Thursday, April 11, 2019

In Defense of Intelligent Share Buybacks

John C. Watkins, CFA®
Author position
Equity Portfolio Manager - Hilliard Lyons Trust Company

In recent years, share repurchases have come under heavy fire, with the chorus of naysayers getting louder in the last few months. Prominent pundits and politicians, including members of Congress, have called share repurchases “evil,” “manipulative,” “corporate selfindulgence,” and even the “cause of wealth inequality.” In fact, legislators from both sides of the aisle recently proposed legislation to restrict corporations’ ability to buy back their own shares.

While share buybacks aren’t perfect, we find much of this criticism misguided. Stock buybacks are not inherently either good or bad. They can create enormous value when executed intelligently, and they can destroy value when used inappropriately. Not all buybacks are created equal.

Sometimes an optimal allocation of capital

Buybacks often reflect management’s effort to optimize capital allocation. Put simply, optimal capital allocation is the distribution of financial resources to their most productive use. Over the long term, effective capital allocation is the most significant driver of business and share-price performance. A great business becomes greater through smart capital allocation, but it can also be damaged irreparably when management spends the company’s money unwisely. That’s why, when evaluating whether to invest in a business, we look long and hard at management’s ability to allocate capital intelligently.

To reinvest or to return?

Management has two basic choices when deciding how to use the cash a business generates. Either:

  • reinvest in the business through capital expenditures, research and development, or acquisitions; or
  • return that cash to the owners of the business – its shareholders.

Normally, management reinvests some cash and returns the rest to owners. In his 1984 letter to shareholders, Warren Buffett remarked, “You should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.”

Cash is returned to shareholders through either dividends or share buybacks. From the company’s perspective, these are identical. With a dividend, the company pays a fixed sum of cash at regular intervals to every shareholder proportionately to their ownership. Share buybacks are more nuanced in that excess cash is returned by repurchasing outstanding shares in the market. With a share buyback, shareholders have a choice. Those that want the cash in hand, similar to a dividend, sell their shares back to the company and receive cash. Those who choose not to sell receive a slightly larger percentage ownership in the company, essentially reinvesting their pro-rata share of the excess cash.

When buybacks make sense

Unlike dividends, share buybacks can either create value or destroy value. For a share buyback to enhance value, it must meet one strict criterion: Shares should be repurchased only when they are trading at a discount to the company’s intrinsic value per share. In his 2018 letter to shareholders, Buffett stated, “Obviously, repurchases should be price-sensitive: blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or ever-optimistic CEOs.”

Many critics argue that the increase in buybacks over the past decade is diverting resources away from productive reinvestment in companies (capital expenditures, research & development, employee compensation and benefits, etc.). In essence, this implies CEOs (and their boards of directors) are forgoing value-enhancing reinvestments in order to repurchase shares. While there are certainly some instances where this is true, we believe this to be the exception rather than the rule.

Reinvestment opportunities are finite

Most management teams look for reinvestment opportunities that grow the firm and provide an attractive return to owners. This can take the form of opening new stores, expanding the supply chain, or developing a new product. However, these opportunities are not infinite. Many businesses generate more cash than they need for all productive reinvestment opportunities. They return this leftover cash to shareholders through dividends and buybacks. To reiterate, most of the time the cash return comes after investments are made, not before.

Further, fundamental to this criticism is the belief that more investment is always good and less investment is always bad. Reinvestment back into the company is good only until all projects with an adequate return are funded. By definition, every additional dollar reinvested earns a poor return and destroys value. On the other hand, pursuing buybacks at the expense of productive investments in the business also damages the business, making it less competitive, and resulting in lower profits, lower growth, and a lower stock price.

In a well-functioning economy, companies flush with cash and short on attractive reinvestment opportunities should return all excess cash to shareholders. Those shareholders can then use that cash to invest in companies short on cash but flush with attractive investment opportunities.

Are stock buybacks manipulative?

Another criticism is that share buybacks are a form of financial engineering that artificially inflates or manipulates the value of the firm and props up the stock price. This is a misunderstanding of how buybacks work. This claim argues that reducing the share count “falsely” increases earnings per share (EPS) with no change in the underlying fundamentals of the company. But the increase in EPS is not “false,” “artificial,” or “manipulated.”

To understand why, it is important to separate two similar but distinct measures: total firm value vs. per-share value. The total firm value is based on the absolute level of free cash flow the company generates. Share buybacks don’t affect this value. However, buybacks do reduce shares outstanding – thereby increasing the per-share firm value. Having fewer shares outstanding means that each remaining share now represents a larger percentage of the total firm value. Critics are correct that this doesn’t change the company’s underlying fundamentals. But it does increase the intrinsic value per share – assuming shares are bought back at prices below intrinsic value.

When we like buybacks

At Hilliard Lyons Trust Company, the foundation of our investment philosophy is to think and act as long-term business owners. When we buy shares in a growing, competitively advantaged business, we intend to be an owner of that business for decades rather than months. For this reason, we normally rejoice when management uses excess cash to repurchase shares at attractive prices. This dynamic results in a growing ownership percentage of a growing stream of earnings. Over years, this can have a powerfully positive effect.

Home Depot (HD) is a great example of how powerful this effect can be. In 2004, Home Depot generated $5 billion in net income and had 2.2 billion shares outstanding, so its EPS was $2.26. By 2018, its net income more than doubled, to $11.1 billion – but its EPS more than quadrupled, to $9.89. How did that happen? Basically, they kept increasing the numerator (net income) while decreasing the denominator (shares outstanding) of the EPS calculation.

Between 2004 and 2018, Home Depot reinvested heavily in its business: The company spent $28 billion, or 35% of its total net income over the period, on its stores, website, new technology, and supply chain to grow its business and enhance customer service. HD also spent heavily on its employees, paying success-sharing bonuses almost every quarter to nearly all of its hourly store employees. These massive yet targeted investments fueled its healthy revenue and profit growth.

Meanwhile, over the same 14-year period, the company used excess cash, after reinvesting heavily in its business, to repurchase almost 50% of its outstanding shares. Management pursued these buybacks methodically, when shares were trading at attractive prices. By the end of 2018, each share outstanding represented twice the percentage ownership of the company compared to 2004. The resulting 11% annualized increase in per-share earnings – over years that included a severe recession and a housing market collapse – is not “fake” or “manipulated.” It wasn’t driven by management trying to inflate the share price over the short-term or prop up the stock price. It simply reflects that roughly half of outstanding shares were bought out over the period.

How we see it

As always, we will continue our search for high-quality companies run by excellent management teams. Partnering with intelligent capital allocators gives us the best opportunity to compound capital at attractive rates and help you meet your investment objectives and goals. Thank you for placing your trust in Hilliard Lyons Trust Company.

Past performance is not a predictor of future success. All investing involves the risk of loss. Hilliard Lyons Trust Company does not provide tax or legal advice. Please consult your own tax and legal advisors about your own personal situation.