A Discussion of Share Buybacks and Capital Allocation

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John Emerson
Jun 12, 2013
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There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds cash plus sensible borrowing capacity beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated." --Warren Buffett

Nothing can raise my blood pressure quicker than listening to Jim Cramer chide management teams about buying back stock rather than issuing dividends. I am not implying that Cramer is incorrect in advocating that many companies should pay dividends rather that retire shares; rather, I become provoked by his misguided reasoning in regard to share repurchases.

Cramer believes that the foremost reason for instituting share buybacks is to raise the price of the stock in the near term. However, should the stock subsequently drop, then he deems the management foolish for pursuing the share repurchase. In retrospect, he insists that they should have paid a dividend instead of retiring shares. On the other hand, if the stock rises shortly after a share repurchase then the decision is deemed prudent without regard to the price paid for each share which was repurchased.

In essence, Cramer is insinuating that the pertinence of share buybacks is their effect on the short term volatility of a stock rather than their effect on value creation for the shareholder. Simply stated, Cramer believes that the reason for a share repurchase is either to raise the price of an equity or to stop its descent in price. Should the buyback fail to achieve the aforementioned result, it is deemed to be a failure. Unfortunately, this misguided sense of priorities is quite prevalent on Wall Street, where the pursuit of short-term movements frequently trumps the creation of value. After all, many pundits still believe that Mr. Market is omniscient.

Oddly enough, Mr. Buffett's decree about Berkshire's (BRK.A, Financial) policy on repurchasing their own shares (shares will be repurchased at 110% of Berkshire's published book value) seems to fit both Cramer's and Buffett's views in regard to share buybacks. Specifically, the publicity generated by the share repurchases would likely cap the downside on Berkshire Hathaway stock as well as fulfilling Buffett's two requirements that were stated in the opening quote. Indeed, sometimes an investor can have "the best of all possible worlds" when investing, to borrow the phrase from the philosopher Leibniz.

Today's discussion will examine the methodology an investor can utilize to determine whether stock buybacks are prudent. Additionally, the article will analyze how a shareholder can determine if management is allocating capital properly.

Allocation of Capital

Management has three choices in utilizing excess capital (actually four, they can choose to do nothing): They can reinvest the excess capital to grow the business, or they can return the capital to shareholders in the form of dividend payments or by retiring shares of company stock.

Superior management teams distinguish themselves when they maximize shareholder value by employing the most effective method of capital allocation for a business. If a company possesses a durable competitive advantage in its products or services, or is blessed with a management team who is able to identify and purchase businesses at prices well below their intrinsic value, then the shareholders are best served by the investment of the companies' excess capital and retained earnings to grow the company's earnings and equity. However, if the business holds no competitive advantage and the management is unable to identify "undervalued" acquisitions, then the excess capital and retained earnings should be returned to the shareholders.

Proper Methods of Capital Allocation

Companies which exhibit high rates of return on invested capital (ROIC) are usually better served by allocating capital for growth likewise with holding companies that possess management teams which excel in identifying undervalued businesses that are available as acquisitions or possess the ability to purchase a percentage of an undervalued business in the form of its common stock, preferred stock or as a joint venture. This generalization assumes that the company's own stock is not available for repurchase at a price that reflects a discount which is greater than the company which they are acquiring.

It would seem that Buffett arrived at the latter conclusion when he decreed that Berkshire shares would be repurchased if they dropped sufficiently in value. The decision makes perfect sense in light of the behemoth size which Berkshire has achieved. It has become increasingly difficult for Berkshire to identify companies of sufficient size to justify making an investment which would have a material effect on the underlying value of the holding company. Further, the large acquisitions which Berkshire now pursues (such as Burlington Northern) are not available at large discounts to their intrinsic value. Rather, they are cash-generating machines with superior moats, which supply significantly higher rates of return when compared to fixed-income alternatives.

Dividends should only be issued to shareholders when none of the aforementioned conditions exit. Generally speaking, dividends should only be issued if the stock is trading above its intrinsic value and the company is unable to achieve a suitable return on investment by reinvesting its capital in pursuit of growth. Unfortunately once a dividend is initiated, it hard to discontinue the practice without raising concerns about the solvency of the business. Therefore, I prefer the issuance of special dividend rather than regular dividends when conditions merit returning excess capital to the shareholders. That said, I am sure that my stated belief represents a minority opinion.

When Is a Share Buyback Recommended?

A company should initiate share buybacks when of the following conditions exist: Shares are trading at a substantial discount to their cyclically adjusted earnings, at a historical discount to their price to book ratio or some other valuation method which signals a discount to the intrinsic value of a company. Further, buybacks should take place only when growth is not a viable option due to the size of a business, its lack of a competitive advantage or if the anticipated rate of return on the capital invested is less than could be recognized by repurchasing shares. In such cases, assuming debt to repurchase shares would be advisable so long as the interest rate did not destroy the value proposition and the liquidity of the company was not put in peril.

Of course a buyback is usually indicated only if the business contains a viable future. A company which holds a negative business value should not retire shares unless it can do so at a significant discount to its liquidation value. Such business would be described by Benjamin Graham as "worth more dead than alive." An example would be a business which traded at discount to its cash, cash equivalents and short-term investments when all its liabilities were subtracted.

When Are Dividends Recommended?

Issuing dividends is usually advisable for mature companies which are unable to reinvest their earnings at a rate which is sufficient to justify the cost of the investment. In other words, each dollar reinvested in earnings growth must result in a return of significantly more than the dollar which was invested, otherwise the company is not creating any value for its shareholders. Furthermore, dividends are indicated when the price of the stock is equal to or greater than its intrinsic value. If the market price of the stock is below its intrinsic value then a share repurchase is indicated since the repurchase of its shares not only defers taxes but also results in recognition of shareholder value.

Improper Use of Share Buybacks

Unfortunately, many stock buybacks are not performed in the interest of creating shareholder value; rather they are initiated in the interest of hiding the impact of excessive stock options which would result in significant shareholder dilution. The practice is particularly untenable when the stock is trading at multiyear highs and results in an excessive capital drain which should have been invested in growing the business or returned to shareholders in the form of dividends. Such companies usually trade at high multiples because of their perceived growth potential and many unwitting shareholders have no idea that they are being robbed blind by the excessive price paid to repurchase company shares.

Concluding Remarks

Every shareholder should routinely review and evaluate the performance of management in properly allocating the company's capital and retained earnings. It is incumbent upon the shareholder to evaluate whether the management team is attempting to maximize shareholder value.

Many times, the difference between a terrific investment and a mediocre one is the effectiveness of the companys management in properly allocating capital. Proper allocation of capital goes hand-in-hand with long-term capital appreciation in a stock and in the case of mature companies; the dividend payout will likely make the difference in determining whether the investment outperforms an index fund.

Proper capital allocation should be a function of a company's ability to reinvest its profits at an acceptable rate of return as well as a function of the management's ability to calculate the intrinsic value of their stock. Shareholder-friendly management should exhibit a willingness to maximize shareholder value rather than promote the price of their stock or maximize their own compensation.

As Buffett noted in the opening quote, proper share buybacks are subject to only two conditions: The company must have the liquidity and funds to pay for them and the company must be trading below its intrinsic value.

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I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.