This is the fortieth (and final) in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2016. For all of the prior shareholder letters, see here.
The 2016 letter weighs in at 15,520 words, a 4% decrease from 16,200 words the prior year. Berkshire's $27.5 billion increase in net worth during the year was 10.7% of beginning 2015 net worth.
TO REPURCHASE SHARES, OR NOT TO REPURCHASE SHARES?
Often a company will try to "increase shareholder value" through a stock repurchase program. Hardly ever, however, will such a company actually provide to its owners (the shareholders) a detailed rationale as to why a repurchase program is an intelligent use of capital. For example, when Allergan (AGN) announced its $10 billion repurchase program in November 2016, its press release stated that the repurchase program "reflects the Company's conviction in its business strategy and strong future cash flow position, allowing for periodic return of cash to shareholders through dividends and a significant share buyback program". The company also included the following quote from the CEO:
"We continue to believe there is no greater investment than Allergan stock, given our powerful growth prospects. This decision underscores our commitment to continuously enhancing value creation for our shareholders. In its decision, the Board is demonstrating its confidence in our growth potential, pipeline, strong balance sheet and cash flows," said Brent Saunders, Chairman, CEO and President of Allergan. "We believe that these bold actions strike the right balance in our desire to return significant capital to our shareholders while maintaining our investment-grade credit ratings and preserving significant firepower to invest for growth."
Usually, when a company spends $10,000,000,000 buying an asset, the most important thing to consider is the price paid--in other words, is the company getting a good deal, or is it overpaying? Yet, here, where the asset bought is the company's own stock, there is no apparent analysis of whether the stock is over- or undervalued. The company merely refers to its "growth potential, pipeline, strong balance sheet and cash flows".
In the 2016 shareholder letter, Buffett includes the following primer on share repurchases, describing exactly under what circumstances repurchases make sense:
In the investment world, discussions about share repurchases often become heated. But I’d suggest that participants in this debate take a deep breath: Assessing the desirability of repurchases isn’t that complicated.
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. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.
It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn’t be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision.
When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price. Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not.
It is important to remember that there are two occasions in which 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, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser. Long ago, Berkshire itself often had to choose between these alternatives. At our present size, the issue is far less likely to arise.
My suggestion: Before even discussing repurchases, a CEO and his or her Board should stand, join hands and in unison declare, “What is smart at one price is stupid at another.”
To extend the analysis, we would propose the following reasons as to why dumb repurchase programs often get instituted at large companies: (1) despite the rhetoric in the press releases, company management--not the board of directors--usually controls whether or not (and when, in what amount, etc) a buyback program is instituted (and the board of directors merely rubber-stamps this decision), (2) company management is usually aligned with the exiting shareholders, as in most cases they expect to be net sellers of shares in the near future (say, within the next year) and rarely, if ever, purchase shares with their own money on the open market, (3) consequently, management will be willing to put share repurchase programs in place that make no economic sense from the perspective of the remaining shareholders (who become poorer, not richer, from irrational repurchase decisions).
To give another example of a repurchase program that massively destroyed shareholder wealth (but made upper management much richer), consider Viacom (VIA; VIAB). According to a February 2016 Reuters article, "Between October 2012 and March 2015, Viacom spent about $9.7 billion on buybacks, at an average cost of $73.58 per share, based on company filings". Today the stock price of the A shares stands at just above $38, almost 50% below the average repurchase price, for an overall loss of $4.65 billion. So much for "enhancing shareholder value":
But, wait, there's more. To compound this foolishness, Viacom paid for much of the repurchases by incurring additional indebtedness rather than via operational cash flow; long-term debt climbed from $8.15 billion at the end of September 2012 to $13.21 billion at the end of March 2015. Now the company claims it is "focused on paying down debt"--hmmm...
One person who absolutely loved the Viacom repurchase program, though, was the then-CEO, Phillippe Dauman, who personally managed to unload nearly $339 million worth of Viacom shares during the buyback program with the following trades (notice how most of Dauman's sales fortuitously occurred right around the time the company was buying back large amounts of stock at premium prices in the mid- to high-$70s):
Date - Shares Sold - Price($) - Proceeds($)
11-May-12 - 286,447 - 48.02 - 13,755,185
21-Aug-12 - 66,689 - 50.79 - 3,387,134
21-Aug-12 - 1,465 - 50.62 - 74,158
5-Aug-13 - 212,205 - 78.82 - 16,725,998
6-Aug-13 - 475,000 - 78.81 - 37,434,750
6-Aug-13 - 687,205 - 78.81 - 54,158,626
7-Aug-13 - 657,000 - 78.92 - 51,850,440
8-Aug-13 - 275,000 - 80.00 - 22,000,000
24-Nov-14 - 300,000 - 74.33 - 22,299,000
25-Nov-14 - 499,255 - 74.93 - 37,409,177
1-Dec-14 - 332,604 - 74.46 - 24,765,694
2-Dec-14 - 241,901 - 74.41 - 17,999,853
3-Dec-14 - 494,508 - 74.67 - 36,924,912
TOTAL - 4,529,279 - 74.80 - 338,784,928
Fortunately, Dauman was ejected from the CEO chair (although not before receiving a $72 million golden parachute--in C-suites in corporate America today, nothing succeeds like abject failure) and (hopefully) Viacom shareholders will begin to recover some of their substantial losses.
NON-GAAP SHENANIGANS, PART 178
In this, our final installment of this series of blogs, it is fitting to conclude on one of the main themes covered by Buffett in prior letters, namely the deliberate manipulation of accounting by company management in order to fool investors. Unfortunately, when people stand to gain financially by misleading others, greed all too often triumphs over principle, and wealth is transferred from the gullible to the unscrupulous. We allow Buffett to have the final word on this topic:
Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.
Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.
Charlie and I cringe when we hear analysts talk admiringly about managements who always “make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.
Let’s get back to the two favorites of “don’t-count-this” managers, starting with “restructuring.” Berkshire, I would say, has been restructuring from the first day we took over in 1965. Owning only a northern textile business then gave us no other choice. And today a fair amount of restructuring occurs every year at Berkshire. That’s because there are always things that need to change in our hundreds of businesses. Last year, as I mentioned earlier, we spent significant sums getting Duracell in shape for the decades ahead.
We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary. Indeed, when there is a total rebasing of a business, such as occurred when Kraft and Heinz merged, it is imperative that for several years the huge one-time costs of rationalizing the combined operations be explained clearly to owners. That’s precisely what the CEO of Kraft Heinz has done, in a manner approved by the company’s directors (who include me). But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney.
To say “stock-based compensation” is not an expense is even more cavalier. CEOs who go down that road are, in effect, saying to shareholders, “If you pay me a bundle in options or restricted stock, don’t worry about its effect on earnings. I’ll ‘adjust’ it away.”
To explore this maneuver further, join me for a moment in a visit to a make-believe accounting laboratory whose sole mission is to juice Berkshire’s reported earnings. Imaginative technicians await us, eager to show their stuff.
Listen carefully while I tell these enablers that stock-based compensation usually comprises at least 20% of total compensation for the top three or four executives at most large companies. Pay attention, too, as I explain that Berkshire has several hundred such executives at its subsidiaries and pays them similar amounts, but uses only cash to do so. I further confess that, lacking imagination, I have counted all of these payments to Berkshire’s executives as an expense.
My accounting minions suppress a giggle and immediately point out that 20% of what is paid these Berkshire managers is tantamount to “cash paid in lieu of stock-based compensation” and is therefore not a “true” expense. So – presto! – Berkshire, too, can have “adjusted” earnings.
Back to reality: If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.
During the accounting nonsense that flourished during the 1960s, the story was told of a CEO who, as his company revved up to go public, asked prospective auditors, “What is two plus two?” The answer that won the assignment, of course, was, “What number do you have in mind?
We concur 100% with the statement that "business is too unpredictable for the numbers always to be met". A company that always magically seems to hit their numbers should inspire fear, not confidence, in investors--reality just isn't that convenient. Reagan said "Trust, but verify". We would adopt an even more negative view with respect to statements emanating from executives occupying C-suites: "Trust nothing, verify everything" (and also "Guidance is garbage").
For the record, in 2016 Berkshire's stock rose 23.4%, beating the S&P 500 by 11%, the Cubs (yes, THE CUBS!!!) beat the Indians 4-3 in the World Series for their first world championship since 1908, the Patriots beat the Falcons 34-28 in OT in Super Bowl 51, and after the 40th Berkshire/Buffett Blog...he rested (amen).