Why You Should Short Companies Doing Share Buybacks

Am I the only guy who believes that stock buybacks are a waste of shareholder money and a management diversion?

Theoretically, if the earnings yield (inverse of P/E) is higher than the after tax interest rate, buybacks add to the EPS number. Buybacks are dilutive otherwise. (This provides no information on the value of the company.)

Here's why I don't like buying companies doing stock buybacks, and would rather short some of them:

• Some of the announced buybacks never happen.
• P/E multiple compression. A dividend or a buyback is a cash flow to the investor right now, versus a possible higher return later on through future profitable growth. According to the classic Gordon growth model, a company's price earnings multiple is proportional to the retention ratio. Well, a buyback is another way to return cash to the shareholders (or a lower retention ratio). Lower rates of reinvestment suggest lower future growth rates, and hence a lower multiple.
• Implicit recognition that the avenues for internal growth through reinvestments are not that high as returning cash to shareholders through buying back 'undervalued' stock. Let's say you have a debt-free company with a 20 P/E doing a buyback. Does this imply that the company cannot find enough investable projects with returns in excess of 5%? Would you want to invest in that kind of a company? The company might be signaling a lack of investment opportunities above the cost of capital.
• Buybacks are effectively a leverage on the EPS numbers. In good times, profitable growth leads to aggressive buybacks, further magnifying EPS numbers. During a downturn, a negative growth with reduced buyback would amplify the EPS compression. Cyclical companies with huge buybacks are the best short candidates for this.
• If the management thinks that the stock is undervalued, why isn't a value investor or activist hedge-fund buying your stock? Palm (PALM) and Motorola (MOT) are two companies that had huge buybacks when the stock price was a lot higher. Even the activist funds have lost money on their initial investments so far.
• A lot of tech company buybacks are to offset equity dilution due to stock options, and the net buyback is minimal. (That's a really big short). I've seen companies with 5-10% annual stock dilution. (Let's not even get into the whole option expensing debate!) Yahoo (YHOO) and Nvidia (NVDA) are examples of companies with a sizable equity dilution.
• Buybacks to combat short sellers is a questionable tactic with dubious merits. This gets into the whole ego turf. Good short candidate. Example: Overstock (OSTK)
• Buybacks followed by heavy insider selling are a big red flag.
• Possible internal management conflict to boost EPS numbers for executive compensation, instead of long term shareholder growth. (This paper suggests that the combination of a share buyback, insider selling, and a high ratio of incentive compensation is a high risk event.)
• Cost cutting and restructuring: Increasing cash flows through temporary cost cutting measures don't really add to the firm's innovativeness. Using that cash to buy back shares instead of reinvesting is a good short candidate, since the uptick in cash flow is temporary.
• If you pay more than your book value, you reduce your book value effectively.
• As investors, you care for the "intrinsic valuation" of the company. This doesn't change with a buyback. By pandering to short-term speculators, management risks alienating value investors.

Hey, if buybacks are such a great thing, how come Berkshire (BRK.A) doesn't have one? That's because it chooses to reinvest earnings in profitable enterprises, thus increasing intrinsic value, and consequently the share price. Gaming and managing quarterly earning numbers through buybacks is not a good long-term investment thesis. It doesn't matter if the stock is trading at half the intrinsic worth. The company should essentially ignore what the market thinks in the short term.

If the company is returning all that operating cash flow to the shareholders, aren't you better off just buying a conglomerate like Berkshire or Luecadia (LUK) that reinvests that cash in profitable enterprises for you? They effectively take away any reinvestment risk.

The implicit assumption in a buyback is that the company feels that the stock is undervalued. The belief is that insiders know something that Mr. Market doesn't. Often times, this is not based on a strong order book, or an increasing sales profile. More often, an overly optimistic and rosy outlook leads to the buyback. Given the folly of forecasting beyond a few quarters, that's questionable.

Sometimes, the announcement is made after an earnings shortfall, or if the company has some future negative outcome which the market is possibly 'discounting'. For example, even right now, the average analyst estimates for the last two quarters of 2008 are too high. From a bottom-up analysis, companies feel that even though there is a general economic downturn, they won't be affected. Some of them have buybacks in place.( This 2005 article from the McKinsey Quarterly provides some further food for thought)

I'm not saying that buybacks are bad per se. There are genuine occasions when Mr. Market throws a temper and gives us a steep discount with a nice margin of safety. Just that there are situations where shorting companies doing buybacks might actually be a profitable strategy. Using the guidelines above can help us in reaching this decision.

Disclosure: Long LUK since 2005.

Comments

[DSX Lover]

How is a buyback dilutive? If you get a larger percentage of the company with your shares, when the company is buying stock from others.
Would you rather pay the dividend tax from excess cash flow if the company's shares are undervalued, and not doing a buyback?
You're an idiot too.

[hhcramer]

This is a terrible article. It does not differentiate between a fairly valued stock and an undervalued stock. It makes no sense for a fairly valued or overvalued copmpany to buy back stock. But it makes tyremendous sense for an undervalued company to say: "We can find no more a compelling use of our money than to buy back our stock". That is how Buffet made his money, It's just that the compelling value was never his company, but other copmpanies.

[theguy]

I disagree with your basic premise: you do not like a company that buys back stock because it cannot find other business opportunities to expand. A company (such as Linear Technology) could never find another company as profitable as itself, so it bought back stock with hoards of non-perforning (<5% return) cash. I think this was the perfect reason to buy back stock. This purchase, of course, did reduce dillution due to stock options of course but this was going to happen anyway. If they had purchased another company at a profit margin lower than their existing business, the "numbers" would certainly degrade instantaneously. The stock buyback was the way to improve the "numbers" instantly without having to improve a non-performing business up to their level of performance. Bigger is not always better. In the case of Linear Technology, the stock over the last 6-12 months went back down but so did the entire industry. They still maintain fantastic "numbers".

[BudH]

Managements like to buy back shares because it increases the value of their stock options. Same market cap, less float, the share price goes up. And it helps the option holder the most. Warren Buffet pointed that out in his shareholder letter a couple of years ago.

[User 190882]

Yes, you are the only guy who believes that stock buybacks are a waste of shareholder money and a management diversion.

[Sajal]

I like the comments. Taking the opposite side of a well accepted notion does upset quite a few people!

Firstly, the opinions expressed by me are also shared by the McKinsey Quarterly article and the Audit Integrity report I linked to above. So clearly, I'm not in a minority here.

hhcramer: value is a matter of perspective. We've had periods in the world where markets went nowhere for 30-40 years, and stocks ended up trading at 2-3 times earnings multiple.
Buffett has a margin of safety to fall back on in case he is wrong. Even Buffett, despite the margin, has commited mistakes with his initial investment thesis. He has been right, on average.
The problem is you cannot really forecast industry trends, substitutes, competitors, pricing power, markets, economy too much into the future. A lot of times, companies don't have an intrinsic valuation to backup their claims.

Budh: Even though you are cynical, you are mostly right.

Theguy: I like LLTC, I do think using debt to buyback their stock was a smart strategy.
The analog sector is a great example to illustrate share buybacks. ADI MXIM LLTC TXN have all bought back stock, sometimes even buying back 40% of their float. This has been going
on for a few years now. Look at where the stocks have gone over the last 5-6 years.
Maybe Mr. Market is delivering a verdict on the undervaluation thesis here? If no one recognizes the undervaluation argument, and the stocks remain where they were for the past 5-6 years, maybe we need to revisit the argument? I intend to blog about financial engineering in mature tech sectors like analog in the future. I'll elaborate on a few of my thoughts there.

DSX Lover: Here's an example of how a buyback can be dilutive to earnings. Let's ignore effect of taxes for now. Say a $1 billion market cap company has 100 million in cash.
Interest rates are 5%. It's net income was 40 million, including 5 million in interest income.
Let's say the EPS is 2 and it had a 25 P/E multiple, giving it a stock price of 50.

The company completed a stock buyback with it's $100 million in cash, buying back 2 million in shares. The number of shares went down from 20 to 18 million. The new net income would be 35 million, giving it an EPS of 1.94. So the EPS just went DOWN from 2 to 1.94 after a buyback.

Result : dilution.

Hope this helps.

[icandoitdon]

i agree with the author.

there can be certain cases where buybacks make sense, i.e....

1. when the firm has limited internal growth prospects
2. when the firm has no plans to grow by acquisition.
3. when the firm's future capital needs are modest and it has stable or growing operating cash flow.
4. when the firm is entrenched because of high barriers to competitive entry.

even under these circumstances i'd rather have a dividend, thank you very much. double taxation, the commonly perceived bugaboo of dividend payments, is a red herring. our system double taxes many things; neither do corporations pay as much in taxes as commonly perceived, as anyone who understand the concept of a growing deferred income taxes liability understands. besides....i'd rather have a company willing to put it's money on the line with a steady or growing stream of dividend payments to shareholders than not. it will do far more to support the stock price than share buybacks will ever do.

another reason i object to buybacks is simple but important....it shrinks the capital base of the firm. capital is a precious resource and it might be needed one day. citigroup, wachovia AIG, lehman, merrill lynch, etc. have learned this lesson the hard way. they're all issuing new equity at prices far lower than at which they've repurchased shares in the past. guess they aren't as smart as they thought they were....

[Sajal]

icandoitdon,

Your points sum it up very nicely. Thanks.

I'll be posting a follow up on my blog this weekend. Stay tuned.

[THofler]

I loved the article, especially the "dilutive" buyback part.

Excuse my possible ignorance, but perhaps in your next post you could address the issue of whether a share bought-back is a "retired" share or merely a "warehoused" share? How easy or common of a practice is it to sell such a share? Does it always require a formal secondary offering?

[RJW]

Sajal - have you looked at any empirical evidence to support your claim (e.g. share price performance 1 month, 6 months, 1 year from announcement)? You present a few rifle shot share repos that were ill-conceived but no real evidence (FYI: it's not surprising that McKinsey is promoting operational improvements over share repos).

[fabien_hug]

I like this article and saved it for future reference. It is always good policy to look behind the headlines and analyze why things happen.
Thanks

[InvestorsLive.com]

It worked for IBM but I do see your point

www.investorslive.com/blog /

[jimsep]

No, you are not the only person to think that stock buybacks are a waste of time and a management diversion.

Some of the rude reactions to your article suggest the emotion and lack of clear thinking on this subject.

I would add to your thoughts that companies are no better than anyone else at figuring out when and at what price to buy back their own stocks. How many financial and housing companies are wishing to-day that they still had the cash they expended earlier, at higher prices? Many of them buy when they think prospects are good, only to suspend or cancel when things don't look as good. A good example is Home Depot which bought back lots of stock in the high thirties. How did that return cash to shareholders? The stock is struggling to maintain a price ten points lower.

Somebody should forward copies of the aricle to Jim Cramer who continues to babble that stock-buybacks are good, despite the many examples in this market cycle, that they are the perpetuation of a myth.

[kurt walter]

I don't trust many managements. I want dividends not buybacks.

[Sajal]

Hmm.. never say never, and never say always! There will always be companies where the buybacks made sense. (As InvestorsLive points out about IBM)


THofler: I'll keep your points in mind when I post a followup to summarize the excellent comment exchange.

RJW: I hope you'll excuse the fact that the article doesn't have statistics to refer to! This was a gut feel overnight writeup and I think it made some valid points.

I've looked at a few papers which studied the 'outperformance' of a buyback, and I agree they suggest a quantifiable outperformance. My point is I don't WANT to look at 1 month or 6 month returns. Anything less than 12 months is short term. If anything, a 1 month pop would be a good short fade. From a casual observance, I can tell you right away that I can think of many more companies whose stock prices are lower after a buyback than those where they are higher (I do think a good chunk of this is because they didn't see the economic cycle turning).

As the others rightly observe, what's the point of a buyback if the companies have to dilute the shareholder's equity? I'm also looking at some mature tech sector companies where a buyback of almost 40% of their float has not budged their stock price (eg. ADI)

InvestorsLive, fabien_hug, jimsep and kurt walter: thanks for the added insight.

Valuations and investing is a tricky business. Companies are best served to focus on their core competencies (eg. Google, Apple).

[icandoitdon]

thofler:

repurchased shares reside in a treasury stock account, which is a contra-equity account (i.e. the balance is a reduction of shareowners' equity).

these shares may be reissued at any time without a formal secondary offering. i believe a "shelf registration" is required, however. in oher words the company has previously registered with the SEC it's intent to issue new shares "off the shelf." they may do so out of treasury or by issuing brand new shares.

this is based on distant recollection, as i've been out of the financial reporting field for some years....

[User 159092]

One needs to carefully assess stock buy backs.... it could be a warning sign, it is sometimes used to cover up problems in the business

[BillyRayValentine]

Your example of a dilutive stock buy-back is worthless. You ignore the tax effect for simplicity, but by doing so you invalidate the entire exercise.

In your example, at a marginal tax rate of 20% or more the buyback is accretive. Which is to say, unless the company has NOL carryforwards, EPS will rise due to the buyback.

[stonebluff]

There is an elemental flaw in the concept of buybacks. They reward exshareholders, not shareholders. Buybacks may make sense for closed end funds selling at a discount, and for other companies whose assets for whatever reason are discounted in the share price.

Money is the capital of banks, brokers and insurance companies. When they buyback shares above tangible book they actually reduce their ability to do business. Otherwise they tend to be paying $2 for $1. I hope that the management of financial institutions that squandered their capital on buybacks and now are hustling capital on outrageous terms have learned their lesson. For banks and bank holding companies, at least, the regulators should enforce restraints on buybacks that may impair the business.

Some S & P guys recently did a study(so I read) that purported to demonstrate that buybacks rarely helped the price of a company's stock. I wish someone would do a study demonstrating the effect of buybacks on financial institutions during the current mess.

Buybacks are so generally treated as beneficial in the financial press that is seems almost heretical to call them into question. Sajaz' article is extremely timely because it makes one at least question the alleged benefits of buybacks.

Does anyone compile a list of companies like LUK and BRK that as a matter of principle do not do buybacks? I'd like to see it.

will remember that.Nobody except the management of the banks and insurance companies now trying to hustle new capital because they squandered their old capital on buybacks seems to believe that.

[drposhmoney]

Inflation devalues cash, so over a say 5 year timeframe, with inflation at say 3% and a marginal tax rate of 20%, your dilutive example is actually *not* dilutive at all! :-). Moreover, after 5 years, the EPS will have risen 1.038^5 = 20%, whereas if the buyback had not taken place, the cash would have devalued 1.03^5 = 16% and detracted from the 20% gain in EPS. It is nevertheless surprising that buybacks have a such a minor effect on EPS over a 5 year timeframe and perhaps explains why announced buybacks sometimes never happen. In fact, it would seem that they are more of a political statement, perhaps announced when management have no confidence in growth but are in need of something hopeful to say to investors.

[MC]

I would like to see more of management that sells stock when they think it overvalued, and buy it back when they think it undervalued, and to stick to this consistently.

I think, with the tech stocks, maybe buybacks have had little effect because they were overvalued before the buyback, now they are slightly less overvalued after the buyback.

If management is consistent, I fail to see how buybacks aren't an excellent use of capital to retire undervalued stock. Take the retailers right now, for example. You have a lot of retailers selling at 10X or less. Assuming no earnings growth and capital expenditures inline w depreciation, I'd rather management take that 10% cash yield and buyback stock, not pay dividends. Example:

Market Cap = 1B, FCF = 100M. If they pay that as a straight dividend, that's 10% a year.

W buybacks, first year, 10% of the co is cut off; 2d year; 100/900=11% of the co is cut off; by the fifth year, the same amount of money is reducing shares outstanding 20%, etc. There is a nice compounding effect that you get with buybacks that you do not get with dividends. The market has to respond to this eventually.

As to value being "relative" if your hypothetical co has a P/E of 2 that is just not sustainable assuming normal interest rates because it is a so much more attractive investment than any other investments; the price has to go up. I don't know where and under what circumstances you have seen companies regularly trade at 2X earnings?

[Sajal]

Thanks for the insightful comments everyone. I'm trying my best to keep up :)

BillyRayValentine: I agree with you.

If you were to include taxes, then you should compare after tax interest rate with earnings yield.

I agree that using a 20% tax rate in my example would imply breakeven in EPS. But if you were to bump up the P/E to 30 or increase the interest rates to 6%: you'd still get an EPS dilution.
The idea was to illustrate that dilution CAN occur.

MC: Valuations are a matter of perception. With cyclical stocks, the least you should do is use normalized 5-10 year earnings and then compute the earnings yield. Cyclical stocks always look the cheapest at the peak of the economic cycle because of earnings which have been inflated due to the business cycle. Using a 10% earnings yield based on the trailing 12 month PE may not be a valid exercise IMO.

To take your suggestion a step further, every company then should employ a trading division to trade their stock in the market!

When Buffet invested in Korea, stocks there were trading at an everage of 2 PE. In Japan right now, I believe the average stock is trading below book value. In 1982, with the market trading at low single digit PEs, you had several stocks trading at low single digit PEs.

Stonebluff: do you have a link to the S&P study?

drposhmoney: Two things:
1. You are assuming the company has the pricing power to pass on any inflationary increases. A lot of companies can't do that.
2. If you are adjusting the cash for inflation, you should also be adjusting the earnings for the same. A $1 in earnings today versus $1 in earnings in 2015 have different buying power implications.

We are talking in nominal terms here. Inflation adjustments to all the numbers should cause no difference to the buyback argument.

[MC]

Sajal

Speaking of Korea, do you know how an average investor can find out more about and invest in South Korean stocks? I don't have access to much more than Yahoo/Google Finance. I've been wanting to maybe invest in Korea but info has been real tough to find. I don't want to buy the ETF bc those companies don't seem too appealing

[Ceviche Fund Partners LP/Dan Jacome]

"Lower rates of reinvestment suggest lower future growth rates, and hence a lower multiple."

Not if ROE is going up. Remember g = ROE * rr. You can lift one to offset the other's decline

[Ceviche Fund Partners LP/Dan Jacome]

"Market Cap = 1B, FCF = 100M. If they pay that as a straight dividend, that's 10% a year. "

don't you need to look at this FCF vis a vis the enterprise value, not the market cap?

[Ceviche Fund Partners LP/Dan Jacome]

Don't forget that buybacks are sometime a tool to avoid a takeout -- companies sitting on a pile of cash, earning the risk free rate -- that's not a good thing.

along the lines of other things you mentioned, a company with limited internal growth prospects and a lot of cash is takeover bait, since if mgmt is not doing anything useful with the cash, a buyer could swoop in and use some of the target's cash balance to finance the deal!

overall, this is a COOL article and I saved a PDF copy for future reference -- thanks for drumming up an excellent and provocative debate!!!

[Ceviche Fund Partners LP/Dan Jacome]

"4. when the firm is entrenched because of high barriers to competitive entry.."

GOOD POINT -- someone should do a study to see if repos are more pervasive in wide moat industries, like software and quarry/aggregate manufacturers.

[Richard Schweitzer]

In the words of a thousand lawyers:

"It all depends..."

Take the almost classic case of AFL, which borrowed funds for cash flow to cover buy-backs, at a particular period.

Consider: interest deduction; cap gains rates (in that era) to investors looking to the liquidity positions of portfolios; classic shift to "cost of capital" approach (the absolute measure of quality of operations); greater ROE. Interest rate lower than net earnings rate (i.e., AFL surplus rising at greater rate than interest rate).

A thing to look out for is the a big build up in cash position that may indicate that the enterprise can not deploy its assets profitably, or at least, if so, at a less profitable rate.