Buying at Precisely the Wrong Time: Stock Buybacks

Tom Macpherson

 

This article is based on one that originally appeared in Guru Focus on February 25, 2015.

One of the truly critical requirements for a CEO is the wise allocation of capital. Perhaps no other task can have such an impact on shareholder return over the years. Certainly it is one of the key measures I use when analyzing a prospective investment’s management team.

Management is faced with three options when deciding how to allocate profits after all operating expenses have been paid. They can declare a dividend, return cash through share repurchases, or retain the cash to grow the business. In the past 25 years, stock buybacks have been an increasingly popular choice. But often, managements do buybacks at precisely the wrong time.

I look for management that sees stock buybacks the same way we see as investing. Warren Buffet – as usual – said it best:

Charlie and I favor repurchases when two conditions are 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 and Munger share repurchases (when you have the money and when the stock is cheap) are driven by both qualitative measures and timing. I think the latter is a key area of potential improvement for US management teams.

Stock Buybacks: Returning Capital Through the Back Door

Since 1992 there has been an explosion in management’s use of stock buybacks as a core capital allocation choice. In that year roughly 38% of S&P companies repurchased their shares at roughly 0.8% of market cap annually. By 2013 85% of S&P companies were buying back 3.2% of their market cap annually. The graph below shows the explosion in these transactions.

If one were to plot the timing of these purchases it would show that managements routinely disregard Buffett’s second criterion.  The graph below shows share buybacks track market indices pretty closely. The higher the market goes the greater the amount of buybacks. As a value investor this is the antithesis of what I look for.  In assessing managements, I downgrade those who fall into this pattern.

Why This Matters

I like to invest in businesses where senior executives use their business savvy to achieve both high returns on capital and return of capital. I believe there are a couple of key learnings that can be taken away from the research.

By Low, Sell High: It Isn’t Just for Personal Investors

As simple as it may seem, it is extraordinarily difficult to live by the credo of buy low, sell high. Whether its personal investors pouring money into tech stocks in 2000 or management stopping the repurchase of shares at market lows in 2009, the record shows that investors get caught up in the prevailing mood.  All allocators of capital (and that’s what we do as investors – allocate capital) must have a disciplined process in place that doesn’t succumb to despair in down markets or euphoria in up markets.

Aligning Incentives Makes for Smart Return of Capital

Management is rarely incentivized to maximize return on capital. Far too frequently capital is used for propping up the share price or driving EPS growth through a reduced share count. If we are to see a wiser use of corporate funds we will need to see a collective action to move the goal line for managers. I recognize that there are tremendous capital allocators out there and we are painting with a very broad brush, but the bulk of data show this to be an ongoing issue.

Allocating Capital: It’s Our Job Too

It’s fine for me to poke holes in managements that exhibit poor allocation skills, but I need to understand as fiduciary steward I have an equal – if not higher – responsibility. The decision to allocate capital through my investment decisions – buy/sell orders, dividend reinvestment, etc. – demands a great deal of circumspection and thought.

Conclusion

Decisions about stock buybacks provide investors with great insight into the allocation skills of corporate management. None of us would expect to succeed if we followed a buy high, stop-buying-at-lows policy. We shouldn’t expect corporate managers to succeed that way either. Understanding the “when” is as vital as the “what” when it comes to capital allocation. When you invest along with extraordinary allocators of capital (those who get the “what” AND “when”) it makes your life as an investment manager so much easier. And that’s something all of us would be happy to take to the bank.

As always I look forward to you thoughts and comments.

 

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