From Warren Buffet via AAII

Please note the bold italic portion toward the bottom.  It is so important to not fall into that mindset.

Charlie [Warren Buffett’s partner] Sand I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. 

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions—even serious ones—are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation—whether the money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan (JPM); I recommend that you read his annual letter.) 

Regarding price performance, Buffett argued that investors are better served if a stock price doesn’t move higher when buybacks are made. Rather, he said that long-term shareholders are better served if the stock price languishes for a period of time. Using IBM (IBM), a stock that Berkshire-Hathaway owns, as an example, Buffet explained his rationale:

If IBM’s stock price averages, say, $200 during the [next five years], the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the disappointing scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1-1/2 billion more than if the high-price repurchase scenario had taken place. 

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. 

Buffett acknowledged that his line of thinking won’t win many investors over. Behavioral scientists are documenting how hard it is for humans to pass on a certain, but smaller, reward now for a potentially bigger, but uncertain reward in the future. Yet, the math shows that the potential is there for Buffett’s approach to work.

Even if you don’t agree with Buffett’s logic, cast a critical eye toward announcements of stock repurchase programs. Question whether they are the best use of the company’s cash. Ask whether the company is trading at a discount to its intrinsic value. Ask why insiders aren’t also buying the stock. Finally, consider that there may be better uses of the corporation’s cash, including instituting or boosting the dividend payment.

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