Forget all the hocus-pocus the analysts tell you. A company can be profitable for you in only two ways
- The price of the stock goes up since the time you bought it.
- The company pays you dividend.
Stock repurchase is one of the ways to achieve a price boom. Share repurchase is the acquisition by a company of its own stock. Under U.S. corporate law there are five primary methods of stock repurchase: open market, private negotiations, repurchase 'put' rights, and two variants of self-tender repurchase: a fixed price tender offer and a Dutch auction. There has been a meteoric rise in the use of share repurchases in the U.S. in the past twenty years, from $5 billion in 1980 to $349 billion in 2005.
Buying back of outstanding shares is often looked at as a bullish sign and for good reason. There are a few reasons why a company might want to buy its own shares.
- Increasing the price of shares. Buybacks lead to smaller number of shares in the open market which leads to less supply. From a valuation point of view if there are less shares of the business, each share has more value.
- To invest in themselves. The company has surplus cash and the management think that the stock is very undervalued and the best way to invest the surplus cash is to buy its own stock which is cheap.
- Reduce the dilution of shares. Sometimes companies may fund an acquisition by issuing new shares. At other times management issues stocks and options to rewards its employees. The extra dilution of stock is not seen favorably by the market/value investors. The management may decide to buyback shares to reduce the dilution.
- A company (or its management) may simply want to make the ratios look prettier. Because of buying back shares, the number of shares reduce. This boosts the earning per share, book value per share. When a company spends its surplus cash, its assets are reduced. This will cause its return on assets (ROA) to increase. Also, return on equity (ROE) is upped because there is less outstanding equity.
- Sometimes the management may want to repurchase stock to stop a hostile or unfriendly takeover. If a company can succeed in buying back a substantial amount of its own shares, this makes it more difficult to be taken over.
It makes sense that buying back shares is a good and bullish sign. After all the company knows itself better than anyone else. If they are investing in themselves, they can’t find a better way to invest their extra cash. It becomes a bullish sign as insider buying.
Studies show that stocks with buy backs generally outperform the market as a whole by almost 3%. Even so you should not buy a stock just because their is a buy back announcement. There has been instances where the management has announced buyback to hide something else. Furthermore, studies also show that two thirds of the companies either do not follow through completely and some did not even buy any shares. Regardless as you may have seen numerous times, when a company announces that they will buy back shares, it will normally have a short term bounce up (remember the BRK buyback announcement last month, which made to stock shoot up from $67 to $75). This generally offers a good short term opportunity or trade but it should not be seen as a long term indicator as such. Doing our own research will help us avoid buybacks gone bad.
In this article, I will discuss when stock buybacks are good.
Warren Buffer, the CEO of Berkshire (BRK-A) is arguably one of the best capital allocators. In a career spanning more than 4 decades he has clocked in a gain of over 20%. Mr. Buffet has recently announced that he will buyback shares of Berkshire if the share price went below the book value by more than 10%. What this means is that he thinks that buying a dollar for 90 cents is good. Previously, Buffet has stated that it is a good idea to buy back shares for a company if two conditions exist.
- The company has surplus capital
- The company can buy shares below its intrinsic value
Alas, few executives follow the above philosophy. At other times the management is grossly mistaken about the intrinsic value of the company. As I read through annual proxies of companies, I see a few more troubling behavior which underscores the fact that increasingly managements are putting their own interest ahead of shareholder interest. These behaviors include stock options plan (management gets call options for the stock at a strike price which is much lower than the current price), right to re-price options (see Google), exchanging underwater stock options (options that are at loss) with restricted stock. It seems that executives increasingly want all the upside of the stock with no risk of the downside. These practices also put question mark on managements abilities to allocate capital.
A simple reason to gauge if the buyback is good is to look at the company and decide if you will buy shares in it i.e., is the company cheap enough to be a candidate watchlist candidate. If yes, maybe the management is on the right track. Stock buybacks are as good as the company itself. In an overpriced market it will be foolish for a company to buy stocks at all, let alone investing in itself. Instead, the company should use this opportunity to buy assets that can be easily converted into cash. In this way, when the market has gone down, the company may sell the asset and buy its stock when they are selling for below its worth. A good rule of thumb is to remember that the best investment in the world may become a money looser if one pays too much for it.
If executed properly, share buybacks are more beneficial to long term shareholders than dividends. This is because dividends are taxed and share repurchases are not (you end up paying for the capital gains tax when you sell but this is less than the dividend tax in many countries like Switzerland, India etc). But there is a big “if” in front of the statement. Dividends although less efficient are generally more beneficial because they do not require management to value their own company. Even the best management can be a bad judge of value and a worse investor.
