AAII Investor Update: Buffett on Buybacks—Price Matters

Thursday, March 1, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 44.5%, up 0.8 points
  Neutral: 28.7%, down 0.1 points
  Bearish: 26.8%, down 0.7 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


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I want to start with a quick reminder about our new Dividend Investing service. The special discount charter rate expires tonight at midnight. If you would like to join the many AAII members who have already subscribed, click here to lock in the charter price of $99 for a one-year subscription (a $50 savings).

Warren Buffett published his annual letter to Berkshire-Hathaway (BRK.B) shareholders last Saturday. I always enjoy reading these, not only because I am a Berkshire shareholder, but also because intermixed with Buffett’s discussion of how the company has performed are words of investing wisdom.

This year’s letter was no different. Buffett devoted many paragraphs to the subject of share buybacks, a topic he has opined on before. This year, he focused specifically on valuation and price performance.

Regarding valuation, here is what the Oracle of Omaha wrote:

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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The Week Ahead

Just three S&P 500 companies will report earnings next week. Brown-Forman (BF.B), H&R Block (HRB) and Pall (PLL) are all scheduled for Wednesday.

The week’s first economic reports will be the February ISM non-manufacturing (“services”) index and January factor orders on Monday. Wednesday will feature the February ADP Employment Report and revised fourth-quarter productivity. February employment data—including the unemployment rate and the change in nonfarm payrolls—and January international trade will be released on Friday.

No Federal Reserve officials are currently scheduled to speak.

AAII Sentiment Survey

Bullish sentiment edged up slightly and bearish sentiment declined slightly in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, increased 0.8 percentage points to 44.5%. This is the 10th consecutive week and the 11th out of the last 12 that bullish sentiment has been above its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 0.1 percentage points to 28.7%. This is the fourth consecutive week that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 0.7 percentage points to 26.8%. This is the ninth consecutive week and the 10th out of the last 11 that bearish sentiment has been below its historical average of 30%.

This is the longest streak of above-average bullish sentiment since 2011, when optimism stayed above average for 24 weeks between September 9, 2010 and February 17, 2011. The S&P 500 increased by approximately 22% over that period.

Individual investor optimism continues to be aided by signs of improving economic conditions, as well as rising stock prices. Europe's sovereign debt problems, slow economic growth, Washington politics and rising gasoline prices are keeping bullish sentiment from being extraordinarily high.

This week’s special question asked AAII members if the rise in oil prices is currently affecting their sentiment or if there is a price where it would do so. The majority of respondents said that oil prices would impact their sentiment if prices kept rising. Specifically, many respondents said oil above $120 per barrel or gasoline above $4 a gallon would be a cause for concern.

Here is a sampling of the responses:

  • “Not yet. Gas prices over $3.85 a gallon would change my opinion.”
  • “Yes, if higher oil prices result in an average cost of gasoline increasing to over $4.50 a gallon.”
  • “The current price is not impacting my sentiment. If oil reached $125 per barrel, it would make me even more bearish.”
  • “The prediction of $5 per gallon of gasoline by summer does impact my sentiment.”
  • “Yes. Every dollar that goes into the tank is not spent, saved or invested elsewhere. It is equivalent to a huge tax hike, greatly affecting those who least can afford it.”

» Take the sentiment survey

AAII Asset Allocation Survey

February Asset Allocation Survey results:
Stocks/Stock Funds:
    59.1%, down 1.8 points
Bonds/Bond Funds:
    22.6%, up 1.7 points
Cash:
    18.3%, up 0.1 points

Asset Allocation details:
Stocks:
    30.5%, up 0.9 points
Stock Funds:
    28.6%, down 2.7 points
Bonds:
    5.6%, up 0.7 points
Bond Funds:
    17.0%, up 1.0 points

Take the survey »


Allocations to bonds and bond funds rose to their highest level since September 2010 in the February 2012 AAII Asset Allocation Survey.

AAII members allocated 59.1% of their portfolios to stocks and stocks funds in February. Though down 1.8 percentage points from January, this is still the second-highest allocation to equities in the past seven months. The historical average is 60%.

Bond and bond funds allocations accounted for 22.6% of individual investors’ portfolios last month, an increase of 1.7 percentage points. As noted above, this is a 17-month high for fixed-income allocations. It is also the 33rd month that fixed-income allocations have been above their historical average of 15%.

Cash allocations were essentially unchanged, rising just 0.1 percentage points to 18.3%. February was the third consecutive month that cash allocations remained below their historical average of 25%.

Fixed-income allocations rose as individual investors became less fearful of a rise in interest rates over the foreseeable future, in large part due to the Federal Open Market Committee’s intention to leave interest rates unchanged until at least 2014. The decline in equity allocations shows that optimism among individual investors about the short-term outlook for stocks is being tempered by ongoing concerns about Europe’s sovereign debt problems, slow U.S. economic growth and the Federal deficit.

This month’s special question asked AAII members how the Fed’s decision to leave interest rates unchanged until 2014 has affected their portfolio allocations. Responses were mixed with many respondents saying the decision did not impact their portfolio allocations. A large number of respondents said they were increasing their allocations to stocks, particularly dividend-paying stocks. Others said they were increasing their allocations to bonds and bond funds.

An underlying theme was higher risk. Many AAII members said they are shifting to riskier investments, including stocks and higher yielding bonds, in an attempt to increase their portfolio income.

Here is a sampling of the responses:

  • “I am less likely to reduce my bond holdings for a time.”
  • “I have taken on more risk in retirement than I had originally planned.”
  • “More bonds—government agency debt and corporate—and less CDs. In effect, I’m taking on more risk in the fixed-income portion of my portfolio.”
  • “The Fed’s policy is inconsequential since I’m maintaining a 60%/40% stock/bond allocation.”
  • “It lessens my haste in moving money invested in dividend-paying stocks to bonds and cash.”
  • “No change, but I’m prepared to act if there is a change in interest rates.”
  • “It has made me more disgusted with our central bankers!”

» Take the Asset Allocation Survey



Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor