2009-12-12

Why Does Warren Buffett Buy Entire Companies?

This might be obvious to some, but Warren Buffett buys whole companies for different reasons than the average CEO does. The average CEO is concerned about building empires, pleasing their egos, diversifying, expanding market share, etc.

Warren Buffett simply wants to make more efficient use of capital. That's it. By buying companies outright, he's essentially unlocking the free cash flow (what he calls "owners earnings") and making that available to his holding company, so that it can more profitably be employed in other businesses or used to buy shares of public companies.

Free Cash Flow

Let me explain in more details. A portion of earnings that a company retains (retained earnings) is not available (free) to be taken by the owners or paid in the form of dividends. Some of that is needed to re-invest in the business: buy new equipment, hire new people, train the workforce, invest in a brand new computer system, build a necessary office in a foreign country to support the business there, etc. After all re-investment needed to support the business is accounted for is when free cash flow or owners earnings appears.

But most companies don't pay out as dividend their entire free cash flow. They retain more earnings than is necessary, to have reserves for a rainy day.

Warren is after these reserves, which he can more ably allocate within his holding company than any single company could within itself.

But why wouldn't Buffett buy lots of shares, take a board seat and simply force the company to pay out all its free cash flow as dividends? That wouldn't be efficient from a tax perspective due to double taxation in the corporate structure. So, the alternative is to buy at least 80% of companies and consolidate their assets on Berkshire's balance sheet.

How Can Small Investors Benefit?

The rest of us who can't afford to buy their own conglomerates still has options. It has been shown that following Buffett's move -- even 30 days after the fact -- can still provide enough of a return to beat the market average over long time periods.

Current Opportunities

One current opportunity is to buy out-of-favor Kraft (KFT). Buffett purchased it last year for around $30 per share. It's currently trading for $26. So, if you believe Buffett will be proved right once again, buying below his entry point makes a lot of sense -- you'd be getting an edge over Buffett himself!

Disclosures: I own shares of KFT.

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