What Buffett's rare buyback says about large-caps

Warren E. Buffett's determination that Berkshire Hathaway Inc. (BRK/A) shares are cheap enough to buy back may mean that the S&P 500 also is a bargain. The company has been authorized to repurchase stock for the first time in four decades, as long as its price is less than 1.1 times book value, or assets minus liabilities, according to a statement last week. The level is 29% below Berkshire Hathaway's average of 1.55 since 2000, almost the same discount that investors are getting in the S&P 500, according to data compiled by Bloomberg. On Sept. 22, shares of Berkshire Hathaway fell to $100,000 for the first time in almost two years. Declines that have erased about $2.8 trillion from the value of American equities in the past two months are luring Mr. Buffett, who said that his company spent more to buy stocks Aug. 8 than any other time this year. The S&P 500 tumbled 6.7% that day and has lost about 15% from its 2011 high April 29, driven down by concerns that Europe's debt crisis will spread and shrink the global economy. “If he thought the possibilities of a recession were on the horizon, then he'd wait to do this,” said James Dunigan, who helps oversee $109 billion as chief investment officer for PNC Wealth Management. “You can make a number of arguments that on some traditional measures, the market is undervalued.” Mr. Buffett didn't respond to an interview request e-mailed to his assistant, Carrie Kizer.

MARKET VALUATIONS

Repurchasing Berkshire stock is a bet that market valuations are too low, partly because so many of its investments are public, said Mark Luschini, chief investment strategist at Janney Montgomery Scott LLC, which manages $54 billion. Berkshire Hathaway owns stakes in 27 companies whose trading is overseen by the Securities and Exchange Commission, an August filing showed. “This announcement is a bit out of character. For that reason, it is seen as very constructive, both in terms what he sees as an opportunity to buy a great asset, namely Berkshire stock, trading at a discount to historical book value, as well as the portfolio of companies within Berkshire that he thinks is undervalued,” Mr. Luschini said. The plan may signal that Mr. Buffett, Berkshire Hathaway's chairman and chief executive, is finding fewer opportunities in the stock market, said Michael Shaoul, who helps oversee more than $1 billion as chairman of Marketfield Asset Management LLC. Although the S&P 500 is priced close to the same discount to its historical book value as Berkshire Hathaway, fewer than 20% of its companies are trading below the 1.1 ratio Mr. Buffett requires for his own repurchases, data compiled by Bloomberg show.

"NOT A DIME'

In the past, Mr. Buffett has preferred to use profits to buy companies and securities issued by others. “Not a dime of cash” has been spent on buybacks or dividends in four decades, the billionaire told investors in his annual letter, published Feb. 26. Mr. Buffett invested $5 billion in The Goldman Sachs Group Inc. (GS) and $3 billion in General Electric Co. (GE) in 2008 when the Lehman Brothers Holdings Inc. failure cut companies off from traditional sources of funding. Archer-Daniels-Midland Co. (ADM), the biggest U.S. grain processor, CME Group Inc. (CME), the largest futures exchange operator, Goldman Sachs, the securities firm, and 89 other companies have price-to-book multiples below 1.1, the data show. Excluding intangible assets, such as goodwill, 47 of the 500 companies in the benchmark U.S. equity gauge meet the criteria. “It could be argued that if the market is cheap, in his view, he could find something else to buy instead of his own stock, since making timely acquisitions was the way he built up his company in the first place,” Mr. Shaoul wrote in an e-mail. “I am sure that is the question most people are asking.”

ADJUSTED VALUATIONS

Comparing a stock's price-to-book value may not be the most reliable valuation technique, because assets reflect estimates that may not prove accurate, said Malcolm Polley, who oversees $1 billion as chief investment officer at Stewart Capital. “Analyzing book value is a difficult way to determine the relative worth of a company,” he said. “It's because of a lot of intangibles that you really don't know what the value is. It'll give you an idea about the trend,” Mr. Polley said. The S&P 500's book value fell to about $442 a share in March 2009, from $533 a share in May 2008, data compiled by Bloomberg show. The decline occurred as banks and financial companies were writing off more than $2 trillion in loans tied to subprime mortgages, the data show.

MATCHING BERKSHIRE

Lowering the S&P 500's price-to-book ratio to match Berkshire's would cut the index's price by 42%, data compiled by Bloomberg show. The benchmark gauge for American equity has a combined book value of $611.38 a share, based on the most recent filings of its companies. Cutting the multiple to 1.1, from 1.9, would send the S&P 500 to about 673, from 1,162.95, according to data compiled by Bloomberg. Berkshire Hathaway's Class A shares dropped 17% to $100,320 apiece this year, prior to the buyback announcement. They were trading at 16.3 times earnings as of Sept. 22, the lowest price-earnings ratio of the year, according to data compiled by Bloomberg. “The underlying businesses of Berkshire are worth considerably more than this amount,” the company said last week in a statement. “If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares.”

RAILROAD ACQUISITION

Mr. Buffett bought railroad Burlington Northern Santa Fe last year for $26.5 billion in what he described as an “all-in wager” on the U.S. economy. In July, he told Bloomberg Television that he expects economic growth to continue and will “bet very heavily” against a second recession in three years. Mr. Buffett said that his company spent more on stocks Aug. 8 than on any day this year. That was when the S&P 500 tumbled 6.7%, the most since December 2008. “I like buying on sale,” he said in an Aug. 15 interview with Charlie Rose, broadcast on PBS. The market's rout last month erased $1 trillion from U.S. equities amid concern that Greek insolvency was inevitable and Europe couldn't contain the damage. The S&P 500 last week was trading at 12.4 times earnings in the past 12 months, 4.6% below its average valuation at the lowest point during the last nine bear markets, according to data compiled by Bloomberg. “He has a lot of investments in the largest companies in the market, so putting his money in Berkshire is another way of being bullish on the market,” said Eric Green, a fund manager at Penn Capital Management which oversees about $6 billion. “If the stock market is going down, then his stock will go down, and he's certainly smart enough to know that and he thinks the market is undervalued.”