An Often Unexploited Advantage of a Controlling Shareholder
In October 2016, we had a discussion with the CEO of one of our companies about not surrendering the advantages of having a controlling shareholder or a small group of well-aligned controlling shareholders who have a long-term orientation. The conversation with this executive began with a question around how the company thought about its investor relations function and the relative value placed on that effort within the organization. We understand the psychological desire for executives to put their best, or at least a reasonably good, foot forward, and often their economic incentives are tied to higher share prices. Ultimately, however, a management team who has the strong backing of a majority owner should not care what a Wall Street analyst thinks the value of the business is on any given day. In fact, trying to get analysts to fully value, or even overvalue, the business is against the economic interests of long-term shareholders.
TThis claim may strike you as bold or even odd – why would owners of an asset want it to be undervalued while they own it? Does not that just hurt these owners’ investment returns, especially if the undervaluation persists for a long time? The answer is driven by one’s time horizon. Let us back up and first explain the overall framework for this counterintuitive assertion. A company is worth, that is its intrinsic value is, the sum of all the future cash it will earn for its owners in perpetuity discounted back to today’s dollars. This estimated intrinsic value is a function of the company’s future earning power but not its stock price. The market value for a business on any given day, as reflected in this share price, is simply the amount of money the marginal buyer and seller of the stock are willing to exchange for shares. These participants’ views about the company’s value are certainly shaped by their expectations for future cash flows, but they are also influenced by recent price movements of the stock, beliefs about how the broader market will react to next quarter’s earnings, rumors about potential buy or sell-side M&A activity, cash needs, etc. This market value, as represented by daily stock prices, can be found in some mound-shaped probability distribution around the underlying intrinsic value. The variance of this distribution can fluctuate widely[1] depending on the predictability of the underlying business, the level of disclosure made by the company, the number of intelligent investors following the business, the prevailing mood of the market (animal spirits), etc.
Most public companies have fragmented shareholder bases. If a company has a fragmented shareholder base and its stock price trades dramatically below its per share intrinsic value, the company is vulnerable to an acquisition at this discount. A “forced” sale like this would permanently destroy value for current shareholders, so, in such cases, management has some responsibility to encourage shareholders to value the business close to intrinsic value. Additionally, if a company expects to access the capital markets in the future through a debt issuance or a secondary offering, or if a company wants to use its shares to make acquisitions, it is optimal (although less than honorable) to try to inflate the company’s market value above its intrinsic value to help lower its cost of capital. In all cases, of course, a company has the obligation to make any and all required disclosures in a forthright manner and to communicate the business’s current situation and prospects in an accurate and complete way. However, a company has no obligation to market its shares with the same enthusiasm it might market its products or services. Unfortunately, we find this salesmanship to be the norm. For example, we believe the standard practice of earnings guidance damages long-term shareholders by constraining management flexibility and inflating the current share price.
If a company has a controlling shareholder or shareholder group, however, management should eschew this standard investor relations practice of promoting the company’s stock price. In fact, this promotion could cost patient shareholders a great deal of long-term value if it prevents the company from buying its stock back at prices that are below intrinsic value. To demonstrate, consider a hypothetical company that will earn $1 million in 2017 with one million in outstanding shares. This company will grow earnings 8% annually for several years, with this annual growth rate falling to 3% until decaying to no growth after 25 years. The company has a 100-year life, making it a good business with a defendable moat.
A company can use its free cash flow to reinvest in the growth of the business, to pay a dividend, and/or to repurchase outstanding shares. We assume for simplicity that internal reinvestment opportunities are unavailable, and we examine the per share effect for a shareholder of either the company (i) paying dividends that the shareholder can reinvest at a reasonable rate, or (ii) buying back shares at various discounts from or premiums to intrinsic value. The compound effect of systematically buying back shares at a discount is dramatic. Over thirty years, a shareholder’s investment will be worth four times as much money if shares are repurchased at a 60% discount to intrinsic value versus buying those shares at intrinsic value or paying a dividend. Buying shares above intrinsic value, on the other hand, is destructive to value and leaves the shareholder worse off than if the company distributed its excess capital. Please see year 2047 in the table below:
This simple analysis illustrates the non-linear nature of and exponential results for a company that is able to repurchase shares with retained earnings at prices below intrinsic value. What sounds mostly absurd in the short-term– do not worry if your share price is depressed – is a boon over the long-term if a company astutely takes advantage of this mispricing.
This illustration begs the question: why do so many companies surrender this possible advantage? We think responsibility starts with the board, which should make the long-term compounded return ultimately enjoyed by shareholders the primary goal of the business. Board members should, for example, design management incentives that avoid promoting the shorterterm movements of the stock price or near-term earnings goals. Stock option plans, at least as typically constructed, are often major roadblocks to achieving this goal. Many of these plans reward management for a rising share price in the medium-term rather than an increase in the per share intrinsic value of the business, and these systems are easy to game. For example, such plan constructions encourage management to unnecessarily retain or reinvest earnings at sub-par rates of return. Each dollar per share not paid out as a dividend should mathematically increase the price of the stock by one dollar, which is nice if you hold stock options. This responsibility for setting the right overall tone for a business extends to management, of course. Accordingly, an investor should demand a management team who thinks and acts like shareholders, preferably because they are owners who have significant portions of their net worth invested in the company’s stock with it at-risk over the long-term.
Warren Buffett provides a useful illustration of this overall point. Mr. Buffett is the largest shareholder in Berkshire Hathaway, and he famously has an insignificant base salary and does not participate in any other incentive programs. He is as well-aligned as an executive can be with shareholders. As for decisions about capital allocation, his menu of options is the same as all others – reinvest in the business, pay a dividend, and/or repurchase stock. His aversion to paying dividends is well-documented, and this distaste is driven by his superior ability to reinvest in his business and generate high rates of return (something we assumed away in our model for illustrative purposes). Also, Buffett eschews dividends because of the tax advantages of buying back shares. He has pursued share repurchases twice – once in early 2000 and again in 2011. In his March 2000 shareholder letter[2], Buffett wrote (emphasis ours):
Recently, a number of shareholders have suggested to us that Berkshire repurchase its shares. Usually the requests were rationally based, but a few leaned on spurious logic. There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds – cash plus sensible borrowing capacity – beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down…
When available funds exceed needs of those kinds, a company with a growth-oriented shareholder population can buy new businesses or repurchase shares. If a company’s stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded. In most cases, those that did made their owners much wealthier than if alternative courses of action had been pursued. Indeed, during the 1970s (and, spasmodically, for some years thereafter) we searched for companies that were large repurchasers of their shares. This often was a tipoff that the company was both undervalued and run by a shareholder-oriented management.
That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around…
Of course, both option grants and repurchases may make sense – but if that’s the case, it’s not because the two activities are logically related. Rationally, a company’s decision to repurchase shares or to issue them should stand on its own feet. Just because stock has been issued to satisfy options – or for any other reason – does not mean that stock should be repurchased at a price above intrinsic value. Correspondingly, a stock that sells well below intrinsic value should be repurchased whether or not stock has previously been issued (or may be because of outstanding options)…
Some of the letters we’ve received clearly imply that the writer is unconcerned about intrinsic value considerations but instead wants us to trumpet an intention to repurchase so that the stock will rise (or quit going down). If the writer wants to sell tomorrow, his thinking makes sense – for him! – but if he intends to hold, he should instead hope the stock falls and trades in enough volume for us to buy a lot of it. That’s the only way a repurchase program can have any real benefit for a continuing shareholder.
We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated. Nor will we attempt to talk the stock up or down. (Neither publicly or privately have I ever told anyone to buy or sell Berkshire shares.) Instead we will give all shareholders – and potential shareholders – the same valuation-related information we would wish to have if our positions were reversed…
Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire’s price. Rather we will make them if and when we believe that they represent an attractive use of the Company’s money.
Jumping forward to 2011, Buffett again let shareholders know that Berkshire would repurchase shares whenever the price dipped below 1.1 times book value (since increased to 1.2 times book value) as he considered that price a substantial discount to intrinsic value. We are obviously supporters of this strategy, and we encourage Buffett and Munger to deploy their capital when Berkshire’s stock price is attractively below its intrinsic value. In fact, as long-term shareholders, we hope the market begins meaningfully mis-assessing Berkshire’s value and does so for a very long time. This market mistake would be a boon for the Fund – we would be given the opportunity to, on a look-through basis, own a progressively higher percentage of Berkshire’s future earnings without having to deploy a single dollar of additional capital.
Walmart, Arca, Embonor, Anheuser Busch InBev, and Lindley are also companies in the Fund’s portfolio that should be using this framework as a strategic tool to advance the long-term interests of their owners. Each of these businesses are controlled by a single owner or group of shareholders who are particularly long-term in focus and disposition. It is not by accident that six of the Fund’s eight holdings share this characteristic. We would enthusiastically applaud a period when these companies’ stock prices languish below our estimate of their intrinsic values. Rather than requesting that management call analysts in an attempt to change their minds about the value of the business, we would encourage these executives to allocate every appropriate incremental dollar of capital to repurchase their mispriced shares. Patient capital, like the Fund, that is focused on maximizing compounded annual returns over decades should use the advantages afforded to that temperament to gain an advantage over competitors forced to forgo long-term returns to satisfy short-term concerns.
The Importance of This Long-Term Mentality
Seth Klarman has opined that, “[H]aving clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.” We are fortunate to have partners who reinforce our distinctly long-term philosophy. Your support has allowed us to build structural advantages into our approach that promote the building of long-term wealth, including:
- We use an absolute value, instead of relative value, framework meaning we only make investments that satisfy our minimum expected rate of return requirements, rather than investments that happen to be cheaper than other existing options. We are more than willing to hold cash in the absence of these opportunities, as opposed to investors who are required to be fully invested at all times and must buy stocks even if prices are rich, risk is high, and potential returns are low or negative. We do not feel compelled to swing the bat when the best course of action is to wait for compelling opportunities.
- We are not worried about next quarter’s results for a business whose long-term prospects we like. As explored above, we prefer for the stock prices of the businesses we own to decrease over the short and intermediate-term. This disposition and discipline is difficult or impossible for most, but we believe our ability to be satisfied by delayed gratification is a major advantage as it allows us to own proportionally more of a company’s earning power over time at compelling valuation levels. We cherish opportunities to invest in the currently “unloved” where patience is rewarded.
- Our lack of concern with measuring our results relative to a benchmark over anything other than multiple market cycles allows us to concentrate the Fund’s capital only in our most compelling ideas. This willingness to absorb volatility and withstand tracking error is a prerequisite for market-beating returns over a long time horizon.
In our conversations with capital allocators, we remain surprised by how often those with long time horizons forfeit advantages like these. The reasons include: herding in an effort to not look too different, an unwillingness to stomach volatility, career risk, institutional financial pressures, management by committee, etc. We recognize the impact of these psychologies, and we are ultimately thankful for them as they provide the inefficiencies that, from time to time, produce truly compelling investment opportunities.
[1] We use a Student’s t-distribution when thinking about probability distributions for financial securities due to its robustness against departures from normality. We find the industry-standard assumption of normality to be dubious. For more on this topic, visit: https://www.cookandbynum.com/our-investment-approach/how-we-think/einstein-cern/.
[2] http://www.berkshirehathaway.com/letters/final1999pdf.pdf; ‘Share Repurchase’ section on pages 16 & 17.