August 4, 2015
by Michael Lebowitz
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Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
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“To arrive at a contradiction is to confess an error in one’s thinking; to maintain a contradiction is to abdicate one’s mind and to evict oneself from the realm of reality” – Ayn Rand
The positive short-term price advances from buybacks lures unsuspecting investors with the promise that such a shell game is sustainable. Many on Wall Street support such activities as they promote rising stock prices, ultimately bolstering their wallets. However, clear-headed reason shows that unless one is an executive whose compensation is tied to metrics influenced by the effects of share buybacks, there are few instances that support this use of corporate resources. Indeed, shrewd investors can profit at the expense of companies that have aggressively bought back shares.
Those who promote buybacks base their support on the fact that fewer shares outstanding, a by-product of the share repurchases, produces more earnings per share (EPS) as the numerator in the EPS equation is unchanged while the denominator is smaller. A previous article, “Corporate Buybacks; Connecting Dots to the F-word,” showed that most investors fail to consider the use of assets required to execute the buyback and the current valuation of those companies. Even more worrisome, they fail to fully understand the implications of spending corporate capital to repurchase (often expensive) shares instead of investing it in the future growth of companies.
The obscured shortcomings of share repurchases highlight a blatant contradiction. Share repurchases boost EPS, making valuations appear cheaper, but they reduce the ability of companies to grow future earnings. Recognition of this circumstance presents significant opportunities for those willing to embrace the “realm of reality.”
This article uses logic and mathematical analysis to demonstrate the serious price distortions share buybacks are creating and offers specific trade recommendations to capitalize on those distortions.
Buybacks distort financial ratios that many investors rely on to evaluate stock prices. This is most evident in the widely used price to earnings ratio (P/E). This straightforward ratio divides the price per share of a company by its earnings per share. The resulting multiple tells an investor the price one must pay for each dollar of earnings. Investors calculating P/E can use a wide variety of historic, current or estimated future data for the denominator, earnings per share. On the other hand, the numerator, price, is a known number – the current equity price of the company in question. Therefore, when using P/E as a valuation technique, the validity of the earnings per share input must be given careful consideration.
Stock buybacks distort EPS data and produce lower P/E ratios, thus making the shares ostensibly cheaper. As an example, consider a company with a $20 price per share, $1 EPS and plans to buyback half of its outstanding shares. Upon completion of the buyback, the company’s P/E will drop from 20 to 10 as the price remains at $20, but EPS will double to $2, due to the reduced share count. This P/E distortion (an investor now only needs $10 to claim $1 of earnings instead of $20 prior to the buyback) will lead investors to conclude that the equity is cheap. However, those investors have failed to consider the use of cash to purchase the stock and the now impaired ability of the company to fund and produce future growth.
This analysis considers publicly traded companies listed on U.S. stock exchanges with a market capitalization greater than $5 billion. To quantify the distortions to P/E created by share repurchases, a buyback “adjusted” P/E is calculated. This adjusted P/E ratio normalizes EPS, the denominator, by assuming no shares were repurchased since 2011. Normalizing EPS in this way reduces the denominator and therefore increases the P/E ratio. Comparing the current P/E to the adjusted P/E gives one some sense of just how much buybacks have been distorting values. To illustrate, the adjusted P/E of the company used in the example above would be 20 instead of the post buyback P/E of 10. The distortion of P/E highlights how buybacks lead investors to misinterpret value and then misallocate investment capital.
Of the over 600 companies analyzed, including 99 which did not conduct buybacks, the average adjusted P/E was 3.99 higher than the average, non-adjusted P/E. Based on the trailing 12 month S&P 500 P/E of 18.25 currently present in the market, investors are unknowingly invested in an adjusted market P/E that is over 20% higher than they assumed. Buyback distortions are larger than ever and not limited to any one industry grouping. The table below shows the average distortion to P/E by industry.
Data Courtesy Bloomberg, 720Global
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