Share buybacks are a strange corner of the investing world where you’ll often find great disagreement. On one hand, you have a group of investors that say “Stock buybacks are great, they increase my percentage of ownership in the business”.
Indeed, this group has a point — under the proper conditions stock buybacks can be a form of internal compounding that adds value to shareholders.
However, on the other hand you have another group that suggests “stock buybacks are a gigantic waste of money, used to cover-up excessive share dilution that arrives in the form of executive compensation.” This group of investors also has a very good point. Many share buybacks accomplish nothing (shares outstanding is not reduced), and yet billions are spent annually on what amounts to an executive handout.
Share buybacks can eat-up shareholder cash like nobody’s business, so it makes sense to understand the how and the when of what a good share buyback look like.
In 2018 alone, over $1 trillion dollars in buybacks were announced by US companies. Just counting S&P 500 companies, a humongous $700+ billion dollars was spent on share buybacks last year. Apple alone announced a $100 billion buy back in 2018!
That’s A LOT of cash to spend on something that may or may not benefit shareholders.
So who’s correct? Like most things, the truth lies somewhere in the middle. There’s a lot of grey area. Frankly, it depends…
Uses For Cash
When most people invest in stocks, they tend to invest in companies that generate something called “free cash flow”. That cash, is money generated in excess of what is required to maintain the existing operations of a business. Having this extra cash is extremely important for shareholders, because it’s how value gets built over time.
If you’ve ever wondered how compounding works when you invest in a stock, free cash flow is where it’s at. How that free cash gets invested is really the “secret sauce” of internal compounding.
How is it invested? Well, management has a limited number of possibilities for using “free” cash:
1. Expand operations — This is an organic expansion of existing operations. Meaning, the company can invest in new buildings, stores, raw materials, equipment, machines, as well as hiring the employees necessary to run those operations.
2. Fund R&D — New ideas, services and products must be developed into real products. This process is called “R&D” or Research & Development, and is usually a line item on the income statement. If a company develops new products, it likely has a R&D expense.
3. Pay down debt — Paying down debt, like paying extra on a home mortgage, is generally a value building activity. But, also like paying down a mortgage it might not be the best possible use of free cash.
4. Buy another company — Just like buying small businesses, sometimes large corporations also want to buy businesses. Cash typically changes hands to pay for the transaction, as well as issuing shares, warrants, options, debt, and other forms of compensation.
5. Pay a dividend — Paying dividends is one of my favorite uses of corporate cash, because it means I receive a regular check from the companies I invest in. Once I receive that dividend, I can either choose to invest it or spend it. This isn’t always the optimal use of cash however, because shareholders must pay taxes on those dividends (dividend tax rate varies considerably around the world).
6. Buy back stock — In most cases, share buybacks are purchases of shares on the open market that reduce the number of shares outstanding. There are other forms of share buybacks, but open market purchases are by far the most common form that investors are going to encounter.
It’s also worth mentioning that not all of these uses for cash will make sense for every company. Growth companies typically use all free cash available to grow. Conglomerates and large companies with limited internal growth options, tend to purchase other companies.
Cash cows (like Apple) have more than enough cash to fund options 1 – 4, and are going to be the largest repurchasers of stock. These tend to be some of the largest and most secure companies in the world. That said, investing in companies with share buybacks is by no means a magic bullet — just look at GE. GE used to buy back billions in shares.
Fat lot of good it did them. Even the mightiest of giants can fall if they don’t take care of business first.
It should be said (in no uncertain terms) that there are “Good” buybacks, “Bad” buybacks, and everything in between. Bad buybacks are a waste shareholder money, and generally fall into two categories:
- Buybacks that fail to reduce the number of shares outstanding.
- Buybacks that are done at a very high price, thereby rendering a very poor return for shareholders.
Finding companies with buybacks that fail to reduce shares outstanding is relatively easy — Just graph the number of shares outstanding and compare against the dollars spent annually on buybacks.
Google is always my poster child for a bad buyback plan. Great company, love the products, but terrible share buyback plan. It should just be a renamed the “executive compensation plan”. Google effectively awards *billions* here every year.
When it comes to buying back shares, you’ll hear a lot of techno-babble from CEO’s about buying back shares when prices are “below intrinsic value”. But here’s the funny thing — you’ll never see published a calculation as to HOW that particular intrinsic value number is calculated. What discount rate is used? What assumptions are made about cash flow and growth rates? And so on…
In my view, all that talk about intrinsic value is really just hand-waving. You’ll see management spending X dollars per year regardless of the current price per share. More than likely this happens because corporation management simply wants to hit earnings targets where executive compensation bonuses get triggered.
This means many companies buy back shares at *almost any* price, as long as they have spare cash. In good times, this tends to still work OK, but in bad times it means share buybacks effectively dry-up during recessions.
Like it or not, this means many share repurchase plans only happen when prices are highest. Those same repurchase programs get halted again when recessions happen (and share prices are lowest).
This is kind of plan is a rather poor use of shareholder cash.
While ‘bad’ buyback happens to be easy to find, good buybacks are considerably harder to discover (and I’ve spend a lot of time looking). How can you tell if your stock investment has a good repurchase plan?
First, the shares outstanding should actually fall over time as shares get purchased with extra cash.
One such stock from my own portfolio, is LyondellBasell (LYB). It exhibits this property quite handily:
As you can see in the chart above, once LYB began share buybacks in mid-2013 the share count shrank annually. Executive compensation with shares does happen with LYB, but it’s not large enough to really move the needle on the share count.
Secondly, even though calculations of intrinsic value are never published, we should still see the size of the buyback change according to share price conditions.
Again, LyondellBasell (LYB) provides an example of what an intelligent buyback program might look like:
(Note: I’m using Price to Book in the table above to give us a rough estimate of valuation relative to price.)
What I see in the data, is that in years when prices are lowest they buy back *lots* of stock. In years when prices are high, they buy back less stock. You can see this in years 2015 through 2017, when the amount spent on buybacks really tapers off. Yet it began to grow again in 2018 as soon as share prices fell.
As a shareholder, I would have like to have seen an even bigger repurchase in 2018, but shares only fell to those ultra cheap levels in the second half of the year. So we’re really only looking at a few months of accelerated buying.
This appears to be what a smart share repurchase plan should be doing — buying back shares when prices are dirt cheap, getting shareholders the best ‘bang’ for their buck. Then, when shares get expensive, the buybacks slow down.
I don’t have a lot of data here, but it certainly looks like LYB is doing it right. Only time will tell if this “good behavior” will continue.
In summary, I would like to say that despite my criticisms, I really do like share buybacks. They’re not all bad. They can make a lot of sense (at the right price) to build shareholder wealth internally. But no two share buyback plans are created equally — Each must be researched on its effectiveness on a case-by-case basis.
While you often see headlines about share prices rising when buybacks are announced, by no means do shares become an immediate ‘Buy’. It’s just an announcement! It actually hurts the effectiveness of those plans when shareholders bid-up prices!
So tread carefully. Share buybacks are no magic bullet. They can’t prop up the stock price of a failing company (like GE), but they can build value over time when the stock has few other good uses for excess cash.
Do you know of any good share repurchase programs? I’d love to hear about it in the comments!
[Image Credit: Flickr]