Mohnish Pabrai (Trades, Portfolio) once said that Charlie Munger (Trades, Portfolio) once told him three rules that could create investment results vastly better than the rest:
1. Follow the great investors.
2. Look at the cannibals (share repurchasers).
3. Carefully study spin-offs.
The first and third rules are very straightforward, despite the somewhat difficult application in reality. In this article, I want to provide a precautionary note on rule No. 2 above because I have seen many non-professional investors fall in the trap of fake cannibals, which I will explain further below.
Charlie Munger (Trades, Portfolio)'s second rule is to pay close attention to cannibal companies, or businesses that are buying back huge amounts of their stock. Berkshire’s largest holdings almost all fit into this category. Take IBM (IBM, Financial) as an example. It has repurchased more than $100 billion of its own stock in the past decade, reducing its shares outstanding by more than a third. Legg Mason’s Bill Miller once noted, “IBM is the only one of the mega-cap stocks that were popular in the late 1990s to go to an all-time high. The reason for that is, IBM has an absolutely unequal record in capital allocation."
A less familiar name, Strayer Education (STRA, Financial), is another good example. Under the leadership of Robert Silberman, STRA’s share count has reduced 30% during the past 10 years from 15.1 million shares to 10.6 million shares. Now whether the share repurchases were made at the right price is another question, but repurchases of that magnitude itself demonstrate the cannibal-like characteristic of the business.
At the other end of the spectrum, there are tons of companies who actually increase share count through numerous rounds of equity financing or secondary offerings. Technology stocks are notorious for their propensity to dilute their shareholders. For instance, LinkedIn increased its share count by 30% in its short life as a public company. If you think that’s bad, take a look at Tesla’s share count since its IPO —Â it will blow you away.
Obviously I don’t like equity diluters, but at least they don’t try to hide that fact that they are diluting the previous generation of equity holders. Between the cannibals and the proliferators, there is a dangerous species in the stock market, which I call “fake cannibals.” These are the companies that publicly tout the fact that they’ve spent so much money on share repurchases but either they pay a very high price for their shares or they merely use the repurchase program to offset share dilutions. The former case (pay a high price) should be fairly familiar to most investors, but the latter deserves further discussion. Many investors who bought the cannibal story found themselves befuddled when they later discovered that the share count has hardly changed or even increased. This is because the shares repurchased are used to offset the dilution due to option exercise or vesting of restricted stocks.
Tenneco Inc. is a good example of fake cannibal. During the past three years, Tenneco Inc. has publicly announced a few rounds of share repurchases, but its share count has actually increased a bit during the past three years. Here the Statement of Owner’s Equity may come in very handy.
From the above Statement of Owner’s Equity, which not many investors even bother to check, we can glean very useful information with regard to the share count. Although Tenneco Inc. has repurchased between 400,000 to 600,000 shares, it has issued even more shares to partially offset the dilutive effects of share issues. To Tenneco’s credit, the company did state that the "repurchase program is intended to offset dilution from shares of restricted stock and stock options that were issued to employees in 2014 under Tenneco’s long-term compensation plan.”
However, the news release title, which is “Tenneco Announces Share Repurchase Program,” could give the misleading impression that Tenneco is dedicated to share count reduction for those investors who don’t go into the details of the press release.
There are plenty of companies like Tenneco Inc. Non-professional investors can be fooled by a company’s frequent announcement of share repurchase programs if he or she does not spend time digging into the details of the share repurchase program and statement of owners' equity.
Next time you hear a stock repurchase program, you know what to do.
