Is there a legitimate justification for the redemptions made by Berkshire? Yes, and they come with a treasure of thinking Buffett – Berkshire Hathaway A (NYSE: BRK.A)

Matt Levine does not like the buybacks made by Buffett in Berkshire (NYSE: BRK.B).

Do not mistake yourself. I like the Money Stuff blog from Matt Levine. Something has brought me to sign a few months ago, and I think most of his works are fantastic. His specialty is thinking about companies and leaders doing absurd things (think Elon Musk). Levine is a fly. It calls for both scandalous corporate behavior and unwavering acceptance. His writing combines irreverence and insight into corporate shenanigans, and a devastating analysis of "Netflix Theory" is contained in the same article that inspired this article.

That said, I must say that he has presented an extremely ridiculous argument against Buffett's redemptions in Berkshire. His argument seemed to me (1) to ask a potentially interesting question, but (2) to lack major factors to take into account. His main argument attacks a straw man – "Buffett the market timer". In doing so, he missed the opportunity to discover very interesting information about Buffett's thought process, which contains workable elements.

Here is Levine's argument against redemptions

When a company has more money than it can invest in value projects, it is too big and should shrink by making money for shareholders so they can invest in value projects; or When the shares of a company are an attractive investment, they should buy some of them.

Model 1 is a fairly conventional business financing. A company raises money from investors to do one thing, it does the thing, the thing generates money, it uses the money to reinvest in the thing. If the system is working well, the company will generate more money than it needs to reinvest, and it has to give that money back to its investors, because they may have a better idea of ​​how that money is managed than it is -this. (because the company is really specialized in this area) and because after all, it has invested in the company in the hope of recovering its money with a profit … Model 2, on the other hand, is a bit ridiculous. It is difficult for anyone to time the market. It is particularly difficult for business leaders to synchronize the market with their own actions because they tend to be selected in part for their enthusiasm towards their businesses. In addition, companies tend to want to buy back shares when they have a lot of cash, which is usually the case when things go well, which in cyclical activities means that they have trend to buy high and sell low. In addition, if companies know how to program buybacks of their own shares, it is a mixed bag; this suggests that they are using their preferred view of inside information to carry out transactions against their shareholders. There is however Berkshire Hathaway Inc. It is difficult to defend the model 1: Berkshire does not specialize in building a particular type of widget; it's more or less an investment company. It's run by Warren Buffett and his hand-picked lieutenants, and there's good reason to think they're investing better than you. "They have" struggled to find a way to invest an ever growing mass of funds that has exceeded $ 100 billion each in the last five quarters ", well, you 're the only way out of it. have done. "Berkshire is too big and so should bring some money back to the shareholders so that they can find some good investment ideas because Warren Buffett can" not feel somehow in the money. ;fault. It may be right! ("Even though it does not manage to cope with all the money that Berkshire generates," writes Tara Lachapelle, a colleague of Bloomberg Opinion, who has some ideas about what he's doing. should do.) But it is presumptuous to think that Berkshire's shareholders would be better. stewards of their money that Buffett is. This leaves the timing of the market as an explanation. Berkshire repurchased $ 928 million worth of shares in August, with a new policy allowing for greater flexibility in market timing: the company's former policy limited redemptions to equities when their shares traded in the US. less than 20% of their book value. At present, Buffett and Vice President Charlie Munger can decide when the stock is trading at a lower price than what they consider to be intrinsic value. "Stocks have traded below its average purchase price for much of the past two weeks," however, even Buffett's market timing is not perfect.

Model 1: A confused writing equates to a confused thought

The funny thing is that when I read Levine's discussion on Model 1, I can not say whether it presents a positive or a negative argument. The latter, I suppose. The only time I have a clear idea of ​​Levine's side is the line on which it is "hard to defend Model 1." His major problem with redemptions seems to be that Berkshire is not a company specialized in producing a particular type of widget.

Well, duh. But that is also true of almost all big companies. As an argument, this makes no sense unless you want to try to argue that Procter & Gamble (PG), just to serve as an example, makes only one product. I guess they do it so the soap and toothpaste are essentially the same thing. Gosh, maybe they're sort of. I guess the legitimacy of Procter & Gamble buyouts depends on my willingness to brush my teeth with Tide and wash my laundry with Crest.

With respect to Levine's argument that Berkshire Hathaway (BRK.A) (BRK.B) is "more or less an investment business", you might have said that it 20 years ago, you wanted to ignore the insurance business. Berkshire is now a conglomerate, sometimes qualified as financial and sometimes industrial, composed of over 80 operational entities with decentralized operational control but a centralized capital allocation. It also happens that there is a large portfolio of shares.

On the whole, Berkshire 's many distinct entities are dumping more cash than they can reinvest productively – something north of $ 2 billion a month and up. Yes, Berkshire does not specialize in building a particular type of widget. You can certainly say that you would not eat a locomotive or produce electricity with the Dairy Queen Sundaes. However, the differences between the various widgets produced by all major companies are only a matter of degree. The allocation of capital is a universal problem, whether you are a giant conglomerate like Berkshire or the last single-idea start-up. All companies must decide how to use capital rationally.

To argue that Berkshire is different from any other company that takes money from investors to do something, does it well and generates more cash than the reinvestment needed is to make a distinction without difference. Like all other companies, Berkshire ranks first in the capital allocation business. It simply does it better than almost everyone and relies on a wider range of options.

For a moment, I thought Levine was about to argue that dividends were generally a more legitimate form of cash yield than buybacks, but he did not really advance that argument. If he did, I would have referred to Buffett's clear and elegant counterargument presented in his famous 1977 article Fortune article that I quoted and linked in this article on the subject. In all respects, including taxes and fairness to the remaining shareholders, the ability to realize liquidity by selling shares has a more effective and equitable result than cash dividends. Buybacks are merely an extension of this argument, with the remaining holders again benefiting from a larger share of the company.

Model 2: still confused and uninformed

Model 2 does not make more sense than Model 1. Buffett is a valuable investor. Or you could call it GARP investor – growth at a reasonable price. Berkshire's buyback policy has nothing to do with "market timing". Buffett has never been a "market timer", although he acts from time to time and describes his point of view on market valuations at a turning point or a turning point. If buying things when they are cheap or holding money when they are expensive, that is "market timing", Buffett should plead guilty. Otherwise, the timing of Buffett is purely fortuitous.

I think there is a more global way of thinking about Buffett's buyouts. Buffett has a clear hierarchy for equities with available liquidity – internal reinvestment is the first and then accretive acquisitions. The purchase of publicly traded shares comes in third place and the redemption of Berkshire shares itself comes last. Despite this, the Berkshire share buyback is equivalent to a composite of the other three uses of cash available:

1. Reinvest effectively in one's own business by spreading one's cash flow on fewer shares.
2. Benefit from the key benefits of buying entire companies, namely total cash flow control and the elimination of any tax implications, whether for Berkshire itself or its owners.
3. He just buys an attractive publicly traded stock, but it's the only company he knows best.

This is the reason for the legitimacy of the redemptions made by Berkshire. I suspect that Matt Levine thinks more like a writer and a critic and less like an investor. Stock trading one month after redemptions would only matter if you were a trader hoping to sell quickly. Buffett buybacks are a capital allocation decision, not a trading decision. The market price is only important as a measure of the commercial value of the shares purchased.

Expanding the Buffett Buyback Vision

Redeeming your own shares is equivalent to buying shares. There is no doubt that many companies buy their products at bad prices and for the wrong reasons. The worst is done by companies that pay high-level employees with stock options and then buy back shares to offset the options, which dilutes their shareholders. Berkshire Hathaway does not use stock options as compensation.

It is also true that many companies are buying stocks at high prices mainly to boost earnings per share. Buffett is well aware of this problem. For years, he set the low multiple of book value as a barrier to share repurchases. In recent years, he has recognized that a true estimate of the value of Berkshire was starting to move away from book value. This is due to the fact that a growing share of Berkshire's revenue came from Berkshire's whole-company cash flow. These companies continued to be recorded in accounting at their purchase price – an accounting policy. Meanwhile, their cash flow has increased tremendously. Buffett was simply correcting an obstacle to redemption that was irrationally low.

Buffett always looks at the risks and the probable returns. For a variety of reasons, he prefers to buy entire businesses over which he has absolute control and unrestricted access to cash flow. It also pays special attention to taxes. He is aware that internal cash flows are not taxed twice as dividends. The purchase of something on the market, like Apple's huge purchases (NASDAQ: AAPL), has real but very small tax consequences on the dividend, but the tax consequences on capital gains are much higher. important for a particular investor. Full companies will never trade again, so the problem of capital gains tax does not arise.

Buffett is pleased to redeploy its cash flow internally to all 100% owned companies with the highest probable rate of return on additional capital. The repurchase of Berkshire shares itself is only a last resort, but it offers many advantages in terms of internal reinvestment. The difference is that it involves weighing one's estimate of Berkshire's intrinsic value against any external opportunity. He has been very conservative about Berkshire's redemptions in the past. So what has changed as a result of the current modification of the buyback rules and recent purchases?

Buffett knows a lot about Berkshire and his many businesses. He knows it as a business and understands the persistence of the increase in his cash flow, as well as the right range of risk to use in calculating his best estimate. By buying publicly traded shares or entire companies, there is always something you do not know. It's like the little flaws that a home seller knows and that the buyer does not know about. By buying back shares in Berkshire, Buffett simply buys shares in a publicly traded company, but knows as intimately that a home seller knows his home.

Deconstruct Buffett think of past offers

Buffett transactions often carry a lot of collateral information. The predominant trend of its transactions over the last two decades has been to buy industrial companies that would be expected to grow at a rate similar to the US economy, but perhaps at a slightly higher rate, such as Burlington Northern Santa Fe and Precision Castparts.

These two operations were part of a trend towards acquisitions requiring a significant capital injection, but with a relatively safe return: a huge gap compared to previous acquisitions such as Dairy Queen and publicly traded stocks such as Coca-Cola. (KO), which generate a huge amount. cash with very little investment required. The most recent offers show the disengagement of companies with strong present ROIC but no place to reinvest with a similar return. What is easy to miss is that buying a large industrial company dilutes the importance of subsidiaries like Dairy Queen or titles like Coca-Cola.

There is always an implicit structural message in large inventory transactions and purchases. Apple probably reflects a rebalancing and an update of its assets towards an area of ​​brand technology that it understands. Apple is trying to bring Berkshire into the contemporary economy through a mainstream society using technologies that combine the power of the brand. He gently moves the Berkshire structure.

Buffett's most interesting structural bet was about the 1998 purchase of General Re. It was no secret to him that he thought the dot.com era market was ridiculously expensive. Let's give him credit for being right about it, even though, at the time, it was perceived as an old fog. But what could he do with the valuation of the market? The shares he owned, such as Coca-Cola, had been swept away by the market at absurd heights, but selling them was tantamount to giving up more than a third of his capital (capital gains within companies being taxed as an ordinary income of 35% at the time). He should also have given up dividends, which earned him a high return and which, once held in other companies, were very slightly taxed.

General Re presented a solution. Gen Re was a pillar of reinsurance that put aside capital for future claims with a large bond portfolio – about $ 22 billion. By buying Gen Re, the bond / equity ratio within Berkshire has been replaced by bonds. Buffett told attendees at this year's Sun Valley conference that he "was not unhappy," adding that "This has resulted in a change in portfolio allocation." This is the kind of second-level reflection of Buffett and shows how carefully he considers the question of Berkshire's overall composition.

Well-informed readers may be aware that the acquisition of Gen Re has solved a problem, but has created a few others. Gen Re came up with derivative contracts that Buffett does not seem to have scrutinized and that gave him years of headaches. She also suffered from poorly paid subscriptions. That's the problem the other guy knows about his house in a way you can not. We, the investors, are always the others.

Finally, what bothered Buffett most was the fact that he paid for the purchase of Gen Re in Berkshire shares. While Gen Re has straightened the ship and has behaved reasonably well in the long run, Berkshire Hathaway as a whole has done much better. Ironically, Gen Re's purchase ended up diluting the growth of Berkshire's other businesses. Buffett did not miss the implications of that.

The Gen Re experience has led to two things at home: (1) you can change the shape of your company with an acquisition, and (2) Berkshire shares are a valuable currency and the value of their future prospects must be kept in mind. Both of these ideas had an impact on Buffett's subsequent decisions, particularly on the current buybacks.

What Buffett is telling us now

Given the context of the past two decades' trend in Buffett contracts and lessons learned from specific contracts, large and small, it is possible to identify some current views of Buffett on Berkshire and the market. I will present them as a list.

1. Buffett is unable to find many things to buy in the current market. Review the previous sentence. This is not a market timing decision nor a commentary on the future of the economy. It means exactly what it says. Buffett thinks the current market offers thin choices for a value investor.
2. Buffett has even more trouble finding whole businesses to buy. His criteria include being a good or a large company at a reasonable price and being available for purchase with a single offer (without trading) and without the need for a hostile bid. One of the suggestions cited by Matt Levine's colleague, Tara Lachapelle, is Parker-Hannifin (PH), who could meet his first criterion. PH's management is exceptional, both fair and friendly to shareholders, and cautious enough to minimize the effects of recessions. I have the size in family accounts, but would add strongly if another step of this correction made it 10-15% cheaper. From Buffett's point of view, the problem would be that PH has no long term manager or owner with a significant stake in the company – a person with whom he could discuss an agreement. Public health management is made up of engineers and not negotiators. The current management can reasonably say that she is doing pretty well as she is, thank you very much, and Buffett has always honored a non gentleman.
3. Buffett has more than $ 100 billion in cash that brings him short-term treasury bills and he clearly feels the pressure to do something better with it. At the same time, he does not want to rush and pay too much, nor take risks in a company for which he has information and an imperfect understanding. The only company for which he has the best understanding of value and future prospects is the one he himself created.
4. Buffett has no utility for bonds at currently offered rates. Period. For what it's worth, I totally agree.
5. Buffett loves his own company. Knowing him from the inside, he probably goes back two or three kilometers and says to himself: "Well, among all the things available on the stock market or between individuals, I do not see anything that I really like better than the mine. Why not do the most obvious thing? Why not use capital so that I and other stock holders can have a slightly higher percentage?
6. Buffett also seems to appreciate the general makeup of Berkshire companies. Berkshire has significant holdings in the insurance, energy (including utilities, power generation and pipeline), industry (including BNSF and Precision Castparts), housing and related to housing, branded consumer activities (including Apple) and financial services.
7. The companies and industries mentioned above are what he buys when he buys his own shares. They include a balanced portfolio of companies highly dependent on the growth of the US economy and a few more stable companies. It is important that he is satisfied with this mix of industries and demonstrates this by buying stocks that represent in terms of overall economic growth. Investors and potential investors in these industries should take note. In the past, it has taken steps that structurally serve to diversify away from its current activities. He is not currently seeking to diversify away from his current holdings.
8. Buffett seems to have a positive long-term view of housing-related businesses and financial services in general. He is certainly well placed to have a clear vision of how these companies work. What they share, is to be the least expensive areas of the current market. The fact that finances and housing are cheap can come from the persistent negative sentiment about their performance during the last major market crisis. This is what has happened with technology for more than a decade after the dotcom bubble and its collapse. Buffett probably sees this as erring crowd behavior and feels that this concern is misplaced and represents an opportunity. He is well placed to know. (For what it's worth, I'm with him on finances and a little less on housing.)
9. While working on this article, the 13F Berkshire was published and showed, among others, a major purchase of JPMorgan (JPM), a personal choice probably Buffett, as well as Travelers (TRV). Think about it. Berkshire is already full of banks and its main business is insurance. If Buffett buys JPM and TRV, he must really like banks and property and casualty insurance companies. He must think that they are cheap and he must fear no future. He probably also likes the way each of them uses buybacks, especially travelers, who have increased their earnings per share and stock price at a high single-digit rate for a decade, with no growth in turnover. All the growth came by reducing the stock float with redemptions. What Buffett sees when looking at this is the underwriting discipline and usability for shareholders.

Conclusion

What you do with the above projection of Buffett's thinking belongs to every investor. Needless to say, I think Buffett is always with her and is better able to make important decisions than ever before. I am less sure of his skills in the field of technology, partly because I am not sure of my own opinions on the field.

I am heavily overweight in Berkshire B shares. I also have positions in all major banks with the exception of Citigroup (C) – no solid reason for its omission – and in the Travelers and Chubb (CB) groups. I also own industries such as United Technologies (UTX) and Parker-Hannifin. I bought them on the basis of my own analysis and judgment, being influenced by Buffett only in terms of fundamentals. Last February, I abandoned my home builders on an evaluation basis and wrote about it about SA at the time.

My wallet is a little unbalanced because it contains elements I have knowledge and beliefs that were inexpensive when I bought them and are still reasonably priced at a reasonable price. This reinforces my confidence that Berkshire has a similar selection of full-fledged companies and a somewhat unbalanced portfolio, not too different from mine. This further reinforces my belief that Buffett is willing to buy more by buying back shares in Berkshire.

Disclosure: I am / we have long been BRK.B, CB, TRV. JPM, PH, UTX.

I have written this article myself and it expresses my own opinions. I do not receive compensation for this (other than Seeking Alpha). I do not have any business relationship with a company whose actions are mentioned in this article.