When your client holds stock, and the company announces it wants to buy it back, your client may not know how to react. Should she take the offer? And why did the company do this in the first place?
David Goodridge, vice-president and portfolio manager at 3Macs in Montreal, says to tell clients a company is “not very different from a regular investor.” Your client wants to buy low and sell high to create value in her account. Likewise, a company uses a buyback (buys low) or issues stock (sells high) to create value.
Expect positive returns…
In the case of a share buyback, says Goodridge, the company knows it has undervalued stock, and so uses the buyback to buy low. When the stock price rises, as is expected with an undervalued stock, value is created for shareholders.
So when a buyback is announced by a company that has sound fundamentals, tell your client to hold on to her stock instead of selling it back.
Although many factors affect price, Goodridge says share buybacks can result in stock out-performance over time.
Alexander Dyck, professor of finance and business economics at the University of Toronto’s Rotman School of Management, concurs. He says companies tend to experience positive returns both on the day a buyback is announced and over the longer term. “Studies in the U.S. found a 30% abnormal return over the ensuing three to four years,” says Dyck. And in the European Corporate Governance Institute’s financial working paper “Buybacks Around the World,” published in August 2014, “they came up with a number between […] 25% and 44% over the ensuing four years,” says Dyck.
…But look under the hood
But Dennis Starritt, principal at Bluewater Investment Management in Toronto, is cautious about share buybacks. “What I don’t like about share buybacks is when they’re opportunistic,” he says, meaning “when stock is cheap relative to history.” His concern is that a buyback could mask a company’s true fundamentals.
And it can. For example, the reduced number of shares in the market results in an increase in earnings per share (EPS), “even if [earnings] are flat or down in some cases,” says Goodridge, citing the example of IBM.
From 2011 to 2014, IBM’s revenue fell from $107 billion to about $93 billion. During this time, IBM bought back tens of billions of dollars worth of shares despite declining fundamentals, including revenue. But EPS grew each year, from $13.06 in 2011 to $15.59 in 2014.
And, during those years, the stock under-performed the S&P.
“Make sure cash flow is growing, make sure revenue is growing, make sure the firm is actually growing. […] Then you can make the case they’re undervalued,” says Goodridge. “Buybacks are the icing while good fundamentals are the cake. Finding companies with both yields the best results over time.”
And an overvalued stock, which Goodridge says IBM was, will usually be shown on the market for what it is: a poor performer.
Dyck dismisses the claim that executives primarily use share buybacks to boost their compensation. Although this idea has been particularly common since the financial crisis, he says there’s no basis in the research for such a perception.
To get a true sense of valuation, Starritt says his firm performs discounted cash flow analysis, which uses myriad factors—long-term analysis of revenue, expense patterns, profitability—to estimate a company’s future cash flow in today’s dollars. From that, the company’s current value is ascertained. Stock trading below this estimated value is a reasonable purchase, says Starritt. He says companies should perform this analysis to ensure they have an undervalued stock before considering a buyback.
Behind the buyback decision
Beyond having undervalued stock, two things drive companies to repurchase shares: excess cash reserves and diminished investment opportunities.
However, Starritt says a lack of investment opportunities doesn’t make a buyback the default solution. “First choice of capital allocation is to invest in the company and in its future growth. The second choice would be sensible acquisitions, and the third choice would be return of capital to the shareholders. […] The companies I admire the most have better options with their allocation of capital than buying back their own stock.”
But if there are diminished investment opportunities in the market, as has been the case for many companies in the last few years, Dyck says returning value to shareholders, either through dividends or a share buyback, is the best thing to do with cash on hand.
Apple is an example. The company sits on hundreds of billions of dollars in cash reserves. “They’re massively investing in research and development at Apple, but they’re still bringing in way more cash than they can [direct toward] reasonable investment opportunities. […] At some point, they’re sitting on way too much cash,” says Dyck, which can cause management to become complacent. “At some point you’re better off giving that money to shareholders.” Apple did just that, with $56 billion in share buybacks in 2014.
Goodridge points out a company could use extra cash for R&D, but says such initiatives take longer to bear fruit, if they do at all. With above-average growth behind them, mature companies get a more immediate benefit from using at least a portion of their extra cash to buy back shares. Newer companies, however, are best served by expanding the business with R&D. “A buyback is only good for that next quarter or that next year, particularly if earnings are flat,” he says. Successful R&D “could impact growth for quarters and years to come.”
Types of buybacks
There are two main types of buybacks:
- Tender offer: A specific number of shares is bought either at a fixed price or by Dutch auction over a given period, usually several months. In the latter, the company gives a price range for the stock, and shareholders willing to sell offer a price in that range. The company pays the lowest price to achieve the number of shares announced in the buyback. (All shareholders who sell receive this price, even those who asked for less.)
- Open market: The company buys back shares on the market, which potentially gives the company greater price flexibility. This type tends to be more common.
Dyck says both types have positive market results, with negligible differences. Regulations are what make the difference, and vary by country. In Canada, for example, only board approval is required for a share buyback.
In other countries, such as Japan, both the board and the shareholders must approve a buyback. In those cases, evidence shows announcement returns are cut in half because timing the market becomes more difficult.
Starritt says he prefers a steady stream of dividends to share buybacks. He admits it may simply be personal preference, but as a long-term investor he sees more meaning in dividends, and prefers not to rely on short-term market performance. A client who requires income from her portfolio may be similarly inclined.
If a buyback causes share prices to rise, however, that creates a tax advantage over receiving dividends because only 50% of capital gains are taxed. (The advantage is theoretical, says Starritt, because shares held are subject to market forces, and cash-in-pocket from dividends isn’t.) Buybacks also allow tax deferral for clients who hold on to their shares, since your client doesn’t pay tax on any capital gain until she sells later.
When it comes to share buybacks, motivation is key. Why does a firm decide to buy back its shares?
|The Good||The Bad|
|To create shareholder value by purchasing undervalued stock||To boost the price of a failing stock|
|To use excess cash wisely when investment options are scarce||To improve ratios (EPS, ROE, ROA)|
To ascertain a firm’s motives, you must understand its financial statements.
by Michelle Schriver, assistant editor of Advisor Group.