Stock buybacks get a bad rap these days. Senators Bernie Sanders and Chuck Schumer took time out of their busy days to knock them in a New York Times op-ed (February 3, 2019). Even the financial press takes frequent stabs at buybacks, like this Forbes article:
“For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed. And it’s obvious why Wall Street loves them: Buying back company stock can inflate a company’s share price and boost its earnings per share - metrics that often guide lucrative executive bonuses.” (February 28, 2017)
I write here to not just defend buybacks, but to highlight that they are crucial reasons why I’ve recommended three stocks - MGIC Investment Corp. (MTG) (and its mortgage insurance peers), Ally Financial (ALLY) and American Airlines (AAL) - in prior Seeking Alpha articles. The reasons are that buybacks often underscore management discipline and they do so efficiently.
Stock buybacks often underscore management discipline
“Growth” has become an obsession in the investment world today. For most of my Wall Street career, company quarterly reviews focused on bottom line earnings. Today, all eyes are on top line revenues. Take my heroes Wayfair (W), an online furniture retailer. Last spring, after 2018 first-quarter earnings, the company was expected to lose about $2 a share this year. Despite that sorry outlook, the stock had risen to $90. Four quarters later, Wayfair is now supposed to lose $5½ a share. Despite that far sorrier outlook, the stock is more than 50% higher. Why? Better top line growth - at last reading 39% versus the prior year, in a business with 5% or less organic growth.
But as the Wayfair story shows, taking market share frequently, and probably usually, comes at the cost of lower earnings. Sometimes a company really does discover a better mousetrap and exploits that advantage to profitably take share. Think Apple. But taking share usually just means undercutting competitor pricing, spending more on marketing, rapidly building production and the capacity to produce, etc. Think Blue Apron or, I argue, Uber. Or the airline industry of 15 years ago. I’ll call this investor value-destroying behavior “over-investing”.
A key protection against the lure of over-investing is getting rid of excess cash flow, which in capitalism means distributing it to shareholders. My buyback heroes - MGIC, Ally and American Airlines - all have limited growth opportunities:
- MGIC insures home mortgage debt, which currently grows at only 3% a year. Even low down payment mortgage debt grew by only 7% over the past year, according to brokerage firm Keefe, Bruyette & Woods.
- Ally Financial invests in auto debt, which grew by 4% over the past year.
- American Airlines (I bet you know this!) flies people around and feeds them tiny bags of peanuts. Airline passenger growth is around 3% a year.
All three of these businesses have seriously over-invested in the past, with dire results. But today, all three are instead showing admirable discipline by distributing excess cash flow. Avoiding doing a stupid thing can be half the battle.
Stock buybacks can be a very efficient means of distributing cash to investors
Bizarrely, public discussions of stock buybacks often ignore their basic function - to reduce the number of company owners to the benefit of the remaining owners. Let’s say you and the 12 members of the Golden State Warriors started Dribbles, a restaurant catering to messy eaters. Each of you would therefore own 7.7% of Dribbles, with the right to 7.7% of Dribbles’ earnings. But Steph Curry runs into some unexpected home repair bills and Kevin Durant needs some cash to complete his acquisition of Paraguay. They sell their shares back to the remaining 11 owners, increasing your profit sharing rate to 9.1%. Nothing wrong with sharing more profits, is there?
To illustrate, possibly the greatest buyback story never told
- Since 2000, NVR grew its home sales by 3½% a year. Because homebuilding went into a funk over the past decade, that seemingly modest growth allowed NVR to nearly triple its market share. But Lennar’s unit sales growth kicked NVR’s butt, at 7½% annually.
- Lennar efficiently turned its 7% sales growth into 8% annual EPS growth. That beats the S&P 500’s 6% a year EPS growth since 2000, so pretty darned good. But NVR’s EPS growth averaged 15%! From only 3% unit growth!
- Check out the chart below. It shows that the S&P 500 index more than doubled since the end of 2000. Lennar handily beat that with an impressive 868% gain. NVR? Little ‘ole nobody ever heard of them, sleepy homebuilder NVR? Up 7227%!
Source: Yahoo Finance
How the heck did that happen? Very largely through the power of stock buybacks. Check out this chart:
Source: Company reports, Yahoo Finance
Today’s NVR owner has to share profits with only 39% of the owners it would have in 2000. And considering the shares it granted to employees (yes, mostly those elite executive employees) over the years, only 28% of the potential owners. That fact hugely boosted EPS, which is obviously the earnings measure that drives stock prices.
One other critical point of interest. Note in the chart just above that the bulk of NVR’s share reductions were in the early years, when the company’s P/E ratio was relatively low. So, while buybacks help by limiting stupid overinvestment, they really help when the buybacks are at a cheap price.
Circling back to MGIC, Ally and American Airlines…
All three meet my Buyback Medal of Honor criteria. First, their business growth was moderate over the past year:
- MGIC’s insurance in force growth was 7%
- Ally’s loan portfolio grew by 4%
- American Airlines’ capacity (available seat-miles) grew by 1.3%
All three growth rates are in line with industry averages and are sustainable by their customers.
Second, instead of over-investing, they used significant percentages of their earnings to buy back stock and pay dividends in 2018:
- MGIC - 24% (This number will grow a lot, I promise.)
- Ally Financial - 94%
- American Airlines - 72%
Finally, they can buy back their stock today at remarkably low valuations (P/E ratios):
- MGIC - 7.9
- Ally Financial - 7.6
- American Airlines - 6.0
Are you getting those NVR goosebumps like I am?
Disclosure: I am/we are long AAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.