Category Archives: Buybacks

Stock Buybacks Equal Simple Interest

This article originally appeared on Seeking Alpha

Summary

  • Share buybacks are a poor asset allocation decision.
  • Buybacks reward share sellers not shareholders.
  • Buybacks can’t compete with investment returns.

seeking alpha logoConclusion: From the shareholders’ perspective, most stock buybacks produce little benefit when compared to investing the same funds in the company. They produce a one-time gain in earnings per share (usually small) but contribute nothing to the growth of the net profit or market capitalization. If a company is truly unable to successfully invest the buyback funds in its business, it would be much better for the majority of shareholders to receive a special dividend.

For the twelve months ending September 2016, total share buybacks were close to $600 billion for the S&P 500 companies. This is an enormous amount of money being 66% of the earnings and only slightly less than fixed capital expenditures in the same period. The average buyback program resulted in a “buyback yield” just shy of 3%. This resulted in a very modest annual decline in the shares outstanding which led to an equally modest one-time gain in earnings per share for shareholders, i.e. the vast majority who did not sell their shares.

Because buybacks and dividend yield are considered to be returns to the shareholder, they tend to be lumped together in statements like “total shareholder yield is currently close to 5% comprised of a 2% dividend yield and a 3% buyback yield”.

“Buyback yield” is very misleading. As the source of funds for buybacks is operating cash, it should be first and foremost compared to what they would have achieved if invested.

A 3% “buyback yield” is greatly inferior to investing in the company’s business, acquisitions, or even a special dividend, which would be shared by all shareholders in hard dollars as opposed to soft dollar benefits attributable to fewer shares.

Here is an example of a typical S&P 500 equity. It has a market cap of $15 billion; its shares are at 15x earnings and it buys back 3% of its outstanding shares. This is compared to a hypothetical, but very conservative investment producing 3% in the 1st year, 8% in the 2nd and 10% thereafter. (This analysis is independent of the underlying profitability of the company.)

The Mechanics of Stock Buybacks

Conclusion: From the Shareholders perspective most Stock Buybacks produce little benefit when compared to investing the same funds in the company. They produce a onetime gain in Earnings per Share (usually small) but contribute nothing to the growth of the Net Profit or Market Capitalization. If a company is truly unable to successfully invest the Buyback funds in its business, it would be much better for the majority of shareholders to receive a Special Dividend.

For the twelve months ending September 2016, total share buybacks were close to $600 billion for the S&P 500 companies. This is an enormous amount of money being 66% of the earnings and only slightly less than Fixed Capital Expenditures in the same period. The average buyback program resulted in a “buyback yield” of just shy of 3% [1] . This resulted in a very modest annual decline in the shares outstanding which led to an equally modest one time gain in Earnings per Share for the Shareholders, i.e. the vast majority who did not sell their shares.

Because Buybacks and Dividend Yield are considered to be returns to the Shareholder they tend to be lumped together in statements like the “Total Shareholder Yield is currently close to 5% comprised of a 2% dividend yield and a 3% buyback yield”.

“Buyback yield” is very misleading. As the source of funds for Buybacks is operating cash, it should be first and foremost compared to what they would have achieved if invested.
A 3% “buyback yield” is greatly inferior to investing in the company’s business, acquisitions, or even a Special Dividend which would be shared by all Shareholders in hard dollars as opposed the soft dollar benefit attributable to fewer shares.
Here is an example of a typical S&P 500 equity. It has a market cap of $15 billion; its shares are at 15x earnings and it buys back 3% of its outstanding shares. This is compared to a hypothetical but very conservative Investment producing 3% in the 1st year, 8% in the 2nd and 10% thereafter. (This analysis is independent of the underlying profitability of the company.)

feb7-chart1

The share purchase of 3% of the float produces a 3.5% pop in the EPS on day one.  Annualized that is 3.5% in the first year, 1.7% per annum in the second and so on declining each year.  By the second year, the Investment produces a higher return.  By year 8, the Investment led to a Net Profit of $985m which is almost double the first year’s investment while the Buyback produced zero contribution to Net Profit.

Were the stock price reduced by half and the Buyback amount kept the same you would get the following result.

feb7-chart2

The original gain in EPS is increased to 7% but it soon pales by comparison to the Investment.

Using the original price of $15 and twice the buyback funds ($1,000m), the result would be the same as in the previous example but the dollar gain in the Net Profit from Investing would double as twice the funds were used.

feb7-chart3

These hypothetical examples illustrate the mechanics of stock buybacks.  Now let us look at two actual examples.

The first is Apple as it is listed as the most aggressive in terms of dollar amount of funds spent on buybacks in the last 12 months.[2]

feb7-chart4

Despite Apple having spent the over $30 billion, it confirms the disadvantages of Buybacks compared to Investments.  In this case we used the average Return on Capital that they earned from 2009-15.

Now let us look at one of the most aggressive buyback programs in terms of the percentage of stock that was bought.  Corning Inc. purchased over 20% of their outstanding shares in the last 12 months [3] which produces an initial gain of 27% in EPS on day one.

feb7-chart5

However, even this aggressive program fails by beat the Investment after year three even though Corning’s Return on Capital is only averages at 10.3% over the 7 years. This illustrates that even massive amounts of buybacks can’t change the fundamental disadvantage compared to investing.

One of the reasons that investors are not more critical of management for stock buyback programs may be because, by doing it year after year, it creates the illusion that it is compounding.  As shown here, each year’s transactions is still the equivalent of getting simple interest.

The proof of this is found in the Net Profit Test[4]. It answers the question:

What is the Required Rate of return on an Investment of the funds, that would grow the Net Profit at the same rate that the EPS grew due to fewer shares.  Like Apple, the answer is surprisingly low in most instances.  We analyzed 30 stocks[5] whose buyback programs resulted in a median decline of 25% of their outstanding shares from 2008 to 2015. The median Required Return would have been only 4.9%.

The median growth rate for their EPS was 7.7% pa while the Net Profit grew only at 2.4%.  Instead, by investing at less than 5%, the Net Profit would have been 42% higher in the 7th year. Over the seven years the cumulative gain in Net Profit would have been 1.8x the original investment.

It makes no sense to put the growth of Earnings per Share ahead of the growth of Net Profit and as a result, the growth of the Market Capitalization.

A Simple Test to Dispel the Illusion Behind Stock Buybacks

Fair Game

By GRETCHEN MORGENSON AUG. 12, 2016

“Mr. Colby has developed an illuminating analysis that identifies a crucial difference between many truly successful companies and their underperforming counterparts. The exercise highlights the growth mirage that buybacks have on earnings-per-share measures. In addition, it shows that returns on investment need not be that large for a company to generate growth rates exceeding the evanescent earnings-per-share gains associated with buybacks.”

Footnotes

1.Factset Buyback Quarterly December 19, 2016. Defined as the buyback funds divided by the market capitalization.
2.Factset
3.Factset
4.The Net Profit Test: Comparing Buybacks to Investment
5.Stocks with significant buybacks between 2008-2015

© 2017 Robert L. Colby

CEO Pay vs Buybacks

CEO Pay vs Buybacks

In response to John Simon’s excellent article in today’s Wall Street Journal on “Shareholder Value” and CEO pay:

http://www.wsj.com/articles/the-two-words-that-earn-ceos-a-pay-raise-1478622713

Here is a different take on the same subject.

The correlation between a company’s percent change in outstanding shares from 2008-15 and the rank of the CEO’s pay[1] in 2015 was found to be -.18 in a sample of 100 S&P equities.

The reduction in shares outstanding leads to an increase in Earnings per Share but not in Net Profit.  The correlation between the rank in change in shares outstanding and the rank of EPS – Net Profit growth is .88.

The conclusion therefore is that there is a tendency to pay CEO’s more for the illusion of growth rather than growth itself.

©2016 Robert L. Colby

A Simple Test to Dispel the Illusion Behind Stock Buybacks

The following appeared in the New York Times on August 12, 2016 in Gretchen Morgenson’s column Fair Game. Click here to read Full Article

14gret-master768Stock investors have had one sweet summer so far watching the markets edge higher. With the Standard & Poor’s 500-stock index at record highs and nearing 2,200, what’s not to like?

Here’s something. As shares climb, so too do the prices companies are paying to repurchase their stock. And the companies doing so are legion.

Through July of this year, United States corporations authorized $391 billion in repurchases, according to an analysis by Birinyi Associates. Although 29 percent below the dollar amount of such programs last year, that’s still a big number.

The buyback beat goes on even as complaints about these deals intensify. Some critics say that top managers who preside over big stock repurchases are failing at one of their most basic tasks: allocating capital so their businesses grow.

Even worse, buybacks can be a way for executives to make a company’s earnings per share look better because the purchases reduce the amount of stock it has outstanding. And when per-share earnings are a sizable component of executive pay, the motivation to do buybacks only increases.

Of course, companies that conduct major buybacks often contend that the purchases are an optimal use of corporate cash. But William Lazonick, professor of economics at the University of Massachusetts Lowell, and co-director of its Center for Industrial Competitiveness, disagrees.

“Executives who get into that mode of thinking no longer have the ability to even think about how to invest in their companies for the long term,” Mr. Lazonick said in an interview. “Companies that grow to be big and productive can be more productive, but they have to be reinvesting.”

Broadly speaking, those reinvestments appear to be in decline. Indeed, economists are concerned about the comparatively low levels of business investment since the economy emerged from the downturn more than seven years ago. This phenomenon may be attributable in part to the buyback binge.

One of the best arguments against stock repurchases is that they offer only a one-time gain while investing intelligently in a company’s operations can generate years of returns.

This is the view of Robert L. Colby, a retired investment professional and developer of Corequity, an equity valuation service used by institutional investors.

“The simplest way to evaluate a company’s asset allocation decisions over the years is to see whether its net profit growth is close to its earnings-per-share growth,” Mr. Colby said. “Unlike an investment in the business, share buybacks have no effect on net profit and there is no compounding in future years.”

Mr. Colby has developed an illuminating analysis that identifies a crucial difference between many truly successful companies and their underperforming counterparts. The exercise highlights the growth mirage that buybacks have on earnings-per-share measures. In addition, it shows that returns on investment need not be that large for a company to generate growth rates exceeding the evanescent earnings-per-share gains associated with buybacks.

In his test, Mr. Colby compared net profit growth and earnings-per-share gains at pairs of companies in the same industries from 2008 through 2015. In each case, he contrasted a company that bought back loads of shares during the period with another that did not.

One case study examined Cracker Barrel Old Country Store and Jack in the Box, two restaurant chains. Cracker Barrel bought back only $160 million worth of shares over the period while Jack in the Box repurchased $1.2 billion, reducing its share count by 37 percent.

Cracker Barrel passed the net profit test ably: Its growth in earnings per share over those years was 13.6 percent a year while its net income grew at a virtually identical 14 percent.

Jack in the Box made quite a contrast. Its annual earnings per share rose by 6 percent over the period, but its net profit declined by 0.5 percent a year.

To bring its net profit to the level of growth it showed in per-share earnings, Mr. Colby said, Jack in the Box would have had to generate after-tax returns of only 4.8 percent on the $1.2 billion it spent buying back shares. That doesn’t seem insurmountable.

Linda Wallace, a spokeswoman for Jack in the Box, said the company’s business model generated significant cash flow, “which our shareholders have told us they prefer to be returned to them in the form of share repurchases and dividends.”

She added that the average price the company paid to buy back its stock during the period was just under $37 a share, well below Friday’s closing price of $98.93.

Another notable buyback comparison was between Costco and Target, two large discount retailers. While Costco spent $2.7 billion to repurchase shares from 2008 through 2015, Target allocated $11.4 billion, reducing its share count by 20 percent.

Costco’s annual earnings-per-share gains of 9 percent during the period were almost identical to its 8.9 percent net profit growth.

Target’s numbers tell a different story. On the strength of its repurchases, Target’s earnings per share rose by 7.3 percent each year. Its annual net profit growth was just 4.3 percent, Mr. Colby found.

To close that gap, Mr. Colby calculated the after-tax investment returns Target would have had to generate on the $11.4 billion it spent on buybacks. The answer was a surprisingly nominal 5 percent.

Erin Conroy, a Target spokeswoman, said the company’s capital allocation priorities focus on “growing long-term shareholder value and supporting our enterprise strategy.” She cited Target’s practice of annual dividend increases and said that last year, the company added an infrastructure and investment committee to its board to provide more oversight of investments.

Testing for the buyback mirage is a worthwhile exercise for investors. That’s why it is the topic of a new program at the Shareholder Forum, which convenes independent workshops to provide information to help investors make sound decisions.

The net profit test, said Gary Lutin, a former investment banker who heads the forum, “cuts through to the essential logic of comparing a process that grows a bigger pie — reinvestment — to a process that divides a shrunken pie among fewer people: share buybacks.

“It’s pretty obvious,” he continued, “that even mediocre returns from reinvesting in the production of goods and services will beat what’s effectively a liquidation plan.”

Investors may be dazzled by the earnings-per-share gains that buybacks can achieve, but who really wants to own a company in the process of liquidating itself? Maybe it’s time to ask harder questions of corporate executives about why their companies aren’t deploying their precious resources more effectively elsewhere.

The commentary from the companies was a very good addition.  While I am sure that Linda Wallace is right about the average price that they paid, their timing wasn’t so good.  This chart shows that they bought 60% of their 7 year total in the last 2 years earning a positive correlation of .82 between price and annual total spent.

Indrustry Pairs and Contrasting Asset Allocation Strategies

Altria Group (MO) spun off Philp Morris (PM) in 2008 and the two have persued strikingly different asset alllocation strategies since.  PM has bought back 23% of their shares since 2008 while MO only bought back 5%.

As a  result, MO grew their EPS and Net Profit 61% and 52% respectively over the period.  This contrasts to +33% and 0% for PM.  Had PM invested the  $28 billion that they used to buyback stock at a 5.8% return, their 2015 Net Profit would have been $2.3 billion higher or 34% of what they achieved.

Company                    MO PM
INDUSTRY TOBACCO TOBACCO
MARKET CAP LARGE CAP = $125 B LARGE CAP = $157 B
P/E 23X 24x
YIELD 1.2% 4.0%
2008-15 CASH FLOW  – DIVIDENDS $ 5.0 B $ 28.3 B
2008-15 STOCK BUYBACKS -$ 4.5 B -32.4 B
2008-15 CHANGE IN SHARES O/S -5 % -23%
GROWTH OF EPS 2008-2015 +61% or +7.0% pa +33% or +4.2% pa
GROWTH IN NET PROFIT    “ +52% or +6.2% pa 0% or 0.0% pa
REQ’D AFTER TAX % TO = EPS GROWTH[1] 5.3% 5.8%
2015 NET PROFIT WOULD HAVE BEEN $278 M more or +3% $2.3 B more or +34%
CORREL’N PRICE  vs  ANN. % BUYBACK -.79 -.21
It should be noted that both companies that both companies had a –ve correlation between the annual percentage of the stock that they bought and the price they paid.  This is the exception to the rule.

clipboard01       Clipboard02.png

Note on Executive Compensation:  PM’s average executive compensation over the last 5 years was 57% more than MO’s or $64.2 million vs$ 40.8[2].

Cigna vs Aetna

Cigna Corporation (CI) and Aetna (AET) also show a contrast in asset allocation.  CI bought only 5% of their stock back whereas AET reduced their float by 23%.  AET spent $10.3 billion vs $3.9 for CI. As a result, CI grew their Net Profit and EPS at nearly the same rate (+14.4% pa vs 13.3%).  AET on the other hand grew their EPS at twice the rate of their Net Profit (10.1% pa vs 5.1%).

Company CI AET
INDUSTRY MEDICAL SRVCS MEDICAL SRVCS
MARKET CAP LARGE CAP = $33 B LARGE CAP = $40 B
P/E 14X 14x
YIE 0% 0.9%
2008-15 CASH FLOW  – DIVIDENDS $ 13.4 B $ 18.6 B
2008-15 STOCK BUYBACKS -$ 3.9 B -$10.3 B
2008-15 CHANGE IN SHARES O/S -5 % -23%
GROWTH OF EPS 2008-2015 +153% or +14.2% pa +96% or +10.1% pa
GROWTH IN NET PROFIT    “ +139% or +13.3% pa +41% or +5.1% pa
REQ’D AFTER TAX % TO = EPS GROWTH[3] 3.3% 9.1%
2015 NET PROFIT WOULD HAVE BEEN $136 mil or 6% more $1,046 mil or 38% more
CORREL’N: PRICE vs ANN % BUYBACK .63 -.63

the negative correlation between the annual percentage amount that they bought and the  price, the  Required Rate to equalize the Net Profit growth to their EPS is quite high at 9.1%.

Had they had achieved that, they would have earned $1 billion more in 2015 than they did.  If they had earned only a 6% return, for example, the increase in Net Profit would have been $624 million more or 23% above what they  achieved.

Note on Executive Compensation:  AET paid their executives an average of $42.2 over the last five years, which was 17% more than the $36 million that CI executives were paid.[4]

                                                                      Costco vs Target

Costco (COST) spent $2.7 billion on stock buybacks from 2008-2015 but their shares outstanding increased by 1%.  By contrast, Target (TGT) paid $11.4 billion to reduce their float by 20%.  As a result, COST achieved almost identical growth in the EPS and Net Profit whereas TGT had a divergence of +7.3% vs +4.3% pa over the period.

Company COST TGT
INDUSTRY RETAIL STORE RETAIL STORE
MARKET CAP LARGE CAP = $68 B LARGE CAP = $52 B
P/E 28X 16x
YIELD 1.2% 2.8%
2008-15 CASH FLOW  – DIVIDENDS $ 16.3 B $ 36.4 B
2008-15 STOCK BUYBACKS -$ 2.7 B -$11.4 B
2008-15 CHANGE IN SHARES O/S +1 % -20%
GROWTH OF EPS 2008-2015 +82% or +9.0% pa +64% or +7.3% pa
GROWTH IN NET PROFIT    “ +82% or +8.9% pa +35% or +4.3% pa
REQ’D AFTER TAX % TO = EPS GROWTH[5] 5.0%
2015 NET PROFIT WOULD HAVE BEEN $658 mil or 22% more

Had TGT invested the $11.4 billion instead and earned a return of 5.0%, they would have earned close to $700 million more in 2015, or 22% more than they did.

Note on executive compensation:

Can you guess which of these two companies paid their executives more?

Target paid their top executives 120% more than Costco did over 5 years!  The average was $47 million compared to $22 million.  In 2015 alone the comparison was $60 to $24 million![6]

Hypothesis:  Executive compensation is positively correlated to the spread between the growth of Earnings per Share and the growth of Net Profit.

[1] The required rate of return applied to the buyback funds to grow the Net Profit at the same rate as the EPS.

[2] Morningstar

[3] The required rate of return applied to the buyback funds to grow the Net Profit at the same rate as the EPS.

[4] Morningstar

[5] The required rate of return applied to the buyback funds to grow the Net Profit at the same rate as the EPS.

[6] Morningstar

30 Stocks with significant buybacks between 2008 and 2015

Thirty equities with significant buyback programs in the last 7 years show that their average EPS grew at 9.9% pa while Net Profit gained only 4.9% (Median numbers are 8.1 vs 1.7%.)  Using the averages, the give up is 5.0% pa which is an enormous  difference in the amount of cash generated.

Our analysis is based on the Net Profit Test which asks the question:  what rate of return is required on investing the buyback funds to grow the Net Profit and EPS at the same rate as the Earnings per Share (EPS) grew due to the buyback. The answer is not very much.  The average for the 30 stocks is 5.8% and the median 5.4%.

This give up in Net Profit is directly attributable to the size of the buyback program as shown in this chart.  On the x-axis we have the size of the reduction in shares outstanding from 2008 to 2015.  On the y-axis, we show the give up in the growth of EPS and Net Profit.  The correlation between the two is 0.94.  In plain English, the larger the buyback program, the greater the penalty as measured by cash generation.

correl

There are two main reasons for this apparent anomaly.  One, the price paid for the shares is too much to compete with alternative investments (the average P/E for all stocks is 15x for the period).  An example of this is given in the paper “The Net Profit Test: Comparing Buybacks to Investment”.  Secondly, the correlation between each equities annual percentage of total buyback and average annual price is very a positive: it averages 0 .48 and the median is 0.59.   The exceptions are ANTM (-0.60), CSCO (-0.03), GPS (-0.33), TMK (-0.12) AND TRV (-0.16).

Ranked from the bottom in terms of Required Return to equal EPS growth we have BOBE (-0.7%), MCD (2.3%), LM (2.9%), KO (3.7%), DRI (3.8%), KMB (2.9%), VAR (4.3%), FOSL (4.3%), CAKE (4.5%), OMC (4.8%), AAPL (5.0%), ALL (5.1%), TXN (5.1%), PH (5.2%), SHW (5.3%) and DE at 5.4%.

table

To open table, click here

Correl  is the Correlation between average stock price and the %age of annual buyback to total buyback from 2009 to 2015.  There is a definite positive correlation between the size of the annual buyback and the price.
Shares O/S is the %age contraction from 2008 to 2015
Cost (B$) is the cost in Billions of total shares bought back from 2009 to 2015
% Growth in EPS and NET PRF is the % annual growth in Earnings per Share and Net Profit from 2008 to 2015
Give up is the difference between the growth in EPS and growth in Net Profit.

Required Return ADJ and NOM.  The nominal required return is the % growth applied to the buyback cost to equalize the growth in net profit to earnings per share growth.  ADJ is the adjusted required return to reflect that our method of calculation of buyback cost  is less than actual cost (using last 4 years of data)

Average  Prc/Bk (Price/Book Value) and Ave P/E (Average Price to Earnings ratio) are based on 2009-2015

©2016 Robert L. Colby

Email from Len Sherman, Adjunct Professor, Columbia Business School

Robert, I read with great interest your recent blog post demonstrating the relatively low ROI’s  required to replicate EPS growth from equivalent share buybacks.  Your analysis suggests profound flaws in the two most common rationales corporate executives give for their share buyback programs

  1. Our actions reward shareholders by making their shares more valuable
  2. Our stock is undervalued. Our actions reflect management’s confidence in our growth potential

The first argument may be true for EPS, but not for long term stock price appreciation. The second argument is even more galling, as your analysis suggests exactly the opposite.  Given your results, the only logical explanation to go ahead with an aggressive buyback program is that management actually doesn’t  believe it can generate even modest returns on its cash from current operations.  Or said another way, management is in essence saying they are giving money back to shareholders because they have run out of ideas on how to generate attractive returns within the company.  Or course, the more likely explanation for share buybacks is  management bonus kickers based on EPS.  So much for CEO’s and boards acting in the best interest of shareholders.

I teach business strategy in the MBA program at Columbia Business school where I share a perspective that effective capital allocation is one of the most important responsibilities of the CEO.  To illustrate the point, I point to IBM who has skewed its use of capital (including debt financing) towards share buybacks at the expense of value-creating investments in R&D and capex.  As a result, IBM’s R&D lags its technology peers, and not surprisingly (despite aggressive acquisition activity), its revenues have declined for 15 straight quarters.  The attached figure graphically depicts these trends.

HP is another case of the folly of favoring share buybacks over R&D in the tech industry.  Carly Fiorina is often criticized for her disastrous acquisition of Compaq, but her successor Mark Hurd also deserves notoriety for slashing HP’s R&D expenditures while sizably expanding HP’s share buyback program.

Shareholders who maintained their investments in both of these companies through their periods of substantial share buybacks have not fared well.

I’d be curious to learn whether you’ve done any analysis tracing the stock price performance (relative to the S&P 500) of companies who have been most active in stock buybacks.  Has management unwittingly practiced buy high/sell low?!

Len Sherman

Columbia Business School

Attachments area

March 27th 2016