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Warren Buffett’s Simple Advice About Apple Inc. (AAPL)

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Last month, Fortune magazine published its annual “Fortune 500” list, with Apple Inc. (NASDAQ:AAPL) ranking sixth, making a big jump from last year’s spot in 17th place. Fortune offered a closer look at Apple in that issue, centering on what the company might do with its massive pile of cash. One of the biggest takeaways for investors in the article might have gone unnoticed by many, though: Why Warren Buffett recommended that the company repurchase Apple Inc. (NASDAQ:AAPL) stock.

Warren Buffett

As veteran financial journalist Carol Loomis recounted, around early 2010, Steve Jobs picked Buffett’s brain about what Apple Inc. (NASDAQ:AAPL) might do with its pile of cash. Regarding the option of repurchasing Apple stock, Buffett offered a simple guideline: If you believe your stock is cheap, “then the best thing you can do with your cash is buy in shares.” Apple stock was trading in the $200s at the time, and Jobs did think it was cheap. It went on to top $700 within a few years, though it has since pulled back to the $400s. Jobs, long averse to buybacks because they can squander money if the stock later falls, chose not to initiate a buyback. (Loomis noted that he had also seen some hard times at Apple, when cash was in short supply — thus, the idea of letting it pile up was attractive to him.) But Jobs’ successor, Tim Cook, did decide to buy back Apple Inc. (NASDAQ:AAPL) stock.

When asked by Buffett if he thought Apple Inc. (NASDAQ:AAPL) stock was cheap, Jobs had answered with a definitive yes. To understand why he might have thought so, it’s instructive to look back at where Apple was in early 2010. Then, as now, opinions were divided on the stock’s valuation and the company’s future. As 2009 drew to a close, my colleague Rick Munarriz named the company a “Best Stock” for 2010, citing strong iPhone sales (more than 7 million in a single quarter!) and anticipating the debut of Apple’s new tablet, as yet unnamed, and the many apps that would be created for it. But others viewed it as one of the worst stocks, seeing an unattractive risk-reward ratio, looming competition, the threat of commoditization, and inevitable slowing growth. Looking back, the bulls were right, and a stock buyback would have rewarded shareholders. But management was averse to buybacks, with the CFO stressing the company’s focus on “preservation of capital” when it comes to cash. Buffett, too, seeks preservation of capital, but he also welcomes compelling value propositions. Indeed, he recently bought back shares of his own company.

The price matters

Buffett’s advice is often forgotten by investors when they hear about a stock repurchase plan. It’s not just CEOs who should heed it — investors need to keep valuation in mind, too, regarding buybacks. Buybacks have appeal for shareholders because they reduce the number of shares outstanding, and thereby boost the value of remaining shares. (Imagine, for example, a pizza that is cut into six equal slices instead of eight – each slice will be bigger.) But all buybacks are not created equal. Since a company has many options for its excess cash, it should choose the most productive ones. Alternatives include buying another company, paying down debt, hiring more people, buying more advertising, paying a dividend, and letting the money accumulate further. If stock is bought back when it’s at inflated levels, that can destroy shareholder value. Simply paying that money out as dividends could permit shareholders to redeploy it into more compelling investments.

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