Warren Buffett on Stock Buybacks

U.S. companies are expected to buy back $1 trillion in stock this year, which would shatter the previous record of $589 billion set in 2007. The primary reason is tax reform, as the lower corporate tax rate is freeing up much more cash that companies can put to work. And despite a historically expensive stock market, many companies seem to think that buybacks are a great way to put this extra cash to work.

One company that has been in the news recently regarding buybacks is Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B), the conglomerate led by Warren Buffett, which recently loosened its buyback criteria. Buffett confirmed that Berkshire has bought back some of its own stock for the first time in years.

While Buffett obviously feels that buybacks make sense in Berkshire's case, how does he feel about the wave of buybacks throughout the stock market? Here are some of Buffett's thoughts on buybacks and whether they make good financial sense for shareholders.

Buybacks are the best use of a company's cash if the stock is cheap

Buffett's first rule of buybacks is that they only make sense when a stock is trading for a significant discount to its intrinsic value. As Buffett has said, "Anytime you can buy stock for less than it's worth, it's advantageous to the continuing shareholders...but it should be by a demonstrable margin."

In Berkshire's case, the recently revised buyback policy allows Buffett to repurchase shares if and only if both he and Vice Chairman Charlie Munger agree that the company's stock is trading at a discount to its intrinsic value as determined by a very conservative methodology.

Buffett also generally prefers buybacks to other methods of returning capital to shareholders, especially dividends.

While Buffett likes to receive dividends from the stocks he owns, when it comes to Berkshire, he considers buybacks to be a far better solution. Simply put, when management is authorized to buy back shares, they can choose when and if they want to buy shares and can deploy the capital only when it is in the best interest of shareholders. On the other hand, when a company implements a quarterly dividend, it is generally committing to making the payments, even if, during a particular quarter, there could be a more efficient way to use the money.

Buybacks work out better for investors when prices fall

One of Buffett's favorite things about stock buybacks is that they automatically increase his percentage ownership in a business without investing any more money.

Buffett often remarks that he doesn't really care when his long-term investments decline in value as long as the underlying business fundamentals remain strong. From a buyback standpoint, he actually likes when prices fall.

Berkshire's largest stock investment, Apple (NASDAQ: AAPL), has a massive buyback program. In April, Apple announced a new $100 billion share buyback program to supplement the existing $210 billion buyback program that was previously authorized. It might surprise you to learn that although Apple is trading near record-high levels, Buffett really wouldn't be disappointed if the stock went down, even though it could temporarily cost Berkshire billions of dollars on paper.

"I'd rather have it go down for one thing, if it goes down Apple is going to buy a lot of stock back, already buying stock back," Buffett told CNBC. "If it goes down 10% it means they get to buy 10% more shares and my interest will go up 10% more for spending that money."

Buffett thinks lots of companies are doing it wrong

So Buffett is generally a fan of share buybacks, but only when they're done at a substantial discount.

There's one thing Buffett feels many companies get wrong when it comes to buybacks, however. In a 2015 CNBC interview, Buffett mentioned how authorizing X amount of buybacks to take place by a certain date is missing the point. "Many management are just deciding they're gonna buy X billions over X months. That's no way to buy things. You buy when selling for less than they are worth," Buffett said.

Instead, look at how Berkshire's buyback program is structured. Buffett can buy back as much stock as he wants, as long as it's trading at a discount and it doesn't bring Berkshire's cash reserves below $20 billion. With more than $100 billion on its balance sheet, this isn't exactly a big restriction.

On the other hand, if Buffett doesn't think shares are trading at a discount, he doesn't have to buy back any stock at all.

Open-ended buyback authorizations like this are extremely rare, but Buffett would like to see other companies follow his lead in creating a valuation-based buyback program instead of one based on a certain dollar amount of stock.

The bottom line is that Warren Buffett is definitely a fan of buybacks, but only when they're done the right way.

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Matthew Frankel, CFP owns shares of Apple and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.