Renowned Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) Vice-Chairman and investor extraordinaire Charlie Munger (Trades, Portfolio), who passed away last week at the ripe age of 99, once urged investors to "Look at the cannibals." Cannibals are typically defined as species which eat their own kind, but in this case Munger meant companies that are "eating" their own shares. Munger used this vivid metaphor to convey the importance of monitoring companies engaging in share buybacks as potentially profitable investment opportunities.
Publicly traded companies typically have a large number of outstanding shares owned by a wide range of shareholders (this is called a "float" in industry jargon). A share buyback occurs when a company buys back some of its own shares from shareholders on the stock market and subsequently adds them to its own treasury or cancels them, resulting in a reduction in the total outstanding shares among all outside shareholders. Thus the float goes down.
Pros and cons of share buybacks
Now, you might think why should share buybacks be viewed positively? While not universally advantageous, when a mature, financially robust company repurchases its own shares at undervalued levels, it often benefits shareholders. With fewer shares outstanding post-buyback, the remaining shareholders typically experience higher earnings per share. In short, share buybacks can contribute to the growth of a company's earnings per share and, consequently, enhance the value of its shares. Buybacks are essentially concentrating the available pool of shares so that each share is now more valuable (this is the opposite of dilution, which makes each share less valuable).
In some instances where a company can repurchase shares below its book value, it may increase the book value per share. However, it is important to note that such actions are most appropriate for mature, financially stable companies with undervalued shares. Buybacks only help if the shares bought are below the intrinsic value of the stock. As Munger's business partner Warren Buffett (Trades, Portfolio) once said: “Price is what you pay, value is what you get.” This goes for buybacks as well.
For emerging growth companies or those facing financial challenges, allocating capital to share buybacks may not be prudent. Startup companies may be giving out shares to employees in addition to salaries and bonuses. While this is OK to a degree to incentivize them, it could become very costly for shareholders who are not insiders. Investors should be aware of this potential conflict of interest, that management is not double dealing.
Further, share buybacks may not yield benefits if a company merely repurchases shares issued as part of annual employee compensation. This is a tactic frequently done by even mature companies, so watch out for this as it is not buybacks that directly benefit non-insider shareholders. Moreover, if a company pays excessively for its own shares, it could potentially harm all shareholders, as those funds could be better utilized elsewhere. Another thing to watch out for is that frequently the companies will borrow to fund stock buybacks to boost share price. This is OK as long as the cost of debt is much lower than that of the cost of equity. But it increases risk. Companies who do that can get into trouble if interest rate rise and debt becomes unbearable.
Some real-world examples
The insurance company American International Group Inc. (AIG, Financial) is a good example. Shareholders went through a harrowing period in 2008 when the U.S. federal government had to rescue the company from bankruptcy in order to save the financial system from breaking down as AIG was insuring hundreds of billions of collateralized debt obligations which had gone bad. In the rescue process, the government diluted the shareholders by issuing a huge amount of shares to recapitalize the company. Basically, the equity holders were almost (but not absolutely) wiped out. Since AIG was recapitalized, it has been buying back shares. The blue line is the share price, the purple line the book value per share and the green line is the fully diluted shares outstanding. ("Fully diluted" means its takes into account non-vested share based compensation to insiders.)
Note that AIG has mostly buying back its shares at below book value. This is more clearly visible in the chart below, which shows a shorter window of time.
Berkshire Hathaway
We see the buyback dynamic with Munger's own company, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial), which turned "cannibal" around 2019 and started buying back its own shares. Watch the green line plunge. This is a clear sign the Buffett-Munger duo thought the shares were undervalued. The buybacks at Berkshire continue as we speak.
Hanesbrands
Hanesbrands Inc. (HBI, Financial) is a cautionary tale of stock buybacks while taking on debt. The shares have crashed, the company has had to cut dividends and is currently in survival mode. The red line below shows total debt per share.
Others
Some other companies which I found through the Gurufocus All-in-One Screener which have been consistently buying back shares are Imperial Oil (IMO), Cisco (CSCO), Booking Holdings (BKNG), eBay (EBAY), Cognizant (CTSH). There are many others. These companies appear to be undervalued and are financially strong, but please do your research to verify.
Conclusion
Echoing Munger's advice, we too should watch out for the cannibals. We should favor observing mature, financially robust companies repurchasing their shares at seemingly undervalued levels without taking on unmanageable debt. Conversely, companies engaging in buybacks under unfavorable circumstances while taking on debt may find themselves in big trouble, akin to going hungry and shirtless in the merciless world of investments. As always, investors need to be cautious that the board of directors of companies buying back shares are of high integrity and working for the benefit of all shareholders.
