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.

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Paul Wilmott on the Black Scholes option pricing model.

Paul Wilmott had an interesting post last week about his tryst with the Black Scholes option pricing model. On how his opinion of the model has changed with time and experience.

I had gone from a naïve belief in Black-Scholes with all its simplifying assumptions at the start of my quant career, via some very sophisticated modelling, full circle back to basic Black-Scholes. But by making that journey I learned a lot about the robustness of Black-Scholes, when it works and when it doesn’t, and have learned to appreciate the model despite its flaws. This is a journey that to me seems, in retrospect, an obvious one to take. However, most people I know working as quants rarely get even half way along. (As discussed elsewhere, I believe this to be because most people rather like being blinded by science.) "

"My research now continues to be aimed at questioning commonly held beliefs, about the nature of ‘value,’ about how to use stochastic calculus to make money rather than in a no-arbitrage world, about the validity of calibration (it’s not valid!), and how people price risk (inconsistently is how!). All the time I strive to keep things understandable and meaningful, in the maths sweet spot that I’ve mentioned before. "

The many improvements on Black-Scholes are rarely improvements, the best that can be said for many of them is that they are just better at hiding their faults. Black Scholes also has its faults, but at least you can see them. It’s simply that more complexity is not the same as better, and the majority of models that people use in preference to Black-Scholes are not the great leaps forward that they claim, more often than not they are giant leaps backward.

Wilmott has posted some good stuff on this topic, and I suggest you check out his blog.

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Quotable Quotes: The World this week.

This is a weekly update on what I've been reading and watching. To encapsulate, you had asset class predictions from GMO and BCA's perspectives on Brazil. Three strategists recommended selling this rally. Peter Bernstein reflected on the similarities to the Great Depression, and Bill Gross talked about a fat-tail possibility. The Indian finance minister's comments qualified him for the "bizarre quote of the week".


I haven't had a chance to read the transcript of the annual Berkshire conference. I did manage to catch this quote from a Marketwatch article, which discussed Berkshire's acquisition of a portfolio of subprime mortgages with frozen interest rate resets.

Buffett: "We're not in the business of resetting mortgages higher". That's quintessential Buffett for you. Candid, honest and fair. Long term profitable ventures are sustainable in nature, and you cannot sustain predatory lending which dupes gullible borrowers beyond a point. Berkshire's enterprises have a very human face to them (Sudan and PetroChina controversy notwithstanding), something that corporations would do well to keep in mind. With this fitting prelude, let's dig in.

Jeremy Grantham came out with GMO's seven year forecast on various asset class returns. I thought this chart was good food for thought:

BCA Research is clearly positive on Brazil's prospects:

P Chidambaram (Indian Finance minister) (Bizarre quote of the week) :

"If rightly or wrongly people perceive that commodities- futures trading is contributing to a speculation-driven rise in prices, then in a democracy you will have to heed that voice."

Comment: I seriously worry that we could have a black swan event in food and commodity prices, further exacerbated by political expediency. There are elections in India next year, and the political posturing has begun. Deficit is high, inflation is out of control, futures trading on food staples has been banned, fuel subsidies are distorting fuel usage, exporters are demanding tax incentives, sops or government intervention in keeping the rupee pegged to the dollar. The list goes on . The news from China isn't getting any better. Increasing emerging markets trade protectionism could undo the WTO trade benefits, further throwing a spanner in the Doha round of negotiations.

Check out this Don Coxe interview for his take on the current situation..

Former fed official Vincent Reinhart :

"The central bank's rescue of Bear Stearns was the worst policy decision in a generation.
The panicked decision jumped over other possibilities and may prove as damaging as Fed policy errors that caused the "great contraction'' of the 1930s and the "great inflation'' of the 1970s.
The Fed's actions eliminated forever the possibility that the Federal Reserve could serve as an `honest broker'. The central bank also "tilted the political playing field toward direct mortgage relief. "

Desmond Lachman, Chief Economist of the American Enterprise Institute:

"Further interest rate cuts and a second stimulus package are required. Unorthodox measures are needed to stabilize the housing market. "

-Household wealth reduced by $2 trillion till date.
-Real prices 20% above equilibrium.
-Excess inventory of 1 million.
-Case-Shiller Indices predicting further declines.
-Sub-prime lending dried up.
-Record foreclosures.
-Commercial property burst
-Goldman Sachs estimates 1.2 trillion in losses
-Interest rate spreads have widened, neutralizing Fed's interest rate cuts.
-Fiscal stimulus neutralized by high oil prices.
-CDS market a hidden non-bond sector danger.

Peter Bernstein:

"I'm a child of the Depression, and I am thinking about what the early years were like after World War II. It took a very long time to get the memory of the Depression out of business decisions, and certainly banking decisions. I think this is going to be the same.

The people who think we will have turned in 2009 are wrong. There has to be a respite along the way. Nothing goes in one direction forever. But it will take longer than people think."

Adam Myers, market strategist at Credit Suisse:

“Money markets are reflecting a level of caution which is not reflected in credit or equity markets. The difference between the two is that … a money market trader has a much better idea of solvency of their trading counter parties than does an asset fund manager. Given money market traders’ proximity to balance sheets, they get clear information from buying and selling of money between each other. The view of the equity and credit market is far too sanguine.”

"The real economic effect of this credit crunch is only beginning to be felt. We are going to see a much more substantial impact than is reflected in equity and credit markets."

Morgan Stanley analyst Betsy Graseck: Sell bank shares

“We think it is a mistake to chase this rally,” she writes. “The risk is much greater that credit deterioration will accelerate and banks will raise more dilutive equity and cut dividends than expected.”consumer net worth is likely to decline 11% over the next two years due to the housing decline, and loan losses will continue to rise. This will drive weakness in commercial asset classes, “as corporates who sell to consumers suffer from slower top-line growth.”“we think we are only in the 3rd inning of the credit cycle and expect this credit cycle will be worse than 1990-91.”

Jeffrey Saut:

"We turned bullish at the January 2007 “lows,” cautious at the subsequent February “highs,” and aggressively bullish on the March downside re-test of those January “lows” believing the re-test would be successful; and, that the ensuing rally would carry the averages above the February highs, eventually scooting into the 1400s basis the S&P 500 . From there, if the envisioned pattern continues to play, we should see a decline. To reiterate, that decline should be measured by “if” the U.S. economy spills into a recession; and that then, the extent of the decline should be measured by if the recession is short-and-shallow or long-and-deep.

To take advantage of the aforementioned potential stock market pattern, we have recommended numerous trading and investment positions. Speaking to the trading positions, we have continued to move stop-loss points “higher” as the rally has progressed; and would look to sell many of these positions into any “blue heat” upside type of hour toward SPX 1440. "

Bill Gross Investment Outlook:

"Lower Fed Funds? They would, in PIMCO’s opinion, likely do more damage than good from this point forward.

Mohamed El-Erian has been counseling to at least consider a fat-tail possibility that could stop us in our tracks on the list of our strategic battle plan. (Note: I pondered on the possible consequences of this possibility in this post)

Mohamed suggests the possibility, not the probability, that recent euphoric moves in equity prices and credit market spreads might be premature. The market’s justification may rest on the two-barreled conclusion that, 1) the delevering of the financial system is reaching a natural culmination as prices stop going down and banks and investment banks recapitalize their balance sheets, and 2) that numerous and previously unthinkable policy responses have restored enough liquidity to relubricate our finance-based economy. Recession, and its vicious-cycle effect on employment and consumer spending, remains a threat and this recession, although currently mild and as of yet not even officially validated, may not be your garden-variety, father’s Oldsmobile-type of downturn.

Because the U.S. and selected other economies are now substantially asset-based and dependent on stable and upward tilting prices, a deflation of an economy’s primary financial asset can be ruinous. Its deflationary thrust must be countered, wrote Minsky, or else the battle might be lost. If so, the real economy as Mohamed El-Erian suggests, might become so shell-shocked that financial markets once again turn down instead of up. "

Full Disclosure: No positions in any securities mentioned.

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Three reasons to buy consumer staples right now!

Mr Market has been in a good mood these days. The recent upward movement in stock prices has led to a return of investor’s risk appetites. While we may very well trend higher, it may be a wise idea to consider a shot of consumer staples in your portfolio.

Here’s why:

• The arguments for and against a recession are purely academic. The simple fact is that we are looking at below trend GDP growth for at least the next 2 years, and possibly a decline in GDP per capita. Right now, large caps with consistent cash flows are trading at historically cheap valuations. As the investing boat tosses and turns, investors will begin to pay up for companies generating stable consistent cash flows that are impervious to a slowdown. Advantage: consumer staples.

• While energy prices are really high right now, quite a few strategists have called this a commodity bubble, with fundamentals justifying lower prices (You can check out my posts here and here discussing this further). When the bubble deflates and energy prices come down to reflect the new realities of slower global growth (based on IMF predictions), the money flowing out of energy issues could very well flow into the consumer sector. (I’m not recommending exposure to the consumer discretionary sector, because some of them will take a hit in a slowdown.)

• Emerging markets strength. A lot of the growth in these names is through emerging markets. Consumer staples are a good way to play the ‘decoupling’ argument. You are not affected by a developed world slowdown, and stand to benefit from any growth in the developing world.

Best ways to play this? For a quick and dirty diversified way, you can buy the Consumer Staples Select Sect. SPDR ETF (AMEX:XLP). For active stock investors, Unilever plc (NYSE:UL), PepsiCo, Inc.(NYSE:PEP) and The Procter & Gamble Company (NYSE:PG) would be my picks.

Full Disclosure: no positions in any securities mentioned.

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