This should be short. Let me start with some facts.
- Buybacks are preferred on a taxation basis to dividends.
- But buybacks are especially good when the stock is trading below its franchise value, and especially bad the further above franchise value the stock is trading.
- Using slack capital to improve operations, or do little tuck-in acquisitions is probably best of all. Organic growth is usually the best growth, and small acquisitions can facilitate that. Small acquisitions are usually not expensive. Be wary of acquisitions to increase scale, they don’t work so well.
- Paying a dividend makes management teams more cognizant of the cost of equity capital, which makes them more effective.
- In the reinsurance business in Bermuda, companies with slack capital tend to buy back shares below 1.3x book value, and issue special dividends if they are above that level.
Franchise value is management’s best estimate of the value per share of the company’s equity. If a management team does not have a firm handle on the value of the company, it has no business buying back stock. Stock should never be bought back over franchise value. If you want to reward shareholders then, issue a special dividend.
I am reminded of how in 2000 the CFO of The St. Paul cleverly bought back shares in the 20s, wisely bought back shares in the 30s, stupidly bought back shares in the 40s, and foolishly bought back shares in the 50s. He was a Johnny One Note, except that he impaired the balance sheet so badly that he became the one of the main causes of why The St. Paul sold out to The Travelers. Price matters with buybacks.
The reinsurance industry is a good example, because well-run reinsurers are simple companies. The book of business is worth book value. The reserves are conservative, which is worth ~0.1x book value or so. Future underwriting profits are worth ~0.2x book value of so.
So the reinsurers have their standard — the companies are worth around 1.3x book value. That gives them a discipline for capital — buying back at under 1.3x book, and issuing special dividends above that.
It is my opinion that most buybacks are a waste, even with the tax advantages, given that the buybacks occur at prices over franchise value, sometimes significantly over. It’s also my opinion that a 2% dividend makes management teams think harder about their shareholders, which is a good thing.
If you get to talk to a management team doing buybacks, ask them if they have a model for what their stock should be worth. If they don’t have one, tell them they should not be doing buybacks, unless they are buying back the stock cheaply. Above franchise value, buybacks are a value destroyer.
By David Merkel, CFA of Aleph Blog
