“The Outsiders” by William Thorndike Jr. has received a good amount of press in the investment community since being published. My review for the book is simple: Read it. If you’re like me and keep a running list of books that you would like to buy and/or read, put this one at the top.
This isn’t a book review. Instead, I would like to discuss something Mr. Thorndike discussed in the chapter about Henry Singleton of Teledyne; this quote comes from page 55 of the hardcover copy of the book:
“Fundamentally, there are two basic approaches to buying back stock. In the most common contemporary approach, a company authorizes an amount of capital (usually a relatively small percentage of the excess cash on its balance sheet) for the repurchase of shares and then gradually over a period of quarters (or sometimes years) buys in stock on the open market. This approach is careful, conservative, and not coincidentally, unlikely to have a meaningful impact on long-term share values. Let’s call this caution, methodical approach the “straw”.
The other approach, the one favored by the CEO’s in this book and pioneered by Singleton, is quite a bit bolder. This approach features less frequent and much larger repurchases timed to coincide with low stock prices – typically made within very short periods of time, often via tender offers, and occasionally funded with debt. Singleton, who employed this approach no further than eight times, disdained the “straw”, preferring instead a “suction hose”.
I think Thorndike is spot-on with the key characteristics for the suction hose: infrequent (only when a true opportunity arises) and in a quick and sizable manner to take advantage of that opportunity in a meaningful way before it disappears - in a word, “opportunistic.”
The “straw” conjures up a slightly different image from that conclusion: Thorndike suggests that it is the timid nature of this approach (“gradually over a period of quarters…”) that causes it to be “unlikely to have a meaningful impact on long-term share values.” My argument with that characterization is that I think Thorndike is simply being too nice to the management teams that take the “straw” approach to share repurchases. His conclusion is essentially that these activities are unlikely to have a meaningful impact on long-term share values; my argument is that the ebbs and flows of equity markets and corporate profitability all but assure that this “careful, conservative” approach will actually lead to a subpar repurchase outcome.
Let’s take a second to think about why this might be the case: most large cap companies tend to discuss capital allocation policies in the context of earnings, especially when it comes to dividends. Management teams recognize that many people love dividends above all else, and that these individuals only buy the stock with the hope that the dividend will keep growing, year after year after year.
When times are good, earnings and cash flow generation tend to ramp up, and companies have lots of money rolling in; however, management teams recognize that moving too quickly on dividend increases when times are good can put them in a tough spot when things invariably turn for the worse at some point down the road. Rather than get too aggressive on the dividend growth rate or payout ratio, many companies decide to funnel their excess cash hoard towards repurchases: they talk about the action as if it’s solely a last resort for excess cash, one that can be cut at a moment’s notice without igniting a backlash from shareholders. Here’s what Coca-Cola (KO) CFO Gary Fayard had to say about share repurchases on the company’s third quarter call:
“Couple of thoughts on share repurchases. Our view on share repurchase is that share repurchase is value neutral. It is not something that grows value. It does for the short-term holder, so maybe you can get a buck in the share price. but for the long-term holder it is not something that's value enhancing. It is much more like a cash sufficient dividend, which is the way we treat it. And that our priorities for cash are number one to reinvest in the business, to grow the business that will include bolt-on acquisitions, etc. Number two would be dividends, which we have increased for the last 51 years, 10% this year and third, excess cash would be put into share repurchase. And just because we don't need the cash in the business, so it's a return of cash to shareholders. But leveraging the balance sheet to do something that we would view as value neutral, we don't think is the right thing to do.”
That is the definition of the straw approach as laid-out by Mr. Thorndike – value neutral and unlikely to have a meaningful impact on long term share values; Coca-Cola’s CFO doesn’t mince his words - and apparently hasn’t read the shareholder letters from that guy in Omaha (BRK.B)...
Of course, “value neutral” is a bit deceptive; “neutral” would imply a balance between advantageous and pricey repurchases, which nets out to a non-event (before considering frictional costs); the problem is that companies don’t take such an approach: they tend to buy when times are good - and stock prices are high. The first two priorities mentioned above have relatively steady capital requirements - leaving plenty of room for doing something stupid when a lot of cash starts pouring in (sometimes this will play itself out through priority number one – an overpriced acquisitions).
A better description than neutral would be value destruction – buying high and sitting out when prices start to fall. A great example of this in action recently played out at John Deere (DE); here’s a Power Point slide that was presented on their most recent quarterly conference call:
As you can see, their allocation strategy fits the picture I laid out above – a set dividend payout ratio as a percentage of earnings, with the implicit understanding that repurchases will be a last resort, the destination for excess cash; in a business where earnings can move quite substantially from year to year, this is material. Well, let’s see how they’ve done with such an approach in the last few years:
From 2005-2008, Deere’s stock was on fire: from $35 per share in January 2005, the stock would cross $90 per share thirty-six months later – good for a 3-year CAGR of 37%. Not surprisingly, the business was doing quite good as well: free cash flow from the equipment operations increased by approximately 80% from fiscal 2005 through fiscal 2007. Cash proceeds funneled towards dividend payments, however, increased by only one-third over the same period; much of the difference went to repurchases, with the total spend increasing by 65% - or $500 million – in 2007 compared to the amount spent on buybacks in fiscal 2005.
Even into 2008, Deere kept the pedal to the metal – but not for too long: Of the $1.7 billion the company spent on repurchases in the fiscal year, about 60% was completed by May 2008. As 2008 progressed and moved into 2009, the business was in trouble and management had lost all enthusiasm for repurchasing shares; after spending $1.7 billion in 2008 to repurchase shares at an average cost above $80/share, Deere didn’t repurchase any shares in 2009, with the stock trading below $50 for the vast majority of the year – and bottoming out near $25.
As the stock has rebounded along with the business, management’s interest in repurchases has been renewed. Here’s a breakdown of Deere’s repurchase activity over the entire period:
You would be hard pressed to make the case that over a market cycle, this result can be considered neutral; the fact is they became increasingly interested in buying as the stock moved higher and higher (intrinsic value was not increasing north of 30% per annum from 2005-2007), but wouldn’t step to the plate when the stock cratered more than 50% below where they had been buying hand over fist a few quarters earlier.
By the way, this happened by design – when the world was scary and when the business was struggling (and the stock was cheap), Deere couldn’t afford to commit to repurchases; the cash flow from operations in fiscal 2009 was $1.4 billion – down 40% from the prior year. Moving down the cash flow statement, we see that Deere spent nearly $800 million on CapEx in fiscal 2009; regardless of the economy, you need to invest in maintenance CapEx to stay in business – and hopefully will be investing in some organic growth if opportunities are present as well. Moving to financing activities, Deere spent another $475 million on paying dividends; as noted above, cutting the buyback is just fine – but cutting the dividend would be a sacrilege. That doesn’t leave much “excess cash” for repurchasing shares without accessing capital markets – and it was a scary time when executives would be uninterested (or possibly even unable) to issue debt to fund the repurchase. As a result, Deere stopped buying back stock after spending more than $3 billion in the prior twenty-four months. The negative signs from Mr. Market were reinforced by an inability to repurchase shares without rocking the boat (slowing repurchase spend in good times, temporarily suspending the dividend with the intent of using funds towards an opportunistic tender at $30-$40 per share, etc); overcoming the first factor is hard enough in the thick of things without adding the second deterrent as well.
By the way, Deere isn’t alone; here’s the repurchase activity for the S&P 500 (SPY) over the past few years (which brings to mind a Singleton quote - "if everybody's doing them, there must be something wrong with them"):
This is a direct result of a fundamentally flawed thought process, as well as a misunderstanding of what share repurchases can do if executed intelligently (by individual investors and management teams alike). I think there's a strong argument that the “straw” approach is value negative, not value neutral. Ironically, Deere announced an extension to their share repurchase program as this article was being written (with no indication to the size, timing, or criteria for the repurchase - another feature of repurchases that makes little sense in my mind, and which I've spoke about previously); the market took it in stride, sending the stock higher by a few points on the news.
Chairman and CEO Samuel Allen added this to the announcement: "Today's action reflects our confidence in the company's long-term future growth opportunities… the decision announced today exemplifies our commitment to creating superior long-term value for investors."
I’m a bit more skeptical about the value created by these repurchases than Mr. Allen seems to be.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.