Thursday, 21 February 2019

Flawed thinking on buybacks, and why buybacks are still underutilized

Something I encounter repeatedly in the world of investment commentary/analysis is a lot of flawed thinking and fundamental confusion about the issue of dividends vs. corporate buybacks. You'll often hear people say things like "I would prefer the company reduce the dividend so it can increase buy backs, as the shares are undervalued", or "management shouldn't be buying back stock at current elevated prices; they should instead be returning excess capital to shareholders via dividends".

A lot of this confusion has been caused by Warren Buffett's past discussions of buy-backs, which have muddied many investors' thinking. Buffett has simultaneously noted that companies should only buy back shares when they are trading at an appreciable discount to intrinsic value, while he has also said, in differing contexts, that companies that cannot find productive ways to reinvest capital into their businesses (where at least one dollar of intrinsic value is created for every dollar retained), should instead return excess cash to shareholders. This seems to imply companies should return capital to shareholders via dividends, unless a company's shares are undervalued.

I will argue that the latter is a flawed perspective, because the truth of the matter is that - tax efficiency considerations aside (discussed later) - when it comes to returning excess cash to shareholders, dividends and buybacks are essentially identical in nature. As is often the case, the issue lies not with Buffett having misunderstood the issues, but instead with investors having taken what he said out of context. Buffett's buyback remarks were likely intended for a context where a company does have productive means to reinvest capital internally, and therefore buybacks do not represent the return of excess cash to shareholders, but rather an active decision about where to best allocate scarce capital. In this situation, the prospective returns on buybacks need to compete with the prospective returns on corporate reinvestment projects, and assuming a company is only reinvesting in projects with a decent return on capital, such buybacks should therefore only be undertaken when the stock is meaningfully undervalued. I will describe these as opportunistic buybacks.

However, the situation is completely different where a mature company has limited reinvestment prospects and has excess capital that needs to be returned - one way or another - to shareholders, and I do not believe Buffett's buyback comments should be interpreted as suggesting Buffett favours dividends over buybacks, regardless of factors such as tax efficiency. When it comes to returning excess capital, dividends and buybacks are actually functionally equivalent, and after allowing for tax considerations, buybacks are usually the vastly superior option. I will refer to these types of buybacks as capital return buybacks.

Here is the proof. Let's scrutinize the claim that a company should 'cut the dividend to increase buybacks'. This statement overlooks the fact that if you are a shareholder and are receiving those dividends, you can use those dividends to purchase more shares, and in the process, create your own 'synthetic buyback'.

Consider a situation where a company is generating stable distributable earnings of $10 per share; the stock trades at $100 per share; and the full $10 is paid out as a dividend (10.0% dividend yield). We will ignore taxes for the moment. If I own 1,000 shares (worth $100k), I will receive $10k in dividends, and assuming the stock continues to trade at $100, I will be able to purchase another 100 shares with the proceeds. One year hence, I will own 1,100 shares worth $100 per share, with a market value of $110k.

Now, let's say at the end of year one, the company decided to undertake a 10:11 share consolidation, or cancel 1 out of every 11 shares. Everyone knows that share splits or consolidations (reverse splits) do not impact underlying value, so that point need not be argued. After the share cancellation, I would now own 1.0k shares instead of 1.1k, and they would be worth $110 instead of $100. In both cases (before and after), my second-year dividend income would be $11k. Before the reverse split, I would receive $10 per share on 1.1k shares, and after, I would receive $11 per share on 1.0k shares.

Importantly, this is exactly the situation I would be in if the company had bought back shares instead of paid a dividend. If instead of paying a dividend at year-end and then conducting a reverse split, the company had instead used the $10 of earnings to buy back shares at $110 at year-end ($110 being $100 plus the $10 of undistributed earnings), it could buy back 1/11th of the company's stock. Post buyback, the shares would trade at $110 with $11 in distributable earnings per share the following year, due to the reduced share count. I would still own my 1.0k shares, and would be entitled to $11k of distributable earnings the next year. In essence, capital return buybacks are actually little more than a form of automatic dividend reinvestment.

Now let's consider the inverse situation, where it is claimed a company should not buy back shares, because they are not undervalued, and should instead return excess capital to shareholders via dividends. This is also an equally flawed approach, because just as investors can create a 'synthetic buyback' by reinvesting their dividends, they can also create a 'synthetic dividend' by selling shares on market in proportion to the company's buyback, yielding cash while maintaining a constant percentage ownership in the company. Indeed, this is exactly what Buffett has been doing in recent times with his shareholding in Wells Fargo, where he wishes to keep his shareholding below 10% of the total company for regulatory reasons. He sells shares on market in proportion to the amount of shares WFC buys back, thereby preserving his shareholding at about 10%.

Let's continue our example, where after one year, the company has bought back 1/11th of its stock, and the shares are trading at $110. I have the same number of shares (1.0k), but they now represent a larger percentage ownership of the company, as the share count has shrunk. That is why they are now worth $110 (US$110k). If I am in need of income, and want to receive $10k in cash, I can create a synthetic dividend by selling 1/11th of my shareholding at $110, yielding $10k. I will now own 909 shares worth $100k (at $110 per share), and will have $10k in cash. My percentage shareholding will now be the same as it was at T=0, and my dividend the next year will be 909 x $11.00, or $10k - exactly as before (the DPS has grown due to the reduced share count). I have created a synthetic dividend.*

Furthermore, the company could at this point conduct a 11:10 split, or a 1:10 bonus issue, to return the share count to its pre-buyback level. Post split, I would end up with 1,000 shares worth $100, instead of 909 shares worth $110, and be in exactly the situation I started (with my $10k effective dividend).

For these reasons, the debate which often happens as to whether a company should return capital to shareholders via dividends or capital return buybacks often makes little sense. By contrast, what does make sense in the real world - but which ironically is seldom discussed - is the tax consequences of one choice over the other, which can be material, and in the majority of cases, favours buybacks. Unless there are practical liquidity constraints limiting the ability of a company to implement a sufficiently-large buyback, tax considerations ought to be the primary determinate of the choice between dividends and buybacks.

Buybacks convert dividend income into capital gains, and in most jurisdictions, capital gains - particularly long term capital gains - are taxed at a lower rates than dividend income. Furthermore, capital gains taxes are deferable, as they are typically only payable when a position is sold, and this also carries very meaningful advantages for long term holders.

As Warren Buffett has explained in the past, when deferred capital gains taxes are accrued but not yet payable, they function like a perpetual, unsecured, interest-free loan from the IRS, where the principal amount of the loan also falls if the capital value of the shares fall.

For instance, let's say I had bought and held the said company in our initial example at $100, and through many years of compounding buybacks, the stock price had risen to $300. Let's say long term capital gains taxes were 25%, which have been accrued but are not yet payable. I now have a gross position of $300, and a deferred tax liability of $50 (25% x the $200 gain), for a net carrying value of the position of $250.

In economic terms, the gross $300 position is leveraged by 16.7%. If the stock rises further to $400, the gross asset return is 33.3% (or 24.9% net of 25% taxes). However, the net value of my $250 position would rise to $325 (now net of $75 of deferred taxes), or by 30.0% after tax, which is 5ppts higher than it would be for someone initiating a position at $300 without this deferred tax leverage.

Furthermore, on the downside, this leverage does not function like a normal margin loan. Not only does it not accrue interest, or face any risk of being withdrawn and hence forcing liquidation, but its size also automatically shrinks if the stock price falls. If the shares fall to say $200, the deferred tax liability will shrink to $25. It is therefore a wonderful way to leverage your returns in a low risk way.**

What this means in practice is that most of the time, buybacks are the far more tax efficient means or returning excess capital to shareholders than ordinary dividends (which are often subject to immediate taxation at shareholders' marginal tax rates, which are usually higher than long term capital gains rates). There are some exceptions (such as Australia/NZ where dividend imputation exists), but they are in the minority.

Consequently, buybacks should be vastly more prevalent than dividends, and in the US at least, they increasingly are. Outside of the US, however - particularly in Europe - many companies continue to pay large dividends subject to high taxes, while returning very little by way of buybacks. Outside the US, opportunistic buybacks are really the only sort of buybacks undertaken, and even then, are undertaken far less often than they should be. Indonesia, for example, has 10-20% dividend taxes, but no capital gains taxes on domestic equities, and yet buybacks in Indonesia are vanishingly rare. It makes no economic sense. Major holders could create tax-free synthetic dividends by buying back stock and then selling shares into the market in proportion, and yet they don't.

There has been a lot of hand-wringing in recent years about the high pace of buybacks in the US, but high buybacks and low dividends is actually the economically rational course of action from the perspective of shareholder value maximisation, and companies should be applauded by analysts for prioritising buybacks, not condemned. And the truth is, even today, US buybacks are still far rarer than they should be, given current tax rates.

If there was more clear-headed thinking about the issue of buybacks, some of this misguided criticism might subside, and better yet, more companies outside of the US might consider following the US example. Here are the rules of buybacks from LT3000:


LT3000's buyback rules


*There are two types of buybacks - opportunistic buybacks and capital-return buybacks. They should not be conflated or confused.

*Opportunistic buybacks should be undertaken only when the shares are undervalued, and the rate of return being offered on capital committed to buybacks exceeds the risk-adjusted return that can be achieved from reinvestment into the business.

*Capital return buybacks are fundamentally different to opportunistic buybacks, and tax considerations aside, are functionally equivalent to dividends. However, the tax treatment of dividends and buybacks can vary significantly. In the absence of share trading liquidity constraints, whether dividends or buybacks are to be preferred should be purely a function of tax efficiency considerations.

*In most (but not all) cases, buybacks are more tax efficient than dividends. The tax benefits of buybacks should consider not only the differing rates of long term capital gains taxes and dividends, but also the value of the deferability of CGTs. If buybacks are more tax efficient, all capital returns should take the form of buybacks, and if dividends are more tax efficient, then all capital returns should take the form of dividends.


LT3000


*Some might argue at this point, 'but what if the company shares are overvalued'? If the shares are overvalued, investors will receive either a subpar dividend yield or a subpar buyback yield, and it makes no difference which is incurred. The problem is the stock's overvaluation, not the means by which excess cash is returned to shareholders. Furthermore, presumably, at any given time, all existing shareholders do not believe the shares to be overvalued, or else they would not hold them in the first place. 

**This is one reason why Buffett holds on to fully-valued positions like Coke after they have risen many many multiples from his original purchase price - the value of the interest-free deferred tax leverage is too significant to relinquish, and significantly reduces the effective economic P/E multiple. Note that Berkshire's book value is net of accrued but unpaid deferred tax liabilities, and this significant deferred tax leverage (along with float leverage) has contributed meaningfully to Buffett's performance in recent decades.  




23 comments:

  1. All of the points above apply well if the stock price is constant and approximates fair value. The tax treatment is also a good point that is usually ignored. I disagree that overvaluation is irrelevant though. It's clear that if the stock price is cheap, buybacks are superior to dividends in that management can purchase more ownership than normally would be the case per dollar of shareholder funds and so would allow for higher returns than dividends (because the cash returns to owners would be the total market value of shares bought plus the capital gains being the difference between the current stock price and its fair value). The same should apply if the stock is overvalued. If it is overvalued, you can distribute a certain amount of cash to owners via a dividend and that cash balance is constant regardless of the stock price. With buybacks however, owners lose money if they are occurring in an overvalued stock, as they will experience a capital loss being the difference between the current stock price and fair value, so they should lead to lower returns than dividends would.

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    1. Thanks for your comment Aaron,

      I understand where you are coming from, and that is also the view I used to hold, but I've changed my mind and I now frame it differently. My argument is that a buyback is like a dividend with compulsory reinvestment.

      Now obviously we all prefer to own cheap stocks on high dividend yields & thus with superior reinvestment prospects, but investors in the aggregate have to settle for the market clearing level of valuations. What I would argue is that existing shareholders obviously don't think the stock is overvalued, otherwise they wouldn't own it. And if they do think it's overvalued, they can either sell out, or sell down shares in parity with the buyback to avoid increasing their stake.

      Buying back shares at a lower price is better than at a higher price. So is receiving dividends - you can reinvest them at a low price instead of a high price. The problem is the high price of the stock, not the method of returning capital.

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  2. I see your point and again, it remains valid as long as stock prices remain stable or if we operated in efficient markets where management had no reason to value the stock. If stock prices can be wrong or change rapidly, as they do, then it become clear very quickly how well management has allocated funds towards a buyback. When management forces reinvestment at high stock prices it dilutes returns, and they should have the wherewithal to assess the situation given that most shareholders can't. You can choose to reduce your stake, but the point remains that if management is buying back when the stock is overpriced they are destroying wealth unless if you immediately sell that additional ownership at overvalued prices. At a low price if you reinvest after receiving a dividend, firstly I believe you pay tax on the dividend which is why management should've bought shares back for you and secondly dividends can come later and the valuation may have changed by then, whereas shares can be bought back immediately if a plan is in place. Owners should be entitled to a proper return of cash and I'm not a fan of saying they can just sell out. Let's say the firm is growing at 20% year for example, so temporary overvaluation doesn't matter much- few will sell it but if management is wasting cash "returning it" to shareholders at current prices because they view it as equivalent to a dividend or are unable to value the firm, the returns for owners would be lower than if they waited to buy at reasonable prices. I think it matters because most management agree with you on equivalence and view buybacks as superior given the tax benefit, and since most management believe the stock price mimics reality they buy it back at any price (corporate management are really terrible at stock valuation and it benefits their options to force the reinvestment through buybacks rather than dividend it out). There are a lot of examples in which shareholder funds have been thrown away in an overvalued stock due to this belief. I dont think it should be the long-term owner's job to sell out after their management has wasted funds through ineffective buybacks, there seems to be something inherently wrong with that to me. Management are stewards of the company and shareholder capital, they should be able to assess these options well and not waste funds, regardless of whether each shareholder can or can't.

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    1. Hi, Aaron. I think LT's point is that if your main concern is expressed in this line:

      "Owners should be entitled to a proper return of cash and I'm not a fan of saying they can just sell out."

      that you can effectively create that return of cash by selling down only the incremental % of the company that you now own due to the reduction in shares. In other words, nothing prevents the shareholder from capturing their share of any cash returned. But I understand that this might remain an unsatisfactory answer, as it creates a job for a shareholder that they otherwise would not have if they simply received the cash in the form of a dividend.

      The bigger issue in the discourse, especially now that people are talking regulating or taxing buybacks in the U.S., is the confusion not merely over the equivalence of buybacks and dividends, but also over the idea that buybacks tend to "push up share prices" to the benefit of capital. Everyone understands that the share count is reduced, but seem to lose sight of the fact that the cash in the company (a component of equity value) is reduced as well. I see pros in the industry still laboring under this illusion, as well, so just think of how easily non-experts are led to believe that capital is capturing some illicit gain through "financial engineering" and that this gain should be prohibited or otherwise taxed. Which might be fine if the gain existed. Of course, I understand that there are other arguments for banning buybacks, primarily of the sort that imagines by restricting the field of action, certain preferential actions will be more likely to occur (wage increases, reinvestment). I am opposed on the grounds that what is really being argued for is less freedom and more inefficiency.

      Hope this contributes. Thanks to you both.

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    2. You are right on the point that buybacks should not push up the share price anymore than dividends do given the effect on the firm's cash balance, although I do believe in practice, management tend to focus on the eps and so are willing to buy the stock back at any price, forcing this issue whereby all shareholders would have to sell their increased stake in an overpriced stock in order to not have lost wealth. The eps focus, along with tax savings and the possibility that market participants also care about eps more than they should I think primarily is why management would more often than not prefer buybacks to dividends even if they were taxed similarly and even when the stock is overpriced. Certainly in the long-run as you say there is no additional gain produced unless the stock is undervalued, I think it just may be a principal vs agent problem where the incentives are skewed towards management acting in their own interests as the firm's net debt levels are often less cared about than eps in the short-run. Although it may be an important and interesting issue due to public perception, I don't really have any opinion on tax treatment- my main concern was about management acting to the detriment of shareholders.

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    3. My thoughts on the principal vs agent issue is easiest for me to link to in the Twitter thread starting here (TLDR: I don't disagree with your concern, although rereading the thread, it doesn't address your specific concern on "eps focus", so I try to do that further below):

      https://twitter.com/willandidea/status/1094740211672797184?s=20

      What is relevant to your concern in the thread are the issues surrounding expecting a mgmt team that need only be expert in operations and project evaluation to be expert, more broadly, in business valuation and investing. Basically, if mgmt has excess cash, by defn you don't want them reinvesting in their business, as to call the cash excess is to say that any investment would mean overinvesting. What to do instead? One could argue that mgmt should keep the cash on the balance sheet instead of doing a "value destructive" buyback, which would give them the option of doing a value neutral or value accretive buyback at a later date and at aa lowe share price. But if instead, mgmt gets that excess cash out of the company as quickly as possible, you as the shareholder will then have that cash to buy at the same prices at which you are merely hoping mgmt will buy back shares in the future, but also the optionality to use that cash in all the other possible ways. This would seem to favor returning cash immediately rather than focusing on when a buyback should be done (LT's point, I think). And if we ultimately conclude that excess cash should always be returned as quickly as possible, then I still think it's helpful to know how either dividends or buybacks can be used to achieve that end. And I agree, there will be conditions which make the dividend more attractive, but LT has also highlighted just a few of many cases I can think of where I'd prefer buybacks be employed.

      You also make good points on eps-focus, but either you believe mkts are basically efficient with respect to that sort of thing (in which case it's a myth that doesn't really influence values and prices) or else inefficient, in which case we should benefit from the inefficiency of investors and mgmts overvaluing EPS "growth," i.e., growth that is only growth because it was bought expensively via buybacks and not attractive reinvestment opportunities.

      Hope all that sounds fair. Thanks, again.

      PS: One other thought-provoking take on buybacks I've come across lately, is this one. Thought I'd link it:

      https://medium.com/@byrnehobart/alpha-buybacks-and-beta-buybacks-ca710997536e

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    4. All fair points and I take your argument and Lyall's quite well. The article recites many of my concerns and also states that your argument stands only under the assumptions that the stock is fairly priced and that investors are reinvesting all returns of cash, which is often not the case and so I believe (and the authors agree) a bit of nuance applies. To an active investor either immediately selling or reinvesting (assuming tax treatment is similar, which it isn't) it doesn't matter if you're paid dividends when the stock is undervalued or if you're given additional ownership when its overpriced. The issue of the commons remains in that not every investor can capture that lost wealth if overpriced shares are repurchased, as not all of them can sell their shares, so management has given a capital loss to someone- what one investor may be able to do, the rest cannot. We agree that to an active investor it may not matter much although tax treatment usually favors one or the other depending on the valuation. Your statement that we benefit from market efficiency may be true if you own an overpriced stock and sell, but again, that loss has been passed to long-term owners who keep the burden. I probably agree that a "value investor" can't expect management to ascertain the stock's fair value, but it should be known that their decisions will have an impact on the returns of most shareholders. In any case, I think this is my last comment since I've gone full circle here. Appreciate the responses and thoughts.

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    5. It's a good point about how dividends ensure that every owner is treated equally in a way that buybacks can't. Maybe it would just be helpful if more investors and mgmts went through the kind of exercise we've now gone through, thanks to more people like LT writing clear essays on the topic. I think they'd agree with you that buying back extremely overvalued shares might pose a problem that any advantages buybacks might otherwise possess can't compensate for. For you're right that there are practical considerations and not merely theoretical ones. On the other hand, better appreciating some of the points LT has made, one might concede that there is a wide range of values at which shares might be bought back, even slightly overvalued levels, which are not problematic and will often be superior to dividends for investors.

      As for your principal-agent concerns, those are also important. Bad mgmt is bad mgmt, and buybacks are definitely a way that a bad mgmt can find ways to express its badness.

      I would only add that the mkt efficiency argument also applies to your concerns regarding excessive net debt levels (see bad mgmt, again), and the excessive net debt level concerns apply as much to companies that have supported and paid out excessive dividends as much as excessive buybacks.

      I think you're right that we've probably each made the points we're most eager to make. I appreciate your thoughts and responses, as well.

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    6. I would certainly concede the range of overvaluation at which buybacks are superior to dividends is likely quite wide. Cheers.

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  3. When you say, "where at least one dollar of intrinsic value is created for every dollar retained", do you mean investing in a manner that increases the return on equity of the business?

    That's Roger Montgomery's definition of growth that increases wealth, and Roger has suggested several times that businesses should not invest additional capital if it causes the RoE to decrease.

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    1. Sorry, it should be earnings yield rather than RoE.

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  4. Good article Lyall. Of course, you're probably pushing shit uphill. I can't even get through to an (otherwise well managed) unlisted company that's paying out unfranked dividends at the same time that it's raising fresh capital.

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    1. Gareth - yes totally agree. The quality of thinking on this issue amongst many corporates is indeed woeful.

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  5. Look at what STMP just did! The buybacks weren't a "waste" - selling shareholders sold at a high price and received cash (the money makes its way into the economy) but they screwed remaining shareholders because they did this knowing the stock was overvalued due to big upcoming guidance cut.

    I believe it's fair to ask management to act in the best interest of remaining shareholders.

    Though the net impact is the same (i.e. cash makes it's way into the economy), the buybacks benefit remaining vs. selling shareholders based on whether the stock is overvalued/undervalued.

    How many of us would want to own a company like STMP, where management allows shareholders to exit at the expense of the suckers who put faith in management?

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  6. How do the tax considerations effect people/funds who are domiciled in low/no tax territories?

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    1. It means buybacks are almost always more tax efficient. My fund is Cayman domiciled for instance. It is not subject to tax. However, most countries implement some form of automatic dividend withholding tax, which can often be as high as 20-30%. Very few countries tax capital gains based on source, however, so for a Cayman fund, capital gains are almost always tax free.

      As a result, all else held constant, I prefer companies that buy back stock instead of paying dividends, as it's far more tax efficient.

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  7. Ah I didn’t appreciate the withholding tax. Do countries like Russia Indonesia and China withhold tax for dividends? Thanks.

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    1. Yes they do. Indonesia & Russia withhold 20%. China 10%. Cheers

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  8. Shareholders getting upset at buybacks vs dividends because it might be value destructive are so silly. Why you holding overvalued stock then? Why not sell and buy something that is undervalued?

    So in theory the vast majority of shareholders everywhere believe they either hold undervalued or fairly valued shares, so getting upset at buybacks seem a bit silly.

    Although if a stock is more binary I can see it, since getting dividends would derisk it vs spicing return in case things go right (like with a dying business for example). But calling it value destructive would still be silly in that case.

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    1. In the most recent BRK report:

      "Earlier I mentioned that Berkshire will from time to time be repurchasing its own stock. Assuming that we
      buy at a discount to Berkshire’s intrinsic value – which certainly will be our intention – repurchases will benefit both
      those shareholders leaving the company and those who stay.
      True, the upside from repurchases is very slight for those who are leaving. That’s because careful buying by
      us will minimize any impact on Berkshire’s stock price. Nevertheless, there is some benefit to sellers in having an
      extra buyer in the market.
      For continuing shareholders, the advantage is obvious: If the market prices a departing partner’s interest at,
      say, 90¢ on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by
      the company. Obviously, repurchases should be price-sensitive: Blindly buying an overpriced stock is value destructive, a fact lost on many promotional or ever-optimistic CEOs."

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    2. First Anonymous - exactly. The criticism of companies buying overvalued shares usually derives from people that do not own shares in the company. But why should they have any say? A company should be answerable to its own shareholders, and those shareholders wouldn't be holding the shares if they believed them to be overvalued.

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    3. Second Anonymous - Buffett still seems to not be addressing the issue of how Berkshire should distribute capital if it deems itself to have EXCESS capital and wants to distribute it either via dividend or buyback. Berkshire has never had to cross that bridge in the past, although it likely will have to some day. At that point, I suspect they will select the option that is most tax efficient.

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  9. Great article as usual although I disagree that stock buyback is almost always better than dividends. I think you are ignoring principal-agent problem inherent in modern corps. The sporadic nature of buybacks vs. sticky dividend payouts provide management with an opportunity to signal to shareholders that they will be disciplined capital allocators. Such signals are valuable to shareholders, especially in countries where corp governance / minority rights are weak. So investors in weak governance countries should value a dollar of dividend higher than buyback, all else equal. This can account for the fact that stock buybacks are emphasized in the US while dividends are emphasized in Europe and Asia.

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