Last Updated on 10 February, 2024 by Abrahamtolle

If you’re a future net buyer of stocks you want to pay as little as possible for the earnings.

Let me explain why:

Let’s assume you buy Disney at 100 and one year later it trades at 130. A 30% return in one year, isn’t that great!

Not necessarily:

A high share price is not necessarily good.

Some time ago I used to cheer when my stocks rose to new highs. It felt great to count the paper profit but as a long-term investor, this logic is irrational.

Why?

Because the only time you would want the highest possible price is when you sell. If you have no plans to sell, it means you either are a future net buyer or just holding your shares. Under both scenarios, you would want the share price to not trade above intrinsic value.

Buybacks are more effective the lower the price is

This might be counterintuitive for many investors (for me as well), but it makes perfect sense and the logic is simple. I let Warren Buffett explain:

If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

The above quote is taken from page 7 of Berkshire’s shareholder letter of 2011.

At the time of writing, Berkshire had taken a big position in IBM, in hindsight, a mistake, and Buffett commented that they hoped IBM’s stock price would languish throughout the next five years.

He expected IBM to continue buying back shares, and obviously the shareholders increase their ownership the more shares are repurchased. It makes sense to buy back shares for a lower earnings multiple than a high one.

1. If you have no intention of selling and are a net buyer in the future, you would want the share price to not exceed intrinsic value because many companies buy back shares, and obviously it’s better to buy back at for example 100 per share instead of 125. The more shares bought back, the more you own of the company.
2. If you have no intention of selling but are reinvesting the dividend, it’s much better to reinvest at 100 and not on 125. (I don’t recommend DRIP).
3. If you are a net buyer in the future, obviously you want to pay as little as possible for that earnings.
4. If you plan to sell in the immediate future, this is the only time you want the share price to be as high as possible.

A rational shareholder base is underappreciated

Warren Buffett has spent his whole life attracting the “correct” shareholders.

I believe a rational shareholder base is an underrated asset of any company because without competent ownership it’s challenging to have the proper investment horizon.

I assume most companies end up with the shareholders they deserve, and that’s why it makes sense to attract and educate a knowledgeable investor base to ensure the share price does not deviate much from intrinsic value – either up or down. An overvalued stock has the potential of attracting the wrong shareholders and this, in turn, might lead to overreactions on the downside.

FAQ:

– Is a high share price always a good sign for investors?

No, a high share price isn’t always a positive indicator for investors, especially if you have a long-term perspective. While a rising share price can seem attractive, it may not be beneficial if you’re not planning to sell. In such cases, it’s more advantageous for the share price to align with the intrinsic value of the company.

– Why are buybacks more effective when stock prices are lower?

Buybacks are more effective at lower stock prices because they allow the company to repurchase a larger number of shares with the same amount of capital. This increased repurchasing means that the ownership of remaining shareholders is enhanced, which can boost the value of their investments.

– How does being a net buyer in the future affect your perspective on stock prices?

If you anticipate being a net buyer of stocks in the future, it’s in your best interest to pay as little as possible for that earnings potential. This perspective highlights the importance of not overpaying for stocks, as you intend to continue accumulating shares over time.