The Fallacy of the Share Repurchase
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.
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.
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.