is no reason to believe that repurchasing Berkshire shares will be Mr. Buffett’s favored choice under such conditions.  

If Berkshire does indeed trade at or slightly below the threshold in a given quarter and it is revealed that Berkshire did not repurchase shares, or repurchased only a modest amount, all talk of a “floor” will likely disappear.  As Mr. Buffett said in the 2011 annual report, he has no interest in repurchasing shares simply to “support” Berkshire’s stock price.

Repurchase Threshold is a Long Term Buying Signal

Rather than viewing Berkshire’s repurchase threshold as a floor or as a short term buying signal, long term oriented investors should instead regard it as a long term buying signal.  This is not merely because of the fact that Mr. Buffett plainly regards purchases at such a level to be a bargain, but because Berkshire demonstrably provides more intrinsic value at such a price than one must pay in exchange for shares.

We last commented on Berkshire’s valuation in September 2014 when the shares were reaching record highs.  The shares continued to advance up to the end of 2014 and have declined since that time.  There are many methods that can be used to estimate Berkshire’s valuation but buying at a low price-to-book ratio has proven to be a reliable approach in the past.

Through year-end 2014, Berkshire delivered annualized book value growth over the preceding ten years of 10.1 percent.  This was a ten year period that included the tail end of a bull market, the most severe economic downturn since the Great Depression, and the subsequent recovery.  Even if we assume a somewhat lower rate of book value growth over the next decade, such as 9 percent, Berkshire’s book value will likely be close to $350,000 per share by 2026.

A number of valuation methods, such as the two-column approach, confirm that a price-to-book ratio of 150 percent is not unreasonable.  This would imply a stock price of around $525,000 ten years from now representing somewhat more than 10 percent annualized returns if buying at the current stock price.  This is quite attractive for a company with Berkshire’s overall risk profile and there is room for some upside beyond that.  (Note that if Berkshire starts to pay dividends at some point over the decade, which seems more likely than not, total returns would be somewhat lower due to less internal compounding and, for some shareholders, tax consequences).

The lesson is clear:  Use Berkshire’s repurchase threshold as a long term buying signal, not as a short term signal.  The threshold does not represent a short term floor and people buying the stock as a short term safe haven could very well be disappointed.

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

An Introduction to Charlie Munger’s Investment Philosophy

Of the tens of thousands of attendees at every Berkshire Hathaway annual meeting, it is likely that a majority have a working understanding of Warren Buffett’s overall investment philosophy.  Mr. Buffett is not only the public face of Berkshire Hathaway but also has become a celebrity in recent years.  There are probably only a handful of business leaders in America who have similar name recognition.  The same, however, cannot be said about Charlie Munger, Mr. Buffett’s longtime business partner and Vice Chairman of Berkshire Hathaway.  Much less has been written about Mr. Munger over the years and he has a far more modest media profile.  Many shareholders probably assume that Charlie Munger and Warren Buffett have an interchangeable view of investing but the reality is much more nuanced.

Charlie Munger: The Complete InvestorA number of excellent books have covered Charlie Munger’s life and philosophy but, until now, there has not been a relatively brief summary likely to be approachable for a Berkshire shareholder who is simply looking for a quick introduction.  This is why Tren Griffin’s new book, Charlie Munger: The Complete Investor, is likely to be of interest to thousands of Berkshire shareholders as well as others who make it a habit to study the ideas of those who have achieved remarkable success.  Since the book is relatively brief and can be read in one or two sittings, many readers who are already familiar with Charlie Munger may be skeptical regarding whether this book can provide a legitimate overview without being excessively simplistic.  A number of Amazon.com reviews are very skeptical and call the book a mere rehash of previously published material.  In our view, the book has value primarily for individuals who have not been introduced to Charlie Munger’s thinking in the past.

The fact that the book has many direct quotes from Mr. Munger is a source of derision in some of the negative reviews, but it would be almost impossible to write a book purporting to explain the Munger way of thinking about life and investing without extensive use of quotations.   Furthermore, although most of the quotes will be familiar ground for those who have followed Charlie Munger for years, the material will be new and captivating for other readers.  The witty nature of many of the quotations will likely prompt a curious mind to seek additional information elsewhere.

However, the book is not merely a compendium of quotations.  Mr. Griffin does a very good job of presenting the basic concepts of Benjamin Graham’s approach to value investing and this will be useful for readers who are new to the topic.  If all investors simply absorbed the information presented in Chapter 2, Principles of the Graham Value Investing System, much folly would be avoided even if that simply means that a reader resolves to use index funds and avoid the expenses, fees, and underperformance associated with poor active management.

Although most readers already familiar with Charlie Munger will find the chapters on worldly wisdom and psychology to be familiar ground, the book presents this material in a concise and approachable manner that can be read in a very short period of time.  Readers who want to delve deeper will no doubt want to read Poor Charlie’s Almanack which is, by far, the most entertaining and comprehensive coverage of Charlie Munger’s philosophy.  But Mr. Griffin succeeds in presenting the basics to a reader who could very well be intimidated by the time commitment required to read the Almanack.

One of the curious aspects of the book is that Mr. Griffin often repeats the term Graham Value Investing System while discussing Charlie Munger’s specific investment approach.  While it is no doubt true that nearly all value investors have adopted the foundational elements of Mr. Graham’s writings, Charlie Munger has been influenced to a much greater degree by Philip Fisher’s approach to owning higher quality companies.  Mr. Griffin does discuss Mr. Fisher’s influence but seems to more heavily weigh Benjamin Graham when it comes to explaining Charlie Munger’s overarching approach to investing.

Charlie Munger is often described as Warren Buffett’s “sidekick” at Berkshire, a depiction that is both disrespectful and inaccurate.  Although Mr. Munger is modest about his contributions to the success of Berkshire Hathaway, his role in nudging the company toward purchasing higher quality businesses rather than “cigar butts” has added enormous value over time.  Berkshire Hathaway shareholders, as well as other interested investors, would do well to study Charlie Munger’s life and investment philosophy.  Mr. Griffin’s book makes this process approachable with a minimal time investment.  As Warren Buffett has said, value investing is like an “inoculation”:  once presented with the basics, one either “gets it” or does not.  This book makes is far more likely that someone new to value investing will “get it” and seek out additional information on Charlie Munger in particular and value investing in general.

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

 

When to Sell a Successful Investment

“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” — Philip Fisher

“Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously. ” — Howard Marks

There are many approaches used by value investors to identify investment candidates but the obvious common theme is that one makes purchases only when the offered price is significantly below a conservative estimate of intrinsic value.  In times of significant pessimism, there are often far more investment candidates than one would wish to add to a focused portfolio.  This was the case for a number of years following the 2008-09 financial crisis, not only in retrospect but as a function of the opportunities clearly available at the time.  During such times of abundance, the purchase decisions are mainly a function of which opportunities within an investor’s circle of competence offer the greatest prospective returns with acceptable business risk.  Making such bargain purchases, assuming the availability of the necessary cash and the right mindset, is usually an enjoyable experience.

On the other hand, the decision to sell can frequently be agonizing for various reasons.  If a business unexpectedly deteriorates, one must determine whether the relationship between the lower stock price and lower intrinsic value still justifies ownership.  Numerous psychological pitfalls await investors who must decide whether to sell an unsuccessful investment.  Often times, the best approach is to pull the band-aid off quickly and move on.

The more interesting question, and the subject of this article, is when one should sell a successful investment.  This question is almost certainly timely for most readers as markets reach new highs and signs of investor optimism becomes more and more common.  In retrospect, we know that the pendulum referred to by Howard Marks reached its most pessimistic limit in early 2009 bringing with it the greatest opportunities for success.  We cannot know today where the pendulum is exactly located but it seems to be drifting more toward the optimistic end of the spectrum.  This necessitates careful consideration of when a successful investment has run its course.

Motivations for Selling

There are obviously a number of motivations that would lead an investor to sell a successful investment.  Many of the reasons are somewhat beyond the scope of this article.  It is possible that an investor seeks to raise cash for personal reasons such as increased consumption or purchasing a personal residence.  Such needs may be immediate or on the horizon.  Clearly it is not advisable to hold common stocks, regardless of valuation, if the time horizon for the remaining period of ownership is very short.  In such cases, with cash being necessary, one simply sells the investment, pays the required tax, and moves on.

Aside from time horizon constraints, an investor will often consider selling in order to fund the purchase of another investment.  This is the more interesting scenario for purposes of this article.  When does it make sense to sell a successful investment in order to purchase something that is perceived as “better”?

Assess Prospective Returns

Perhaps it goes without saying, but when tempted to sell a successful investment it is necessary to revisit the valuation again in considerable detail.  It is possible that an advancing stock price is in response to an unexpected positive development that was not considered in the original investment thesis.  Investors are subject to both good and bad luck.  When good luck takes the form of an unexpected positive surprise, it wouldn’t make sense to immediately sell and abort the benefits of that good luck.

Assuming the valuation has been revisited and the investment is indeed trading above a conservative estimate of intrinsic value, it is still important to consider the prospective returns of the investment from its current price level.  For example, a month ago, we posted an article on Markel trading above $800 per share for the first time.  Since that time, the stock has advanced an additional 10 percent and currently trades above the $840 intrinsic value estimate provided in the article.  As no obvious new developments have taken place over the past month, the stock appears to be trading about 5 percent above the intrinsic value estimate.

The intrinsic value estimate was based on requiring a 10 percent annualized prospective return over the next five years.  Although the stock recently traded at $875, it still offers the possibility of 9 percent annualized returns over the next five years, holding all other aspects of the valuation constant.

Consider Tax Consequences

Warren Buffett has often discussed the major benefit Berkshire Hathaway realizes by investing policyholder “float” in securities.  Float represents funds that Berkshire holds in anticipation of payment to policyholders, in some cases in the distant future.  However, Berkshire also benefits from another type of “float” represented by deferred taxes on appreciated securities.  Effectively, Berkshire is able to invest deferred taxes that will eventually be payable to the government.

All investors have the same opportunity to benefit from retaining highly appreciated investments with large deferred tax liabilities.  For example, consider an investor who purchased Markel shares at $400 approximately four years ago.  Of the $875 share price, $400 represents the cost basis and $475 represents embedded capital gains.  The current effective top Federal income tax rate on long term capital gains is 23.6 percent.  Assuming residence in a state without income taxes, the investor would have to pay taxes of around $112 per share leaving him with $763 to invest in new opportunities.  In contrast, holding on to the Markel shares will allow the investor to keep all $875 invested.

Continuing this example, if the investor retains Markel shares at $875 and the share price compounds at 9 percent over the next five years, the ending share price would be $1,346.  At that point, taxes of $223 would be owed on the capital gain (assuming no change in tax rate policy) and cash raised on sale would be $1,123.

If the investor instead sells Markel today and reinvests the $763 proceeds, it will be necessary for the new investment to compound at nearly 10.1 percent to match the after tax proceeds realized by holding on to the Markel investment.  At that rate of return, the new investment will be worth $1,234 in five years.  Of this amount, $471 will represent a capital gain and taxes of $111 will be owed to the government  resulting in net proceeds of $1,123.

(As an aside, one must also overcome transaction costs, both explicit in the form of commissions and implicit in the form of bid-ask spreads.  We have ignored transaction costs for purposes of simplicity.)

The Hurdle May Be High

As we can see from the example, the tax friction associated with selling a successful investment and purchasing a new one can be considerable.  In this case, it would be necessary to find an investment offering a return 1.1 percent higher than Markel in order to make the switch pay off.  Furthermore, one would need to be satisfied that the level of business risk is similar or, better yet, lower.  Markel also could have upside above and beyond the intrinsic value estimate if the company succeeds in emulating Berkshire Hathaway’s business model.

It might still make sense to sell Markel and find another investment if it can be done in a tax exempt or tax deferred account.  In such cases, the tax friction disappears, but the other issues remain.  Ultimately, each investor must make an educated decision when it comes to the question of selling appreciated securities.  It goes without saying that frequent activity on a short term basis is almost always ill advised.  The same is often true in the long run, as Philip Fisher pointed out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel.  Since publication of the article on Markel on June 18, fifteen percent of the Markel shares held on that date were sold in tax exempt and deferred accounts and invested in Berkshire Hathaway with no plans to sell the remaining Markel shares.  See also general disclaimer.