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).