The Dark Side Of Share Buybacks
Share buybacks are popular right now… it seems like everybody is doing one. If you’ve ever watched a business news channel, you’ve probably heard the talking heads blathering on about who just authorized a giant share buyback, and how much it’ll boost share prices.
In general, share buybacks are seen in a positive light by the financial media, and they often can be. But there’s a dark side to buybacks that rarely gets talked about — Buybacks don’t always make good financial sense.
In certain situations they can be a gigantic waste of shareholder capital, or they can mask the terrible excesses of
the Empire corporate management.
At What Price?
In most cases, companies buy back shares when they have A TON of extra cash lying around. This usually happens when the economy is doing well — profits are good and share prices are up.
But what if the company could do something even better with all that spare cash? Could they grow the company by investing in new product lines? Buy a competitor? Pay down debt?
There’s a veritable mountain of options for what could be done with excess cash, but (due to their current popularity) share buybacks are seeing a flood of cash right now.
Imagine for a moment you are the CEO of a company with two options for excess cash:
- You could buy back shares of your at 30 times earnings.
- Keep the cash and simply invest it in some low-risk corporate bonds earning 4%.
- You could pay off some debt with an interest rate of 4%
Which option would you take?
At 30 times earnings, those shares are richly priced. It’s the equivalent of buying a company with a 3.33% earnings yield. At first blush option #2 or #3 might seem mathematically better (4% is greater than 3.33%), but this doesn’t take into account corporate growth rates.
It’s right about this time when you hear CEO’s start talking about “intrinsic value” and how they only buy back shares below the “intrinsic value” of the company. How that intrinsic value is calculated? Is this value ever published?
In all my years of investing I’ve never seen a company publish how it calculates intrinsic value. (More than likely it should be some form of discounted cash flow)
Don’t get me wrong here, I don’t completely hate share buybacks — I’ve made some incredible profits over the years due to well timed buybacks.
At one price they can add incredible value for shareholders, but at another price share buybacks just waste cash. Quite simply, the price paid matters.
When I see companies like Alphabet (currently trading at a PE of 35), I really wonder if spending $3 billion a year on buybacks is an optimal use of shareholder money.
Some Buybacks Do Nothing
When most people think of share buybacks, they automatically assume the number of outstanding shares drops as a result. This cannibalistic behavior is suppose to boost earnings per share as a result of having a lower share count.
But what if it doesn’t?
In many cases, the net result of a huge corporate buyback, is a share count that remains roughly the same year over year. Why?
Stock is frequently issued to high ranking employees at the same time a share buyback is going on. (Typically the stock is issued as part of a executive compensation package.) The net result is billions of dollars are being spent on a buyback, but no shareholder benefit.
This illusory behavior is surprisingly common. Want an example? Take a look at Johnson & Johnson’s shares outstanding from the last couple decades:
Despite decades of continous share buybacks, JNJ’s share count is no lower than it was 20 years ago.
Currency For Acquisitions
There’s another reason why the outstanding share count might not drop after years of large buybacks — shares are occasionally used as a “currency” for corporate acquisitions.
This kind of transaction can turn out to be a bargain if the acquired company goes on to great things, OR it can turn into an absolute disaster.
Even the best CEO’s can make mistakes here — In 2016’s shareholder letter, Warren Buffett owned up to a billion dollar mistake he made issuing shares to acquire a shoe company:
“I made one particularly egregious error, acquiring Dexter Shoe for $434 million in 1993. Dexter’s value promptly went to zero. The story gets worse: I used stock for the purchase, giving the sellers 25,203 shares of Berkshire that at yearend 2016 were worth more than $6 billion.”
Yikes! Six billion worth of stock for a company whose value went to zero. See, even Warren Buffett gets tempted by the dark side!
Buying At The Wrong Times
It’s worth noting that even the best intentioned buyback plans can end-up purchasing shares at the wrong time — it’s a product of cash levels throughout the business cycle.
When times are good, there’s excess cash to spend on buybacks. When times are bad, companies seek to preserve cash.
While this all sounds logical, it doesn’t maximize shareholder value. Every investor knows in order to maximize returns you need to buy when shares are low, not when they’re high.
Here, Starbucks provides a example of dark-side behavior from 2009:
Back in 2009, Starbucks shares reached their lowest levels in nearly a decade. That’s when Starbucks should have been repurchasing shares hand-over-fist. Instead, the company stopped repurchases despite $390 million in corporate profits, and a $600 million dollar cash balance.
Repurchases resumed again in 2010, but Starbucks missed a big opportunity to buy back shares at very low prices.
To grow shareholder value, companies with buyback plans should be buying back the shares when they’re priced lowest… NOT at the peak of a bull market.
So what does all this add-up to? Don’t buy into the media-hype around share buybacks. They aren’t always good news.
In the height of a bull market when share prices are high (like we see today), buybacks tend add very little in shareholder value.
I suppose buybacks (today) make more sense than buying another corporate jet or another gold-plated executive bathroom… but not by a lot.
If you’re an index fund investor, there’s really nothing you can do about this — just know that there’s a huge amount of money being spent on buybacks that could be better spent elsewhere.
However, if you invest in individual stocks, you absolutely should be paying attention to stock buyback plans. Are buybacks in your stocks being used to cover-up excessive executive compensation? When shares rise to big valuations does the company stop repurchases?
Asking such questions could be a canary in the coal mine of your long-term stock performance.
22 thoughts on “The Dark Side Of Share Buybacks”
I have never heard of share buybacks before. This is a new and interesting concept to me.
I really like your honest conclusion. Just because the media is throwing a fanfare about something doesn’t mean that it’s good. In a way, it can be almost like those commercials about products people are told they should buy. But in fact, people might not even need those products in the first place.
Really? Wow! Glad to introduce something new to you!
Great post and love the Warren Buffet meme.
Don’t buy into the media-hype around share buybacks. …. I would add “don’t buy into any media hype”.
Good point Accidental! The big question is, how can you tell if it’s media hype or not?
I think most of what the media drums up is hype since they make money by keeping you watching. And exaggeration and hyperbole seem to be effective at keeping people watching.
Ever notice now how routine weather forecasts on many channels are now called “extreme” weather forecasts (from their “extreme” weather center)? Calm, placid sunny days, from the “extreme weather center forecast”….
I am not a big fan of buybacks, for the reasons you mentioned – they are done regardless of valuations, typically at inopportune times. I would much rather prefer special dividends.
If a company has been successful (Coca Cola), buybacks look like a smart decision in hindsight. If it is not, they look like a waste ( Kodak, Sears). Tough to say in advance which one is which 😉
The best case against buybacks is General Electric (GE). They spent tens of billions on buybacks in the early 2000s when prices were high, only to sell the same number of shares are lower prices during the financial crisis.
I think they resumed the buyback at higher prices recently… But may have halted it as well.
Great point about GE. I was actually going to use them as a case study for buyback waste, but decided to go with JNJ instead as they’ve been fairly successful, but the buybacks have had no major benefit.
Both GE and JNJ aren’t perfect models of course. They’ve been around for decades and they both used shares for purchases and executive compensation. In fact, it’s hard NOT to find a major corporation that hasn’t done both.
I am an index fund investor, so I don’t follow share buybacks closely. I agree I don’t think share buybacks always make a lot of sense and seems that these companies buy at the top of the market and have to issue shares when the market tanks.
Absolutely true Steve, yet they remain incredibly popular!
Dear Mr. Tako,
Thank you so much for making the time to write about this. I found it very informative.
Have you found any research that suggests that certain sectors might be more prone to buybacks than other (irrespective of stock price) and it isn’t an indication of funny business and/or something to worry about?
I have seen numbers detailing how much each sector spends on share buybacks, but essentially all it tells us is how big and profitable each sector is.
Each case has to be evaluated independently.
I’d actually argue they are usually bad… the reason is the time periods when a company can afford a buy back are probably highly correlated with when the price is highest.
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Absolutely FTF! It’s one of the reasons I’m don’t emphasize buybacks in my investing strategy.
Nice article. I’d agree that the timing of buybacks is generally poor, especially with the benefit of hindsight. Few managers do well with this. For example oil & gas companies (XOM) were buying back shares when oil prices and valuations were high. After oil crashed and focus was on paying the dividend buybacks stopped.
One could even though Buffett made a poor decision issuing shares for Dexter shoe, he rightly did acquisitions using premium priced shares in the early 2000’s. At least he can compare market pricing to his internal book value calculation.
Thanks (as always) Mike!
Dexter shoe was a mistake, but I might argue that General Re (which was purchased with shares) worked out rather well.
Buybacks, when done right can be a tax efficient means of returning capital to shareholders especially for high earners. We have a few holdings where the buy back has performed very well, normally when used along with a growing dividend. The problem is too many companies use buybacks for the wrong reason, like covering executive compensation or boosting a quarterly EPS number. Its important to look past the authorizations, and look at the share count reduction over time.
As with other forms of returning capital to shareholders, like dividend growth, you still need a healthy underlying business with growing free cash flow.
I couldn’t have said it better myself TPM! Thanks!
That’s an interesting take on buy backs! I never thought of it as a neutral or bad thing from a corporate perspective, but it makes sense now.
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I remember Amazon doing buy backs and asking my husband why. He said they’re trying to increase the price by limiting the supply up for sale. I didn’t know that about Buffet but then again Buffet prob wouldn’t miss that 6 billion today 🙂
Add another one to the list: GE is looking at buybacks after cutting the dividend payout by 50%. Actually, it may be a reasonable thing to do depending on how low the stock winds up. Time will tell, and it depends on how well the turnaround of the business is executed. There are some great product lines in GE buried in the massive organization.
I don’t like buybacks. Rather pay me dividends with the cash and I’ll decide if I want more of your company.
However share buybacks don’t always make sense, in many cases it is more interesting than dividends for Belgian investors like me. Considering US stocks, first we pay 15% American taxes and then another 30% in Belgium. This way we only keep 59,5% of our precious dividends.