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Don’t Buy In to Share Buybacks

Andrew Mickey

Andrew Mickey

8 followers
Bull Market - A random market movement causing an investor to mistake himself for a financial genius. – Anonymous

The bull market is over and the days when everyone was an expert are gone. Merely buying a stock and watching it go up day after day is history. “Buy and hope” is dead.

But that doesn’t mean you can’t make money and get your portfolio back in shape. You can. You just have to separate the fact from fiction. And one of the most dangerous myths that could cost you even more money is that share buybacks are good.

You see, the world is not coming to an end. The economy will recover…eventually. A new bubble will form. And greed will replace fear. It always does. And here’s the best part, a few companies will emerge stronger than they were before. The trick is to identify which ones will make the best of a bad situation.

This is a time when great companies increase their market share. The strong get stronger and well…the weak disappear.

Companies have to make investments to get stronger. They can refurbish factories, develop new products, or aggressively build a brand while advertising costs have dropped significantly. If a company has a mountain of cash, it should be reinvesting it to take advantage of future growth opportunities, reduce costs, and increase efficiency. Frankly, there’s no better time to do it than now.

That’s why it pains me to see the sharp increase in share buybacks recently. A share buyback, or repurchase, is when a company buys its own shares. It’s a way for companies to reduce the number of shares outstanding. Earnings per share will increase because there are fewer shares to divide profits.

It makes sense on the surface. Less shares and same profits equal more profits per share and a higher share price. It seems like they’re doing something good for shareholders. In fact, the markets will usually reward a buyback plan and bid shares up a few percentage points when the plan is announced. But it’s just one of the many stock market myths that are allowed to live on.

Over the past couple of weeks dozens of companies took “advantage” of the market turmoil to announce share buybacks. In some cases, the buyback programs are reaching well into the billions.

Last month Microsoft (MSFT) set a new record when it announced it would be buying back $40 billion worth of its stock. Following behind are other cash-heavy companies including Intel (INTC) , Nike (NKE), Hewlett-Packard (HP), and Oracle (ORCL).

All of these buyback announcements were viewed positively by Wall Street. It’s considered a sign of strength to be buying back your own shares.

But Wall Street, as it has been so many times before, is dead wrong. Share buybacks are not positive. There are some benefits, but the long-term benefits are limited.

When a company is buying back shares, it is telling the world, “We cannot find anything better to do with our money.”

It’s just that simple. A company that is buying back shares is doing so because it can’t find any better investments to make. Microsoft isn’t launching any more major projects. Intel is not building any new plants. They’re giving up on growth. And when the economy does recover, these companies will not turn out to be any stronger, more efficient, or more profitable.

Two Big Pharma companies provide the perfect example.

Pfizer (PFE) has repurchased more than $19 billion worth of its shares since 2005. Its share price has steadily slid from $28 to under $17 during that time.

Meanwhile, its core business has gone down the tubes. The company’s pipeline of new drugs is very limited. And a few of its key cash cow drugs are set to go “off patent,” which means generic drug companies will start selling generic versions for much less.

Pfizer’s share buyback has been a big mistake. For $19 billion it could have bought itself a very strong pipeline of new drugs. A few patent-protected blockbuster drugs would keep the cash flowing in for years to come.

One of Pfizer’s competitors, GlaxoSmithKline (GSK), isn’t taking the same path. Earlier this week, Glaxo announced it will be halting its buyback program.

Andrew Witty, Glaxo’s CEO, explains, “We're not reserving capital for a rainy day that may or may not come. Opportunities are surfacing with some frequency on the small to medium scale. More of these have surfaced in the last month.”

Glaxo is setting up to start making acquisitions while the markets are in turmoil. It’s not buying its own stock for marginal benefit. And it’s not announcing an extended buyback plan just to get a slight uptick in its share price either. Glaxo is taking its cash hoard and going shopping.

As a result, it will be in a much stronger position when the economy recovers. While the rest of its competitors are buying back their own shares, Glaxo is investing in its future. That’s what I like to see. It’s thinking long-term.

Just imagine if the banks would have thought long-term. Over the past few years some of the biggest share buyback leaders have been the banks. Bear Stearns, Lehman Brothers, and Freddie Mac (FRE) all were buying billions of dollars worth of their own shares. If they would have sat on the cash to bolster their balance sheets, they might have had the reserves to save themselves.

Also, corporations have a knack for buying their own shares at the worst possible times. S&P 500 companies spent $135 billion on share buybacks in 2003 when the market was bottoming. In 2007, when the Dow was setting new all-time highs, they bought $590 billion worth of their own stock. In fact, between 2000 and 2005 companies which bought back their own shares only beat the rest of the market by one percent.

Don’t get me wrong, we can learn a lot from buybacks. Just take a look at ExxonMobil (XOM). The oil giant has been a very aggressive buyer of its stock. Over the past three and a half years Exxon bought back just over $96 billion worth of its own shares.

If oil really was going to $200 a barrel or more, wouldn’t the world’s largest oil company who employs thousands of true oil industry experts, spend some of that cash on acquiring smaller oil companies which have made new oil discoveries or have large amounts of reserves? Exxon kept it’s cool throughout the oil boom. And now it’s still in a great position.

That’s exactly what we need to be doing now, keeping our cool and looking at the facts. And the fact is share buybacks don’t tell us much about the long-term prospects of a company or the value of its shares. At Q1 Publishing we try to avoid a lot of the myths that can destroy even a conservative portfolio. So if you see one of the companies you’ve held on to announce they’re buying back shares, it’s time to re-evaluate.

Good investing,

Andrew Mickey

Chief Investment Strategist, Q1 Publishing


About the author:

Andrew Mickey
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.4/5 (23 votes)

Comments

grep
Grep - 5 years ago
Great article.
frankiwa
Frankiwa - 5 years ago
You are misinformed on share buybacks.
516632
516632 - 5 years ago
Too absolustistic and in my view incorrect interpretation. Buybacks and growth prospects of competitive companies usually go hand in hand.
doubleh
Doubleh - 5 years ago
In the 80's, companies were buying other companies for diversification purposes, but the more appropriate term should have been "di-worsification".

Sure, right now would be a good time to buy other companies, but ONLY if it's a synergistic acquisition. Market is a weighing machine in the long term
John Krantz
John Krantz - 5 years ago
Is the whole forum turning into a bunch of Commoditys? lol.

Just how is the author misinformed on share buybacks? Please tell me, I'd really like to know. I love how many one star votes the author of this piece got while trite one line blanket responses like "You are misinformed on share buybacks" get multiple 5 star votes. We are all here to learn, and if you think the author who took the time to write this article is wrong and you want to type a response then please enlighten the more ignorant members community, like the author and apparently myself, as to why he is wrong. The author provided his reasoning, and if your reasoning comes to a different conclusion then please have the courtesy to present it or don't bother with a response stating your disagreement.

I don't see how share buybacks are better than either growing the business or paying out the money to its shareholders via dividend. The author is right that the market is flooded with very ill-timed share buyback programs. Oftentimes the company also issues tons of free shares to its employees via options so in effect the company is using its cash to buy shares and then turns around and gives executives free shares.

In light of how easy (and highly-probable to occur) it is to increase share count, what exactly are the long term benefits of share buybacks? Can anyone provide an example of long term value being created by them? Under what scenario is a share buyback the best thing for a company to do with its cash, and why?
buffetteer17
Buffetteer17 premium member - 5 years ago
Okay, I'll take a stab at it. The principle is to buy back your own shares if your stock is undervalued and you don't have a better use for the money. Say XYZ shares sell at $50 and are intrinsically worth $100. Say there are $100M shares out, and XYZ is sitting on $1500M of cash.

We can split the intrinsic value of the company into the cash part, $1500M and the business value part, $8500M. Say XYZ buys back $1000M of their own shares at $50. Now they have $500M of cash and a business value of $8500, but only 80M shares. The intrinsic value per share has increased to $112.5. A 12.5% increase in share value by simply exploiting the mis-pricing by the market.

So if XYZ cannot use their excess capital to make 12.5% otherwise, it makes good sense for them to buy back shares. Such a massive buyback in ordinary times would push up the share price as it went, making it impossible to buy back the full 20M shares at $50. But in times like these, it is possible to do the buyback without driving up the price.

When does a company not have a chance to make big returns on their capital? There might be many reasons for this. Perhaps their core business is pretty well saturated and either not growing or growing slowly. For example, Microsoft. They pretty much have a lock on the desktop computer OS and business apps. Putting more capital into this would not increase their revenue. There is no reason to think they could be sucessful by branching out into other areas, say by buying Yahoo to get into search.

Another reason is that the business doesn't want to grow too fast. Consider a successful chain store or restaurant. It is best for them to grow relatively slowly, to keep the business under control and reduce risk. Too-fast expansion can lead to inefficiencies or mistakes. Walmart did not do well in Mexico and Latin America. If they had opened stores everywhere at once there, it would have been a disaster. Instead they eased in slowly, and discovered their business model did not work there. In China they are growing fairly slowly as they learn the ropes.
Fusion
Fusion - 5 years ago
I don't think you can lump together all the share buy backs that emptyheaded.

Some thoughts of Andrew is completely right. For instance in Pfizer's case it did not make sense to buy back shares and contemporaneously invest nothing in the pipeline. But we all can talk that smart after things turned out.

For Microsoft it clearly makes sence to buy back shares, i think. There aren't any great threats endangering Microsoft's survival and the strength in a recovering environment.

This also holds for Exxon. For the Oil industry it doesn't make sence to explore new fields at current prices. Also, you can hardly acquire some oil reserves since they are mostly owned by the states themselves. You only get the right to exploit the fields and to participate in profits.

For many other industries this is really different. Consider Telecom operators for instance. There are far better ways to invest the money. Licenses in (future growth)countries like Africa are sold at (currently) an relatively attractive price. So why not growing, getting stronger (like Andrew points it)??

However, i than think again about the price... Currently, shares are trading at the same relative attractivity. The conclusion is (like it is often), you have to have a deeper look in valuating both opportunities.

At the end it depends on the economic environtment in the industry. You have to find out if growing the business is sustainable enough to pay out your investment. Or (in the case of pharma) is an investment necessary to survive??

One thing i have to add is wether paying out the money as a dividend or via share buy backs. In the long run a share buy back is more profitable for investors. This is due to two facts. Dividends are biased by taxes paid on them. So you enrich the state contemporaneously. The 2nd advantage of a share buy back is its durability. Profits far in the future are still divided by a smaller amount of shares.


John Krantz
John Krantz - 5 years ago
See those are the kind of replies that add value to the forum. Thanks for explaining the other point of view for me.

I do get how share buybacks are supposed to work in principle. But to me, with executive/employee options and various other means of dilution common in public companies, the share count always seems to end up being continually increased in the long run. A share buyback would temporarily increase the value of the shares until more shares were issued again. So I question the real durability of the reduction in share count. In a company with a long history of non-dilution then I'd agree that the value was durable. Those companies who don't offer executives and employees "company script" via tons of options don't seem common to me.

I'd personally prefer extra cashflow to be pushed out to the shareholders. While the tax would take away from the return, at least you'd be able to reinvest it as you see fit.

buffetteer17
Buffetteer17 premium member - 5 years ago
I think Microsoft quit handing out employee stock options a couple of years ago.
DaveinHackensack
DaveinHackensack - 5 years ago
Mark Cuban agrees with John Krantz on buybacks, as I noted elsewhere recently. In theory, it makes sense to buy back shares if they are trading below intrinsic value, but in reality, even the smartest investors get their calculation of intrinsic value wrong. It makes more sense to consider buying back shares when they are trading below book value. USEG, a stock I've mentioned here before, has been doing that recently, but its stock is trading for less than half of the company's book value and even less than the value of its cash and short-term investments (AlanB9, I have a message in to the company regarding your question related to this; I'll post an answer here when I have one). The CEO of the company mentioned recently that he envisions using these shares he's buying back as currency for acquisitions after the shares have appreciated significantly.

Regarding Exxon Mobil, XOM's share buybacks have resulted in significant net reductions of its share count (about 5-7% per year, if memory serves), but I agree it would have been better off not buying back its own stock. The company has historically been prudent enough to avoid over-investing when oil prices are high, but if it doesn't make sense to look to acquire other companies and their reserves during periods of high oil prices, then it doesn't make sense to buy back your own stock then either. XOM should have horded the cash, so it could make even more acquisitions of over-leveraged smaller companies when oil corrected. Either that, or increased its dividend.

Regarding Pfizer, saying it hasn't invested in its pipeline isn't accurate. They have had some well-publicized failures, but there has been, and continues to be plenty of investment in new drugs at various stages of development. Here's the company's pipeline as of September.
Fusion
Fusion - 5 years ago
John, thank you for the hint on the executive/employee options. In a study of 2001 this is expressed as the option-funding hypothesis. In fact, the number of outstanding (even stronger for exercisable) options is positively correlated with share buy backs. A way to distinguish option related buy backs from buy backs due to undervalued shares is to have a look at the peformance preceding the buyback. Falling share prices reduce the probability of (profitably) exercisable options. The study shows a positive correlation of the share price development preceding a buyback and shares outstanding following the buy back (ie. rising share prices lead to a higher amount of exercisable options reducing the net effect of the buy back).
alanb9
Alanb9 premium member - 5 years ago
John Krantz Wrote:

-------------------------------------------------------

> But to me, with executive/employee

> options and various other means of dilution common

> in public companies, the share count always seems

> to end up being continually increased in the long

> run.

A few companies share counts in 2003 v. 2008:

MSFT 10882--9387 a 13.7% decrease

KO 2462--2342 a 4.9% decrease

CISCO 7223--6163 a 14.7% decrease

XOM 6659--5401 a 3.9% decrease

PFE 7286--6799 a 7.3% decrease

At least in these 5 companies (the only ones I checked) long term (5 year) share counts decreased significantly.

If the companies you look at seem to maintain stable share counts in spite of buying back shares, then I would hazard a broad statement that those companies are not shareholder friendly and should not be bought by a long term or value investor.

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