An index for the monthly screens for value is created by linking the following months’ average returns, excluding income. The Undervalued Screen index outperformed the S&P 500 by 395 basis points per annum while their counterparts, the Overvalued Screen index under-performed by the S&P by 158 basis points pa. The spread between them was 552 basis points
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
Stock 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.
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
May Screens for Value
(C) 2016 Robert L. Colby
June 30th Valuation Screens
(C) 2016 Robert L. Colby
The Effects of ETF Cash Flows on Equity Values
The chart below shows the relative strength of 50 of the larger stock holdings in the USMV. The index is the relative performance of these stocks compared to the average of our universe of close to 500 equities. It shows a gain of 25% from the low in the summer of 2014.
Finally, this is the average Valuation Return/Risk (VR) of these stocks, again relative to our universe. From a high of +5% in early 2014, the average Risk is now -15%. (VR is the projected price change between the current price and the price at which it would equal its inherent value)
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.
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%.
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