With cash continuing to pile up on U.S. corporate balance sheets and capital investment opportunities limited by anemic economic growth, shareholders are going to increasingly clamor for excess cash to be returned.
Corporations are earning nearly the same paltry returns on their cash that individual investors are earning, so if corporate investment opportunities can not be found, investors will ask for some of the cash back in the form of higher dividends or share repurchases. This article examines share repurchases and how companies repurchasing a portion of their own company have performed historically.
Before we get into how share repurchases influence shareholder value, we should set a solid foundation on this topic. When shares are repurchased in the open market by the issuing company, the repurchased shares may be retired or held as Treasury stock for future re-issuance, lowering the number of shares available to the public. Once the stock is repurchased by the company, it does not receive dividends and has no voting rights. If markets are efficiently valuing the company pre-share repurchase and post-share repurchase, the value of the firm will be unchanged. While a company's earnings per share will rise with the reduced number of shares outstanding, the market should adjust the value to reflect the reduction in cash as well as shares.
The Modigliani-Miller Theorem on capital structure, which eventually led to Merton Miller's Nobel Prize, states that absent taxes, bankruptcy costs, agency costs, and assuming information efficient markets, how a firm is financed is irrelevant to its value. This theorem is important for our understanding of the impact of share repurchases because of the number of caveats that must be imposed for the theorem to hold. For a firm with debt in its capital structure, repurchasing shares with excess cash increases financial leverage. A firm borrowing money to repurchase shares should not be able to increase the value of the firm because the discount rate applied to the value of the firm should increase due to the increased risk.
The assumption on perfectly efficient markets assumes that all stocks are currently trading at their intrinsic value because all information both public and private is fully reflected in the share price. If markets were perfectly efficient, Berkshire Hathaway (BRK.A, BRK.B) could not have grown from a failed textiles manufacturer to a dominant conglomerate that has made its chairman one of the wealthiest men on the planet because perfectly priced markets would have meant that Berkshire's holdings would have only returned the market return. In Warren Buffett's most recent letter to investors accompanying Berkshire Hathaway's annual report, the Oracle of Omaha devoted several paragraphs to share repurchases. Importantly, Buffett discussed his thought process on share repurchases in a wrap-up to a year that saw Berkshire initiate a sizeable stock buyback plan, he stated:
"Charlie (Munger, Buffett's long-time business partner) and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company's intrinsic business value, conservatively calculated."
Of course, if we all knew the intrinsic value of a company, the investing game would be quite a bit easier. Even corporate management, who should have the best information about the intrinsic value of the firm and its future prospects, have performed poorly in past periods when repurchasing shares. A recent article by Credit Suisse suggests investors think about corporate share repurchases from the lens of a portfolio manager. After all, as a shareholder, it is your money that the company is re-investing in its own shares. The CS analysis demonstrated that from 2004-2011 36% of the S&P 500 constituents (SPY, IVV, VOO) beat a low return hurdle of just seven percent with their share repurchases. The histogram below highlights the range of outcomes for S&P 500 companies repurchasing shares in this period. These companies would have been better served buying back their bonds than their stock in what turned out to be a weak equity market environment.
The graph below from Factset shows the share repurchases by the S&P 500 constituents over the trailing seven years. Notice share repurchases peaked before the market collapse in 2008, and hit their lows when markets were bottoming early in 2009.
While equity markets often respond positively to share repurchase announcements, investors should analyze whether this signaling effect is warranted, and if they would add additional shares to that company with their next available investment dollar.
In the current low-economic growth environment, share repurchases may also serve as a use of cash if organic investment opportunities that produce a positive net present value are limited. If a company can not find available projects that beat its cost of capital, would you invest incremental dollars in that firm?
Companies also repurchase shares for other reasons than management's belief that the shares are undervalued. Employee stock option grants can be dilutive, and companies will buy back shares to offset this effect. Threat of hostile takeovers can cause companies to buy back shares as a defense mechanism. Even outside of a takeover situation, it is important to understand whether management is well-aligned with the long-term interests of shareholders. Is management compensated based on short-term earnings, and are share repurchases being conducted to boost earnings per share to achieve these incentives?
In my February article entitled Earnings Yields Versus Bond Yields, I demonstrated that U.S. companies were producing earnings yields (earnings/stock price) at historically high premiums relative to their financing yields. This gap has widened over the last six months as interest rates have continued to fall and bond credit spreads have compressed. Given the tax deductibility of corporate bond interest expense, blue chip U.S. corporations can borrow at an after-tax real cost of zero. Think about a company that can borrow for ten years at a credit spread of 140 basis points over the ten-year Treasury for a yield of 3%. With a 35% marginal tax rate, the tax-adjusted yield is 3%*(1-.35) = 1.95%. If inflation averages just 2% over those next ten years, then the debt will be repaid with dollars worth sufficiently less such that inflation and the tax savings fully offset the increased interest expense. Debt-financed share repurchases can increase the ownership stakes of current stockholders with what appears to be limited cost. Theory would say that the increased cost of financial distress from higher leverage would offset this benefit, but companies with strong balance sheets can use this low rate environment to modestly lever and increase shareholder returns to equity.
Of course, the best outcome for existing shareholders is that the company is trading below the opaque concept of intrinsic value when the shares are repurchased. Since there is no accounting concept of intrinsic value, and book value can be skewed by the important but difficult to value intangible assets, the compounded growth rate of book value can serve as a proxy. Leaning back on the techniques of the greatest value investor of our time, Warren Buffett has historically compared the compounded annual growth of the book value of Berkshire Hathaway to the total return of the S&P 500. In 38 out of 46 years, his company has outperformed.
Berkshire Hathaway, like the components of the S&P 500, is sitting on high cash levels. How this cash is deployed will determine future relative performance, and I would bet that the Berkshire will deploy this cash more artfully than the market in general. To ensure that you deploy your own capital skillfully, favor repurchasing companies which have consistently grown book value per share, have a wide gap between earnings and financing yields, and have management whose incentives are well-aligned with long-term shareholders and have a past history of better timed share repurchases than the woeful market record.
Disclosure: I am long SPY.