Thursday, May 8, 2008

Why you should short companies doing a share buyback.

Am I the only guy who believes that stock buybacks are a waste of shareholder money and a management diversion?

Theoretically, if the earnings yield (inverse of P/E) is higher than the after tax interest rate, buybacks add to the EPS number. Buybacks are dilutive otherwise. (This provides no information on the value of the company.)

Here’s why I don’t like buying companies doing stock buybacks, and would rather short some of them:

  • Some of the announced buybacks never happen.
  • P/E multiple compression. A dividend or a buyback is a cash flow to the investor right now, versus a possible higher return later on through future profitable growth. According to the classic Gordon growth model, a company’s price earnings multiple is proportional to the retention ratio. Well, a buyback is another way to return cash to the shareholders (or a lower retention ratio). Lower rates of reinvestment suggest lower future growth rates, and hence a lower multiple.
  • Implicit recognition that the avenues for internal growth through reinvestments are not that high as returning cash to shareholders through buying back ‘undervalued’ stock. Let’s say you have a debt-free company with a 20 P/E doing a buyback. Does this imply that the company cannot find enough investable projects with returns in excess of 5%? Would you want to invest in that kind of a company? The company might be signaling a lack of investment opportunities above the cost of capital.
  • Buybacks are effectively a leverage on the EPS numbers. In good times, profitable growth leads to aggressive buybacks, further magnifying EPS numbers. During a downturn, a negative growth with reduced buyback would amplify the EPS compression. Cyclical companies with huge buybacks are the best short candidates for this.
  • If the management thinks that the stock is undervalued, why isn’t a value investor or activist hedge-fund buying your stock? Palm(PALM) and Motorola(MOT) are two companies which had huge buybacks when the stock price was a lot higher. Even the activist funds have lost money on their initial investments so far.
  • A lot of tech company buybacks are to offset equity dilution due to stock options, and the net buyback is minimal. (BIG short). I’ve seen companies with 5-10% annual stock dilution. (Let’s not even get into the whole option expensing debate!) . Yahoo(YHOO) and Nvidia(NVDA) are examples of companies with a sizable equity dilution.
  • Buybacks to combat short sellers is a questionable tactic with dubious merits. This gets into the whole ego turf. Good short candidate. (Example: Overstock(OSTK))
  • Buybacks followed by heavy insider selling are a big red flag.
  • Possible internal management conflict to boost EPS numbers for executive compensation, instead of long term shareholder growth. (This paper suggests that the combination of a share buyback, insider selling, and a high ratio of incentive compensation is a high risk event.)
  • Cost cutting and restructuring: Increasing cash flows through temporary cost cutting measures don’t really add to the firm's innovativeness. Using that cash to buy back shares instead of reinvesting is a good short candidate, since the uptick in cash flow is temporary.
  • If you pay more than your book value, you reduce your book value effectively.
  • As investors, you care for the “intrinsic valuation” of the company. This doesn’t change with a buyback. By pandering to short term speculators, management risks alienating value investors.

Hey if buybacks are such a great thing, how come Berkshire doesn’t have one? That’s because it chooses to reinvest earnings in profitable enterprises, thus increasing intrinsic value, and consequently the share price. Gaming and managing quarterly earning numbers through buybacks is not a good long term investment thesis. It doesn’t matter if the stock is trading at half the intrinsic worth. The company should essentially ignore what the market thinks in the short term.

If the company is returning all that operating cash flow to the shareholders, aren’t you better off just buying a conglomerate like Berkshire(BRK) or Luecadia(LUK) which reinvests that cash in profitable enterprises for you? They effectively take away any reinvestment risk.

The implicit assumption in a buyback is that the company feels that the stock is undervalued. The belief is that insiders know something that Mr. Market doesn’t. Often times, this is not based on a strong order book, or an increasing sales profile. More often, an overly optimistic and rosy outlook leads to the buyback. Given the folly of forecasting beyond a few quarters, that’s questionable.

Sometimes, the announcement is made after an earnings shortfall, or if the company has some future negative outcome which the market is possibly 'discounting'. For example, even right now, the average analyst estimates for the last two quarters of 2008 are too high. From a bottom-up analysis, companies feel that even though there is a general economic downturn, they won’t be affected. Some of them have buybacks in place.( This 2005 article from the McKinsey Quarterly provides some further food for thought)

I’m not saying that buybacks are bad per se. There are genuine occasions when Mr. Market throws a temper and gives us a steep discount with a nice margin of safety. Just that there are situations where shorting companies doing buybacks might actually be a profitable strategy. Using the guidelines above can help us in reaching this decision.

Ticker symbols discussed: BRK, LUK, OSTK, YHOO, MOT, PALM, NVDA.

Full Disclosure: Long LUK since 2005.

7 comments:

Anonymous said...

What if the market assumes the company does not have sufficient new projects that are expected to yield a return greater than the cost of capital? This assumption may already be priced into a stock.

A share buyback can signal a degree of discipline with capital budgeting and will therefore should be rewarded by the market. Remember, investing in projects that yield less than the cost of capital can result in earnings and revenue growth while reducing the value of the company.

Sajal said...

Anonymous, you are right. In this situation, the company will be rewarded for it's discipline.
While it may be the right strategy for the company, as an investor, I'd rather invest in companies which CAN find profitable ventures above the cost of capital, thus maximizing my ROIC.

Thanks,

Anonymous said...

Do you feel the same way about dividends? Obviously, a lot of different implications (e.g. dividends hard to cancel and enforce management discipline, dividends return cash without forcing shareholders to effectively purchase more of the company's stock, etc). But it is still a return of cash to shareholders, which you argue against. I believe Coca Cola has paid dividends for a long time now, and KO is one reason that Buffett has done so well. Graham heavily favors companies that pay dividends in Intelligent Investor.

I don't think share buybacks are bad in the sense that the company in question is now doomed to mediocre growth. If a company is extremely disciplined and uses their retained earnings only to invest in extremely good projects, and pays the rest out via buybacks or dividends, that is not a bad thing. But your other points around the potential for mishaps around buybacks is what I think the emphasis should be.

Sajal said...

Anonymous,

I would buy a dividend paying company for the stability it offers.

A stable and growing dividend is clearly not tied to any management incentive to boost EPS numbers. It's a stronger signal than a buyback. It's also clearly not dilutive. Yes, a dividend would obviously lead to a multiple compression. I've seen tech companies which started paying out dividends, and their stock has
not gone anywhere for many years now (Intel, Microsoft).

Note that there are some growth investors who avoid dividend paying companies for precisely this reason. I suggest they avoid the buybacks too.

Multiple compression would be the most important point that I have listed.

"I don't think share buybacks are bad in the sense that the company in question is now doomed to mediocre growth. If a company is extremely disciplined and uses their retained earnings only to invest in extremely good projects, and pays the rest out via buybacks or dividends, that is not a bad thing."

Well, the company should at least make sure that the buyback is not dilutive!

I agree with your point though. I'm not saying that the company is doomed to mediocre growth. The company could still have EPS growth rates ,ROEs and ROICs in excess of 25%. I do think any dilution in ROIC would result in Mr.Market awarding the company a
lower earnings multiple.

And just to elaborate, I'd rather be a lower multiple stable grower than a high PE high flyer which comes crashing down at the smallest whiff of a turn in the economic cycle.

Thanks,

Praveen said...

Hi sajal,
On the dividend v/s Buy-back front
I can think of another scenario where buy-back would create value atleast in countries like India where you have high divedend distribution tax (@17%) but no Long term Capital gain tax (LT defined as 1 yr for india) You can use buy back for tax arbitrage.

Obviously price remains an issue

Praveen said...

Hi sajal,
On the dividend v/s Buy-back front
I can think of another scenario where buy-back would create value atleast in countries like India where you have high divedend distribution tax (@17%) but no Long term Capital gain tax (LT defined as 1 yr for india) You can use buy back for tax arbitrage.

Obviously price remains an issue

Sajal said...

Hi Praveen,

Yes, what you are saying is always true. In the case of India, because you don't have LT Capital gains, buybacks would be the preferred route to return cash to the shareholders.