Why Record Stock Buybacks Are Good News for Value Investors
There are few topics in which there is greater misunderstanding than the subject of stock buybacks. Charlie Bobrinskoy explains why we think that buybacks are one of the best uses of corporate cash.
There are few topics in which there is greater misunderstanding than the subject of stock buybacks.
When a company repurchases shares of its own stock, it is referred to as a stock buyback. A buyback occurs when the company that has issued the stock pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously held by public and private investors. The company has the ability to purchase this stock on the open market or directly from its shareholders. Buying stock directly from shareholders is also a way to return cash to the shareholders—as opposed to paying dividends.
American companies bought a record $806 billion in stock buybacks in 2018, some of which came from savings received following the 2017 tax reform bill. A great deal of cash held abroad by companies was “trapped,” and could not be brought back to the U.S. without incurring a significant tax bill. The tax law removed this obstacle, enabling companies to bring this cash home and put it to work.
S&P Dow Jones Indices tracks share repurchase activity and noted in March that buybacks surged 55 percent above 2017’s level, and were significantly above the record of $589.1 billion set in 2007.
We think that buybacks are one of the best uses of corporate cash. Here’s why stock buybacks benefit companies and value investors.
Stock buybacks are great investments.
As value investors, we buy companies that we believe are trading for less than their fundamental intrinsic value. When a company buys back its stock, it might be paying 60 cents for something that we think is worth a dollar. This is a marvelous use of a company’s cash.
Few companies we own have better investment opportunities than buybacks. Value investors who think the stock is low compared to its intrinsic value get to own a bigger share of the company.
Although famed value investor Warren Buffett has argued his investment opportunities are superior to share repurchasing, even Buffett has made strategic buybacks, such as in September 2011 when he said he would buy back Berkshire Hathaway shares which were trading at the time below 1.1 times book value.
Stock buybacks are superior to paying dividends.
Companies can also return money to shareholders by boosting dividends, but this is less efficient. One dollar in dividends is worth one dollar in cash. No value is created. As investment managers we will use that money to purchase stock, while the dividend payment generates taxable income for our clients who have taxable investments.
When a company repurchases its stock from its shareholders, the company is giving us a choice whether we want that cash, a choice we don’t get with dividends.
Stock buybacks can be opportunities to buy low.
The fourth quarter saw record share repurchases totaling $223 billion. That news is especially heartening because the broader market sold off during 2018’s fourth quarter, which means these companies took advantage of cheaper prices to repurchase shares. We love companies that have stock repurchase authorizations who can take advantage when the market trades lower, to buy when others are fearful, as Buffett says. Capital allocation is one of the most important skills we look for in a management team, and being good at repurchasing their company’s stock when it's trading at a discount is a great skill.
Some of the best CEOs are opportunistic share repurchasers. Tom Murphy, the longtime CEO of Capital Cities Broadcasting (which was eventually sold to Disney in 1996), frequently bought back shares, particularly when the firm’s multiple was low relative to private-market comparables. In the book, The Outsiders by William Thorndike, the author writes over time Murphy spent $1.8 billion in buybacks, generally at single-digit multiples of cashflow. Thorndike writes the buybacks gave shareholders a cumulative compounded return of 22.4 percent over 19 years.
Companies are in a position to take advantage of short-term disruptions because firms are almost always generating cash from operations. They can either use money from savings or modestly increase short-term borrowing to repurchase stock.
Stock buybacks are smarter uses of cash.
Stock repurchases keep companies from making unprofitable acquisitions. Companies sometimes struggle to manage sizable cashflow, and many make the mistake of wanting to get bigger for the sake of being bigger. Management compensation is correlated with company sales in absolute dollars, so bigger companies tend to pay their senior management more than smaller companies. This produces an unhealthy incentive for companies to use their cashflow to make acquisitions, usually at a premium to the market.
The academic paper “Market Underreaction to Open Market Share Repurchases” published in 1994 in the National Bureau of Economic Research by David Ikenberry, Josef Lakonishok and Theo Vermaelen, showed benefits to stock buybacks. In a study of open market share repurchase announcements between 1980 to 1990, firms that repurchased stock beat their peers by 12.1 percent over the next four years. Value stocks saw greater gains, with companies seeing a 45.3 percent higher return. The paper says these companies were more likely repurchasing shares because of undervaluation.
There are times when stock buybacks do not make sense, such as when a company is heavily indebted. Sometimes a company mis-times its stock repurchases. But those events are generally exceptions to our overall belief the stock buybacks are a great use of operating cashflow.
The record corporate stock buybacks have raised eyebrows in Washington. A few senators, including Senators Chuck Schumer (D-N.Y.), Bernie Sanders (I-Vermont) and Marco Rubio (R-Florida), have said they would introduce bills to curb stock buybacks, saying share repurchases do not help the U.S.
We believe this view is misguided. A higher stock market helps pension plans and endowments, participants in 401(k) plans and mutual fund investors, as all benefit from rising share prices. We think this wealth generation—which helps individuals and families to achieve their investment goals by building solid financial foundations—is very positive for our country.
This information is provided for educational purposes only and is not tax, legal, financial planning or investment advice. Neither the information nor any opinion expressed in this section constitutes an offer to buy or sell any securities or advisory products. The information provided is general and is not information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. You should not regard this information as a substitute for the exercise of your own judgment. Investing involves risk.