Friday, May 31, 2013

Stock Buybacks: A Good Thing...If The Price Is Right

From this Barron's article:

PUBLICLY TRADED COMPANIES generally face two choices when their cash exceeds reinvestment needs: Pay shareholders via dividends, which are double-taxed, or buy their own shares in the market, increasing the company's value to remaining shareholders.

What's a sensible use of capital at one price naturally becomes not so sensible at some higher price.

Well, buybacks are only a good thing if: consistently executed when the stock price is below -- and, ideally comfortably below -- per share intrinsic business value, company finances are in good shape with routine operational/liquidity needs of the business well-covered (enough to at least maintain competitiveness but possibly also including those things that widen the all-important moat), and no other action offers, considering the specific risks, a plainly better return.

When a corporate buyback is announced it is frequently greeted with cheers. A buyback, when done the right way and for the right reasons, can certainly end up being a very good thing for shareholders. At times, however, buybacks are executed for the wrong reasons -- i.e. to offset the dilution resulting from exercised stock options, for example* -- or when shares are expensive.

Unfortunately, too often buyback announcements end up not being followed up by wise action.

The net result being minimally beneficial to long-term owners (or worse).

According to Barron's, a study by advisory service MG Holdings/SIP of companies (primarily technology) and their share repurchase behavior reveals, at best, mixed results.

It shows that, while some buyback programs have delivered favorable results, a large percentage have not been effectively implemented and delivered subpar results for shareholders. The article points out that managements have a tendency to execute more buybacks during the good times and less when times are tough. Well, that behavior almost certainly leads to paying, at best, more than necessary, or worse, maybe even a premium to per share intrinsic value.

The study was of $ 457.6 billion in buybacks from 2000 through 2012 of 232 companies. According to the study:

- 75% of the 232 companies bought back stock.
- At the end of 2012, 51% of the programs are now profitable while the rest, of course, were still not.
- The shares are worth just 13% more than what they cost to repurchase for the group. Not a disaster, maybe, but hardly a great result considering it has been over a 13 year period.
(It's worth noting that this is based on market prices. Again, what really matters is what was paid compared to per share intrinsic business value.)

The article also points out that this doesn't include the foregone interest on the cash if the shares had not been bought back. For that and other reasons the 13% is actually an overstatement.
So buybacks can be a very good thing but one cannot assume they will be done in a way that is highly beneficial to shareholders.

That's why -- all else equal -- a firm led by someone with wise capital allocation skills has higher intrinsic value even if that additional worth is difficult to quantify.

A good explanation of when it is advisable to buyback stock and when it is less so can be found in the Share Repurchases section of Warren Buffett's 1999 letter.


* Stock-based compensation is not a small expense for a number of tech firms. Dilution that comes from this form of compensation can prove a meaningful (and costly) offset to what would otherwise be a further reduction in share count. In some cases, this is literally a case of buying high and selling low

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