If you were walking down the street and encountered someone selling $1 bills for 60 cents each, you probably wouldn't hesitate very long before you started buying. With each purchase, you'd pocket a 40-cent profit. Not a bad deal.
The idea of buying $1 bills for 60 cents is cited often by Warren E. Buffett of Omaha, a renowned value-conscious investor. Buffett had the foresight to be an early buyer of stock in two flourishing local enterprises, Geico Insurance Co. and The Washington Post Co.
Both companies have been able to buy $1 bills for 60 cents -- or maybe even less -- by repurchasing large amounts of their own shares during recent years. It is a practice Buffett enthusiastically endorses.
Buffett learned his early lessons in value-investing from Benjamin Graham, regarded as the founding father of securities analysis. Graham was Buffett's teacher and later his boss on Wall Street.
Nine years after Graham's death, the fifth edition of his book, "The Intelligent Investor," first published in 1949, continues to be widely read for its basic lessons on investing.
Today, Buffett is chairman of Berkshire Hathaway Inc., an firm with investments in insurance, textiles, candy and newspapers. Among his other roles, he is a member of the board of directors of The Washington Post. So valuable is the stock of Berkshire Hathaway that it sells for about $2,600 a share.
Buffett's skill at buying $1 bills for 60 cents comes to mind because Geico Corp., in which Buffett holds a 36 percent stake, recently authorized a 3 million share buyback of its own stock. Geico Corp., holding company for the insurance operations, already was working on a 3 million share buyback and, indeed, bought back 1.6 million shares in the last 18 months at an average price of $65 a share. That's a total of $104 million.
Geico expects to buy its next 3 million shares over an extended period, reports Louis A. Simpson, chairman of Geico's finance committee. One of the problems Geico faced in earlier buybacks, said Simpson, was that there were a number of small buybacks in a short time, tending to drive up the stock price. Sellers reasoned that if Geico wanted to buy its own stock, the company would pay top dollar for it.
"The trick," said Simpson, "is that we want to be in a position to buy stock when it is an attractive alternative without impacting the price of the stock." However, Simpson acknowledges that with the current price of the stock -- it closed Friday at $87.50 a share -- the decision to buy additional shares "is not as clear cut." He added, "We're not so enthusiastic now."
Geico has had nine years' experience in buying back its own stock. As many investors will recall, Geico was a prosperous company in the early 1970s until it fell on hard times. Under the leadership of John J. Byrne, it survived and was returned to financial health. But part of the remedy was the issuance of 17 million shares of convertible preferred stock, which boosted the outstanding shares of the company from 17 million to 34 million.
Since 1976, Geico has been working its way back down by repurchasing its own shares, and today it is back to 17.7 million.
Just why a company would want to use its excess cash to buy back its own stock can be mystifying to many investors. Questions include: What alternatives exist? How do companies decide whether they should undertake a buyback program? What kind of impact does a buyback have on company performance? Do stockholders benefit?
Clearly, a company first has to be successful, able to produce excess cash and reasonably certain that if its stock is selling at $60 a share, it is really worth $100 a share. If so, the company has several choices: It can buy another company; it can use the money to invest in the shares of other companies, or it can give the money to the stockholders in cash dividends.
Buffett believes that the choice is clear. Writing in the 1984 annual report of Berkshire Hathaway, he said:
"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases."
" . . . When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.
" . . . By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management's domain but do nothing for (or even harm) shareholders.
"Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value.
"These prices are entirely rational," Buffett concluded. "Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer."
Buffett's view is supported by a study Fortune magazine conducted earlier this year with the Value Line Investment Survey. Fortune reported that "buyback companies showed a median total return, expressed as an annual average, compounded, of 22.6 percent. The equivalent return for the S&P 500 was only 14.1 percent."
In the case of Geico, buybacks clearly have helped increase the share price -- even though recent buybacks have occurred at a time when earnings were flattening out because of industry competition and a higher-than-expected level of claims. Rate increases are expected to improve Geico's earnings.
Geico stock, which had been as high as $65.63 last year, traded at $57.13 at the beginning of 1985. When the stock closed Friday at $87.50 a share, it represented a 53 percent increase so far this year.
One of the clearest results of a stock buyback is that a company's earnings will improve. When you reduce the number of shares in a company, you spread the company's profits over fewer shares and, thus, its earnings per share are likely to grow. Because most securities analysts focus on earnings, when earnings per share rise, so generally does the market's interest in a stock.
The repurchase of stock has an interesting impact not only on a company's net earnings per share but also on its return on shareholder's equity. Stockholders' equity, sometimes called net worth, is the stockholders' ownership of the company.
Strictly for demonstration purposes, Simpson provided us with some hypothetical numbers to show the impact of stock buybacks. They are based on Geico's 1984 annual report, which reported 18.766 million common shares outstanding.
What would have happened, Simpson was asked, if Geico had bought back an additional 3 million shares in 1984 and there were only 15.766 million shares outstanding?
Simpson and his colleagues, after spending some time at their calculators, came up with this answer:
Providing Geico had sufficient resources to support its business operations, and had been able to buy back 3 million shares on Jan. 1, 1984, the cost would have been about $58 a share, or a total of $174 million. The 1984 numbers then would have changed this way:
Book value would have declined from $22.40 to $14.98 a share. Return on equity would have increased from 28.5 percent to 35.2 percent. Operating earnings per share would have risen from $5.11 to $5.28. Net earnings per share would have gone up from $6.68 to $7.14 a share.
Thus the return on equity, a measure of how well a company is performing, would have gone up 23.5 percent. The net earnings would have gone up 6.9 percent.
On another level of calculation, Charles T. Akre Jr., research director at Johnston, Lemon & Co., estimated that Geico's buybacks have achieved a return of 30 percent a year on a three-year rolling average.
But on the question of whether or not to do a buyback, Simpson said: "The main test is whether a current shareholder, who will still be a shareholder five years from now, will be benefited on an economic basis, and whether the stockholder will have more economic value on a per-share basis."
In the case of Geico, that clearly seems to be the case.