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Thomas Macpherson
Thomas Macpherson
Articles (180)  | Author's Website |

Stock BuyBacks: A Lesson Not Learned

When management repurchases stock, they are making a major capital allocation decision. It's usually not the right one

January 15, 2020

When you start looking at stock buybacks, you begin to realize you are playing a game of Three Card Monty. Nothing is really as it seems and the numbers never really add up. It truly is dealing with the cards stacked against you.” - Robert G. Warren

Several years ago, I wrote about how many corporate executives buy back company stock at exactly the wrong time. They generally purchase as the share price hits an all-time high, then cease all activity when the stock crashes. I’ve always been cynical when corporate boards announce share buyback plans in the hundreds of millions (or even billions). After merger and acquisition activity, in general I can’t think of a worse use of capital.

Buybacks: A quick history

Traditionally, stock buybacks were not held in very high regard. In 1932, The New York Times made three specific arguments against buybacks.

First, they used up a corporation’s cash balance. Second, they were simply a cash transfer between the corporation and management and directors who were dumping their shares. Last, they focused management on the whims of the market (through stock price movement) and distracted them from the running of the business. The Securities and Exchange Committee made it more difficult in 1934 with the Securities and Exchange Act making stock buybacks (though not mentioned) a potential violation.

The 1970s provided middle ground by creating conflicting policy of either making buybacks flat out illegal to simply having a corporation disclose their intention to purchase their shares. The SEC never really came up with a good answer, flip-flopping back and forth. Things took a big step in a different direction in 1982 with the SEC’s issuance of Rule 10b-18, which made it very difficult (if not impossible) to sue companies for stock buybacks. By removing mandatory disclosure requirements, companies received a green light to start buybacks with relative abandon.

Which brings us to today. The Trump tax cuts have brought buybacks into focus again. Indeed, buybacks - which have been increasing over the last decade - jumped about 50% last year to nearly $800 billion for the companies in the S&P 500. This is an all new high according to S&P Global. This data seems to contradict the claim that most of the tax cuts have gone toward reinvesting and growing company businesses. (Though to be fair, some would argue share buybacks are a form of capital reinvestment.) Since 2009, U.S. companies have bought back roughly 80 billion shares, but total shares have increased from 289 billion in 2009 to 294 billion in 2019. It’s hard to argue that shareholders have been the winner in this binge of buying and lack of share reduction.

Source: Bloomberg Opinion.

In fact, much research has been published showing that buybacks add little, none or even subtracts value from shareholder returns. One of the most interesting – which I encourage readers to download (sorry to say there is a license of $44) – is an excellent peer-reviewed article[1] outlining that in many countries - whether investors use a dividend model or a total payout model to decompose equity returns - net buybacks explain more than 80% of the cross-sectional dispersion of stock market returns.

Another example of repurchases changing in their scope and value for corporations versus shareholders has been the explosion in repurchases. In a study by David Ikenberry Josef Lakonishok Theo Vermaelen (“Stock Repurchases in Canada: Performance and Strategic Trading”), the authors state:

In recent years, corporations have dramatically increased the amount of capital devoted to repurchasing their own shares. In the mid-1980s, repurchase program announcements in the U.S. amounted to roughly $25 billion per year. Between 1996 and 1998 however, more than 4,000 open market repurchase programs were announced which, if fully completed, amount to roughly $550 billion. During the first quarter of 1999 alone, Securities Data Company reports nearly 350 program announcements totaling $40 billion. Interest in corporate repurchase programs is not limited to the U.S. as repurchase activity worldwide has grown in recent years. Countries such as Hong Kong and Japan recently implemented new regulations allowing companies for the first time to repurchase their shares. A recent Goldman Sachs study (March 1999) foresees stock repurchases becoming more common in Europe and discusses the potential impact on European equity values.”

Why this matters

With this explosion in repurchases – yet no reduction in share counts – the obvious question is whether these actions have been a wise allocation of capital. If the answer is yes, then shareholders should wholeheartedly encourage such behavior. If the answer is no, then shareholders – through their duly-elected representatives on the company’s board of directors – should actively seek to stop these transactions.

Investors should look at share repurchases as no different than their value approach in their own investment process. If shares are bought at a discount to the company’s intrinsic value, then this could be perceived as an appropriate allocation of capital. Repurchasing shares at prices higher than intrinsic value would be a poor use of capital.

Unfortunately, all evidence would suggest that companies go on repurchasing binges as share prices reach new highs and cease purchases as share prices reach new lows. The most recent example of this is the example previously cited with new repurchase highs reached in 2019 as shares reached all-time highs. Another example was the similar pattern seen between 2006 and 2009 as share repurchases reached all-time highs (for the time) in 2007 (the height of the mortgage asset bubble) only to see a near 75% drop in repurchases as the markets collapsed in 2008-09 (see graph below).

Source: FS Investments.

For any investor in a company that has followed this pattern of “buy high and stop buying when low,” they can safely assume management has a poor understanding of capital allocation. Any value investor should avoid companies run by such individuals.

Conclusions

The story of stock buybacks has been relatively consistent since the SEC’s policy change in the 1980s. The enormous number of buybacks – mostly purchased when stock prices are at all-time highs – have provided little to no advantage for the value investor. Only when enough shareholders speak up and force management – through board oversight – to perceive stock buybacks as a means to improve shareholder returns will buybacks become sound capital allocation.

As a value investor, I suggest readers find companies that have firm guidelines about buybacks that are tied directly to value versus intrinsic value. Partnering with such management gives an investor the best chance to see long-term growth in their portfolio.

As always, I look forward to your thoughts and comments.

[1] “Net Buybacks and the Seven Dwarfs”, Jean-François L’Her , CFA, Tarek Masmoudi & Ram Karthik Krishnamoorthy , CFA, Financial Analysts Journal, December 12, 2018, pages 57 - 85

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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 5.0/5 (1 vote)

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Comments

Dilantha De Silva
Dilantha De Silva - 1 week ago    Report SPAM

Apple's buyback program in the last couple of years will go down in the history books as one that provided great returns to investors. If not for the buyback program, there was every chance of a collapse in the stock price. As always, there's a price at which a buyback program will add little to no value to investors and I think now is that price for Apple.

Thanks for the nice read, by the way. I've seen articles that dismiss all the benefits of buybacks and talk about the negatives but this is a more balanced read.

Zoltan Nagy
Zoltan Nagy - 1 week ago    Report SPAM

Cannot recall the source (think it was a podcast) but I remember the interviewee saying (based on the research he did) that large part (cca. 80%) of the buybacks do not create value, because in reality, those shares are (re)distributed among employees ... rather than dilluting the shares by issuing new ones whenever they are needed companies just buy the shares on the open market than give them to whoever they want.

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