Phase I: Returning Cash to Shareholders
Phase II: The Future of the American Economy or Rising Stock Prices
Phase III: Wealth disparity, capital abuse, and politics
The stock buyback debate has taken three phases over the years. Phase one began simply with the question, “what is the best way to return cash to shareholders?” Those in favor of dividends made the case that investors favor cash in hand and allow investors to dictate how excess cash is spent, with the underlying message being that most business executives are not skilled at buying back stock in a way that creates value for shareholders. Those in favor of buybacks discussed the tax inefficiency of a dividend.[1]
Phase two started to veer towards the political, asking the question if company executives were buying back shares to increase the price of their company's stock at the expense of future value creation by sacrificing capital allocation to capital expenditures, including research and development (R&D). Those against buy backs also said that executives were buying back stock in order to improve their EPS, and increase their own compensation as a certain level of EPS is required by some company boards in order for executives to receive their full bonus. Those in favor of buybacks said that even if executives allocate more capital to R&D, that doesn’t necessarily create more value for shareholders. The golden rule of capital allocation is that the investment of capital must create more value in the future than it does today.
The current phase of the buyback debate continues the executive compensation argument, but dives deeper in the social issues such a wealth disparity, corporate abuse, and lack of skin in the game. What started as simple question in the world of finance, has ballooned into an inquisition of capitalism.
As is common with this blog, I will also examine the misalignment of incentives that led to the current phase of the debate. The usual suspects are all here, principle/agent problem, lack of skin in the game, and short-term thinking. I am not going to try to end the debate by declaring an absolute winner. Each situation will have a different answer. What I hope is that after reading this, people will have a better lens to view specific capital allocation scenarios.
Phase I: Returning Cash to Shareholders
Nothing I am about to present is new. Michael Mauboussin already gave people the best way to understand the various methods companies can use to return cash to shareholders. His two pieces are Share Repurchase from All Angles and Distributing Cash to Shareholders. He is one of the greatest investment writers and you should all go read both pieces of research now.[2]
Let’s start with one of the few first principles in finance; shareholder value is created when capital is allocated to investments that will generate returns greater than the companies cost of capital.[3] If a company cannot find investments that will generate risk adjusted returns greater than its cost of capital, and the company isn’t carrying too much debt, then the company can do three things:
Hoard the cash and wait for opportunities
Distribute the cash to shareholders via stock buybacks
Distribute the cash to shareholders via a dividend
Hoarding cash and waiting for attractive investment opportunities to present themselves is a viable option if your shareholders respect you as a capital allocator (Buffett and Henry Singleton). But it can lead to investors discounting the company’s value (see AAPL 2010 – 2012).
The next step is examine if either a dividend to a share buyback program is the appropriate vehicle to return cash to shareholders. To begin its important repeat the golden rule of share buybacks:
“A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.”
Expected value is in the eye of the beholder. Each investor will have a different belief on the expected value of the company. Company management will also have a different view on the expected value of the company as well. With the golden rule as the benchmark as to whether buybacks are good capital allocation decision, there will be shareholders that disagree for various reasons. If they believe that the company is currently overvalued, thus creating a situation where buybacks destroy shareholder value, those investors are welcome to sell their shares. If investors simply prefer a dividend, those investors can sell shares to create their own dividend. But if you are a shareholder, it’s likely you believe that the current market price doesn’t properly reflect the value of the company, so you should appreciate the company deciding to buy back shares.
There are investor who believe that business executive tend to be poor appraisers of their company’s value and buy only when the stock price is rising and stop if the shares are in decline. This can be the case, but there are excellent executives who are able to buy back stock at attractive valuations. The book The Outsiders gives excellent examples of CEO’s who created a lot of shareholder value by repurchasing the company’s stock.
Patrick O'Shaughnessy did some research a few years ago and found companies that repurchase a significant portion of shares (5% or more of shares outstanding in a year,"high-conviction" buybacks) outperformed stocks that were either purchased less than 5% of shares annually or were net issuers of shares.