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SockMarket (42.07)

The Fallacy of the Share Repurchase

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March 12, 2010 – Comments (22)

I get a kick out of it every time I hear a stock recommended because it is currently, or frequently does, repurchase stock. The argument for this is simple: “if they buy back shares (and take them out of circulation), there is still just as much company out there for fewer shares so naturally the shares become more valuable.”

Unfortunately this misses the broad picture. Lets look at 2 scenarios.

Share Repurchase
XYZ Inc. sells a duplicating service, they take little worthless slips of paper and multiply them, if they are successful, into even more worthless slips of paper. Oops, that’s a bank. Lets just say they sell toys. XYZ drags in $100 in net income. Being a share repurchaser they run out and spend that $100 to buy back some shares.

They were able to repurchase 5% of the company with this $100. We will assume that the stock sold for $10 a share before the repurchase so 10 of the 200 shares were repurchased. We will assume the stock is always priced at 10x EPS. So after the repurchase their EPS went from $1 to $1.053. The share price went from $10 to $10.53. BFD, your stock is up 5.2%.

Fine value is up now in the short term but that money is gone to outside (former) shareholders, the company cannot use it now.


Investment

ABC Corp. has the same profits, trades on the same basis (10x EPS), has the same number of shares outstanding, and those shares sell for $10 a share as well. ABC has good management so they decide to invest the money in something other than their own shares. They have two options:
1) If they have debt pay it down. Not only does this immediately improve the balance sheet but it will bring in added profits as well
2) If they don’t have #1 then they should invest the money. The general rule is that an investment should throw off enough earnings within a 10 year period to pay for itself, so to make math easy on me we will say that the company invests the money in something that earns 10% of the investment, $10, a year. This adds $0.05 to EPS. The company is now worth $10.5 per share, with added earnings potential. If the investment works out better than planned and EPS rise any more than the minimum for a good investment you just made money.
Further money spent in this way creates more future growth because total earnings, not just EPS. When you are raking in more money you can more easily finance further growth, so you are more likely to expand when the opportunity arises.

As can be expected the fund (PKW) that tracks companies making share repurchases of over 5% (hence the above figure) underperformed the market when times were good (from inception in late 2006 until the market crash in Oct 08) and slightly outperformed it when things turned ugly. (I chalk up the outperformance to the fact that only moderately healthy companies (or better) could afford to buy shares back so it inadvertently weeded out companies in major trouble).

Honestly I cannot understand why anyone would buy a stock because it is repurchasing shares, or even why they would consider it a positive thing. If I found out about a major share repurchase I might even consider selling. Hopefully I have swayed at least some of you.  

22 Comments – Post Your Own

#1) On March 12, 2010 at 8:02 PM, dragonLZ (99.43) wrote:

Honestly I cannot understand why anyone would buy a stock because it is repurchasing shares, or even why they would consider it a positive thing.

It's considered a positive thing as it shows company's confidence in its stock (management, product, sector, economy in general, etc.).

Stock repurchase also shows company considers its stock undervalued, meaning they expect a nice Return on their Investment (as there are so many other options out there where they can invest/put their money)...

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#2) On March 12, 2010 at 9:20 PM, SockMarket (42.07) wrote:

It's considered a positive thing as it shows company's confidence in its stock

Yes, but why? Do you see any concrete reason behind this? I don't

 

Stock repurchase also shows company considers its stock undervalued, meaning they expect a nice Return on their Investment

yes, but there are 3 reasons not to believe this:

1) it can be used as a propaganda tool to boost the price

2) companies frequently retire much of what they buy so there is no ROI on retired shares

3) even if companies are doing this to get a good ROI they generally aren't very good at predicting when to buy. 2nd paragraph from the bottom is good evidence of this

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#3) On March 12, 2010 at 10:34 PM, awallejr (79.51) wrote:

Another way to look at it is as being "anti-dilutive."  You in effect own more of the company with your same shares after a repurchase than before.  Personally I prefer them simply paying out dividends instead, but that is me.

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#4) On March 12, 2010 at 11:16 PM, Tastylunch (29.31) wrote:

Dwot conducted an interesting experiment about this on her player Dwotbuyback

all it really seems to do is magnify moves by reducing the float.

On the way it accelerates the stock price up and one the way down it does the same going down.

Woe unto the company that buys their stock at too high of a price.

that may be my least favorite thing about it, rarely does the company buy their stock at a good price. For every Cardiome, who looks they are buying low there is three to four National City's who bought at the height of the 2006-2007 bank/housing bubble.

Still it has its' place, somtimes a styock is badly undervalued and it can be useful as a tool to drive share price up above relevnat captial thresholds for the comapny (say like the ten dollar mark which allows mnay mutual funds to buy in) but it's not the slam dunk positive it's been made out to be.

given what we've seen over the past three years I'd rather have dividends instead.

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#5) On March 13, 2010 at 12:10 AM, SockMarket (42.07) wrote:

awall,

eh, anti dilutive could just mean holding the share count steady, you don't have to buy a whole bunch back to prove your not diluting it. 

I personally prefer dividends because I can turn around and use the money to get a return. the CO who makes the purchase can't

 

TL,

interesting, I think dwot was probably right. Do you happen to have a link?

agreed on the rest of what you said. I never really thought that they could use it to pump the stock but I suppose that would certainly be one worthwhile reason to do it. and I would tend to agree with you on the dividends.

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#6) On March 13, 2010 at 12:17 AM, vgaymer (< 20) wrote:

So after the repurchase their EPS went from $1 to $1.053. The share price went from $10 to $10.53.

 

and this is no guarantee.  I dislike share repurchases for the same reason I dislike non-dividend (or at least those who have shown no potential  or  promise of dividends)  stocks:  the market can be irrational.  The market doesn't necessarily recognize this increased "value".

 

G

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#7) On March 13, 2010 at 1:28 PM, kkotwani (99.62) wrote:

MIR is one example of company who recently did major share repurchase but their stock price continued coming down. Most of the shareholders are frustrated because company could have distributed dividends. Right now I find this company extremely undervalued and worth buying. But that is something not the topic of this discussion.

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#8) On March 13, 2010 at 4:12 PM, Tastylunch (29.31) wrote:

Her player profile

http://caps.fool.com/player/dwotbuyback.aspx?source=iersitlnk0000002

a post on it, when it was "Winning"

http://caps.fool.com/Blogs/ViewPost.aspx?source=isesitlnk0000001&bpid=103843&mrr=1.00

given its' performance I'd say it so far exemplifies my magnification explantion

http://caps.fool.com/Blogs/ViewPost.aspx?source=isesitlnk0000001&bpid=103843&mrr=1.00

in 2008 it  killed, in 2009 it got killed

2010?

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#9) On March 13, 2010 at 5:14 PM, TMFBabo (100.00) wrote:

My perfect company would buy back shares at lows and issue shares at highs.  Every company is undervalued and overvalued at different times, so I believe share buybacks and issuances at strategic times should be an integral part of any management team's philosophy.

I've actually seen that many companies seem to do this backwards.  I'm sure that ridiculous executive stock options play a huge part.  

In a nutshell, I don't put much stock into share repurchases.  I do, however, watch the dilution.

If I see a rare case of a company issuing shares at highs and buying them back at lows (in addition to good numbers), I will be doing serious due diligence for a possible purchase. Report this comment
#10) On March 13, 2010 at 5:29 PM, trollsoft (< 20) wrote:

I think taxes could provide a huge reason.  In the days when dividends were taxed at ordinary income levels, but capital gains had preferred rates, a buyback yields more value by increasing the stock price which can be sold for cap gains... instead or ordinary income dividends.  Currently, at least for 2010, dividends vs. rebuy seem irrelevant.

(also, consider that they are the same.  If you have 11 shares, and after a rebuy, 10 shares represent the same equity in the company as 11 shares used to, then sell one, thereby issuing yourself your own dividend.)

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#11) On March 13, 2010 at 6:43 PM, truthisntstupid (92.28) wrote:

How often are shares actually retired?  And how often do they simply take a convoluted route from the market through the treasury stock account to stock options/grants for senior executives, never being actually removed from the float at all?  Shares reissued to executives and others with stock options/grants as part of their compensation package are not a return of capital to shareholders at all.  They are not removed from the float. 

PEP is one of my companies.  I like PEP and consider it a well-run company.  But between 2003 and 2007 PEP spent $10.298B on share buybacks.  Share count was reduced from 1.705B in 2003 to 1.605B in 2007.  So  am I to believe that  $10.298B only purchased 100M shares?  Because the numbers say this comes to $102.98  a share.  The record says that during that entire period PEP never went anywhere near $100 a share. 

What did shareholders get out of this?  Nothing.  Because, I believe, most of the time share buybacks are simply a mechanism facilitating the transfer of shares from the market to dilutive stock options/grants for executives and board members with a short stopover in the treasury stock account.  When your companies do a buyback, check the numbers.  See what's really happening.

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#12) On March 14, 2010 at 9:22 PM, walt373 (99.83) wrote:

I view stock buybacks as the equivalent of a reinvested dividend. Instead of the company paying you a dividend which you then use to buy more of its stock, the company buys the stock for you. Since you technically own the company, which owns the stock, either way you get more of the stock. So I view buybacks positively when I would use a dividend to purchase more shares anyways, since it's more tax-efficient, and negatively when I see shares as fully-priced.

I think lumping the issue of management compensation with the share buyback issue doesn't really make a lot of sense. It's quite easy to find out how much of each the company is doing, so the argument that share repurchases are "covering up" excessive compensation is weak in my opinion. If the shares are undervalued, then buying back stock is wise. If the management gets paid too much, then that's unfair for shareholders. The two often happen together, but you can have one without the other, so they should be considered independently.

One interesting thing that stock buybacks do, that does not get talked about as much as it should, is that it increases leverage for the company. When the company uses cash to buy back stock, the company's equity decreases, while liabilities stay the same. So it's important to also look at whether keeping that cash on hand would be wiser because you might need it for a rainy day, and not just whether the shares are cheap.

Another effect a stock buyback has is that it basically increases the percentage that a stock has in your portfolio, same as a dividend repurchase plan would, as compared to a normal dividend. For example, say you have two stocks that are exactly the same except one pays a dividend (stock A) and the other buys back stock with the same amount of money (stock B). When you receive dividends, you use that cash to buy other stocks, which lowers the % of your portfolio that stock A makes up. But since stock B will have provided no dividends, it would make up a larger % of your portfolio than if you had stock A instead. The effect will be very small at first, but if you plan to hold a stock over a long time, this will have a huge effect on your allocation strategy. Because of this, a stock that does buybacks should take up a smaller percentage of your portfolio than it would if it paid a dividend.

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#13) On March 14, 2010 at 10:27 PM, SockMarket (42.07) wrote:

all,

unfortunatly my eyes were recently injured and I can't read/write much (ill be better in a week or 2) so thanks for your comments all. 

just quickly

"I view stock buybacks as the equivalent of a reinvested dividend. Instead of the company paying you a dividend which you then use to buy more of its stock, the company buys the stock for you. Since you technically own the company, which owns the stock,"

1) the co may or may not make a good choice as to what to do with the dividend. you usually can so there is an added risk, unless of course you have complete and total faith in the management

2) since you are not getting the $ in reinvested divs you are not compounding your wealth...

if there is still activity when i get better ill do a more thurough job of explaining my position

 

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#14) On March 14, 2010 at 10:34 PM, Tastylunch (29.31) wrote:

oh man 

I hope you are going to be alright Daniel

best wishes on what I hope is a speedy and complete recovery

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#15) On March 15, 2010 at 2:01 AM, walt373 (99.83) wrote:

1) the co may or may not make a good choice as to what to do with the dividend. you usually can so there is an added risk, unless of course you have complete and total faith in the management

I agree. But when you use a DRIP, you are basically doing the same thing as if the company continually bought back shares, since you reinvest without looking at the stock price.

2) since you are not getting the $ in reinvested divs you are not compounding your wealth...

This isn't true. When the company buys back its own stock, its compounding wealth its wealth, and since you own the company, your wealth is also compounded. I think it's helpful to think about it as if you were the only stockholder. Whether you own the stock or the company owns, it is actually the same thing.

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#16) On March 15, 2010 at 2:02 AM, walt373 (99.83) wrote:

And I hope your eye is ok :0

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#17) On March 15, 2010 at 12:23 PM, cashkid79 (94.52) wrote:

Interesting blog I just skimmed over but want to add something...just have a tight schedule at the moment - but I do hope your eye(s) are alright and set for a full recovery - always pleasure to read/debate topics of interest with you! ...and I'll add my .02 this evening here...

cashkid79

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#18) On March 15, 2010 at 12:42 PM, dargus (79.08) wrote:

Why is the capital expenditure seen as superior? You set up a scenario that makes buy backs look bad by comparison, but it wasn’t a fair example. You assume the capital expenditure returns 10% a year. I don’t see a capital expenditure as being any less risky than a repurchase, and perhaps even more so. What if you decided to spend the money on something that is a total flop? I’d much prefer a repurchase to this scenario. It also depends on the company itself. If it is a well established large cap, perhaps there aren’t many high return capital expenditures to make.

 

I agree with the essence of what you are saying, but it isn’t a fair assessment. Sometimes repurchases can make sense. I like dividends more, but repurchases don’t make me nervous unless I have reason to believe a stock is overvalued.

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#19) On March 17, 2010 at 11:09 AM, chk999 (99.97) wrote:

The critical question is "is the company repurchasing shares at a price well below the intrinsic value of the company?". If it is, then the share repurchase helps the remaining stock holders. If it buys them above the intrinsic value then it hurts the stockholders.

The problem is that most companies buy their own shares when the shares are high priced and are too afraid to buy shares when they are low priced. Thus most share repurchases actually hurt the company.

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#20) On March 21, 2010 at 7:01 PM, SockMarket (42.07) wrote:

all,

my eyes are better (mostly) and so ill respond to several posts on here since I was last on.

 

gus,

You assume the capital expenditure returns 10% a year. I don’t see a capital expenditure as being any less risky than a repurchase

the 10% rule is pretty common. usually you have a better idea of how additions to your capacity (and the like) will play out than you do stock purchases.

 

It also depends on the company itself. If it is a well established large cap, perhaps there aren’t many high return capital expenditures to make.

true, to some extent, but look at GE and MCD, they have managed to do this rather effectivly. Generally a competent management can find new avenues to expand their business.

 

walt,

thanks for the well wishes! I should be all better in a couple weeks.

 

When the company buys back its own stock, its compounding wealth its wealth, and since you own the company, your wealth is also compounded. I think it's helpful to think about it as if you were the only stockholder. Whether you own the stock or the company owns, it is actually the same thing.

I see what you are saying but differ for 2 reasons: 1) it isn't your money, it is the corporation's. Granted you technically own the company (at least a piece of it) but they have control of the funds invested in the stock before (if ever) they are passed on to you so you cannot be sure of what they will do with them. 2) some of the shares that are repurchased are retired, this money is not reinvested. 

Also with DRIP you get an effective dollar cost average into the stock, which, as Graham proved, generally do better than single stock purchases. 

 

I would tend to agree with TL (thanks for the well wishes!), Dwot that it is not such a good thing and does no good. BBabo, chk, and troll have excellent points too.

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#21) On May 16, 2010 at 2:58 AM, megalong (< 20) wrote:

It all comes down to the expected ROI.  I would guess 70% of companies with a P/E of 20 (as in your example) have an expected ROI over 5% in which case it is better to reinvest within the business, but 30% have an ROI under 5% in which case it would be better to buy back shares or distribute a dividend.

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#22) On May 16, 2010 at 12:02 PM, megalong (< 20) wrote:

Wow, it looks like my guess was good.  I used the FT.com screener to search for US companies with market caps over 100M and PE's from 19 to 21.

Total Companies: 166
Trailing ROI over 5: 113 (68%)
5 Year ROI over 5: 102 (61%)

The data is similar for non-US companies, or for using PEs of 19-20 or 20-21 instead of the larger sample. The companies with lower ROIs include Honda, American Express, Macy's, MetroPCS, and US Cellular. Companies with expected ROIs less than their earnings yield should be returning more to shareholders and reinvesting less in their business.

That said, in practice I am rarely a fan of share repurchases. I like dividends but am not hung up on dividends. I treat them as one indication of management's serious commitment to creating shareholder value. Which can also be found in many companies without dividends - Berkshire Hathaway for example.

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