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.