Today, David Merkel on the Aleph Blog, responded to the slew of stock buyback-related posts. David is always very observant and warned about the shortcomings on buybacks in years past . He wrote a great post taking the other side of the trade, and although I disagree with some of his arguments, we all need to see both sides of the trade as I sometimes become parochial in my views. After this I will give buybacks a breather for now - I swear
First, he put together a great comprehensive list of the problems with buybacks that I thought I would reprint below:
Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend. At that time, I tried to point out (at RealMoney) that buybacks are not costless:
- They reduce financial flexibility.
- They lower credit ratings and can raise overall financing costs, if overdone.
- They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
- They often don’t get completed, leading to some disappointment later, after the initial hurrah.
- They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments. In a sense, shares are shifted from shareholders to management. Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets. Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
- A higher regular dividend could be more effective in some cases
- Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon? That’s what a large buyback implies.
He then goes on to what he sees are some positives:
Buybacks can instill capital discipline, as regular dividends do. A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.
I disagree that buybacks instill capital discipline and do not know what their share price has to do with it. In capital budgeting you want to invest in projects with positive NPV or the highest IRR. You do this by discounted cash flows at the WACC. This is where you look at your own numbers, but the key is their ability to gauge the cash flows it generates. If an acquisition has a NPV over time that is positive and they believe it is the right thing to do, then they should do it, or else pay it out as a dividend or keep it on the balance sheet for future opportunities. Whether management is good or not, human nature is geared towards short term gains and the path of least resistance. If an acquisition takes years for synergies to be realized, and they know they have a few years to get things done or they are out, they are biased towards the short run benefit. They shouldn't even consider their share price in the decision. If they don't want to take the risk, then they should pay out a special dividend and let the market decide whether or not it is a good investment. I want to see management take risk with my capital or give it back to me to take risk with.
The best buybacks are valuation-sensitive. The company has an estimate of its private market value, and the buyback only goes on while at or below that value. When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.
It is management's job to increase long term shareholder value, not take advantage of short term price disparity in the market for its shares. This is the absolute worse reason for such a program - regardless of what the true value is. Shareholders do not give management their money so that they can take advantage of an informational advantage to rip off their own investors. A shareholder holds your stock through a few earnings periods, and you try to take it from him at 4% below what you believe it to be, instead of giving him a 4% dividend for waiting for that value and providing other investors the incentive to wait along with him for the stock to realize its actual value. I sure hope they don't sell shares when the value of their company is much lower than the market would think. Instead of buying the stock at all why don't I just give them $10, wait outside the annual shareholder meeting and bend over. Investors don't need to be told the obvious, they believe your stock is cheap, or else they wouldn't be holding it. Reward those investors with the extra cash who are patient and commit their capital for years, not those who are looking for the door.
A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it. A high quality management team can run with more excess capital. In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.
I agree completely about the management teams, but don't see why I should trust a moderate team with my claim to earnings. After allocating the cash to projects that will generate more cash in the future, give me back the cash that you earned on my dollar, or keep it around if you think profitable opportunities will arise. A good money manager finding himself with a ton of cash and no good opportunities will not just add to his existing positions - giving the reason that they haven't hit their target value yet, in doing so he is doing right by the client. However, if he sat on cash and underperformed his benchmark for a while, there would be a good chance that his client would pull the cash out and invest it elsewhere if not sell out altogether. This is why many managers like to keep cash low and stick to an index. Isn't buying back your stock the same thing? Buybacks closet indexes themselves to their last EPS point and enables management to make sure that their earnings growth does not drift much from what it "should" be in the short run, but not over time. Just as it is in the financial and business interest of the money manager to hold very little cash, it is in the CEO's interest to buy back stock over dividends or cash - not in the interest of the client or shareholder.
My major gripe with buybacks is they are not the most efficient use of capital, ever. If a company deciding whether to retire $100 million worth of shares, issuing $100 million cash dividend, or sit on the balance sheet should be a decision based on the value to a long term shareholder. If a company want to sit on the cash can earn some short term interest on that cash and it allows for it to be flexible during an opportunistic time, then so be it. If it wants to return value to a shareholder, then a special dividend ALWAYS unlocks shareholder value better than a buyback. If shareholders believe in the company they will reinvest the dividend and add 80% of that capital back in and take advantage of the fact that the stock is undervalued. If they don't they will sell, enabling shareholders to move in who APPRECIATE the fact that management actually returns value, not just paper gains.
I would much rather have money now than money later, and must be paid a premium to take money later and deal with market and liquidity as well as reinvestment risk. Buybacks cause long term investors to be subject to enormous earnings surprise risk, while dividends provide an income stream to promote a stable capital base. Since many argue that equity investors should be concerned with their claim to the future earnings of a company, a stock buyback rather than dividend distorts the view of such a claim and puts tons of faith in the fact that someday there will be someone else who is willing to buy that claim from someone who never got any claim whatsoever. It puts downward long term pressure on the stock and rewards short versus long time horizons. One bad earnings announcement could erode away years of built up dividend payments and reinvested returns, whereas if a company paid a decent dividend, the earnings surprises would be much less severe, as the stock would not appreciate so fast.
The best trade in this market right now may be short buybacks long dividends. Or simply just selling stocks that have bought back shares and bought those who haven't. A buyback in my opinion is economically the same thing as a dividend, except for the fact that the holder of the stock is taking on much more risk than if he were to get the cash over time. With many of these companies operating at margins that are stagnant but at all time highs and ROE's that have suspiciously soared to all time highs, cashing out your dividends in a one time lump sum and reinvesting it in a company who may be the investment style de jour soon, sounds pretty good to me into while this major liquidity is still available. Obviously this is not a blanked recommendation but an idea, and you should look at all holdings seperately. This phenomena speaks less to the managers of the company than the people who own the stocks, if they are near sighted on the way in, they will be the same way on the way out. That is the ONE thing about buybacks that actually is a good thing. They allow you to unlock shareholder value and provide liquidity to those who chose to sell. When earnings growth does slow and/or buybacks cease to be profitable, you don't want to be the on the other side of the liquidity eqution, trying to bust through the crowded exits, instead you could be the one right outside with arms wide open and a fistful of dollars (or euros).
Disclosure: I own stocks who buyback shares. We all do.
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