Hi Investors,
SUMMARY
- Stock buybacks has been traditionally viewed as a sign of confidence when management engages in a buyback of their own stock.
- At the heart of it, stock buyback is a capital allocation method.
- How then should investors be able to discern what are the objectives of such a program?
Introduction
Every now and then, I’ll get notifications from CNBC on my phone informing me about a stock I own that has obtained authorisation from its Board of Directors to engage in a “share repurchase program”.
After the news is being announced, the stock price of the company almost always goes up. It seems as though the market is in good cheer of the company when it has plans to buy back stock from the public markets and store them in its treasury vault.
Should every stock buyback be viewed the same way? And if not, how can we evaluate whether the stock buyback program was executed with investors’ best interest at heart?
Buy High and Sell Low
American companies have been spending wildly lately. From tech giants like Google, Facebook and Apple to banks like JP Morgan and Bank of America, companies are not engaging in massive R&D or innovation. Rather, the cash sitting in their banks are used to buy back truck loads of company stock.
According to an article on Forbes, Goldman Sach’s chief equity strategist David Kostin estimated that companies in the S&P 500 will spend an estimated $780 billion on buyback – a stunning record by any measure.
In theory, investors should benefit when companies acquire their own stock. Fewer shares outstanding in the public markets means larger profits per share and hence, a higher stock price. After all, the management of the company knows its business prospects better than anyone else (that’s why its call insider news) who is buying and clearly, that is a good sign.
After reading through some of the headlines, I must admit that the strategies employed by some companies do leave me scratching my head.
Oil giants like Exxon Mobil and Chevron have been very aggressive when it comes to buying back their own stock. That is when oil prices were more than $90 a barrel. When oil prices plunged at the start of 2016, the buybacks essentially froze. It is puzzling because these companies did what we retail investors always try to avoid – buying high and selling low. This leads us to view stock buybacks through a couple of lenses.
What is the Stock Buyback for?
Firstly, stock buybacks that were poorly executed hurt long-term performance of the company. The conventional wisdom is that management team buys back stock so that the short-term performance of the stock price will appear to be good. However, the company’s actual performance will eventually surface when good times come to an end – just like how the oil and gas industry is suffering now because of poor capital allocation decisions made by the management. The best way to boost the value of a company is to invest in R&D or if it is not able to grow organically due to the nature of the business, it can use that cash to make acquisitions.
A frequent excuse given by management teams is that there is still a ton of spare cash after taking advantage of business opportunities. Or if growth opportunities are almost non-existent, the only logical solution would be to engage in share buybacks. While that may be valid reasons, investors would be better off if management considered whether the current stock price offers good value rather than simply buying back overpriced stock.
Secondly, share buybacks are often used to compensate management teams. Of course, no management team will admit to this. They will likely report to investors that buyback is the best use of capital at the moment and since it’s the goal of management team to maximise shareholders return, the move is in-line with investors’ goals. However, we can easily obtain filings from the company’s investors relation to study how is the management compensated. If a huge part of their compensation package involves getting paid in stock or options, there might be reasonable evidence to conclude that the effects of stock buyback will not be felt by investors. Here’s the worst part: Stock buybacks can be used to enrich C-suite executives even when the business deteriorates. Ironically, the Board of Directors approve both buyback programs and executive compensation.
To end on a positive note, stock buybacks can be used to improve the company’s financial ratios. Since there are only two ways to raise money to run a business, the cost of capital has only two components – the cost of debt and cost of equity. The cost of equity will tend to be more expensive and here’s why.
When it comes to distributing financial gains, investors are at the bottom of the barrel. When a company goes bankrupt, assets will be liquidated to pay off creditors and suppliers first. The leftovers, if any, will then be given to investors. And likewise when it comes to distributing profits. Hence, the cost of equity tends to be higher.
A share buyback will enable the company to lower the cost of capital as it will change the composition of equity and debt. If the cost of capital is lower, it will be easier for firms to find investment opportunities. Investment only creates value if its returns are higher than the cost of capital.
Conclusion
While there are evidences to suggest that stock buybacks in general add value, we should be open to the idea that some of the plans are shortsighted and will destory value.
Responsible companies do not invest in any project that comes their way and this should apply to stock buyback programs too.
Marcus Ho
Research Analyst, Mind Kinesis Value Investing Academy
Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.
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