Street Food: What Buffett says about buybacks

Indian companies could learn from his Berkshire Hathaway's repurchase policy

As winter breaks into spring, Dalal Street is also going for a change of season. From initial public offerings and other forms of share sale, companies are now taking a U-turn and embarking on a season of buying back their own shares.

The buyback season is led by the highest valued company – the Rs 4.88 lakh crore Tata Consultancy Services (TCS). And, Infosys and other large companies sitting on cash piles are likely to go for repurchase, too, as investors get restless.

This is unusual, as many stocks are already trading close to their life highs. The benchmark Sensex itself is only about 1,000 points away from the all-time high of 30,000 it touched two years earlier.

Historically, buybacks have been used by managements as a tool to boost investor confidence when prices have been falling. The Union Budget tightened dividend taxation rules to include even trusts and other such vehicles under the tax net. This has made many promoters and large investors look favourably at buybacks. Questions have also arisen about companies being forced into these schemes to accomplish such narrow tax planning objectives and how it benefits the continuing investors.

Globally, too, buybacks seem to have evoked strong emotion. So much so that Berkshire Hathaway chairman Warren Buffett dedicated an entire paragraph to 'share repurchases' in his latest annual letter to shareholders.

Explaining the eternal pricing dilemma, the ‘Oracle of Omaha’ wrote, “From the standpoint of exiting shareholders, repurchases are always a plus. Though the day-to-day impact of these purchases is usually minuscule, it’s always better for a seller to have an additional buyer in the market. For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value.”

Thus, purchase price determines whether a buyback is value enhancing or destroying. Advising chief executives to look at and evaluate the price as if they were managing a privately held company, Buffett writes of two occasions when repurchases should not take place, even if the company’s shares are underpriced. “One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made. The second exception, less common, materialises when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser.”

Recapping Berkshire’s own repurchase policy, Buffett offers an interesting metric of book value: “I am authorised to buy large amounts of Berkshire shares at 120 per cent or less of book value because our Board (of Directors) has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120 per cent-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.”

Buffett added it’s been hard to hit this trigger, having flagged the intrinsic value in this manner. The annual letter put the book value of a Berkshire share at $172,108, whereas the stock closed at $255,040 on Friday. In comparison, TCS’ shares are currently trading close to eight times its book value. The buyback price is even higher. Is the offer, then, fair for continuing shareholders? Where lies its intrinsic value?

Despite the differences in nature of businesses and growth environments, Indian businesses can learn from Buffett on identifying their intrinsic values and communicating transparently through long-term buyback policies.