Category Archives: Gretchen Morgenson, NY Times

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.

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