By Thomas E. Sobon
An investor's realized return on his investment depends primarily on two things: the first is capital gain or loss and the second is cash dividends received. Any other consideration may be important and supportive but it is not relevant to the subject being discussed. A company's free cash flow is one thing and the way it is disbursed is another. The focus here is on the way a company's free cash flow is distributed to shareholders as cash dividends or through share buybacks.
The proverb "A bird in the hand is worth two in the bush" will be used freely to facilitate understanding. When a company distributes a cash dividend that is "the bird in the hand" reward that the investor earns from his investment. It is current the moment he receives it. It is his money. He earned it and he has discretion over its use. He may want to spend it prudently on food, clothing or shelter. He may want to squirrel it away for his children's education. He may want to husband it by purchasing additional shares of the company's stock. Or he may want to blow it on wine, women and song. Any man can think of things his money could be spent on. But if he can't, I'm sure his wife can.
A cash dividend is a known quantity that contributes to the investor's return on capital. Corporations use return on capital as a guide when making investment decisions. Why shouldn't individual investors do likewise? Corporations make decisions based upon alternative uses of their investable capital. Investors collectively are the owners of the free cash flow but they do not determine the method by which it is distributed. That is decided by management. So investors should know about the merits of various ways "their" free cash flow is being disbursed. After all, current stockholders are always the owners of the subject company and management actions should benefit them.
The benefits to shareholders from share buybacks are "two in the bush" propositions and theoretically they should be worth more than "the bird in the hand." Otherwise, why should buybacks be used as substitutes for cash distributions if their plausible value is less than the value of the cash itself? Such benefits are often indirect and not clearly defined. They tend to be of a general nature and not easily quantifiable. They tend to be distant, not immediate. Various reasons are used by corporations to validate the use of buying back shares. Some are more valid than others. And some are not valid at all if it is assumed that their purpose is to benefit stockholders. When management announces that it will embark upon a buyback program, it is in effect telling shareholders that "the two in the bush are worth more than the bird in the hand." The truth cannot be known until after the event and even then it is difficult (if not impossible) to measure. Buyback programs are announced but their purposes and goals are rarely explained. The practice has become pervasive and shareholders tend to accept them as being in their best interest when the opposite may be true.
Perhaps what follows can shed some light on the subject: (1) the reason most often cited for using a buyback is that the share count will be reduced thereby increasing earnings per share which, in turn, "should" lead to an increase in the stock's price from where it would otherwise trade. The "should" cannot be guaranteed because it may not happen. In the short run it is plausible because the free market demand for the stock will be bolstered with that provided by the buyback. But sustainability can never be guaranteed after the support provided by the buyback ends. (2) Management may want to get excess cash off the books so the company will not be a target in a takeover bid. That is clearly not in the best interests of current stockholders because the would-be buyer would have to bid up the price of the stock and such action would be beneficial to current shareholders. (3) Management's compensation may be based upon return on equity. Cash is a non-earning asset. So if excess cash is used to reduce equity without diminishing the company's earning power the return on equity would be increased. Hence management's compensation would be increased. That, too, may not be beneficial to current stockholders. (4) Management often owns stock options and holders of options don't benefit from cash distributions. And, if buybacks are done on a continuing basis as substitutes for cash dividends, the option holders can benefit handsomely.
Self-interest directs the world and it would be naive to think that management always acts in an unbiased and stockholder friendly way when it dispenses a company's free cash flow. Some buybacks can be beneficial to shareholders while others can be beneficial to management at shareholder expense. Oftentimes the merit depends upon the situation extant. Set forth below as examples are buyback programs currently underway involving major corporations. The four companies selected are a diverse group. The merits of their buyback programs and possible results range from good to poor from "a bird in the hand or the two in the bush" standpoint. I will try to provide insight into the motives of management's decision for using a buyback. The reader can follow along and discount my comments as he sees fit.
The shareholders, collectively, are the owners of the company. So I start by assuming that (1) any cash currently on the books that is deemed excessive in relation to the company's current or future needs should go to them. This, after all, is "the bird in the hand" proposition that is to be my standard for judging the merits or demerits of the plausible promise of the buyback. And (2) I assume that if a buyback is in the works is it likely that the benefits therefrom would be a "two in the bush" worthy of pursuit. If not, then I have to question the motives of management and try to ascertain what its real motives might be. After all, the people who run these corporations are usually very intelligent and I should be permitted to assume that there is a well-defined goal that they chose to pursue. If the plausible goal looks like it has merit and is designed to benefit the shareholders, great. But if it lacks merit and/or is destined to benefit management at the expense of shareholders something must be wrong and the stockholders should be apprised of that fact.
The first company to be scrutinized is American Capital, Ltd. (ACAS).
ACAS is a private equity and venture capital firm that specializes in management and employee buyouts. It also makes mezzanine, acquisition, recapitalization, middle market, and growth capital investments. During the boom years leading up to 2008 the stock participated with the market and reached a high of $35.00. The stock dropped like a lead balloon during the bust to $2.20 in early 2009. Insiders own about 0.9% of the 316 million shares outstanding. It is truly an ill wind that blows no good. From a financial standpoint the stock's crash in 2008-2009 was a disaster for stockholders but it was a blessing for insiders who were recipients of stock options when the stock was trading at depressed prices. In recent months they were heavy sellers of the stock. They exercised stock options acquired earlier at about $3.00 and selling the shares at $11.50. There is nothing wrong with that. Lady Luck bestowed a blessing on them; we should all be so fortunate.
In recent years the stock has been trading at a sizeable discount (up to 40%) to its net asset value, due, in part, to the fact that the company's assets are illiquid. The stockholders do not receive cash dividends at this time. Management has a stated policy of using its free cash flow to buy back shares for as long as the stock's price is below its net asset value. And when that condition no longer exists the free cash flow will be distributed as cash dividends.
In Q3 11.4 million shares were repurchased. The net asset value grew by $0.77 to $17.39 per share, driven by net operating income and unrealized appreciation across four of its five business lines. The stock is currently priced at a 36% discount to net asset value. During the conference call management reiterated its commitment to (1) the stock repurchase program and reducing the stock price discount and (2) growing the portfolio of companies with added investments.
The chart below was constructed from data in my workbook. Its salient features are explained in the notes below it.
(1)The bold black line on top is price and the bold pink line below it is relative strength. (2) The dotted lines are moving averages and there is a set of those for price and a similar set for relative strength; they are used to define trends and reversals. (3) The five sets of gray parallel lines that frame the stock's price action are 22-day trading ranges and their progression shows how the trading range shifted during the 110 days charted.
The strong performance of the stock as shown in the chart is a continuation of that recorded during the previous 12 months. The price and relative strength lines trended upward and stayed above their moving averages except for the last few days when the price weakened as the general market sold off sharply. Hence, the price weakness was due to weakness in the general market and not specific to ACAS. The trading ranges shifted upward during the 110-day period in textbook fashion. Overall, the chart action was about as favorable as such action can be.
The gain in the price of the stock during the past 18 months was triple that posted by the S&P Industrial Index. The conclusion that I draw is that the company's shareholders were well rewarded by management's buyback decision. Therefore, the buyback was a good and worthwhile "two in the bush" proposition for both parties involved. Insiders benefited and so did the shareholders. The "two in the bush" became the "bird in the hand" quickly for those shareholders who took profits along the way. And, it is plausible that ACAS's formula could continue to work its magic in the days to come.
The second company to be scrutinized is Intel (INTC).
Buying low and selling high is recommended for corporations as well as individuals. A look at the chart below shows that the stock is in a downtrend. And, the price action (with regard to its downward trending moving averages and trading ranges) shows no indication that a bottoming process is taking place at this time. The implication is that the bottom has not yet been reached.
Management has an authorization to purchase $1.2 billion worth of the five billion shares outstanding. That could reduce the share count by about six million shares. The $1.2 billion is a lot of money but it equates to chump change of only 24 cents per share outstanding. The stock is priced at $21.00 and the dividend yield is 4.3% based on the current annualized rate is 92 cents. It should be noted that the dividend rate gets increased annually.
Insiders still own about 2.9 million shares. They sold some 2.1 million shares during recent months at about $21.50, with many of those shares coming from the exercise of stock options granted at lower prices. In some cases it was exercise the options or lose the value of the options if the price of the stock continued to decline. So the sellers did what any sensible person would do.
The company is a major participant in the personal computer market. And in recent quarterly reports management stated that Intel was being adversely affected by the transformational changes taking place in that market. Smartphones and tablets are becoming pervasive while demand for personal computers wanes. The major computer manufacturers have been hurt badly and so have some of the chip companies. Intel has been impacted to a much lesser degree. It has been introducing new chips and retooling its plants to produce the new products. The company has the facilities, technology, and financial resources necessary to compete effectively in its markets. Its free cash flow is robust and management has latitude to finance its capital projects, pay a liberal dividend, and still buy back shares. The share repurchase program is timely because the stock's price is at its low for the year. Investors strive to buy low and sell high. So do corporations.
Considering Intel's abundant free cash flow and management's liberal cash dividend policy, which equates to "a bird in the hand," the buyback at the stock's low price qualifies as a good "two in the bush" proposition.
Next on the agenda is IBM (IBM)
Buying back shares has been a hallmark at IBM for more than a decade. Since 2002 the company spent more than $68 billion to repurchase its shares. The share count decreased steadily from 1.72 billion shares in 2003 to the current number of 1.13 billion shares. The current authorization is about $10 billion and management expects to repurchase shares to the tune of $50 billion during the next five years. The stock's price went from $100 in 2003 to where it is now trading at $192. The gain was double the gain in the S&P index for the comparable time period. In 2003 the dividend on the stock was 63 cents. It was increased every year since then and the current indicated rate is $3.40. So over the years the shareholders were well treated and they should be satisfied by "the bird in the hand" reward that they got by way of the cash dividend.
There was a 35% reduction in the share count since 2003. With the stock priced at $192, $50 million would be sufficient to reduce the share count by another 26% from its current level of 1.13 billion shares. The company's operating divisions continue to prosper and the buybacks do not in any way adversely affect their earning power.
The stock's performance in recent months, as shown in the chart, has paralleled that of the general market. During the past six months insiders sold about 141,000 shares at prices ranging from $192 to $203 for a total of about $28 million. During those months insiders exercised options granted at no cost to them and accounted for a lot of the shares sold. I mention this to show that management is not guided solely by altruistic principles. The insiders know the difference between "principle" and "principal" so they have their ax to grind and it appears that they grind it very well. But life is what it is and shareholders should be pleased with the totality of management's programs, and that includes its stance on share buybacks.
With regard to the "two in the bush" consideration, I approve of the way management is executing its buyback program.
The last buyback program to be considered relates to WABCO Holdings (WBC)
WABCO is the world's leading producer of technologically advanced products used in the manufacture of trucks, buses, trailers and passenger cars. Its corporate development program is sound. Overall, its business fundamentals are stellar. Its cash flow is robust and well in excess of that needed to fund any capital project that management might want to pursue.
WABCO is the kind of stock that can produce above-average results during a bull market when the market is being fueled by cyclical and secular growth forces that are positive. However, it has nothing to offer the investor in the way of a cash dividend return because there is no such dividend. In sideways or down markets the stock tends to underperform due, in part, to the no-dividend consideration. Therefore, a cash dividend would be beneficial to shareholders for two reasons: (1) it would be "a bird in the hand" contribution toward its return on investment and (2) it would add buoyancy to the stock in dull or down markets.
Management authorized a $400 million buyback in 2011 and another one for that amount a few months ago. Some $340 million was spent thus far to reduce the share count by 6.4 million shares at an average cost of about $53 per share. There is now $460 million to be spent before the end of 2014.
Let's consider the price action of the stock.
As can be seen in the chart the stock has been moving with the market. The high during the past two years was 73 and the low 37. It is now priced a little above the midpoint of that trading range. There were times when it outperformed the S&P index and there were times when it underperformed.
The "prudent man rule" as legally defined is as follows: An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return; all other operations are speculative. The basics of the prudent man rule are sound and all investors would be well served if they used them as guides when making investment decisions. Let's focus on the phrase "satisfactory return."
All the investor gets from a stock are the capital gain (or loss) that the market confers on him and the cash dividend that the company distributes. WABCO's management has failed miserably in the way that it distributes the company's largess to its stockholders. If management had chosen to distribute the $800 million to shareholders as dividends instead of buying back shares, it could have paid $12.50 per share to each of its shareholders. It didn't have to do that in one lump sum; such could be done over an extended period of time as regular dividend distributions.
If the $340 million spent (wasted?) so far in the buyback program had been distributed as dividends, shareholders would have received about $5.30 for each share of stock that they own. If management was husbanding its cash flow to reinvest it prudently in capital projects to grow the company that would be praiseworthy. But to use "all" of it to buy back shares in lieu of cash distributions doesn't make sense from an investor's "a bird in the hand is worth two in the bush" point of view.
WABCO's free cash flow is robust and a liberal dividend policy could easily be sustained. The company's fundamental merits are stellar beyond doubt. It appears to me that management is focused on operating and growing the company but it is not stockholder friendly. Perhaps that's because the insiders own so little of its shares. They were also sellers of some 210,000 shares during the last six months, with the latest sale being just a few days ago at a price above current levels. The shares sold were about three-fourths of their holdings. Their current holdings now amount to a miniscule 0.1% of the total shares outstanding. Perhaps if the stock had a significant dividend yield they would have retained the shares that they sold. They might even decide that the shares are an attractive investment and add to their tiny position.
If 25% of the $800 million being spent on buybacks was distributed to shareholders as cash dividends, the $200 million would be sufficient to pay a dividend of $3.12 per share, which would amount to a current dividend yield of 5.3%. That would be a very attractive feature for a potential investor to consider when evaluating the stock's investment merits in today's low-interest rate environment. And, it is probable that the stock would trade at a significantly higher price with a liberal cash dividend than it is now without one. Furthermore, the stock might not underperform the market when it is trending down; that is what it did in past bear markets.
There is no way that WABCO's buyback program can be considered a plausibly good "two in the bush" alternative to "a bird in the hand" benefit that stockholders could derive if a liberal cash dividend policy was in effect.
I have now had my say about an important topic that is seldom discussed. I am intrigued by it. If anyone has a better argument than that which I presented, I would like to be educated by it. It's tough for an investor to pick winners in the stock market. But it's even tougher when the odds are stacked against him just as it is easier when the odds are stacked in his or her favor. Therefore, it's important to know when a buyback is a worthwhile "two in the bush" as it relates to "a bird in the hand" consideration and when it isn't. When analyzing a stock the analyst tries to look at it from 360 degrees. The pros and cons of buybacks are within the parameters of those 360 degrees and they should not be overlooked. The investor should know when a buyback will be beneficial to him and when it is beneficial to management at his expense. The four examples discussed above provide contrasts that provide perspective worth having.
Additional disclosure: I intend to buy Intel in the very near future