Here’s why Warren Buffett loves share buybacks

You might have heard the phrase ‘share buyback’s thrown around quite a lot in recent years (although probably not since February). It’s a concept that has gotten a lot of media attention in recent years – and a lot of praise from investors.

Even the great Warren Buffett has waxed lyrical about buybacks over the years, saying he prefers them to straight dividend payments from his (meaning Berkshire Hathaway’s) holdings:

“Disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less” Buffett said in his 2012 letter to Berkshire Hathaway shareholders.

But why? Surely receiving dividends in cash is a better option to a share buyback for the average investor? Well, let’s have a look and see.

What is a share buyback?

A ‘share buyback’ program refers to a decision by a company’s management to use its cash to purchase its own company’s shares off of the open market. Once the shares are bought, they are ‘retired’ – it’s the opposite of a company issuing new shares to raise capital.

So how does this help investors? Well, say if Company A has 100 shares outstanding and you as an investor own 10. That would equate to a 10% ownership stake of that company and an entitlement to 10% of the company’s earnings.

But say Company A’s management decide to buy back 20 shares using the company’s profits. Now, there are only 80 shares of Company A on issue, meaning us, the investor, still owns 10 shares. But these 10 shares now represent 12.5% of the company’s ownership – meaning our stake in the company has increased. It’s a similar outcome to if the company paid out a dividend and you reinvested it instead (except without taxes getting in the way).

Are share buybacks always a good idea?

Not always. It can be deleterious to a shareholder’s long-term wealth if a company pays too much for its own shares – much like for an investor.

But conversely, it can be extremely beneficial if the company manages to buy back shares at a discount.

One of my own holdings – Magellan High Conviction Trust (ASX: MHH) – permits share buybacks if the trust’s unit price is trading under the net tangible assets (or real value) of each unit. Just last week, the trust informed the ASX that over $3.5 million worth of MHH shares were purchased on market for a price below what each unit is worth.

As a shareholder, I am very pleased with these actions for the reasons outlined above.

More reading

• How to make a $1 million share portfolio by investing $1,000 a month
• 2 ASX shares I would use for a starter ASX portfolio
• 3 shares to buy if the ASX shares crash again
• Are Magellan shares a high-conviction buy today?
• Where I’d invest $5,000 into ASX shares right now

Motley Fool contributor Sebastian Bowen owns shares of Magellan High Conviction Trust. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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