Season Investments


Finding Value In Buybacks

Posted on December 3, 2019

“When stock can be bought below a business’s value it is probably the best use of cash.” – Warren Buffett 

2019-12-03_sale.jpgIn 1982 a rule change implemented by the Securities and Exchange Commission made it legal for publicly traded corporations to buy back shares of their own stock in the open market. This exercise, called a “stock buyback”, reduces the number of shares in circulation thereby supporting the stock price and improving fundamental metrics on a per share basis. Similar to paying a dividend, it is a way for corporate management to return capital to shareholders when they feel there are no better uses for the cash. 

The efficacy and ethics of corporate buybacks have been the subject of debate for decades, but the growing tension over wealth and income gaps are elevating buybacks in the public discussion - especially as the 2020 presidential race heats up. This week we’ll take a look at some of the common arguments for and against the practice of corporations buying back their own stock. 

First of all, consider the wide variety of things a corporation can do with the excess cash that is left over after running its core business. The obvious and primary use, of course, would be making strategic investments into innovation, technology, research and development, personnel, acquisitions – or any number of other productive activities that further its corporate mission. That, after all, is why the corporation exists. But the key word here is productive. Leadership constantly has to analyze the plethora of opportunities and make decisions on what to pursue and what to pass on, all the while striving to deliver a valuable product or service to the market and doing more with less. Truly productive activities are what collectively drive the economy forward and create a broadly rising tide that can lift many boats. 

It’s important to recognize that corporations can’t do everything at once, and often have to pick and choose what high priority projects to focus on. Sometimes when all the strategic initiatives are fully funded there is still cash left over sitting idly in the bank. What to do with this cash is a matter of comparing the next best investment opportunity with the corporation’s cost of capital. 

Remember, corporations are capitalized with both equity and debt, both of which come with an associated cost. While the cost of debt capital is relatively straightforward (interest expense), the cost of equity capital is more nuanced and is driven by things like dividend policy, volatility and growth relative to the broader market. A corporation’s blended cost of capital, called its weighted average cost of capital (“WACC”), can be thought of as a hurdle rate, or required return, that needs to be met in order for a new initiative to be considered accretive to the company’s value. 

With this in mind, let’s return to our question of what a company can do with its excess cash – which we’re defining as cash left over after all the high priority strategic initiatives have been funded. If there are no other projects promising a return greater than the company’s cost of capital the corporation has a decision to make: sit on the cash, pay down debt or return it to shareholders. Buying back stock in the open market is one way of returning cash to shareholders – and it can make a lot of sense when the stock price is depressed. Warren Buffett, an outspoken proponent of share buybacks, compares the practice to value investing. One caveat, of course, is that management has to believe that the company’s shares are trading cheaply, and are below their estimate of intrinsic value by a wide margin. 

Obviously corporate decision making is infinitely more nuanced and complex than what I’ve outlined above. Making major investments into new projects, research and development, acquisitions, or other sorts of corporate initiatives requires time, expertise and high levels of risk and uncertainty. Paying down debt, distributing dividends or buying back shares can all be thought of as more of an “easy button” for companies that have funded all their strategic initiatives and still have cash left over. 

The whole notion of corporations buying back their stock, however, is incredibly unpopular amongst certain groups. One common critique is that corporate executives should be able to find more productive uses for the cash and that buybacks can never be the most productive use of cash over the long term. Larry Fink, CEO of the investment management firm BlackRock, for example, recently warned corporate America against 

...seeking to deliver immediate returns to shareholders, such as buy-backs…while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.

Likewise, presidential candidate Joe Biden recently claimed that the high level of buybacks had led to significant decline in business investment. 

Another common critique is that buybacks only serve to worsen wealth and income gaps by elevating the wealth of asset owners at the expense of rank and file workers inside the company (implying a better use of the cash would have been investment into personnel). Not only that, but the same executives deciding what to do with the cash are compensated with stock options and thus have a conflict of interest in wanting to boost the stock price by whatever means necessary. 

While these critiques have merit, particularly in specific outlier situations, I don’t believe they thoroughly discredit the practice of stock buybacks across the board. Here are a couple of counterpoints that I think should be considered: 

It’s a free country
On some level, I simply don’t like the idea of the government dictating to a corporation that it can’t return capital to its shareholders via dividends and/or buybacks. If the corporation believes its best use of cash is to buy back a share of its stock, then it should be free to do so. It still has to answer to its board of directors, shareholders, and analysts for its investment decisions. If a corporation is truly being shortsighted, missing out on productive innovation opportunities and alienating its workforce then it’s simply a crappy company. But being crappy has never been against the law. 

Buybacks are not mutually exclusive with other uses for cash
Buybacks are one among many potential uses for corporate cash, and being supportive of buybacks is not synonymous with being unsupportive of all the other good things a company can do with its money. I believe a healthy corporation will prioritize true innovation, long-term productive investments and radical care and generosity for its employee-stakeholders. But paying dividends, paying down debt or buying back stock in the open market can all play a role as well. Stock buybacks are only a piece of the puzzle, a tool in the toolkit. 

Buybacks add to price discovery and market efficiency
Who is better positioned to understand the return on equity of a corporation’s stock then that very same corporation’s finance department. Who is going to question Warren Buffett and Charlie Munger if they determine that Berkshire Hathaway stock is trading below its intrinsic value and is thus a good investment? By allowing the corporation to buy its stock in the open market when it feels its warranted (after all, they’re allowed to issue new stock whenever they want as well), you’re only increasing market efficiency and greasing the wheels of price discovery – something that is general good capital markets and investors. 

The cash is getting repurposed
When a company buys back a share of its stock someone is on the other side of that trade. That cash, in theory, can be reallocated elsewhere in the market where the capital is needed more. Or it can be spent or used for another productive purpose like making a loan, paying down debt or charitable giving. Point being...that cash doesn’t disappear into thin air. As stated by Harvard Business Review: Capital flowing to S&P 500 shareholders does not go down the economic drain: Shareholders use much of the cash, we know, to invest in smaller public and private firms, supporting innovation and job growth throughout the economy. 

Net issuance is what’s important, not just buybacks
Many of the anti-buyback headlines talk about the notional amount of stock that is being bought back without netting out the offsetting impact of new equity issuance and employee stock grants, 85% of which goes to non-executive employees according to the same Harvard Business Review paper linked above. The net numbers are far less dramatic than simply looking at the raw amount of stock that is being bought back. 

Investment is alive and well
Another thing the headlines tend to do is express the level of buybacks as a percentage of net income. The flaw here is that net income is already net of a lot of investment-related expense. Again, according to the same Harvard Business Review article linked above, capital expenditures and R&D expenses have been rising steadily over the past decade and are now at highs (expresses as a percentage of revenue) not seen since the 90’s. So it’s not as if companies aren’t making investments into long-term growth – it appears they are and simply have cash left over to distribute to shareholders via dividends and stock buybacks. 

In 2019 S&P 500 companies are on pace to buy back well over a trillion dollars worth of stock. However you feel about that number, the arguments coloring share buybacks as inherently wrong, although containing elements of truth, aren’t sufficient to support broad stroke legislation outlawing the practice. Corporations should continue to be allowed to return capital to shareholders through a variety of mechanisms if that’s what they choose to do. These initiatives should be viewed and critiqued within the context of the corporation’s overall business and capitalization strategy, and it’s important to remember that they can be a complement to and are not ever mutually exclusive with capital investment, research and development or innovation. Effective managers will always be looking to Find Value in Buybacks, especially when outside forces are pushing their stock price significantly below its intrinsic value.

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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