by Cydney Posner
Lots of companies have been buying back their stock recently, either on their own initiative because, for example, management thinks the shares are undervalued, or at the urging, or sometimes insistence, of euphemistically termed “stockholder activists” to increase the market price of the shares. According to this article from CFO.com, in “the first quarter of 2014, S&P 500 companies repurchased an estimated $159.3 billion of their own shares, although the final numbers aren’t in. That’s after laying out $130 billion for share repurchases in the final quarter of 2013.” While no one suggests that a stock buyback will have the same beneficial impact on stock price as discovery of a cure for cancer (or even a cure for restless leg syndrome), they are expected to have a beneficial impact on the stock price. The article suggests, however, that “buybacks aren’t delivering the same pop to the stock price that they formerly did. So far this year, the performance of the S&P 500 Buyback Index, which tracks 100 stocks with the highest buyback ratios, is lagging the return of the overall S&P 500 by almost one percentage point, after beating it by 10 percentage points in 2013.” Now, the article contends, to “earn a ‘return’ on stock buybacks, [companies] need a more sophisticated message and better execution.” Companies need to be able to articulate how a buyback will not only increase the stock price but also how it will create value. Moreover, companies need to “reassess the execution of their repurchase programs and find out whether they are truly maximizing the bang from their buyback bucks.”
Having abundant cash is not usually viewed as a problem. But, according to the article, when interest rates are low, there may be relatively few good opportunities to put the cash to productive use. For example, according to one commentator, acquisitions “are expensive in the current market…. Investing in organic growth, especially in mature North American markets, in many cases won’t provide enough return for the risk…. And paying a dividend to shareholders, another use of cash with some benefit, has downside for the investor: a substantial tax bill.” In the absence of promising alternatives, cash may continue to accumulate: “[t]he top 1% of cash holders in Corporate America increased their cash and short-term investments by 11%, or $50 billion, during 2013, according to Standard & Poor’s.”
As discussed in the CFO.com article, one alternative that many companies explore is stock buybacks, which, if properly executed, “can bring a good relative return compared with other investments, and do it relatively swiftly. They also make excess cash less of a drag on a company’s return on capital, and help eliminate the rising tension that can be created between shareholders and executive management as cash builds. ‘When there is a big buildup of cash on the balance sheet, there is a very strong tendency for investors to get paranoid that management will use it for acquisitions that do not create value,’ “ commented one CFO. If successful, buybacks can indirectly reward shareholders without creating ordinary income tax liability as dividends would. An academic also argues that buybacks can be used to readjust the capital structure, whether through a buyback only or through issuance of debt in conjunction with a buyback, to achieve a more optimal capital mix of 30% debt and 70% equity, especially where equity may have increased to high levels in the current environment of higher stock prices. In contrast to the 1980s, when companies issued stock to buy back debt that bore high interest rates, today, low interest rates allow companies to add more leverage to bring the capital structure within long-term norms.
Nevertheless, a buyback will not be beneficial if it is poorly executed, and, according to the article, many of them are: “[m]uch research has shown that companies do what naïve investors often do: buy when share prices are high, not low. A 2012 study by researchers at the University of Kentucky found ‘strong evidence that stock prices are higher and valuation ratios … are lower during repurchasing quarters relative to non-repurchasing quarters.’” The study concluded that, on average, companies buy when they should not. As reported in the article, McKinsey has conducted similar studies to the same end: “[c]ompanies buy back more shares when earnings and share prices are lofty. In the current market, with stock indices near all-time peaks, data from S&P Capital IQ shows that nearly 100 U.S. companies announced buyback programs worth $300 million or more in the last 12 months. In contrast, when market prices are low relative to intrinsic valuations, companies withdraw. During 2009, when the S&P 500 Index fell below 700, only 53 share buybacks of $300 million or more were announced. It’s almost to be expected: When companies are doing well they tend to have more cash to deploy, and they arrive at [the buyback] choice for capital allocation more often. No wonder the returns on many share buyback programs are poor.”
In some instances, poor execution can be the result of pure internal optimism – “some management teams may always think the company’s shares are undervalued.” To eliminate this potential bias, some companies regularly examine a range of valuation methodologies “to justify continued share repurchase activities.” Describing the company’s quarterly analysis, one CFO said that every quarter, they “look at things like multiples on EBITDA, multiples on cash flow, multiples on earnings…We look at discounted cash flow, we look at what the market is saying we should be priced at, and what the research community says we should be priced at. It gives our board and management a good compass.’” Another CFO cited in the article “develops a benchmark using the 25th percentile of analysts’ 12-month price outlooks. ‘We typically buy below the 25th percentile of the 12-month outlook’…. The company’s traders are assigned different share-pricing bands. If the shares are within a certain pricing band [the company] might buy back 5% of what it’s eligible to buy back in a day. At a lower pricing band it might push purchases to 10% or 15% of eligible volume. ‘When you get above 15% of a day’s volume you start running the risk that you’re actually moving the stock price,’ [according to the CFO]. Having traders watching the market every day, [the company] can take advantage of overreactions to macroeconomic events that get reflected in its share price.” The article concludes that the system appears to be effective, looking at the average repurchase price relative to the stock price levels. One commentator suggests that smaller companies might find “accelerated share repurchase” agreements to be effective: “[u]nder an ASR, a company buys back shares immediately from an investment bank (ideally when the price is low). The bank borrows the shares it sells to the company, and then purchases shares over time in the open market to settle its borrowings.”
Of course, one problem with “buy low” strategies is the difficulty of predicting or timing the market. The answer to that mystery might lie in dollar-cost averaging. In an academic study, researchers found that “among the companies studied, the average annualized rate of return earned on repurchased stock was 7.66%. But had the same firms smoothed repurchase spending evenly across time — using the corporate equivalent of a dollar-cost-averaging investment strategy — the average return would have been 9.64 percent.” One commentator argued that ‘buyback programs perform best when they ‘distribute a consistent sum of cash every quarter.’ That leads to more shares purchased when the price is low and fewer when the price is high. [The commentator] acknowledges that such a system ‘may be hard to stomach in a financial crisis, and attract activist investors who abhor rising cash balances during good times.’” The same commentator offered the following tips:
“ • Don’t set thresholds for organic investment too high, as this will lead to less organic investment and more share repurchases.
- Don’t overestimate the benefits financially engineered EPS growth will have on the share price.
- Don’t allow internal optimism to exaggerate the potential gap between the company’s market price and its intrinsic value.roach that rewards financially engineered EPS growth.
- Don’t use an incentive-compensation measurement approach that rewards financially engineered EPS growth.”
In any case, companies undertaking buybacks are cautioned to recognize the limitations on what buybacks can achieve: ultimately, the commentator notes, “’the market sees through this engineered EPS growth and typically drives down the price-earnings multiple for companies that rely heavily on buybacks.’ Companies ought to get better at communicating and executing share buybacks, but they shouldn’t go overboard and begin to believe buybacks are the optimal way to deploy capital.”