Why you should take Warren Buffett’s advice on share buybacks

Whatever you think of US investor Warren Buffett's folksy schtick, he's worth paying attention to he's made a lot of money, and everyone else hangs on his every word, so it makes sense to know what he's talking about.

In this year's letter from his investment vehicle, Berkshire Hathaway, he sang the praises of index investing and took another pop at hedge funds.

We've been making the same point for years and I'm not going to disagree with him for a minute getting cheap passive exposure to the market makes a lot more sense than paying over the odds for underperforming active management.

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But he also addressed another point that causes a lot of controversy in financial circles the vexing question of share buybacks...

Share buybacks make sense if your company is cheap

Share buybacks are a point of contention in investing. And for good reason. When companies buy their own shares, it often leaves a bad taste in the mouth.

First off, could they not think of something better to do with the money? Second, if they borrow money to do it, they just add risk for existing investors in a sneaky way if you don't sell during the buyback, then the company you own has just become more indebted, and thus more risky. Third, why not just pay a higher dividend? And finally, is this really just a fiddle for the board to hit their bonus targets?

So you can see why they're controversial, and we'll discuss that more below.

But Buffett defended them. Sort of. And his point gives you a good idea of what to look out for if a company you own starts buying its own shares.

His point is that buybacks don't always have to be bad things. But they only make sense for existing shareholders if the shares are bought "below intrinsic value". In other words, as with any other investment, buybacks can make sense but only if you "buy low".

Clearly, he's defending the fact that Berkshire Hathaway has its own share buyback policy (it'll repurchase its own shares if the price of the stock falls below 120% of its stated book value). But he does have a point.

How discount control mechanisms work on investment trusts

Let's look at "discount control" mechanisms on investment trusts as an analogy. Quick refresher here: put simply, an investment trust is a listed company that invests in the shares of other companies (it can get more complicated than that, but let's keep it straightforward for now).

If all of those companies are listed (so they all have a publicly-quoted share price), and you know how much cash and borrowing there is in the portfolio, then you can know the value of the underlying portfolio on an almost minute-to-minute basis.

So you can know what price the investment trust "should" trade at. But because the trust's shares trade independently of the underlying portfolio, sometimes often the share price is out of line with the value of the underlying portfolio.

If the share price of the investment trust trades below the portfolio value (the net asset value, or NAV), then it's trading at a discount. If it trades above the NAV, then it's at a premium.

A discount control mechanism kicks in if the trust trades at a sufficient discount. Typically, this means buying back shares in the investment trust and cancelling them. The idea, in effect, is that this prevents the investment trust from becoming "too cheap" and looks after the interests of existing shareholders.

Personally, I think discount control mechanisms ruin some of the fun of investment trusts. I like to be able to buy stuff on the cheap, and then rely on the market to bring its price back into line with "intrinsic value".

But at least with investment trusts, there's a clear policy, and an objective measurement of intrinsic value that you can either concur or disagree with.

The real trouble with share buybacks

Buffett's point is that the real problem with share buybacks is that companies often do them with no reference to any sort of target price or intrinsic value. In effect, they could be trading at a huge premium or discount there's no particular rhyme or reason to the decision.

"It is puzzling 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", writes Buffett.

He adds: "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'."

In short, the real problem is that most buybacks are done for the wrong reasons.

For example, buybacks are often used to fiddle bonus figures. If your bonus is based in some way on earnings per share (EPS), then there are two ways to boost that particular metric: you can increase earnings, or you can decrease the number of shares in issue. So if you look a little light on your EPS targets, then buying back some shares and thus driving the figure up artificially is very tempting.

And because they are done for the wrong reasons, they are also done at the wrong price. Plenty of data shows that companies buy back more of their own shares as the market goes higher, rather than the other way about, which would make more sense. For example, buybacks on the S&P 500 hit a record in mid-2007, just before the last epic crash.

What does it all mean? I'm not suggesting selling out of companies that do share buybacks the market likes them and it's not the sort of thing to use as a timing indicator.

But keep an eye on the figures in aggregate they rise during booms and fall during busts, so it can be another useful indicator of "irrational exuberance".

And as for individual stocks, look for a buyback policy. Why is the company repurchasing its own shares? Does it make sense? Or is it just an unimaginative way to ramp its own stock price? And remember if the company is taking on unwise levels of debt to undertake these buybacks, it's the remaining shareholders who'll be left on the hook for that debt if things go pear-shaped.

By the way, if my earlier discussion of investment trusts has intrigued you, our funds expert Max King picks out his top investment trust picks for both income and growth in this week's MoneyWeek Isa special. Subscribe now so you don't miss it.