Friday, December 6, 2013

Apple's Buyback: Does It Still Make Sense?

Not long ago, Carl Icahn began calling for Apple (AAPL) to buyback $ 150 billion worth of its stock.

He eventually pushed for a large and immediate tender offer.

Prior post: A Bigger Buyback For Apple?

Essentially, Icahn wanted the company to quickly buyback lots of its stock before the window of opportunity closed.

Here's what he wrote in a late October letter to Tim Cook:

"In our view, irrational undervaluation as dramatic as this is often a short term anomaly. The timing for a larger buyback is still ripe, but the opportunity will not last forever."

This more recent CNBC article points out that Icahn has now reduced the amount of stock he thinks Apple should repurchase to more like $ 50 billion.

Well, I'll just point out that the stock has not only risen nearly 20% since he started pushing for the $ 150 billion buyback, but is also up more than 40% from its lows earlier this year.

The better time to buyback at that kind of scale has, at the very least, temporarily passed.

So the window of opportunity to buyback stock may not have completely closed, but eventually that rising price begs for the scale of the buyback to be smaller.

The arithmetic is such that what would have had powerful effects on per share intrinsic value at lower prices increasingly becomes less compelling.

Each dollar invested in the stock simply goes less far and naturally, as a result, returns less for continuing shareholders.

So, inevitably, the "relentless rules of humble arithmetic" dictate what makes sense here. For those who own Apple with longer term outcomes in mind, the merit of a very large buyback is just not quite as clear as it was not too long ago.

Naturally, those attempting to trade around the company's nearer term prospects likely have a totally different agenda.

Warren Buffett, who had talked to Steve Jobs about whether buying back Apple's stock was a smart thing to do several years back, did say the following about the idea of increasing the buyback this past October:

"I think the Apple management and directors have done a pretty darn good job of running the company. My vote would be with them."

Now, keep in mind that earlier this year Apple expanded its share repurchase authorization to $ 60 billion and, when the stock was much lower, did buyback a nice chunk of their own shares. So it's not like they don't already have a meaningful buyback program in place even if not at the scale Icahn seems to want.

Share count is down to 909 million compared to 948 million a year earlier (and seems certain to be even lower when they next report).

Buffett, who is no small fan of buybacks when they make sense, also added the following about the pressure on Apple to buyback even more of their stock:

"I do not think that companies should be run primarily to please Wall Street and largely shareholders who are going to sell. I believe in running Berkshire for the shareholders who are going to stay and not the one's who are going to leave."

His emphasis is always on doing what's best for those who are willing to have a longer investment time horizon.

That doesn't change the fact that, as I've said before, tech stocks are generally not what I like -- and that includes an enterprise as capable as Apple -- unless extremely cheap (i.e. selling at a substantial discount to conservatively estimated intrinsic value). It has to be priced in such a way that little good has to happen to get a nice result considering the risks.

With the company's already sizable repurchase authorization and increased stock price in mind, I'm not sure whether an increased/accelerated buyback plan matters a whole lot at this point.

What matters more right now is whether the stock can remain cheap enough to warrant buying more.

"The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another." - Warren Buffett in the 2011 Berkshire Hathaway (BRKa) Shareholder Letter

In fact, if Apple's stock does continue to rise, it will eventually make sense to put a halt to their buyback plans altogether.

More generally speaking, continuing long-term shareholders are generally better off when a stock underperforms in the near term (or even intermediate term) and the business continues to have sound long run economics. Potential reward is actually increased while risk is reduced* when the stock of a sound business remains cheap, there's no imminent intent or need to sell, and the investment time horizon is long enough. The further an investor is away from selling, the better off they become much further down the road. The reason is simple: It not only allows the investor to buy more shares cheap, it allows the company to buyback shares cheap over time. This can have a significant compounding effect longer term.
(Buybacks can make sense when both a stock is cheap AND more than sufficient funds are available to meet all the operational/liquidity needs of the business.)

With patience, the combination of a not so great performing inexpensive stock and a sound business that's been bought at a reasonable price can be a powerful one.**

It may not be a lot of fun -- and professional money managers must consider "career risk" -- to stare at the quoted price of a listless stock, but the arithmetic at work here is undeniable.***

An investor can develop a trained response that more heavily weighs the longer run big picture while mostly ignoring the short-term noise. A more rational response should, on the surface, not exactly be difficult or impossible to learn but things like loss aversion do tend to make it a real challenge.

An investor has to also consider the opportunity costs and make high quality ongoing assessments of future business prospects. Sometimes prospects change; other times they're misjudged out of the gate.

In other words, this approach to investing works for a sound business that's bought well.

It doesn't work for a broken business.

It doesn't work when a big premium to intrinsic value was paid in the first place.

Stubbornly holding onto shares of an unsound business is a great way to wreck investment results.

The same is true for the investor who stubbornly holds onto shares after it becomes clear that a dumb price was paid (usually in a desperate attempt to get their money back out).

These are mistakes that must be avoided.

Adam

Long position in AAPL and BRKb established at much lower than recent prices. No intent to buy or sell shares near current prices.

Related posts:
A Bigger Buyback for Apple
Apple's Buyback
Technology Stocks

* Risk and reward need not always positively correlated even if modern finance theory, not to mention cultural norms, seem to more than suggest otherwise.
** The potential impact on risk and reward over time from this is not insignificant but also may not be completely obvious. For me, creating and working with simple, but meaningful, spreadsheets is one useful way to develop this into something that's more intuitive. The compounded effect over, lets say, 20 years or so isn't small at all. That can be easier to see with a thoughtful, but not unnecessarily complex, spreadsheet.
*** Especially a stock that ends up selling quite a bit below where it was bought -- and for a long period of time. Even if an unpleasant experience for some (I mean, nobody really likes seeing even paper losses no matter how rational this may be) and maybe just a bit counterintuitive, this approach still works out over the long haul if the company produces lots of cash flow, capital gets allocated well over time, and the price paid made sense. This way of thinking will no doubt be of little interest to those primarily in the business of trading price action.
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