Tag Archives: Equity Valuation

Performance of Undervalued outperform Overvalued by 28.4% since June last year

In the last 9 months the Undervalued Screen has outperformed the S&P 500 by 21.2% while the Overvalued underperformed by -7.2%.  The absolute numbers were +33.8% vs +5.4%.

9 mos

Stay tuned for the a look at what Sectors, Industries and equities contributed to the divergent returns.

The graphs below show the performance of the two screens since inception on September 30th 2004.   Relative to the Corequity universe, the respective annualized returns are +2.68% pa vs -3.77% for a spread of over 600 basis points per annum.

The average return on the Universe is +2.04% pa which is more in line with the Equal Weighted S&P 500.

uvov graphs

Here is a look at the returns over the last year as well as since inception.

table

(c) 2017 Robert L. Colby

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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