1/
Get a cup of coffee.
In this thread, I'll walk you through a somewhat counter-intuitive relationship:
When a company is aggressively buying back shares, long-term owners can actually *benefit* if the company's stock price stays low for a while.
Get a cup of coffee.
In this thread, I'll walk you through a somewhat counter-intuitive relationship:
When a company is aggressively buying back shares, long-term owners can actually *benefit* if the company's stock price stays low for a while.
2/
In his 2011 letter to Berkshire shareholders, Warren Buffett shared this particular nugget of wisdom:
When companies buy back shares, Buffett said that long-term owners should *root* for stock prices to languish.
In his 2011 letter to Berkshire shareholders, Warren Buffett shared this particular nugget of wisdom:
When companies buy back shares, Buffett said that long-term owners should *root* for stock prices to languish.
3/
To illustrate his point, Buffett used Berkshire's investment in IBM as an example.
This was unfortunate -- because that investment didn't quite work out.
But the *principle* that Buffett was trying to explain is still valid.
Let's unpack it.
To illustrate his point, Buffett used Berkshire's investment in IBM as an example.
This was unfortunate -- because that investment didn't quite work out.
But the *principle* that Buffett was trying to explain is still valid.
Let's unpack it.
4/
Imagine that we've found a wonderful business.
Not IBM.
Last year, say the business earned $1B.
And at the end of the year, say the business had 100M shares outstanding.
So, Earnings Per Share (EPS) was $1B/100M = $10.
Imagine that we've found a wonderful business.
Not IBM.
Last year, say the business earned $1B.
And at the end of the year, say the business had 100M shares outstanding.
So, Earnings Per Share (EPS) was $1B/100M = $10.
5/
Suppose at the end of last year, shares were trading at a trailing P/E multiple of 15.
That's a stock price of (15 P/E) * ($10 EPS) = $150 per share.
Imagine we bought 1,000 shares at this price.
So, we put in (1,000 shares) * ($150 per share) = $150K into the stock.
Suppose at the end of last year, shares were trading at a trailing P/E multiple of 15.
That's a stock price of (15 P/E) * ($10 EPS) = $150 per share.
Imagine we bought 1,000 shares at this price.
So, we put in (1,000 shares) * ($150 per share) = $150K into the stock.
6/
Let's say we're going to hold the stock for the next 10 years.
At the end of 10 years, we'll sell all our 1,000 shares -- at whatever the market price is at that time.
Let's say we're going to hold the stock for the next 10 years.
At the end of 10 years, we'll sell all our 1,000 shares -- at whatever the market price is at that time.
7/
During these 10 years, let's say the company re-invests 50% of its earnings back into itself each year -- to *grow* the business.
As this is a wonderful business, let's say these re-investments fetch a 30% ROIIC.
So, earnings will grow at a 15% clip over the next 10 years:
During these 10 years, let's say the company re-invests 50% of its earnings back into itself each year -- to *grow* the business.
As this is a wonderful business, let's say these re-investments fetch a 30% ROIIC.
So, earnings will grow at a 15% clip over the next 10 years:
8/
So, that accounts for 50% of company earnings each year -- they're simply plugged back into the company.
What about the *other* 50% of earnings? Let's say they're used for share buybacks -- at whatever the market price happens to be each year.
So, that accounts for 50% of company earnings each year -- they're simply plugged back into the company.
What about the *other* 50% of earnings? Let's say they're used for share buybacks -- at whatever the market price happens to be each year.
9/
Here's the thing:
The HIGHER the market price of the company's shares, the FEWER the number of shares that will be bought back and retired via buybacks. And thus, the SLOWER *per share* earnings will grow over time.
Here's the thing:
The HIGHER the market price of the company's shares, the FEWER the number of shares that will be bought back and retired via buybacks. And thus, the SLOWER *per share* earnings will grow over time.
10/
For example, let's take 2 hypothetical scenarios: A and B.
In both scenarios, we enter the stock at a 15 P/E and exit it -- 10 years later -- at a 30 P/E.
For example, let's take 2 hypothetical scenarios: A and B.
In both scenarios, we enter the stock at a 15 P/E and exit it -- 10 years later -- at a 30 P/E.
11/
The crucial difference is:
In Scenario A, the P/E expansion occurs (and so, the stock doubles) *as soon as* we buy the stock.
But in Scenario B, the P/E expansion occurs *only towards the very end* -- as we're about to sell the stock.
The crucial difference is:
In Scenario A, the P/E expansion occurs (and so, the stock doubles) *as soon as* we buy the stock.
But in Scenario B, the P/E expansion occurs *only towards the very end* -- as we're about to sell the stock.
12/
So, in Scenario A, the company spends 50% of earnings each year buying back shares that trade at 30 times earnings.
That means the share count will decline roughly 1.67% per year:
So, in Scenario A, the company spends 50% of earnings each year buying back shares that trade at 30 times earnings.
That means the share count will decline roughly 1.67% per year:
13/
So, if we start with 100M shares, we'll be left with roughly ((100 - 1.67)/100)^10 * 100M = ~84.53M shares outstanding at the end of 10 years.
At that time, earnings will be (1.15^10) * $1B = ~$4.05B.
At a 30 P/E, each share will thus go for (30 * $4.05B)/84.53M = ~$1,436.
So, if we start with 100M shares, we'll be left with roughly ((100 - 1.67)/100)^10 * 100M = ~84.53M shares outstanding at the end of 10 years.
At that time, earnings will be (1.15^10) * $1B = ~$4.05B.
At a 30 P/E, each share will thus go for (30 * $4.05B)/84.53M = ~$1,436.
14/
What about Scenario B?
Here, for the first 9 years, the P/E remains at 15 -- not 30.
So, each buyback dollar travels twice the distance.
The company thus gets to retire MORE shares.
What about Scenario B?
Here, for the first 9 years, the P/E remains at 15 -- not 30.
So, each buyback dollar travels twice the distance.
The company thus gets to retire MORE shares.
15/
So, the share count in Scenario B will decline at ~3.33% during the first 9 years and ~1.67% the last year.
That leaves us with ~72.48M shares outstanding at the end of 10 years.
At the same earnings level (~$4.05B) and exit P/E (30), each share will be worth ~1,675.
So, the share count in Scenario B will decline at ~3.33% during the first 9 years and ~1.67% the last year.
That leaves us with ~72.48M shares outstanding at the end of 10 years.
At the same earnings level (~$4.05B) and exit P/E (30), each share will be worth ~1,675.
16/
So, we have:
Scenario A: Our $150K grows to ~$1.44M, and
Scenario B: Our $150K grows to ~$1.67M.
Clearly, we are better off in Scenario B.
So, we have:
Scenario A: Our $150K grows to ~$1.44M, and
Scenario B: Our $150K grows to ~$1.67M.
Clearly, we are better off in Scenario B.
17/
In a nutshell:
We only need the stock to be high on the day we sell.
*Between* the time we buy and the time we sell, a depressed stock price actually lets the company buy back and retire MORE shares -- which benefits us as continuing shareholders.
That's Buffett's point.
In a nutshell:
We only need the stock to be high on the day we sell.
*Between* the time we buy and the time we sell, a depressed stock price actually lets the company buy back and retire MORE shares -- which benefits us as continuing shareholders.
That's Buffett's point.
18/
*Financially* speaking, Scenario B wins.
But *psychologically*, Scenario A is easier for most of us to handle.
We *feel* good if a stock shoots up immediately after we buy it -- even if we're in no hurry to sell, and even if the company is continuously buying back shares.
*Financially* speaking, Scenario B wins.
But *psychologically*, Scenario A is easier for most of us to handle.
We *feel* good if a stock shoots up immediately after we buy it -- even if we're in no hurry to sell, and even if the company is continuously buying back shares.
19/
By contrast, we find it hard to hold on to shares that seem to be going nowhere -- even if the underlying business keeps putting up good numbers, and even if management keeps taking advantage of the low stock price to retire more shares.
By contrast, we find it hard to hold on to shares that seem to be going nowhere -- even if the underlying business keeps putting up good numbers, and even if management keeps taking advantage of the low stock price to retire more shares.
20/
This is just one more example of how we tend to behave irrationally when it comes to the stock market.
Being aware of our natural biases is the first step towards overcoming them.
I hope this thread helped with that.
This is just one more example of how we tend to behave irrationally when it comes to the stock market.
Being aware of our natural biases is the first step towards overcoming them.
I hope this thread helped with that.
21/
Thank you very much for reading all the way to the end.
Please stay safe. Enjoy your weekend.
Happy halloween, and happy Diwali!
/End
Thank you very much for reading all the way to the end.
Please stay safe. Enjoy your weekend.
Happy halloween, and happy Diwali!
/End
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