The Paradox of Investing: Why Long-Term Shareholders Should Cheer for Low Stock Prices

When it comes to investing, there's a concept that often baffles new investors: the idea that a true long-term shareholder should want the stock price of their investment to remain low, especially during periods when the company is actively repurchasing its shares. This counterintuitive notion is grounded in the wisdom of Warren Buffett and his longtime partner, Charlie Munger, and is beautifully illustrated in their approach to investing in IBM.

Let’s break it down.

The Power of Share Repurchases

"Pay attention to the cannibals" - Charlie Munger

When a company repurchases its own shares, it reduces the number of shares outstanding. This means each remaining share represents a larger ownership stake in the company. If the company’s earnings remain constant or grow, each share's earnings will increase because there are fewer shares to divide the profits among. In other words, your slice of the pie gets bigger.

Buffett and Munger understood that the effectiveness of share repurchases depends significantly on the price at which the shares are bought back. If the stock price is low, the company can buy back more shares with the same amount of money, further reducing the number of shares outstanding and thus increasing the ownership stake for each remaining shareholder.

A Real-World Example: IBM

Buffett’s approach to IBM in the early 2010s serves as a prime example. At that time, IBM was generating strong earnings and had plans to spend substantial amounts of cash on share repurchases. Buffett noted that “if IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion.” This would reduce the number of shares outstanding significantly, increasing Berkshire Hathaway’s ownership stake from 5.5% to about 7%.

On the other hand, if the stock price averaged $300, IBM would be able to buy back far fewer shares—only 167 million. This would leave more shares outstanding after five years, and Berkshire’s ownership stake would rise to just 6.5%.

In a scenario where IBM's earnings in the fifth year were projected to be $20 billion, Buffett calculated that Berkshire’s share of those earnings would be $100 million greater under the "disappointing" scenario of a lower stock price than they would have been if the stock price had been higher.

Why Low Prices are a Long-Term Investor’s Friend

The logic behind this is straightforward: If you are going to be a net buyer of stocks in the future—either directly with your own money or indirectly through the company's share repurchases—you actually benefit from lower stock prices. As Buffett puts it, “If you are going to be a net buyer of stocks in the future… you are hurt when stocks rise. You benefit when stocks swoon.”

This principle is grounded in the fundamentals of investing, a philosophy pioneered by Benjamin Graham and embraced by Buffett. The idea is that you should view stocks as part-ownership in a business rather than as mere pieces of paper to be traded. The market price is simply what others are willing to pay, and it doesn’t always reflect the intrinsic value of the business.

The Emotional Trap

Despite this clear logic, many investors find it hard to root for lower stock prices. Seeing the market value of their investments drop can be unsettling, especially in a world where rising prices are often equated with success. This is where Buffett and Munger’s deep understanding of investor psychology comes into play.

Most investors “take comfort in seeing stock prices advance,” much like a commuter who “rejoices after the price of gas increases, simply because his tank contains a day's supply.” But this short-term satisfaction is misplaced for long-term investors who plan to buy more shares over time or benefit from a company’s share repurchases.

Buffett himself admits that in his early days, he too “rejoiced when the market rose.” However, after reading Chapter Eight of Ben Graham’s The Intelligent Investor, he realized that low prices were actually his friend. This was one of the “luckiest moments” in his investing life, as it allowed him to embrace the counterintuitive nature of investing.

Conclusion: The Wisdom of Low Prices

In the end, the success of an investment like IBM is determined primarily by its future earnings. However, an important secondary factor is how many shares the company can repurchase with the substantial sums it’s likely to devote to this activity. If the company can buy back shares at lower prices, the long-term shareholders stand to gain significantly.

So, the next time you find yourself cheering for a rising stock price, take a moment to consider Buffett’s wisdom. If you’re a long-term investor—or if the company you own is a net buyer of its own shares—you might just be better off rooting for the stock price to languish. It’s a paradox that lies at the heart of investing, and understanding it can give you a powerful edge in the market.

Source: Berkshire Hathaway Annual Letters