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.
The following graph shows the share buyback, dividends with the price of S&P500 over the last decade or so.
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 (NYSE: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
|Bank||Total Buyback, 2004-2007|
|Goldman Sachs (NYSE:GS)||$21.6 billion|
|Bank of America (NYSE:BAC)||$19.4 billion|
|Citigroup (NYSE:C)||$16.1 billion|
|JPMorgan Chase (NYSE:JPM)||$11.6 billion|
|American Express (AXP)||$8.9 billion|
|Wells Fargo (WFC)||$8.5 billion|
|Morgan Stanley (NYSE:MS)||$7.1 billion|
Goldman Sachs (NYSE: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 (NYSE: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 (NYSE: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