I’ve discussed share repurchases several times over the years. I’ve long believed they are a great way to add value for long-term shareholders when properly executed, as well as an opportunity to intelligently use excess capital when it may not be needed for reinvestment in the core business. As Warren Buffett (Trades, Portfolio) recently noted, “When the price is right, there’s no easier way to make money for your shareholders [than repurchases].” I completely agree.
But my support of repurchases by the average public company has wavered. More specifically, I do not think repurchases over the course of a business cycle have been a particularly effective use of capital for most companies.
There are two key reasons why. First, and most importantly, I’ve seen too many companies that buy back a large number of shares when the stock is doing well, only to step back when it comes under pressure. William Thorndike Jr. captured what this looks like in “The Outsiders”:
“Fundamentally, there are two basic approaches to buying back stock. In the most common contemporary approach, a company authorizes an amount of capital (usually a relatively small percentage of the excess cash on its balance sheet) for the repurchase of shares and then gradually over a period of quarters (or sometimes years) buys in stock on the open market. This approach is careful, conservative and, not coincidentally, unlikely to have a meaningful impact on long-term share values."
Personally, I don’t think Thorndike goes far enough. It’s not that this approach is just unlikely to have a meaningful impact – it’s quite likely to lead to a worse than average outcome.
You can see why by thinking about how this approach plays out in the real world. Many companies set their capital return policies so they can (hopefully) slowly but surely increase the dividend over time. In practice, this means they will let the dividend payout ratio lag earnings growth when the business is booming and then dip into that reserve when the business hits a rough patch. This leads to relatively steady growth in the stream of dividends that public companies pay to their owners, even during difficult periods like the financial crisis of 2007 to 2009:
The problem is periods of boom and bust tend to show up in the share price: When the company is firing on all cylinders and generating excess cash relative to the long-term trend in earnings growth (earnings power), the stock tends to respond accordingly. This means companies are usually committing the most money to repurchase shares when the stock is doing well. On the other hand, they are forced to pull back when the company or the broader economy stumbles to help cover the dividend or even ensure the financial stability of the business; unsurprisingly, the stock price is often under pressure during these tough times. We see this exact behavior when looking at historic repurchase activity for S&P 500 companies:
It’s a major indictment on share repurchases, generally speaking, that you can roughly eyeball when the market did well and did poorly just by looking at the chart above. (For what it’s worth, repurchases by the S&P 500 increased by roughly 50% in 2018 to more than $800 billion.) This suggests the people running public companies may not have the ability to navigate the bouts of euphoria and despair in financial markets any more competently than the average investor.
As a secondary consideration, think about the pressure management could face from activists if they let cash build during a protracted economic expansion and bull market in an attempt to commit to a more ratable repurchase plan over the course of the cycle; the risk of losing your job for trying to do the right thing probably wouldn't seem worth it to you either.
In addition, I don’t have faith that the board of directors will come to save us. Sadly, in my experience, many board memebers do not own enough stock to be particularly concerned with the impact of these type of decisions on the long-term per-share value of the business – especially relative to the hefty compensation they receive for sitting on the board and (largely) keeping their mouth shut. Even for those individuals that know better and have good reason to care (i.e., they own a lot of stock), it can still be difficult to push for change in the boardroom.
Buffett’s recent commentary about his experience as a board member at Coca-Cola (KO, Financial) during the late 1990s is enlightening (he was on the board from 1989 to 2006):
“The truth is, if you look back, Coca-Cola kept repurchasing their shares at a time when it didn’t make sense… and I was a director at the time. But they’re one of many… Sometimes it is difficult for CEOs to be objective about their own stock price; they think the higher it sells, the better. And it’s a fine way to feel, except if you’re repurchasing it at prices up to the sky.”
Here's what he's probably referring to: in 1998, Coca-Cola spent roughly $1.6 billion on shares repurchases, or more than 80% of its free cash flow. During that year, the stock traded at a forward price-earnings multiple of roughly 40 to 50 times. When Buffett was asked why he didn’t do something when he thought the repurchases were dumb, he said:
“If you belch too often at the dinner table, you don’t get invited to parties anymore.”
Let’s remember that Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was a significant shareholder in the company (it owned 8% at that time). And despite that, even when Buffett knew repurchases didn’t make sense, he still felt that voicing his opinion would be somewhat out of line. Now replace Buffett with your average board member who doesn’t own a lot of stock and may not be an expert on business valuation or the importance of capital allocation. I think that gives you a good sense for what’s realistic in the boardroom.
The second reason I think repurchases are less effective than I did previously is the benefit relative to something like a special dividend can be overstated. The major supporting factor for repurchases is they enable long-term investors to defer tax payments to Uncle Sam (and the investors that would prefer a dividend can “create” one by selling some stock if they’d like to).
On the other hand, I think this overlooks a few considerations. One is that the timing of said repurchases matters – not only in the sense of the point made above, but also in terms of time value of money. For a current example, look at the balance sheets of large technology companies like Microsoft (MSFT, Financial), Apple (AAPL, Financial), Facebook (FB, Financial) and Alphabet (GOOG, Financial) (GOOGL, Financial). In each case, with varying degrees of conviction, I’d argue that it is highly unlikely they will find any way to intelligently use the tens of billions of dollars in excess cash on their balance sheets. At the same time, they are all unlikely to complete a comparable dollar amount of repurchases in a short period of time (the only one that even appears to be trying is Apple). For that reason, the value of a dollar of cash on Facebook’s balance sheet, as an example, is worth less to me than the same dollar would be if it decided to pay a special dividend tomorrow. Depending on how long it takes to actually work through that excess cash, there’s an argument that I’m better off paying the taxes on a special dividend as opposed to watching that cash sit on the balance sheet for years. (In addition, I think there’s also an argument that the cash may burn a hole in management’s pockets, leading to value-destructive acquisitions.)
Conclusion
When Buffett was recently asked about Apple’s share repurchases, he said:
“Repurchases can be the dumbest thing in the world or the smartest thing in the world… I like it when we’re invested in companies where they understand that.”
I completely agree with that conclusion.
Generally speaking, I have not lost confidence in share repurchases. When properly executed, they are one of the surest ways for a company to create value for its shareholders.
Instead, I have come to believe very few public companies will commit to an intelligent approach to repurchases that will add meaningful value for shareholders over long periods of time. (As I’ve noted in the past, even some of the people in charge at these companies appear to agree with that idea.)
I wish that wasn’t the case. Sadly, I think the evidence is on my side.
Disclosure: Long Berkshire Hathaway, Microsoft and Facebook.
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