Category Archives: Buybacks

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

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Gretchen Morgenson’s article on Buybacks, NY Times March 25th 2016

BUSINESS DAY

In Yahoo, Another Example of the Buyback Mirage

Becca Hary, a McDonald’s spokeswoman, said the company had a “balanced and disciplined capital-allocation strategy that promotes long-term value for our shareholders.” She cited McDonald’s plans to invest $2 billion to open a thousand new restaurants and “to reimage 400 to 500 locations” domestically.
In an interview, Mr. Colby said his research “confirms my suspicion that while buybacks are not universally bad, they are being practiced far more broadly and without as much analysis as there should be.”
Perhaps the crucial flaw in buybacks is that they reward sellers of a company’s stock over its long-term holders. That’s because a company announcing a repurchase program usually sees its stock price pop in the short term. But passive investors, such as index funds, and other long-term holders gain little from the programs.
Especially problematic are buybacks financed with borrowed money; repurchases of stock made at prices above its intrinsic value are also unwise.
Another hazard: companies that spend billions to repurchase stock without substantially shrinking the number of shares outstanding. That’s because in these circumstances, prized corporate cash is used to buy back shares that offset stock grants bestowed on company executives in rich compensation plans.
And there are plenty of companies whose buybacks have simply left them with less money to invest in more promising opportunities.
By throwing away money on buybacks, companies are giving up on the ability to grow in the future,” said Michael Lebowitz, an investment consultant and macrostrategist at 720 Global in Chevy Chase, Md.
At last, some investors are stirring on this issue. Domini Funds, a mutual fund company, and the A.F.L.-C.I.O.’s investment funds have submitted shareholder resolutions on share buybacks at 3M, Illinois Tool Works, Target and Xerox this year.
The proposals ask the companies to adopt a policy of excluding the effect of stock buybacks from any performance metrics they use to determineexecutive pay packages.
“We’re not against buybacks,” said Adam M. Kanzer, a managing director at Domini. “The question is at what point do buybacks become excessive and when do they undermine the long-term value of the company?”
At 3M, for example, research and development expenditures plus strategic acquisitions have totaled $22 billion over the last five years, Mr. Kanzer said. In the meantime, the company’s buyback program has cost $21 billion.
“When the buyback almost equals all the other expenditures, it makes sense to ask questions about whether there’s a more constructive way to invest that capital,” Mr. Kanzer said.
Asked about these questions, Lori Anderson, a 3M spokeswoman, referred me to the company’s proxy filing, which stated, “We believe these concerns are unfounded, as demonstrated by our long-term track record and our balanced capital-allocation approach.”
A group of institutional investors will also convene soon to examine the pros and cons of buybacks. The Shareholder Forum, which conducts independent programs to provide information that helps investors make sound decisions, is starting a new program on the topic.
“You really have to ask why a company’s board decides to return a big chunk of capital instead of replacing managers with ones who can figure out how to develop the operations,” said Gary Lutin, who oversees the Shareholder Forum.
“If the board doesn’t think it’s worth investing in the company’s future,” Mr. Lutin added, “how can a shareholder justify continuing to hold the stock, or voting for directors who’ve given up?”

The Net Profit Test: Comparing Buybacks to Investment

The Net Profit Test asks the question: what rate of return is required on investing the buyback funds to grow the Net Profit at the same rate as the Earnings per Share (EPS)grew due to the buyback.  If it can be shown that a low rate of return would equalize the growth between Net Profit and EPS, then the probability is high that the company would earn more money by investing.

The return that a shareholder receives when a company buys back its stock occurs at the time of purchase and only then.  It is because the Net Profit is being divided by a fewer number of shares (i.e. decimating the denominator).  This is contrasted to investing the same funds (i.e. enhancing the numerator).
In this example, the company is assumed to have bought back 10% of its shares at 10x earnings. With 10% fewer shares, the EPS is increased by 11% at the outset.
The alternative use of the buyback funds is assumed to be an investment that earns 3% in the first year, 8% the second and 10% thereafter.  As shown in the graph, the annualized returns crossover occurs in the second year and from that point on the investment is the better asset allocation decision.
buybacks-vs-investment

Surprisingly, the return generated by buybacks is independent of the price paid for the shares. Instead, the cost of the decision is measured by what the funds could otherwise have achieved if invested. In the above example, if the buyback was done at $7.20 a share, the Net Profit under the two scenarios would be equal after 8 years. However, with the buyback at $10.00, the investment would have generated 40% more in Net Profit.

(As a corollary, the higher the investment return, the lower the buyback price that can be justified.)

Our analysis of 25 companies with aggressive buyback programs from 2008 to 2015 shows an average P/E of 15x earnings.  It is also evident that most companies spend more on buybacks when their P/E’s are at the upper end of their range suggesting a higher dollar weighted P/E.

My conclusion is that few buybacks in recent years come even close to meeting the Net Profit Test. Given that S&P 500 companies alone have bought back over $2 trillion of their stock since 2009, you have to be in awe by the scope of this misallocation of corporate assets and its consequences for the economy.

© 2016 Robert L. Colby

Cost-benefit analysis of the stock buyback programs

The goal in buying back shares in a company is to increase the growth rate of the earnings per share.  However, there is no benefit accruing to the growth in Net Profit which is unaffected.  This analysis calculates the after tax return on the funds used in the buyback program that would be necessary to grow the Net Profit at the same rate as the EPS.  Clearly this is a desirable goal and the rates required are surprisingly low which suggests that the buyback programs are a poor use of resources.

Imagine if the shareholders of Bed Bath & Beyond were asked a question in 2008.

“Would you prefer to have growth in Net Profits of 9% or 17% in the next seven years, assuming that the growth in earnings per share would be the same?

Surely they would have elected the higher net profit (i.e. more money) and you would think that management would too but you would be wrong.

In the period between 2008 and 2015, BBBY bought back 38% of their outstanding stock at a cost of over $6 billion dollars. (That turns out to be equal to the total net profit during the entire period.)  We calculate that the company would only have needed to earn 6.9% after tax on those funds to grow their Net Profit at the same rate as the earnings per share which was 17.3%.  In 2015, the difference in Net Profit would have been $1,300 million vs $800 million.  That is $500 million more in one year (over 60% and growing!) if management  successfully reinvested the funds at under 7% instead buying their own  stock.

Here is the calculation[1] –

bbby

I should point out here that I don’t think that BBBY is a bad company but rather one of many that are following a very bad practice.

As shown in the following table, BBBY is not alone.   Most of these companies[2] would only have to earn a fraction of what they achieved to have made significantly more money for their shareholders.  This is shown in the last column (MP/NP) where the range of missed profits is from 8 to 101% of Net Profits in 2015.

all

Home Depot (HD) is another good example.  They bought back 27% of the shares outstanding in 2008 at a cumulative cost of $29 billion.  EPS grew at 16.8% while Net Profit grew at only 12.5%.  Had they reinvested those funds at 6.3% after tax, they would have had grown their Net Profit at the same 16.8% and earned close to $2 billion more in 2015 Net Profit.  That is close to a third more than they actually earned.

One possible explanation is that management is motivated to increase their incentive remuneration by increasing the growth of earnings per share without risk. However these companies justify their buyback programs, it is clear that most would need only a small ROI to enhance the shareholders’ real returns.  Seven out of these 12 examples have a required return to balance EPS growth of under 7 % with Allstate (ALL) and Kimberly-Clark (KMB) being the lowest.

Alternatively, in cases like some Banks, the reason might be that they can’t re-invest at even the minimum required return.  However, this explanation would be just as detrimental to the stock.

I recently was with the CEO of an international firm that employees 70,000 persons world-wide, has a market cap of $24 billion and whose stock gained 330% in the last 7 years.  I asked him if his company had bought any stock back and his answer was:  “Non – it is better to finance growth which will generate long term returns.”

© 2016 Robert L. Colby