By Jack Forehand, CFA (@practicalquant)
There might not be a more controversial topic right now in investing than stock buybacks. The debate over buybacks, which started out as a debate over their investment merits, has morphed into a political one that touches many of the controversial topics of our day such as income inequality and whether Wall Street continues to profit at the expense of average Americans. The negative press that buybacks have received has led some to even conclude that they should be completely banned.
I won’t go anywhere near the political portion of the debate here, but I think it is important with a topic like this to take a step back and to understand the facts before we jump to any conclusions. Part of my goal with writing on a regular basis was to use it as an opportunity to learn myself, and this article is an example of that because it will give me an opportunity to sort through what I know about buybacks and to fill in the areas I am not sure about. So here is my attempt to write an article about buybacks without stirring up any controversy. Wish me luck.
What Are Buybacks?
Before we debate the merits of buybacks, it is important to understand what they are. Profitable companies generate excess cash on a regular basis. They have a variety of options for what to do with it. They can reinvest it back in their business. They can just keep it in the bank. They can buy other companies with it . They can pay down debt. They can pay dividends. They can also buy back their own stock.
One of the things that distinguishes the best managers is their ability to properly make these capital allocation decisions. They invest back in their businesses when they expect strong returns from doing so, but they are also willing to return capital to shareholders when they don’t.
When managers decide to return capital to shareholders, they have two main options. They can either pay a dividend or they can buy back their stock. If we ran a focus group and asked investors to react positively or negatively to the word “dividend” and the word “buyback”, you would see a major divergence. Investors love dividends, but they tend to look at buybacks much more negatively. But much of that is a misunderstanding of what a buyback is. The excellent Econompic blog did a much better job explaining this than I ever could, so I will just link off to that, but the bottom line is that from an economic perspective, there is no difference between a buyback and a dividend. And as a shareholder of a company, a buyback is a more tax efficient way for it to return capital to you than a dividend is because it is not taxed right away. So much of the negative press about buybacks has been based on a lack of understanding of what they are. That doesn’t mean they can’t be used for nefarious purposes (more on that later), but it is important to understand the facts before we get into more detail about the pros and cons.
Buybacks and Stock Returns
If you are an investor seeking to invest in companies that generate the best returns, there is no better thing to look for from a capital allocation perspective than firms that are returning capital to shareholders. Take a look at the chart below from O’Shaughnessy Capital Management.
source: https://www.osam.com/pdfs/An_Option_to_Improve_Shareholder_Value.pdf
Stocks that bought back shares and paid dividends have performed better than companies that did anything else with their capital.
Or looked at another way, here is the performance difference between firms with high shareholder yield and low shareholder yield (also from OSAM).
Either way you look at it, investing in firms that buy back their stock has been a very good idea. Investing in firms that do high conviction buybacks at low valuations has been an even better one.
The Downsides of Buybacks
Again, I am only going to look at this issue from an investor’s perspective, so I am not going to get into the arguments about the impact that buybacks have on society. But there are some downsides to buybacks for investors. There are also many perceived downsides that are often mentioned in the media, but that don’t hold up to scrutiny.
The biggest downside of buybacks is one that Ben Hunt of the Epsilon Theory blog discussed in his excellent recent post. To summarize, if the management of a company issues themselves stock options at discounted prices and then uses a buyback to purchase the shares from themselves at a big profit, this is certainly not the type of buyback I would want to see as an investor. How widespread this behavior has become is subject to debate, but there is no question that some of this goes on and it isn’t a positive for shareholders. Not all buybacks are created equal and it is important to look at the details before assuming that a company buying back its stock is a good thing.
There are also other commonly discussed downsides to buybacks that are more perceived than real. For example, the data doesn’t back up the assertion that most of the growth in earnings per share for the market since the financial crisis has come from a reduction in shares due to buybacks. It also doesn’t support the assertion that firms are bypassing more profitable investment opportunities to buy back their shares. This article by Cliff Asness of
Separating Investing From Politics
We all have our own political views that we bring to the table. And it can be difficult not to evaluate everything we see in the world through that lens. But one of our goals with this blog is to try to check our personal views at the door and to evaluate things based on their merits for long-term investors. When looked at on that basis, buybacks have been a strong positive for investors. As I said before, not all buybacks are created equal and it is important to look at the details, but the evidence is very compelling that as a whole, firms that buy back their stock have generated solid long-term performance.
Copyright: Photo: 123rf.com / gopixa
