As with almost everything in finance, the answer is that it depends. Buybacks have been receiving a lot of criticism lately in the financial media. The most common complaint I here is that companies are only growing earnings per share year-over-year because they’re reducing the outstanding number of shares and not making investments in the business to expand, grow and hire more workers. They say this isn’t “real” growth, it’s “financial engineering.”
This is a very generalized statement and the complaint largely comes from people who are upset about companies not hiring more people or raising wages, which almost always contains some sort of political tilt. To that I ask, why is the nation’s unemployment rate one specific company’s responsibility? Answer: it’s not. Companies are free to do what they want with their money and have a responsibility to shareholders to do what they feel is best. If they think it’s wise to expand the business, they will. Or, if they think doing so right now might impose a large risk of losing money due to market uncertainties, why would they make the investment?
The debate regarding stock buybacks should largely be focused on where the money a company is using to buyback stock is coming from. Many companies are taking out long-term debt because interest rates are so low and using a lot of the proceeds buyback stock. This actually has the effect of double leveraging and can be very foolish if a company is already levered with debt or if the business model is cyclical. I’m not a fan of doing this unless the stock is trading so low it offers an extremely compelling value or if the company had little to no debt to begin with (as was the case with Apple over the last year). I’ve actually sold a couple of companies that I felt are now over-indebted but still buying back stock (one being Dow Chemical).
Other companies run their operations so efficiently that they produce a ton of free cash flow (FCF) each year. Free cash flow is the amount of cash that comes in from business operations less the cost to maintain the business (FCF = Cash Flow from Operations minus Capital Expenditures). I have absolutely no problem with a company repurchasing stock every year if they have a solid business model that generates recurring free cash flow. This is like a person that lives within their means and has extra money left over each month after putting money away in savings and paying bills. I never like to see a company overpay when buying back stock, but I’m much more lenient when using FCF for repurchases.
O’Reilly Automotive (ORLY) is one of our core growth holdings and offers a great example. Over the past 5 years, they’ve opened about 200 new stores per year, made investments to maintain their existing stores which has led to same-store sales growth each year, and still generated over $3.3 billion of free cash flow! They’ve used basically all of the FCF to buyback stock. In total, they’re growing revenue and cash flow, and have also reduced the share count by 25% leading to a tripling of FCF/share. By the way, the only thing that matters for stock investors are metrics on a per-share basis. Companies that only report dollar amounts (i.e. “revenues increase 4% to $4.6 billion this year…”) are only telling part of the story. This is usually an indication that they’re trying to make things look more impressive than they actually are. Beware…
In terms of “returning value to shareholders,” another popular term these days which typically means either paying dividends or buying back stock, I greatly prefer stock buybacks – especially if I’m investing in the company with the goal of growth. Stock buybacks are far more tax-efficient since it avoids the issue of double taxation (companies pay taxes on earnings and then pay dividends to shareholders which then have to pay taxes on dividends earned). This is why Warren Buffett will buy back stock of Berkshire Hathaway if the price is right but doesn’t pay dividends.
One final note on share buybacks – most companies have an absolutely terrible track record of buying back stock, to the point that it can be used as a contrarian indicator that stocks are richly valued. This usually happens because management is only thinking about short-term incentives and forgetting that the economy is cyclical. Profits are usually highest at the peak of the cycle and in order to keep the growth in year-over-year numbers going, companies will look to use the extra cash to buy back stock because they see business conditions slowing. If only they would have the patience to save for a rainy day they almost always have the opportunity to repurchase shares at much lower valuations. Here’s a recent piece from FactSet detailing buybacks from S&P 500 companies. Notice the correlation between the amount of share repurchases and the level of the S&P 500 index.
Hopefully you can see now that every situation is different. Whether or not it makes sense for a company to buy back stock is based on numerous factors, including the industry in which they operate, the sustainability of their business model, amount of indebtedness, source of funds and the valuation they’re paying to buy back their own stock. Stock buybacks are a key component of a company’s capital allocation policies and is something I pay very close attention to when looking for growth oriented investments. If done properly, it can lead to significant outperformance because it creates a compounding effect.
Thanks for following!
-Nick
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