As if on cue, news of record buyback authorizations earlier this year unleashed a torrent of media coverage denouncing them as nothing more than an accounting sleight of hand. We think the reaction has been pretty extreme.
Corporate America’s great cash givebacks—totaling $2.1 trillion in stock repurchases and $1.6 billion in (largely reinvested) dividend payments since 2009—have been major drivers of postcrisis stock gains and are likely to prop up prices this year too (Display 1). With valuations at above-average levels and S&P 500 earnings likely to decline this year, nervous investors appear to be pinning their anxieties on anything they can. But companies need to deploy their excess cash productively. So, what investors should be considering is whether buying back stock is a good use of a company’s capital compared with other options for that capital.
How Does a Buyback Work?
Let’s first analyze exactly how a buyback works. A company takes cash and buys its own shares. This reduces cash balances and equity. It can also reduce income by the amount that was earned in interest on the cash spent on the buyback (almost nothing today). But, all else being equal, the buyback also reduces the share count, which increases earnings per share (EPS) and reduces book value per share. Nothing tricky there.
[drizzle]Critics call buybacks a trick because they don’t raise the dollar amount of profits, just profits per share. Mathematically, a share repurchase is about the same as investing cash at a rate of the inverse of the P/E (say 10% for a company trading at 10 times earnings)—an act that would grow earnings. But if you value the company as a multiple of EPS, it does not matter which you choose. And, as a shareholder, you should definitely care far, far more about EPS than about the size of the total pool of earnings.
Finding Uses for Surplus Capital
The decision to repurchase shares is a capital allocation decision, not an accounting trick. Managements that repurchase stock are looking at the panorama of possible investment opportunities, adjusting for risk and then investing, either in their own companies or in other companies or new projects. Today, when returns are hard to come by, and P/E multiples and free-cash-flow yields look attractive in comparison, it’s no wonder that share repurchases—and to some extent acquisitions—look relatively appealing.
The real problem with stock buybacks lies in the fact that managements are not always great allocators of capital. Historically, they’ve tended to ramp up buybacks in bull markets, when stocks are most expensive, and to reduce them in bear markets, when shares sell at bargain prices. And, as is the case with any investment, shares repurchases financed with debt can only make a bad situation worse if the economy or business sours.
Some observers dislike buybacks because they suggest that managements have nothing better to do with the cash and are shortchanging long-term growth. That may be true, but it’s not the buyback decision that sidelined those better options; it’s the fact that the investment landscape is barren. And, as painful as that news may be—especially if the company is richly valued—it’s better for each shareholder to have a larger portion of the pie, enlarged through buybacks, than would otherwise be the case.
The important question here is what’s the best use of that capital today? Is a stock repurchase a worse option than making an acquisition at all-time highs or to paying down the debt it just refinanced at record-low interest rates? Probably not. The flexibility of buybacks also makes them a better choice than a dividend increase if the company is in a highly cyclical business.
In the end, the success of buybacks, like any investment decision, depends largely on the price paid. That’s why it’s important to consider the valuation of a company when assessing the quality of its buyback decisions. Companies that execute share repurchases, and that are attractively valued, deliver much better returns on average (Display 2).
All of which is why we prefer investing in cheap companies that are also buying back their stocks, since that combination raises the odds of success. Furthermore, for most companies, buybacks are a lower risk investment than many alternatives. Managements are human and full of human biases. But at least they are likely to know more about their own current business than about future investments.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Joseph G. Paul is the Chief Investment Officer of US Value Equities at AllianceBernstein.