This past week I read an article on GuruFocus by Andrew Mickey, CIO of Q1 Publishing, entitled "Don't Buy In To Share Buybacks" and the ensuing discussion piqued my interest. In his article, Andrew presented his arguments about why share buybacks are bad news in the long run for shareholders.
I agree with his perspective somewhat. I don't think it is possible to make an indiscriminate statement whether share buybacks are good or bad without examining the underlying motives behind each buyback decision.
As I've mentioned in my article Value Investing - Evaluating Management, it is important to always ask if management is acting on the best interests of the shareholders. Similarly, when evaluating whether a share repurchase is a good decision, we as investors need to decide if management made the right decision under the circumstances.
As Andrew has pointed out, share buybacks may not be all good news. There are three motives we need to watch for when evaluating management's decision of buying back shares with our money:
One of the biggest crime management could legally commit is to grant themselves massive stock options at the cost of shareholders. Buffett has always said that if management wants a piece of the action they should pay. Nonetheless, stock options, when awarded reasonably based on certain performance metrics, can be an effective form of compensation to align management interests with shareholders.
Back in 1999, Microsoft issued about $60 billion worth of stock options to its employees.[1] At the time, Microsoft earned a net income of $7.8bln but issued options worth $9bln.[2] And none of these options were expensed, but that's a story for another time. It wasn't until 2003 when Microsoft announced it would stop issuing stock options, start granting restricted stock and start expensing stock awards.[3] One wonders if the $70bln stock buyback beginning in 2004 is merely to reduce the dilutive impact from the stock options it has issued throughout the years.
Carefully chosen metrics for performance-based compensation is essential to the success of a business. Management incented to increase share price could resort to gaming the numbers to prop up the stock price and ultimately earn their bonuses.
Buying back shares could achieve the same effect. By reducing the number of shares outstanding, management can almost immediately increase earnings per share, increase return on assets and reduce PE all at the same time. Best of all, management would have earned their bonuses at the cost of shareholders money!
Sometimes, buying back shares could mean management lacks the skills to find better use of excess capital. The question to ask here is can the business earn a better return investing elsewhere? A dollar retained should increase the value by at least a dollar. If not, the cash should be returned to the shareholders so they can divert the funds into other investments.
This is where understanding the business is important. Could the business earn a better return by acquiring a related business on sale? Should management invest in organic growth to sustain future revenues? Every case is different and need to be examined carefully.
Needless to say, not all share buybacks are bad. Share buybacks can be beneficial in the following ways:
Substantial share buyback programs typically have an effect of helping the price converge on the intrinsic value sooner. This is, in fact, one of the weapons in the arsenal of activist investors to help realize the value of their investments.
When a share buyback is announced, management is usually sending a signal that the stock is undervalued and management is confident in the growth in future cash flows. Coupled with significant insider open market purchases, a share buyback could boost the share price in a meaningful manner. On the other hand, if after announcing the share buyback, management is quietly selling off their shares, you have to question the real motive behind the repurchase.
Back in the days when capital gains tax is lower than dividend income tax, a share buyback is a more tax efficient way to return money to shareholders than paying a dividend. But since both capital gain and dividend income are taxed at the same rate now, the tax advantage has disappeared.
However, at the corporate level, there are still tax benefits to be had when buying back shares. A company that spends $100 million in cash to repurchase its shares will relieve itself of paying $9 million in taxes on the interest income it would have earned on the same amount had it kept the cash in a money market account earning 3% (assuming no growth in interest).[4] This tax saving in theory should translate into a $9 million increase in market price in a share buyback. In short, by returning the excess cash to shareholders, the business continues to generate the same cash flow but on less equity divided into lesser number of shares. Not a bad way to return money to shareholders and save on taxes.
Buying back shares can be enhanced by utilizing cash from issuing debt. Remember, excess cash held at company is not free for company to use. After all, the cash belongs to the shareholders and the shareholders expect a decent return on the equity.
By issuing debt at an interest rate lower than cost of equity to buy back shares, the company has just increased leverage and lowered the cost of capital. This magnifies the return on invested capital to shareholders. What's more, the interest expenses paid on the debt can be tax deducted. Again, the tax saving translates to an increase in share price.
When there are no other investments that could yield a better return than buying back shares, management should just return the money to shareholders. Spending the money on share repurchase also has the effect of preventing management from getting into silly acquisitions that would in the end cost huge losses to shareholders. Peter Lynch calls these deals deworsifications.
Dumb acquisitions could cost losses that run well into the future. Buffett calls buying Dexter Shoes with $433 million worth of Berkshire stock in 1993 the biggest mistake he has made. Although Dexter is no longer making shoes, Berkshire shareholders has lost $3.5 billion on the deal thus far and will continue to lose money as the shares increase in value.[5]
In summary, don't be too quick to credit or discredit a buyback without first identifying the motive behind the decision. After all, if you were to draw a line here and consider all buybacks to be bad, you could be missing out on many, many great companies selling at a discount.
References
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
I agree with his perspective somewhat. I don't think it is possible to make an indiscriminate statement whether share buybacks are good or bad without examining the underlying motives behind each buyback decision.
As I've mentioned in my article Value Investing - Evaluating Management, it is important to always ask if management is acting on the best interests of the shareholders. Similarly, when evaluating whether a share repurchase is a good decision, we as investors need to decide if management made the right decision under the circumstances.
The Cons
As Andrew has pointed out, share buybacks may not be all good news. There are three motives we need to watch for when evaluating management's decision of buying back shares with our money:
Mask Over-dilutive Stock Option Grants
One of the biggest crime management could legally commit is to grant themselves massive stock options at the cost of shareholders. Buffett has always said that if management wants a piece of the action they should pay. Nonetheless, stock options, when awarded reasonably based on certain performance metrics, can be an effective form of compensation to align management interests with shareholders.
Back in 1999, Microsoft issued about $60 billion worth of stock options to its employees.[1] At the time, Microsoft earned a net income of $7.8bln but issued options worth $9bln.[2] And none of these options were expensed, but that's a story for another time. It wasn't until 2003 when Microsoft announced it would stop issuing stock options, start granting restricted stock and start expensing stock awards.[3] One wonders if the $70bln stock buyback beginning in 2004 is merely to reduce the dilutive impact from the stock options it has issued throughout the years.Earn Performance Bonuses
Carefully chosen metrics for performance-based compensation is essential to the success of a business. Management incented to increase share price could resort to gaming the numbers to prop up the stock price and ultimately earn their bonuses.
Buying back shares could achieve the same effect. By reducing the number of shares outstanding, management can almost immediately increase earnings per share, increase return on assets and reduce PE all at the same time. Best of all, management would have earned their bonuses at the cost of shareholders money!
Lack Capital Allocation Skills
Sometimes, buying back shares could mean management lacks the skills to find better use of excess capital. The question to ask here is can the business earn a better return investing elsewhere? A dollar retained should increase the value by at least a dollar. If not, the cash should be returned to the shareholders so they can divert the funds into other investments.
This is where understanding the business is important. Could the business earn a better return by acquiring a related business on sale? Should management invest in organic growth to sustain future revenues? Every case is different and need to be examined carefully.
The Pros
Needless to say, not all share buybacks are bad. Share buybacks can be beneficial in the following ways:
Catalyst to Narrow The Gap Between Price and Value
Substantial share buyback programs typically have an effect of helping the price converge on the intrinsic value sooner. This is, in fact, one of the weapons in the arsenal of activist investors to help realize the value of their investments.
When a share buyback is announced, management is usually sending a signal that the stock is undervalued and management is confident in the growth in future cash flows. Coupled with significant insider open market purchases, a share buyback could boost the share price in a meaningful manner. On the other hand, if after announcing the share buyback, management is quietly selling off their shares, you have to question the real motive behind the repurchase.
Tax Efficient Way to Return Money to Shareholders
Back in the days when capital gains tax is lower than dividend income tax, a share buyback is a more tax efficient way to return money to shareholders than paying a dividend. But since both capital gain and dividend income are taxed at the same rate now, the tax advantage has disappeared.
However, at the corporate level, there are still tax benefits to be had when buying back shares. A company that spends $100 million in cash to repurchase its shares will relieve itself of paying $9 million in taxes on the interest income it would have earned on the same amount had it kept the cash in a money market account earning 3% (assuming no growth in interest).[4] This tax saving in theory should translate into a $9 million increase in market price in a share buyback. In short, by returning the excess cash to shareholders, the business continues to generate the same cash flow but on less equity divided into lesser number of shares. Not a bad way to return money to shareholders and save on taxes.
Lower Cost of Capital
Buying back shares can be enhanced by utilizing cash from issuing debt. Remember, excess cash held at company is not free for company to use. After all, the cash belongs to the shareholders and the shareholders expect a decent return on the equity.
By issuing debt at an interest rate lower than cost of equity to buy back shares, the company has just increased leverage and lowered the cost of capital. This magnifies the return on invested capital to shareholders. What's more, the interest expenses paid on the debt can be tax deducted. Again, the tax saving translates to an increase in share price.
Prevent Deworsification
When there are no other investments that could yield a better return than buying back shares, management should just return the money to shareholders. Spending the money on share repurchase also has the effect of preventing management from getting into silly acquisitions that would in the end cost huge losses to shareholders. Peter Lynch calls these deals deworsifications.
Dumb acquisitions could cost losses that run well into the future. Buffett calls buying Dexter Shoes with $433 million worth of Berkshire stock in 1993 the biggest mistake he has made. Although Dexter is no longer making shoes, Berkshire shareholders has lost $3.5 billion on the deal thus far and will continue to lose money as the shares increase in value.[5]
Conclusion
In summary, don't be too quick to credit or discredit a buyback without first identifying the motive behind the decision. After all, if you were to draw a line here and consider all buybacks to be bad, you could be missing out on many, many great companies selling at a discount.
References
- Rob Landley, Why Microsoft's Stock Options Scare Me, The Motley Fool, February 17, 2000.
- Bill Parish, Microsoft Financial Pyramid, Parish & Company, November 17, 1999.
- Todd Bishop, Microsoft to End Stock Options For Employees, Seattle Post-Intelligencer, July 8, 2003.
- Richard Dobbs & Werner Rehm, The Value of Share Buybacks, The McKinsey Quarterly - McKinsey & Co., September 20, 2005.
- Jonathan Stempel, Buffett Calls Dexter Shoe His Worst Deal Ever, Thomson Reuters, February 29, 2008.
- Justin Pettit, "Is a Share Buyback Right for Your Company?" Harvard Business Review, April 2001.
Full Disclosure: I have no positions in the securities mentioned above.
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
