Sajal

Why You Should Short Companies Doing Share Buybacks

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.

Why You Should Short Companies Doing Share Buybacks

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).

Why You Should Short Companies Doing Share Buybacks

icandoitdon,

Your points sum it up very nicely. Thanks.

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

Why You Should Short Companies Doing Share Buybacks

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.