“If a fine business is selling in the marketplace for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?” -Warren Buffett

Shrinkage. Not a topic one usually brings up at the dinner table. But as an investor, shrinkage can be wonderful. I like dividends but I love share shrinkage/buybacks. If done properly, a consistent share buyback program that meaningfully reduces shares outstanding is the best way for a company to create shareholder value. In most cases, if you want to increase your ownership in a business, you have to buy more shares with cash. Not so with a share buyback. Over time, your percentage ownership in a business will increase and you didn’t have to do anything to own more, except sit there and wait. Not all share buybacks are created equal. We prefer companies that use existing free cash flow to buyback shares when their stock is trading at an reasonable valuation.

The best share buybacks happen when a company reduces it shares by using existing free cash flow. Sometimes it is smart to use debt to aggressively buyback stock when management believes its stock is undervalued. Using too much debt or consistently issuing debt to buyback stock can create other problems, so one must avoid these types of companies.

Company management has to keep valuation top of mind when buying back stock. Paying too high a valuation will destroy shareholder value. All one has to do is look at the share buyback programs of Cisco and Microsoft in the early 2000’s to see management destroying value by buying back stock at huge multiples to earnings. It would have been smarter for Cisco and Microsoft to sell stock and raise cash then buy back stock at those levels. Now with Cisco and Microsoft trading at low valuations, management should be very aggressive repurchasing shares.

A properly timed share buyback done by a company generating ample free cash flow will create enormous value for shareholders over the long run. In the short run, investors should actually hope for their stocks to underperform so that management can use the opportunity to buyback stock at a lower price. The heavy lifting now will pay dividends in the future (much better than a dividend cheque).

Any ideas Schwartz? A few companies that we think are doing buybacks right include, Oracle, Viacom and AIG. All three are trading at what we believe are low valuations to earnings and are meaningfully reducing their shares outstanding.

The author owns shares in Oracle and Microsoft. Clients of Baskin Financial own shares in AIG, Microsoft, Oracle and Viacom