Thoughts on Share Repurchases and Capital Allocation
Berkshire Hathaway's recent change to its repurchase program provides a good opportunity to examine capital allocation in general
The concept of share repurchases is not particularly complicated. Repurchase programs allow companies to allocate capital toward purchasing their 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:
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.
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.
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.
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.
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.