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The Case Against Share Buybacks

November 12, 2011 | About:
Chandan Dubey

Chandan Dubey

97 followers
Looking at the past gives us a better understanding of the future. In this article I will look at share buybacks during the last decade and see if they are a good way for companies to return value to shareholders. Many of us see share buybacks as one of the strong criterion for evaluating companies. We put share buybacks on a pedestal right there with insider buys. The question this article tries to answer is: Is this warranted?

Buying back outstanding shares is often looked at as a bullish sign. There has been a meteoric rise in the use of share repurchases in the U.S. in the past 20 years as a way to return value to the shareholders. The buybacks have gone from $5 billion in 1980 to $349 billion in 2005. Studies show that stocks with buybacks generally outperform the market as a whole by almost 3%.

Why does a management choose to buy share? These are a handful of reasons I can think of.

  • Making the ratios prettier. This means increased earning per share and an illusion that the company is growing faster than it is.
  • Boosting the share price. A higher earning per share coupled with the vote of confidence from the management that the company is undervalued, can push the share price up. Unless the buyback is done properly, we will see that this short term gain is a small consolation to the stockholders as value has been destroyed. For management who have been piling up stock options, the short-term boost is very lucrative. If the management is not aligned to the shareholders, they will also want to boost share price to get performance-oriented bonuses.
  • Sometimes the management gets caught in the fashion of buying back shares. A good business manager may not be a good capital allocator and may decide to do a buyback without doing adequate analysis of whether the company is undervalued or whether a buyback makes sense.
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.

The following graph shows the share buyback, dividends with the price of S&P500 over the last decade or so.

1875916006.jpg

From the graph we see that when the market was going down during 1999-2003, the buybacks were decreasing but when the market went up the buybacks were on an all time high. The corporations bought nearly $589 billion when the S&P500 was at 1468 and $340 billion when it was at 903.

Warren Buffet, the CEO of Berkshire (BRK.A) is arguably one of the best capital allocators. In a career spanning more than four 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. Do the corporations fare well on Buffet’s philosophy? Let us look at the buybacks of the banks before the crisis. During 2004-2007 when the market was going through the roof, the banks were falling on themselves trying to buy stocks. In the table below, they bought nearly $93 billion of stock.

BankTotal Buyback, 2004-2007
Goldman Sachs (GS)$21.6 billion
Bank of America (BAC)$19.4 billion
Citigroup (C)$16.1 billion
JPMorgan Chase (JPM)$11.6 billion
American Express (AXP)$8.9 billion
Wells Fargo (WFC)$8.5 billion
Morgan Stanley (MS)$7.1 billion


Goldman Sachs (GS) is one of the most respected trading firms which can make money in any scenario. But GS has also made huge losses trading its own stock. It bought stocks during the boom year, then sold them when the economy tanked and no one wanted to buy shares. In an exact opposite of what value investing is; it bought high, sold low and lost quite a bit of money doing it.

Most of these banks diluted shareholders by issuing common equity at prices that were much cheaper than the prices they bought shares at. For example, Bank of America (BAC) bought back $19.4 billion worth of stock when its shares were trading between $40 and $55 and then sold more than $13 billion worth of stock at around $11 a share. Citigroup (C) also repurchased $16.1 billion of its own shares during the bubble, and then sold about one-third of itself to the government when it was nearing the penny-stock territory.

In fact, one can argue that a good indicator of market bubble is when the stock buybacks are going through the roof. If on the other hand the corporations would have returned the money to the shareholders, or kept some for the bad times, the situation would have been very different.

But these are banks, you say. Who knows what they are worth anyway. Well, let us look at one of my current favorite value stock GE and its share repurchase history.

Between 2005 and 2007, GE repurchased approximately $25.7B worth of stock when it was trading in the $32-$42 range. During this period GE’s stock returned 2.3% vs DJIA which returned 23% (without dividends). Buybacks continued in 2008 and amounted to nearly $1.25B. At the offset of the crisis the buybacks were suspended in September 2008 and the dividend was slashed by 68%. Then when the shares were selling in one digit range the company issued $12B common stock in 2008 (as well as $3B preferred stock) and another $620M in 2009. Even after buying so many shares GE’s share count has increased from 10B in 2001 to around 10.7B in 2010. Was the GE stock undervalued when the management was on a buying spree ? During the buybacks, GE was trading for a P/E of more than 30 -- at times it went above a P/E of 40. A company that was expected to grow at the rate of 10-15% tops, it was clearly overpriced and following the Buffet philosophy the share repurchases should have been suspended.

Furthermore, buying at more than $32 and selling at around $8 was a colossal waste of money. The share price is currently at $16 and the word from the management is that share buybacks will be resumed (as much as $11.6B through 2013). This is a sad reality which proves the point that buybacks as a way to return value to shareholders, are much worse than dividends. The financial engineering of the management to meet performance goals for getting more from the company coffers needs to be stopped as it ends up wasting more money than what is returned to the common shareholder through capital gains or dividends.

With the stock market hitting a high again, everyone is excited about stocks. We are hearing of stock buybacks a lot more now. But if history is any judge, this is not something to be happy about. The management needs to be careful lest they make the same mistakes as their predecessors.

In the next article I will look at some of the stocks that are dipping in the company coffers to fund buybacks. We will put these companies through valuation tests to see if the buybacks are going to add value or waste cash.

Previous related article

Share buyback: a primer

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.9/5 (12 votes)

Comments

fcharlie
Fcharlie - 2 years ago
Now you should write an article about how bad the Autozone buyback has been over the past decade..It's gone from $20 to $330.... Or how about the Loews buyback over the past 50 years. Isn't Loews up 100,000% during these 50 years? Philip Morris??? How about IBM?? They are both near all time highs... How about McDonald's?? All time high... Buying back stock quarter after quarter, year after year.

rgosalia
Rgosalia - 2 years ago
Here are Mr. Buffett's comments on buybacks from OID published on September 24, 1998:

"Shareholder: Is there a price at which it becomes inappropriate for a company to buy back its own stock? For example, with Coke selling at 40 times earnings, is that a smart place for the company to deploy its capital?

Buffett: Well, certainly 40 times earnings sounds like a very high price to pay when you buy back stock. However, I would say this: Coca Cola has been around what - 112 years now? And there are very few times in that 112 years, if any, when it would not have been smart for Coca-Cola to have been repurchasing shares. In my view, among businesses I understand, Coca Cola is probably the best large business in the world. I mean it is a fantastic business.

We love it when Coke repurchases shares and out interest goes up. We owned 6.3% of Coca Cola in 1988 when we bought in. We increased our stake a little bit a few years later. But if they had not repurchased shares, we probably would own about 6.7% or 6.8% of Coke now. As it is, we own a little over 8%. And that increase in our percentage stake is thanks to its stock repurchases.

There are going to be about a billion 8-ounce servings of Coca-Cola products sold around the world today. And 8% of that represents about 80 million servings, whereas 6.8% would represent 68 million servings. Therefore, thanks to Coke's repurchases, we have roughly additional 12 million servings attributable to the account of Berkshire Hathaway being sold around the world. And Coca-Cola is earning a little over a penny per serving. That gets me kind of excited.

All I can tell you is I approve of Coke repurchasing its shares. I'd a lot rather have 'em repurchasing shares at 15 times earnings. But while I've looked at other ways to use capital, I still think it's a very good use of capital. And maybe the day will come when they can buy their shares back at 20 times earnings. And if they can, I hope they'll go out, borrow a lot of money and buy a ton of it back at those prices.

I think we will be better off 20 years from now if Coke follows a consistent repurchase approach. When we own stock in a wonderful business, we like repurchases even at prices that may give you nosebleeds. It generally turns out to be a good policy."

My conclusion - don't have cookie cutter rules, understand the specific situation and make rational conclusions based on the situation. Thoughts?

- Rishi

tonyg34
Tonyg34 - 2 years ago
you left off one of the major reasons for share buy backs... to offset the issuance of shares to key executives and directors. When times are good, more options/share based compensation requires more buybacks.

Some managers are good at buying back shares selectively, but most of the real success stories are companies that commit to buying back slow and steady as FCharlie mentioned (L) and Eddie Lampert made a career out of using other peoples money to make his ownership stakes larger and more valuable (if he was so good at allocating capital why is SHLD such a mess?).

More proof that timing the market is harder than you think.

serial share repurchases sends a positive message to shareholders, but I'd rather have the dividends
Adib Motiwala
Adib Motiwala - 2 years ago
I have also seen companies issue debt to buy back stock. The usual argument is that debt is cheap at the moment and so is our stock. So better to buy back stock with this locked in lower interest rate. We can pay it off in a few years. While that may work for companies like Microsoft or Coca Cola, I am not sure its such a good idea for most companies. Who knows what tomorrow holds. If there is a long recession, then you will have to keep paying that interest. And then who knows like all of these examples, you may have to issue equity when the shares are under valued to survive or pay off that cheap looking debt.

Just look at what Janus (JNS) did in 2007 and then 2009. In 2007, they issued debt to buy back shares. Very rare for an asset manager to have debt. ..low capital intensive business. Then they fell on tough times and in 2009 issued equity to buy back debt.

I think NFLX issued debt to buy back shares in the last 1-2 years if my memory serves me right.

I think LOW is doing that right now. Issuing debt and buying back cheap stock.

It may work for some. But, it sounds like a dangerous plan to me.

I like companies where management give out clear capital allocation plan. Like IBM. They clearly tell how they are going to grow the business and then regular buybacks and dividend growth.

I prefer a balanced approach of dividends and buybacks.
tonyg34
Tonyg34 - 2 years ago
if the interest rate is below expected div payments its free money (on 10,20, or 30 year loan). Pretty sure that's why MO PM MSFT et al take on unnecessary debt to buy back shares. It actually reduces their long term debt obligations.

But your underlying argument holds up. Best to own a company that is actually growing, and spends capital in a reasonable manner over multiple business cycles. I think its probably reasonable to assume that a company like Lowes will grow its divvy enough in 20 years to make buybacks pretty good investment with interest rates as low as they are. And if the stock actually is "cheap" then all the better.
cdubey
Cdubey premium member - 2 years ago
Thank you all for comments and different view points.

@Fcharlie: Share buybacks do work sometimes or most of the times (as you chose to believe). The point of the article is this: you should not automatically treat share buybacks as a bullish sign and start buying. There are ample reasons to have an argument against them. The article shows you examples were big and apparently stable businesses have erred and wasted a lot of shareholder money. GE has also been fabulous with buybacks. They have rewarded their shareholders quite well in that way if you chose to look more like 20 years. But the last decade has been horrible.

@Rgosalia: I agree completely. Coke is a fabulous business and we should not talk in generalities. I would actually like to hear Buffet's argument in detail for this one. Paying 40 times earning seems like a large amount of money to pay. But if done consistently through thick and thin, it probably will average out to a more respectable multiple (I hope that was the argument). I would rather have Coke pay more dividend when the stock is very expensive and buyback when the situation looks like today. Do you have a link to the article ?

@Tony: Yes, this is one of the worst practices being used by the management. They are just stealing share holder money. And it is incredible how they get away with this kind of behavior. I miself invested in a few stock who on hindsight seem like a very bad deal because of this very behavior. The insiders hold around 15% shares but this is mostly options and I suspect that they are all awarded. Should have done more research. If I only knew this a year earlier.

@Adib: I agree. A balanced approach is very likely to give the best results. No-one can effectively time the market.

Again, thank you all for comments. Your thoughts are appreciated and I will look at why buying at 40 times earning for coke might be a good use of capital.

rgosalia
Rgosalia - 2 years ago
Cdubey,

The comment by Buffett on buy backs is from Outstanding Investor Digest Sept 24, 1998 publication. Unfortunately, due to copyright restriction, I cannot post the publication on a public forum, however this is his argument in its entirety.

- Rishi
sjzhao2003
Sjzhao2003 - 2 years ago
Hi, cdubey! Thanks for bringing the issue of share buybacks to the forefront. My question is: how should shareholders/investors evaluate buybacks? Is setting aside a fixed portion of your FCF to buybacks through thick and think a good policy? I haven't heard anyone laid out a general set of criteria, in the same fashion in evaluating stocks.

Most of the time, we look at buybacks from hindsight--Look, the management must be dumb because they bought back shares at $x when they could have bought back the same shares at 50% of $x two years later. It's easy to criticize management for poor buyback decisions. Most CEOs are not great capital allocators like Buffett or Singleton. They are also a self-interested bunch--just look at the massive dilution through options grant at many tech companies. But judging performance with hindsight knowledge,however, seems an example of outcome bias. What is important is the process, not the outcome.

Another issue with buyback criticism is what's the opportunity cost of the buybacks. Personally, I find it difficult to evaluate a capital allocation decision without knowing the opportunity cost. Only intimate knowledge of the company and its competitive landscape can help you there.
traderatwork
Traderatwork - 2 years ago
My thought is if company that can grow X%, say 20% the hurdle rate. They should use the FCF or even debt to invest in growing the business, when it's not, they can spend the FCF at share buy back when stock price is at FCFX about 5 (which give you 20% (1/5) return on the company future FCFX) but most of the time company stock price will not be at or below 5, so selling put option at the appropriate strike price will be another good idea to get the 20% return - since if the stock get assigned - the money is well spent, if not the company made the 20% return on those excess cash or they company can pay out the cash. But well, how many CEOs can think and act like this? Most CEOs first thought is how can I give myself more stock options and bonuses. Ah well.

cdubey
Cdubey premium member - 2 years ago
@Sjzhao: I am going to look at companies which have buybacks at the moment and see if the buy back makes sense. Keep a lookout for my next set of articles.

Traderatwork raises some interesting points. But as he points out, no management uses this.

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