Warren Buffett on Buybacks & Boards
Capital Allocation and Governance Takeaways from Berkshire Hathaway's Annual Letter and Meeting
Welcome to the Nongaap Newsletter! I’m Mike, an ex-activist investor, who writes about tech, corporate governance, the power & friction of incentives, strategy, board dynamics, and the occasional activist fight.
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Warren Buffett recently shared some great insights on capital allocation and governance at Berkshire Hathaway’s May 2020 Annual Meeting (transcript, video) and in his 2019 Annual Letter that are worth highlighting and expanding on.
Good capital allocation and governance is conceptually straightforward, but Warren Buffett’s insights on buybacks and board dynamics highlight how difficult they can be to implement in practice.
Note: Obviously, this slide isn’t real but Warren Buffett did say: “…now you get this idiot that buys a farm next to you. And on top of that, he's sort of a nag, depressive and drinks, maybe smokes a little pot.”
Warren Buffett On Buybacks
“There’s a lot of crazy things said on buybacks. Buybacks are so simple. It’s a way of distributing cash to shareholders.” - Warren Buffett
Buybacks are a way to return capital to shareholders. It’s simply a capital allocation tool.
That said, I get why people politicize and/or hate buybacks. When a company’s stock price goes down, buybacks represent a directly measurable decision people can identify and blame. It’s much harder to attribute similar (misplaced) blame on dividends, acquisitions, or internal investments for a stock’s demise.
Buybacks also carry an anti-innovation and “short term” stigma despite sound capital allocations principles being (in my opinion) a great way to attract and retain talent and lowers the cost of capital to pursue more long-term growth initiatives. When done correctly, you end up being a more innovative company.
Overall, I think much of the hate for buybacks is misplaced. If you want to improve “bad” buybacks, you need to improve “bad” (daresay nonexistent) capital allocation processes that determine when and how to execute a buyback program:
“Now whether the company should [buyback stock], depends on a couple of things. One is they ought to retain the money they need for intelligent growth prospects. That's fine.
And secondly, and this is a point that's never mentioned, they should be buying it back below what they think it's worth. Now they'll make mistakes in that, but you make mistakes in a lot of business decisions, but all of that should be the guiding principle.” - Warren Buffett
Implementing a thoughtful buyback program sounds straightforward, but it’s a nuanced process and requires a lot of work to get right.
First, you’re dealing with all sorts of company politics and debates just to determine baseline growth investment needs and “excess” capital.
Then you need management to produce a multi-year financial forecast based on those baseline figures in order to estimate the company’s “base case” intrinsic value. Keep in mind the “base case” can swing widely depending on whether or not compensation is also tied to the financial plan (interestingly, growth expectations tend to come down when tied to compensation).
Without this forecasting and valuation process in place, it’s hard for the Board to properly assess if buybacks are appropriate versus alternative uses of capital. In lieu of a systematic capital allocation process, companies often end up adopting a generalized and often rigid buyback policy. This rigidity is how buybacks end up with a bad reputation:
“But you read about all these buyback problems that we're going to spend $5 billion buying it back or $10 billion. Well, that's like saying I'm going to go out and buy some business this year for $5 billion without knowing what you're going to get for the money.
It should be price-sensitive, obviously. It should be need-sensitive, obviously. But when the conditions are right, it should also be obvious to repurchase shares, and there shouldn't be the slightest taint to it anymore than there is to dividends.”
- Warren Buffett
Buying back stock based on an arbitrary repurchase authorization is a bad policy. It also sets the company up for potentially value destructive outcomes. If you’re going to embrace buybacks, you need to embrace a comprehensive capital allocation process which also includes accounting for growth investments and business risks:
“I've been witness to some [buyback] programs where it really is stupid. But I don't think it's immoral. I think it's stupid, basically. And on the other hand, we favor companies that take care of all our requirements for growth. And…maintain sound balance sheets and all of that, leave a margin of error or things that you can get surprised with. And if they find their stock selling below the -- what the business is intrinsically worth, I think they're making a big mistake if they don't buy in their stock.” - Warren Buffett
In summary, buybacks are simple but implementing a sound capital allocation process is hard. It takes a lot of work and requires buy-in at the top. If a key power broker is reluctant, Board dynamics ensures implementation is incomplete and/or poorly executed.
What “Board dynamics” am I referring to?
Luckily for us, Warren Buffett walks us through some of the nuances and friction of inter-personal Board dynamics in Berkshire Hathaway’s annual letter. Spoiler alert, no one is sticking their neck out and risking their directorship gravy train over buyback policies.
Warren Buffett On Board Of Directors
I’m really curious what compelled Warren Buffett to dedicate a significant portion of his 2019 Annual Letter to Board of Directors, corporate governance, and Board dynamics.
Regardless of the reasons, we are treated to some timeless insights.
“The bedrock challenge for directors…remains constant: Find and retain a talented CEO – possessing integrity, for sure – who will be devoted to the company for his/her business lifetime. Often, that task is hard. When directors get it right, though, they need to do little else. But when they mess it up,......” - Warren Buffett
Finding a world class CEO (and executive team) really is a deus ex machina for all sorts of company shortcomings, including capital allocation and governance holes. It doesn’t completely offset a business with bad economics (i.e. “the reputation of the business remains intact”), but a great CEO can take you very far.
Just keep in mind that superstar CEOs aren’t infallible and are still human. Personal and company regression can still happen if the CEO is tempted by the wrong incentives or there are non-existent governance guard rails to course correct unacceptable, often ego-driven, behaviors.
“[Audit] committees remain no match for managers who wish to game numbers, an offense that has been encouraged by the scourge of earnings “guidance” and the desire of CEOs to “hit the number.” My direct experience (limited, thankfully) with CEOs who have played with a company’s numbers indicates that they were more often prompted by ego than by a desire for financial gain.” - Warren Buffett
Ego is an under appreciated driver of many head scratching “off the rails” decisions, and it’s not just restricted to CEOs. Board members and their egos can push the envelope on propriety as well. Often times, optics and protecting one’s reputation can supersede acknowledging mistakes and reseting to an appropriate course of action.
Even if other directors want corrective changes, “collegial culture” makes dissent difficult and independent directors are incentivized to not rock the boat:
“Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. Frequently, the possession of one such directorship bestows on its holder three to four times the annual median income of U.S. households.” - Warren Buffett
Financial incentives aside, the reality is independent directors typically don’t challenge the CEO or other power players on the Board (at least not directly).
As highlighted in PwC’s 2019 Director Survey, this deferential dynamic can create a lot of (unaddressed) friction:
Nearly half of directors (49%) say that one or more directors on their board should be replaced—a high water mark for PwC’s survey.
61% of directors on boards with CEO chairs say that at least one fellow director should be replaced—compared to just 47% of directors on boards with an independent chair or a lead independent director.
43% of directors say it is difficult to voice a dissenting view in the boardroom.
57% of directors on boards with a CEO chair say it is difficult to voice a dissenting view in the boardroom.
Needless to say, the side effects of this dynamic are numerous and lay the foundation for this newsletter’s existence. We still have a ways to go to fix Board dynamics.
There are windows of opportunity, especially during crisis, to push for meaningful changes but you need to pick your battles. In the mean time, pay attention to Board power dynamics and recognize how those dynamics can impact long-term value.
The Need For Investor Perspective
Warren Buffett (based on my interpretation of the letter) also touches upon a concept I call “investor perspective” and its absence within Boards:
“Not long ago, I looked at the proxy material of a large American company and found that eight directors had never purchased a share of the company’s stock using their own money. (They, of course, had received grants of stock as a supplement to their generous cash compensation.) This particular company had long been a laggard, but the directors were doing wonderfully.
Paid-with-my-own-money ownership, of course, does not create wisdom or ensure business smarts. Nevertheless, I feel better when directors of our portfolio companies have had the experience of purchasing shares with their savings, rather than simply having been the recipients of grants.” - Warren Buffett
Directors buying stock with their own money seems like a trivial gesture, but the act makes them think about valuation and requires them (however fleeting) to view the company with an “investor perspective”.
In my opinion, the long-term public investor perspective is underrepresented in Boards. That’s not to say directors and management aren’t thinking long-term, but knowing how the market values their decisions (or how to communicate those decisions) is generally not a core competency.
Yes, some CEOs have a wonderful intuitive sense for value, and it would actually behoove them to codify their thinking and process at the Board level if possible.
For those interested, I dive into the importance of investor perspective and how corporate governance is the achilles’ heel of “high quality” companies.
Conflicting Investor Perspectives
One thing I want to make very clear is an investor perspective does not always mean alignment. The priorities of a long-term public investor will likely differ from the priorities and time horizon of an activist investor, a private equity investor, or a VC investor. It can also differ from what management thinks is the best course of action long-term. That’s not necessarily a bad thing, but management, Boards, and investors have to be mindful of the differences and balance perspectives.
This is especially important today as COVID-19 pushes companies into crisis. We’re now seeing the emergence of private equity investors getting a seat at the governance table in exchange for emergency capital (via convertible debt). This is going to quickly change the power dynamics of Boards, and public investors will need to pay close attention.
If the conflicts of paying a “non-wealthy director” $250,000-300,000 is a concern, the economic conflicts and concerns brought on by private equity directors are on another level.
Conflicting Investor Perspectives: Occidental vs. Kraft
Incidentally, Berkshire’s May 2020 Annual Meeting highlights the risks of conflicting investor perspective between public investors and strategic investors:
Investor Question: “As both a Berkshire and Occidental shareholder, I was encouraged to see your investment in the company. But with passing weeks, it became evident that your investment facilitated Occidental management's ability to avoid a shareholder vote on the Anadarko acquisition, a very shareholder-unfriendly outcome. This deal proved to be irresponsible and expensive from an OXY perspective and ultimately very value-destructive for OXY shareholders. In my view, it also permanently hurt Berkshire's reputation in the marketplace. Please comment on this unfortunate outcome and tell me why OXY shareholders and other market observers shouldn't feel this way.”
Warren Buffett largely side stepped this question, but the fallout of Berkshire Hathaway investing in Occidental Petroleum as a strategic investor to fund the Anadarko acquisition and deny Occidental shareholders a vote is still being sorted out today as Occidental deals with record low oil prices.
The Occidental situation is especially interesting when you consider 10 years ago Warren Buffett was on the other side of the table in a similar situation as a Kraft shareholder opposed to acquiring Cadbury, but was denied an opportunity to vote on the deal.
At the end of the day, views on governance will be shaded by personal interests and incentives. Like I mentioned earlier, superstar CEOs aren’t infallible and are still human. Personal and company regression can still happen if the CEO is tempted by the wrong incentives.
Warren Buffett got tempted to overlook governance deficiencies at Occidental and it ultimately bit him.
A Business So Good Even Idiots Can Govern It
As you think about the role of governance and capital allocation in driving long-term value, don’t forget Warren Buffett’s “good business” rule is just as applicable to governance as it is to management:
“If you've got a good enough business, if you have a monopoly newspaper, if you have a network television station — I'm talking of the past — you know, your idiot nephew could run it. And if you've got a really good business, it doesn't make any difference.” - Warren Buffett (source)
Sometimes a business is so good even idiots can govern it.