“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
When it comes to distributing surplus profits to shareholders, management teams typically have two options – they can either pay dividends or they can buyback the company’s own stock. Deciding between the two, or indeed pursuing both, is a subject that companies can easily get wrong and one which frequently causes disagreements among investors and analysts alike.
Dividends and buybacks are ultimately designed to do similar things – reward shareholders with either a cash payment or a repurchase of stock (either via a tender offer or in the open market) which should enhance future earnings per share (EPS). In the case of dividends, where a company will typically explain its policy and then attempt to execute it, the process is very straightforward. By comparison, buybacks are rather more complicated because there are a number of variables that can influence their effectiveness and overall success (or otherwise).
A flexible way of distributing cash
On paper, a share buyback enables a company with excess cash to increase its EPS simply by buying up its own stock and reducing the number of its shares in issue. Because this has the effect of spreading the company’s profits between fewer shares, the theory is that the share price should also rise accordingly. As opposed to dividends, which generally require a long-term commitment to distributing surplus profits, buybacks can be introduced with more flexibility (subject to prior shareholder consent) and then carried out as the company sees fit.
Not only is this proving to be a popular option for companies, it has also been found to be effective. A 2002 report by Steven Young and Dennis Oswald, noted that between 1995 and 2000, the aggregate value of buybacks in the UK increased by more than 600 percent – and in the 12 months to December 2000 UK firms returned £8.9 billion to shareholders. The team argued that buybacks were drive by four factors, including: a desire to (i) distribute excess cash, (ii) counteract market under-pricing caused by high information asymmetries, (iii) maintain an efficient capital structure and hence minimise the cost of capital, and (iv) increase future earnings per share.
That research concluded that well-governed firms were more likely to disgorge excess cash while poorly governed firms were more likely to hoard (and subsequently waste) excess cash. It also found that, after adjusting for market and risk factors, share prices rise by 2 percent on average when companies announce they are considering implementing a buyback. Why the price rise? Some analysts claim that company management that introduce buybacks are signalling to the market that they think the shares are undervalued or that they have no plans to use the cash for (potentially value destructive) purposes such as new projects or M&A. In this respect, it is worth considering the views of a man that knows a thing or two about value…
Buffett on buybacks
In his 2011 letter to Berkshire Hathaway shareholders, Warren Buffett spent considerable time explaining his views on share buybacks – given that Berkshire had bought up $67 million of its own stock the previous year. He insisted that buybacks worked only when two conditions have been met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
For Buffett – who studied under legendary investor Ben Graham – buying at less than intrinsic value is a critical component of a value investing strategy. In the case of repurchasing stock in his own company, Buffett said he would buy shares at a price of up to 110% of book value. On the subject of buybacks in general, he also observed that is was essential that existing shareholders were protected: “It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value.”
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Buybacks don’t have to be taxing
From the perspective of individual investors, a further point worth noting about the advantages of share buybacks is the issue of tax. This is something that has occasionally provoked criticism from some commentators, who believe that companies have increasingly used buybacks simply as a tax efficient means of returning cash to shareholders. Nevertheless, for those investors with company shareholdings that are outside a tax wrapper like a SIPP or an ISA, buybacks can frequently be more tax efficient. While the finer points of the tax implications of dividends vary depending on individual tax circumstances, with a buyback there is no share sale or capital gain – meaning that, theoretically at least, EPS should grow at no cost to the shareholder. One problem, however, is that buyback critics claim this EPS boost doesn’t always materialise because…
Companies often get their timing wrong
Companies that launch buyback programmes only to see the value of their stock fall further in the months ahead tend to attract the ire of shareholders and investment commentators. While Buffett himself conceded that “many CEOs never stop believing their stock is cheap”, research into the subject is pretty damning. Earlier this year, Thompson Reuters examined returns on stocks in the S&P 500 in the periods following buybacks and found that repurchases were ‘weakly to moderately negatively correlated with future returns’. It claimed that the majority of companies under analysis had typically timed their buyback activity poorly. Indeed, the research showed that the negative correlation between repurchases and forward returns meant that most buybacks did not pay off within the year after the repurchases.
Other factors at work
Meanwhile, critics of buybacks have pointed to other concerns. Not least, is the argument that because many management teams are encouraged to increase EPS as part of their long term incentive plans, the attraction of launching a buyback over, say, paying a dividend, is prejudiced. Academic research on this subject tends to support the theory that the surge in stock buybacks that started during the 1990s was actually triggered by a concurrent increase in the popularity of stock option schemes to compensate management and employees. In this respect, US academic Kathleen Kahlethat argues that the repurchases have frequently been designed to maximise managerial wealth – a conclusion that was also reached in similar research by Bartov, Krinsky and Lee.
Connected to this issue of stock options and repurchases is that the case for buybacks can be damaged if the management continues to issue stock whilst at the same time buying it back. Typically, companies fall in to this trap when they need to issue share to meet their obligations when employee stock options are exercised or in M&A situations. If the net effect is that more shares are issued than bought back, then the EPS-boosting effects of buybacks can be neutralised and existing shareholders can ultimately end up diluted. Unsurprisingly, analysts have debated this subject too. Among the conclusions are that companies often increase their stock repurchase programmes to take account of employee stock options in an effort to manage their diluted EPS figures.
Dividends vs. buybacks
With the increase in popularity of share buybacks since the 1990s, investors have had to weigh the advantages and potential pitfalls of how their investments distribute surplus cash resources. Meanwhile, towards the higher end of the market (and even some at the smaller end), companies are choosing to pay dividends and routinely buyback shares simultaneously. So how can income hunters adapt to this new landscape? One route is to scrutinise the Net Payout Yield – or the combined impact of dividends and buybacks minus any share issuance. Apart from that, it could well be worth heeding the advice of Warren Buffett, who believes that investors in tune with the intrinsic value of their investments will ultimately have the best fix on whether share buybacks are the most appropriate course of action.
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10 Comments on this Article show/hide all
The politics aside - I obviously hate anything that can disguise management paying themselves off - and any tax implications - I'm still of the view that if you hold the share you should prefer a buyback to a dividend, in nearly all cases.
The talk about management timing buybacks poorly, or of them potentially being value destructive seems largely irrelevant to me. It is possible, but it is not the buyback that is destroying value - for a buyback to destroy value, X amount of cash must have been worth intrinsically MORE than the Y shares they bought. The stock must be worth less than the market price. This is where the value is lost - the share is priced too highly.
This is the paradox. By holding the shares you are saying you think the shares are worth more than the market is pricing them at. How can anyone who owns shares in a company then be opposed to buybacks? Since you believe the value of the shares is greater than an equal amount of cash (if you believe otherwise you should sell them!) buybacks are worth more than dividends!
I agree it's highly stylised, and one may prefer cash in hand now instead of more valuable shares which incurr trading costs to liquidiate et cetra et cetra; but, at the end of the day, it strikes me that much of the complaining about share buyback is done post catastrophe; complaints about share buybacks destroying value can only destroy value for you if you held the shares. Since you held them, refer to the above!
In reply to ExpectingValue, post #1
The flaw in your argument, EV, is that over the course of a year share prices often vary widely. Sometimes a particular company's SP will be at a big discount to intrinsic value but sometimes only at a small one. However, a long term investor is not likely to be constantly trading.
OTOH, buybacks tend to be conducted indiscriminately. When a company has spare cash, I prefer to simply get it back as a dividend, unless the company is disciplined enough to only buy back under the circumstances Buffett prescribes. The choice is then up to me about when and how I choose to spend it. Moreover, the buyback works against my interests as a long term investor by artificially supporting the SP, thus preventing me from using my dividend cash to buy at a more favourable price.
It is because of this indiscriminate nature that buybacks can be value destructive: the company may be buying at times when I would not be and would have better places to invest the cash. This has certainly been the case with Halfords over the course of the last year, for example.
If the buybacks were only made at times when the shares were trading at a big discount, I would have no complaint.
Regards,
Mark
Hi Mark,
Thanks for replying!
Let me begin with my belief in the premise that whether it is a small or a large discount to intrinsic value, a share buyback is more beneficial than a dividend if you hold the stock. As I mention above, if at any point you would rather hold X in cash than X in equity of the company, you should liquidate your position in the stock. I just think of buybacks as the company taking my dividend and buying more stock in themselves.
I do take the point that trading costs obfuscate the issue slightly and make the above sometimes untrue. For a small investor (of which I'm one!) it'd be impractical to make small trades to maintain a stream of cash since the costs would be prohibitive. I think that's a matter of perspective - I have no need for periodic cash flows at the moment and am looking for long term capital gains, so I'm looking for the most efficient way of cash being returned to shareholders if it is decided that returning cash is the best option.
In the case of Halfords for instance, in line with the above I still think that holders of Halfords stock should be supportive of the share buybacks. I would prefer for every one of my stocks to initiate share buybacks over dividends, since I think they are all trading at a discount to intrinsic value. If any of my companies had a windfall of £10m that could not be invested profitably, to distribute to shareholders in some way, and I answered that I don't want them to purchase their own stock with it, that is an admission that I think capital is worth more than equity in the company. That would be a warning bell that I should sell the stock.
I should finally note that if I sound confident about my thoughts it's entirely accidental! It's something I'm genuinely curious about, and so I jumped on the opportunity to stick a post here to hopefully spark a debate.
Cheers,
EV
In reply to ExpectingValue, post #3
Hi EV,
I explained at the time why I objected so much to Halfords' buyback programme:
I am worse off through the company making buybacks than if it had returned the cash to me and allowed me to invest it at a time and in a manner of my choosing. Hence the company has destroyed shareholder value through its buyback programme.
Perhaps the key point is that "intrisic value" is never a determinate value, there is always a degree of uncertainty - hence Graham's central concept of "margin of safety". Buybacks only make sense when (as Buffett says) shares are trading at a material discount to the estimate of intrinsic value - and the company can't generate a better return by making other use of the cash.
Like you, I am not actually drawing an income from my portfolio yet. However that does not mean that I don't value some income generating stocks. Dividends received are simply added to my cash reserves. I then watch for opportunities that Mr Market offers to reinvest those reserves when particular stocks are offered at attractive prices. That may or may not be the stock that paid the dividend, at any given time. What you suggest would only be true if one ran a single stock portfolio, and you had no other way to use the cash than to reinvest it into your one stock.
Just as a point of interest, EV, at an earlier stage in my investing career, I would have agreed with you. However, as I have gained experience and seen many buyback programmes in operation, I have found that often they do not benefit shareholders, as explained in Ben'Hobson's article.
Cheers,
Mark
In reply to marben100, post #4
Hi Marben,
I agree with most of what you're saying actually, I should've explained myself a little clearer. Your points regarding Halfords are well made and well taken. In that situation I don't think any sort of capital distribution is wise. Increasing borrowing to fund dividends would be equally poor though - not that that's a particularly common choice. In that case, it's more of a question of when to distribute capital rather than how.
I'm also making the (sometimes erroeneous) assumption that buybacks are conducted at the market price or thereabouts, with reason given the large scale of the purchases compared to how we as private investors transact!
Regarding the intrinsic value being never a determinate value, I'm of two minds. I think it is a determinate value with a great deal of computational difficulty. Much of what we do as investors is trying to narrow down the ranges of possible outcomes and permutations to come up with a reasonable estimate of intrinsic value. That doesn't mean there isn't one, simply that it isn't attainable given our cognitive capacity, the information available to us, and the multitude of casual factors around the world! Wherever that's relevant or not is arguable, but it probably shapes some of my opinions. "Margin of safety", to me, is just trying to both a) minimise downside risks and b) buying at a significant discount to our best estimate of intrinsic value. Since I always try to apply those, though, I sort of harp back on to rarely disagreeing with buybacks in stocks I own..!
The last point I take to a degree. I still can't see how paying a dividend is any different from executing a buyback and then the investor choosing to sell at the new, slightly higher price. In the second scenario your ownership percentage per share has increased, so you can sell a small chunk without any effective dilution. How trading costs vs. tax efficiency pans out is probably a matter of how big your position is. I'm almost certain I'd be on your side with anything except a substantial distribution!
Perhaps I will change my views as I continue to evolve. It'd hardly be the first time and I welcome the advancement - both experience, discussions and the blog help me on that path, so I welcome them!
EV
PS: As an aside, and a point of interest to something in the article - I note that:
"repurchases were ‘weakly to moderately negatively correlated with future returns’"
I recall high dividend yields also being correlated with poor future performance by some studies.
One potential causal factor, of many - since both are forms of partial liquidation, is it the underlying fact that implicit in both actions is the fact that capital cannot be allocated productively within the company? Is it a signal to the market that the share will stagnate?
In reply to ExpectingValue, post #5
Precisely. The trouble is that if you look at most* buyback programmes, you'll find that once a programme is announced, the buybacks are made irrespective of the share price. That is simply a waste of shareholders' money.
I do say "most" because undoubtedly, some buybacks programmes are "good", where management pays heed to Buffett's edicts. Unfortunately, the good ones are rarer than the bad ones.
Intrisic value cannot be determinate, as none of us has crystal balls: future earnings and future asset values are unknowable with any degree of certainty (except, perhaps for the rare cases where assets comprise cash that we know management intends to return to investors - even then, we have to be careful of the Langbars of this world). All we can do is estimate them and then buy shares that look materially cheap relative to our estimates of future values, thus giving a "margin of safety".
Cheers,
Mark.
I strongly agree with this article, 'Assessing Buybacks, No Matter Where You Sit' by Legg Mason Capital management:
http://lmcm.com/908178.pdf
Puts everything far better than I ever could.
In reply to markgoodhead, post #7
Great article, thanks.
The section on 'Shareholders' (p10) seems to be broadly the argument I outline above, though naturally put with more eloquence and clarity!
That said, they also note that..
"In theory, dividends and buybacks are equivalent assuming no taxes, identical timing of cash receipts, and an efficient market. In practice, they are very different.. Executives consider dividends on par with investment decisions such as capital spending.. Executives think of buybacks as an alternative for spending residual cash."
This probably creates some of the problem. For me, they are equivalent - both decisions that should be made if the company has cash that cannot be invested profitably in the business, cannot pay down debt (within reason) to create a safer balance sheet and so on. In reality, perception and the actions of some management boards have made dividends seem more like a safe income stream to 'protect' your capital from bad management, and buybacks seem like profligate spending that only serves to destroy value.
In reply to markgoodhead, post #7
Well there are parts of that article that I agree with, like this one:
And parts that I dont:
Huh? How is it that the cash that a business throws off isn't part of "accumulated capital"? That's only true if you consider the business in isolation, and not as part of a portfolio, which includes cash and other investments. The accumulated capital of the portfolio is increased just as much by cash dividends as from capital appreciation.
I think the author is once again led astray by the EMH (and theoretical considerations, rather than practical market realities) - and is, in fact, contributing to the market irrationality that doesn't value dividends (which suits me fine, thanks, as it creates the opportunity to buy undervalued divvy payers :0)). In the real world, the share price of an investment drops on xd day, as one would expect (or often slightly less) - but then recovers over time (all else being equal) until the next divvy is due.
Cheers,
Mark
In reply to markgoodhead, post #7
Is this passage available as a tattoo that can be stencilled on various investors' foreheads, please? ....;-)
That is the case for buybacks in a nutshell - although, as everyone knows, many managements haven't been disciplined in the way they have tried to execute.
ee