Share:

There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available fundscash plus sensible borrowing capacitybeyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefitted by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.

Warren Buffett, excerpt from 1999 Letter to Shareholders

By John Goltermann, CFA, CPA

January 2014

In theory, stock buybacks (i.e. when a corporation buys back its own shares in the open market) present an efficient and therefore preferable way to return capital to shareholders relative to paying dividends. This is because the capital used for buybacks, though already taxed at the corporate level, is not taxed again to the recipient (as it is with dividends).

Without getting too deep into the academic arguments around stock buybacks, studies show that companies that undertake them can indeed see a near-term increase in share price. One theory is that this occurs because buybacks may signal that insiders, who supposedly have better information, believe that shares are undervalued. This creates excitement among short-term-oriented participants, who bid up stock prices as they try to exploit this perceived informational advantage for quick gains.

Another theory is that stock buybacks reduce the number of shares outstanding and increase the allocable profit per share to fewer holders, thereby increasing the earnings per share. The stock price theoretically needs to increase for the company to trade at a similar multiple of earnings (or P/E ratio) than it did before the buyback.

On its surface, this is an appealing concept. If stocks indeed always traded purely on constant multiples of earnings per share, a buyback would be a beautiful way to conjure shareholder value from a simple wire transfer and a journal entry. Unfortunately, this is simply not the case. For starters, repurchased shares often barely offset future stock and stock option grants already allocated to insiders. But even if repurchases did exceed future issuances, they should not be confused with real economic growth at the firm. It is simply balance sheet arbitrage. In economic and accounting terms, share buybacks are a wash.

For explanation, lets take a company that is 100% equity financed (i.e. has no debt). If it uses cash to repurchase shares, the companys cash balance (and total assets) decreases as does its book equity (as the repurchased shares are retired proportionally). So there is no economic gain from the buyback; there are simply fewer shares claiming proportionately fewer assets.

Lets also consider a company with debt on its balance sheet, or that uses a combination of debt and cash to fund its share buyback. In this case, buying back shares will increase the companys financial leverage as the net effect is more proportionate debt and less equity thereby increasing the remaining shareholders risk. Moreover, the companys asset mix would have less cash since the cash used to buy back shares is now gone, leaving the asset mix more weighted to the remaining riskier assets. In a rational market, the increased risk from both these sources should manifest itself in the form of lower earnings multiples. While the earnings per share (EPS) may increase in the near term, the multiple of earnings should decline, so the buyback should not move the stock price as the companys balance sheet is more levered (risky).

Some believe that profit alone drives equity prices, but future profits have to be discounted for the risk taken to earn that profit. Moreover, shares are first and foremost a claim on a companys assets not on its earnings or profit. Profit is simply a product of the effectiveness of the assets and managements stewardship of them. The companys assets may or may not generate future profit, or todays profit may not grow, so the periodic profit earned is far less important than the market value of the assets to which the equity holders have claims. In a nutshell, its the assets themselves and their future profit-generating ability not the profit itself that give value to the shares. This is why one must think about the impact of share repurchases on balance sheets when determining effectiveness.

In many cases, there is also an unquantifiable opportunity cost of using cash for a share repurchase instead of using it to improve the business for example, by reinvesting in key assets, expanding distribution, developing new products or intellectual property, and in general working towards becoming more competitive. Not making these investments can come at a significant cost. Moreover, maintaining a larger cash reserve for future adverse business conditions can enable a company to be opportunistic when competitors are forced to retrench. Share repurchases reduce this ability and limit financial flexibility. In other words, there is no free lunch to be had by stock buybacks though investors often act as though there is.

To take a real-life example, IBM earned $16.5 billion in 2013. During this same year, it repurchased $13.9 billion of stock (84% of its earnings spent on buybacks) and saw its debt increase from $33.3 billion to $39.7 billion. IBMs stock, however, declined from $205 to $181/share over this same period. It is likely that the stock buyback program itself wasnt enough to offset markets perceptions of increased risk to IBMs balance sheet, concern that the company may have overpaid for its shares, or the fact that the company was deprived of $13.9 billion in capital that it could have reinvested in its business. Its hard to say what factors investors are looking at, but the point is that buyback programs may or may not be viewed positively.

Leaving aside the mechanics of buybacks, lets talk about whats really going on. After all, short-term market dynamics are driven by investor sentiment and what traders think might impact them in the next week or so. In a liquidity-rich market, the correctness of the crowds views matters very little. The reality is that few care about the true economics of share repurchases. These days, because of widespread myopia and algorithmic trading, share buybacks produce excitement. But for the long-term investor, this can be looked upon as a source of risk and a need for caution, not excitement.

In the current environment of zero rates, cash does not seem to be a very productive asset for companies to hold (though the contrarian in me thinks it may be attractive for this very reason). In addition, for good companies, debt can be issued cheap. Lots of companies are issuing debt and buying back stock instead of investing in their businesses as they would ahead of an economic expansion. They are essentially leveraging up their balance sheets. Whether this increased leverage pays off will depend on future economic, business, financing, and competitive conditions; but with increased leverage comes increased risk. If competition increases, if demand softens, or if interest rates increase, these companies may be at a disadvantage relative to those that managed their balance sheets conservatively. At present, many of the companies that have not engaged in balance sheet arbitrage through buybacks and that maintained a conservative strategy have lagged due to the focus of quick-money guys and algorithmic traders. This conservatism can invite activist investors (such as we currently see with Apple). But conservatism may well pay off in the longer run.

According to the Wall Street Journal. buybacks and dividends in the third quarter of 2013 were at the highest level since 2007s fourth quarter. This is not necessarily good. The act of buying back shares, in fact, does not forecast smooth sailing ahead in financial markets and can sometimes signal the opposite. Despite this history, participants confidence (and risk appetite) seems to increase when heavy buyback programs are under way, and many continue to believe that buybacks signal a green light for risk taking. Memories in markets can indeed be quite short. Lets take a look:

The track record of corporations timing buyback programs well (as illustrated above) could not be much worse. High buyback levels can predict adverse markets and low levels can predict strong rallies. Corporate managers have a poor track record for buying low and selling high when it comes to their own shares. They often buy high and sell low and destroy significant wealth in the process. During 2007s fourth quarter share repurchase frenzy, buybacks of S&P 500 companies hit a record of $128.2 billion at the top of the market. In the following seven quarters, buybacks dropped 86% just at the time share prices reached bargain levels. In other words, the conventional wisdom about what buybacks signal is not necessarily true, and the information asymmetry that markets believe managements have does not necessarily exist (or at least is not acted upon effectively). Now, as in 2007, we are seeing activist investors pressuring managements to once again buy back shares in hopes of quick profits for their backers who pay them large fees to exert such pressure.

Market misperceptions like these can persist, and people do act on their belief that there is a free gain to be had in simple share repurchases. But the reality is that the economics of them is a wash and totally depends on the price/value relationship of the shares. This misperception is evidenced by the dramatic outperformance of the S&P 500 Buyback Index relative to the S&P. This reflects a market full of anomalies and short-termism, so it isnt surprising, though it is not rational. Therefore, investors actively seeking companies that are aggressively buying back shares at this point should instead be cautious as such anomalies are likely to reverse themselves in the absence of economic substance.

To this end, it is important to be aware that prior to the sharp bear markets of 2000 and 2008 the S&P 500 Buyback Index underperformed the S&P 500 (after a period of significant outperformance). The Buyback Indexs outperformance narrowed significantly toward the last half of 2013, and the two indices have recently started to trade in lockstep (also after a period of outperformance). While we cant say for sure, this trend may be another reason that it is prudent to maintain a conservative approach and remain focused on valuations.

One final item that reinforces the need for a cautious approach is the condition of corporate balance sheets in general. I challenge the oft-repeated narrative that since corporate cash levels are at all-time highs, the corporate sector must be healthy. This is one of the favorite talking points on major financial news outlets to make a bullish case for stocks. While some stocks indeed look very attractive, it is important to be aware that cash is only one part of a much larger (and frequently ignored) picture. Debt is also at record levels. As the chart below shows, net debt levels (total debt, minus cash) are 15% higher than they were prior to the 2008 financial crisis. So while its true that cash is at record levels, it is also true that, relative to debt outstanding, cash is at very low levels.

The vast majority of the financial systems deleveraging has been done through asset reflation instead of the more painful approach of debt paydown. Asset reflation is a much more fragile approach to deleveraging than using real cash, generated within a robust and productive economic environment, to pay down debt. This is not to say that future financial market risk will be the same as it was in 2007, but I do think that the financial media narrative is often incomplete can be spun to be more bullish than it actually is, leading many to reckless behavior.

As in 1999, recent market activity has been led by speculative issues such as 3D printers, biotech stocks, social media companies, electric car companies, and other similar stories. Stock promoters are now fully employed, and buybacks have undeniably fuelled a huge bull run in broad U.S. stocks in recent years. Cheap debt issued by companies has been largely converted to market liquidity through corporate balance sheet arbitrage, but this masks weak credit growth in the Main Street economy.

Going forward, in an environment of higher stock prices, buybacks may not occur at the same pace, thereby reducing market liquidity along with the overall reduction from Fed bond purchases. This may temper some of the financial market speculation that has been so obvious lately. It pays to understand stock buybacks as they are usually billed as a return to shareholders, but for the astute investor (as Warren Buffett reminds in his quote), the return only comes if the shares are repurchased at levels below what they are worth. If they are purchased above fair value and financed by debt they destroy shareholder value. As with all investments, it is important to get a full assessment of risk.

History has proven that investment markets are mean-reverting machines that will reliably purge euphorias, false beliefs, and too-easy stories. The trick for investors who are concerned with risk is to be on the right side of trades when the mean does revert.

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