Buying back stock - why it's not always a good idea

Stephen Groff's picture

At Cambridge, we have consistently stressed the importance of capital allocation as a driver of returns for shareholders over time. We were recently asked if our less optimistic view on a company would change given a buyback announcement. The answer in that specific case was “no.” When it comes to buybacks in general, our answer is “it depends.” We thought an explanation of our view on this topic would give people a better understanding of how we think about allocating capital.

To put it simply, buybacks do not always make sense.

Let’s compare two scenarios. The first is a well-known large-cap Canadian company. This company recently announced a share repurchase program for up to a double-digit-million number of shares. Sounds good doesn't it? But it’s important to look past the headline.

Assuming this buyback program reached full completion, you would see a share count decline of approximately 2%; however there are some offsets to consider. Many companies announce buyback intentions but fail to actually follow through on the plan. Also, some companies have natural share count growth or “creep” from options granted to employees, which clearly mitigates the benefit.

Buy low and sell high. Easier said than done, but some companies seem to be better at doing it!

It is easy to see why some companies get the timing wrong, especially in cyclical industries. When times are good, management teams feel confident in their future prospects and believe their stock is a good investment. Unfortunately this is often when the market thinks the exact same thing and prices are usually much higher. When the cycle ultimately turns, these same companies often do not have the financial flexibility or willingness to purchase stock at depressed (attractive) prices.

Below is a chart looking at the price of the company in this first scenario with tan coloured shaded periods representing years in which buybacks were being executed (with buybacks not occurring in years shaded in brown). Not only were buybacks done in years where the share price was at elevated levels, but this company actually raised equity in late 2008 (not far off the lowest point on the chart).

 

Let’s contrast this scenario with a different example and look at a company called AutoZone.

AutoZone has an outstanding track record of buying back stock at attractive valuations on a consistent basis. This approach was carried on right through 2009 when many other management teams were frozen with fear. It also helps that the company’s business model is recession resistant. The result is a share count almost 60% lower over a decade, net of “share creep.” This has clearly benefitted EPS and ultimately created significant value for shareholders.

So when we are asked if buybacks are a good use of funds, our answer is “it depends.”

We tend to favour buybacks when:

  • they are funded prudently so they never put the business at risk, and
  • they are done at an attractive valuation. Buybacks must generate an adequate return on capital, both in absolute terms and relative to alternatives (internal reinvestment, debt repayment or acquisitions).

 

Comments

Submitted by Nic. K on

Great comment. So simple yet so many get it wrong. Natural human behaviour that companies and shareholders usually get wrong especially in commodity businesses. I would add that the most recent sector that seems to be jumping on this wave is technology. The recent "short-term" investors who claim they want the best for a company, forcing management teams to buy back stock or pay dividends so they could get their gains and set off in the sunset is insane. What makes it worse is the fast changing landscape tech firms face hence the need to carry large piles of cash. The recent pressure from Icahn on Apple is a perfect example of this and depending on outcome could play into the scenario you mention above. Seems that the Icahn cheerleaders forgot or have no idea (likely just corporate pirates) what happened to apple in the 80's. Thanks guys, love these short comments.

Submitted by Reid Liske on

Very informative, Steve. I would like to read a commentary on the merits (or absence thereof) of "share creep" and if they are detrimental to shareholders. My view, rightly or wrongly, is that the management of too many companies are padding themselves with share options.

Stephen Groff's picture
Submitted by Stephen Groff on

It’s a very good question. While it’s always nice to not see any "share creep" (from a shareholder perspective) it needs to be looked at along with overall compensation practices.

Having a portion of employee compensation in the form of equity or options is entirely acceptable so long as it is granted for the right reasons and reasonable in size. Some share count growth from incentivizing & retaining high performance employees is preferred to no share creep but excessive cash compensation for mediocre performance.

To your point, granting excessive options where management will benefit if things go right (but have little at risk if things go wrong) is certainly not a best practice.

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