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from Outstanding Investor Digest's July 31, 2000 Edition

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LONGLEAF PARTNERS FUNDS'
MASON HAWKINS, C.T. FITZPATRICK & STALEY CATES

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A primer on the math of share buybacks....
    Cates: On the subject of share buybacks, we just wanted to review that math with you:

    This table shows two companies that have the same share price - which is $10.... Then we show our appraisal. Company A is worth $10 and sells at fair value. And Company B is worth $20 even though it also sells for $10.
    We assume a 20% share repurchase in this exercise. So in both cases, you'll see the shares drop by 20% - the denominator at the bottom. Then you'll see the nominal value go down accordingly - by the cost of the repurchase. As you see, even though it's returned some capital to its shareholders and maybe made its capital structure more efficient, Company A's value per share does not change. Its value stays at $10. And that should ring true since there shouldn't be some immediate valuation benefit associated with repurchasing shares at fair value. Company B, in contrast, is repurchasing shares for $10 that are worth $20. So after the buyback, its $20 value has grown to $22-1/2.
    That growth in value, which occurs before the ink is even dry on the trade ticket, comes with no incremental business risk. So if Company B's normal retention of earnings plus its organic growth would normally mean that its value would grow during the year at, say, 12%, in this particular year its valuation is going to grow more like 25% because of the share repurchase.

Our companies are buying back a huge number of shares.
    Cates: We always own undervalued companies. So we almost always have had more than our fair share of corporate repurchase activity. Even so, it's usually maybe a third of our portfolio companies - and they usually buy in a few percent in any given year which is still a relatively large repurchase program.
    But right now, in Longleaf Partners Fund, all but three companies are buying in their shares. And we're not talking about authorizations where a company puts out a press release trumpeting the repurchase and then doesn't really follow up on it. The median and average amount that they're buying in is 8% of the company per year. That's a huge amount.

It's the equivalent of an 8% dividend yield - only better.
    Cates: Let me put that in perspective. Think of a share repurchase as you would a dividend yield - because, like a dividend, it's a simple check mailed out the door to shareholders. In this case, it's mailed to departing, selling shareholders. So that gives us as remaining owners a proportionally higher percentage of the business. In other words, instead of receiving a cash dividend in the form [of a check], we're in effect receiving a dividend in the form of our higher ownership per share - which is actually more valuable because it is tax-advantaged.
    So our companies right now are in a mode of paying out the equivalent of an 8% yield which, if that were in the form of a tax-inferior cash dividend yield, would certainly get investors' attention. And as illustrated above, that 8% repurchase yield is pushing up our values per share and, therefore, our eventual payoffs.

Buybacks either unlock value or significantly increase it.
    Cates: "But Staley," you may say, "so what if these stocks are so cheap and getting cheaper against your very conservative appraisals? That hasn't done us any good over the last couple of years. And if the market liquidity keeps running to the NASDAQ and other hot stuff, how will we ever get paid?"
    Well, there are four main answers: (1) Share buybacks, (2) merger and acquisition activity, (3) restructurings and (4) partial liquidations. These answers actually apply to all four funds. But I'll just stick to Longleaf Partners Fund since John, C.T. and Andrew will cover the other three.
    We've already talked about share repurchases. At these levels of repurchase, either our cash on cash returns alone are so high that it's effectively its own catalyst or the company ends up basically going private. On the margin, the companies are taking out that last marginal seller. And eventually, the companies' own resources will win the liquidity battle currently being lost in the stock market by value funds.