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Monday, 30 November 2009

Buyback Brouhaha

Optionally Not Good

Share buybacks tend to divide investors between those who love them and those who positively abhor them. The latter tend to come with the view that finding and holding stocks that offer outstanding long-term returns is hard enough without managements surrendering that value in order to artificially boost stock prices.

It turns out that company managements are generally very keen on stock buybacks because they’re linked rather closely to executive remuneration schemes and, in particular, the scourge of all investors everywhere – executive stock options. Nearly everywhere you find significant buybacks you also find large scale stock option schemes and as managements take away from shareholders with one hand they reward themselves with the other. Nice work if you can get it.

The Logic of Share Repurchases

Share buybacks or repurchases occur when a company either goes into the market to buy its own stock or tenders for it, off market. The shares are taken out of circulation and the earnings-per-share of the company goes up – same earnings, less shares. As a shareholder you might well think that this is a good deal – and it may be, but it isn’t always. Often, isn’t.

Although short term earnings per share goes up – and the share price will generally follow to keep the price-earnings ratio stable – the company is, in fact, investing its precious earnings in non-producing assets. The whole idea of a corporation is that it takes its excess earnings – its profits – and invests them to generate growth in future and, therefore, increase earnings. These higher earnings, if no more stock is issued, will automatically and organically generate higher earnings per share and share prices.

Future Earnings Failures

If, however, the company spends its excess earnings on its own stock it’s not investing in its future. Occasionally this may be a valid thing to do – if the company is trading at a very low price in relation to its real value and it has excess cash that it can’t deploy for one reason or another then it makes sense to engage in buybacks because this is rewarding long-term shareholders, who will end up with more real assets for their money, over short-term shareholders, who will be selling out. Of course, these aren’t characteristics common to the modern corporation.

As usual Warren Buffett said it best. Back in the 1999 Berkshire Hathaway annual shareholder's letter he waxed large on stock repurchases:
"There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth. We have, on rare occasions, seen that happen. Usually, of course, chicanery is employed to drive stock prices up, not down."
The point is that if a company is selling in the market below its intrinsic value (see Is Intrinsic Value Real?) and it has the free cash available to make repurchases then stock buybacks make sense. Otherwise they don’t – buying shares in the market at more than they’re really worth makes no business sense whatsoever. It punishes long-term shareholders whose earnings are being deployed in a value destroying way.

In fact the only people who benefit from such actions are those who are intending to sell in the very near future, who are likely to get the artificial boost of a rise in the share price. Given that those people who want to exit the shareholder register should be near the bottom of management’s interests and the fact that most buybacks tend to happen at prices in excess of intrinsic value this suggests that there’s something odd going on.

Management Logic?

There are multiple possibilities as to why managements might behave in this manner. One, perfectly straightforward reason, is that they’re probably not very good at figuring out the intrinsic value of the company they’re responsible for the stewardship of. At the best of times this is a difficult calculation and in some industries it’s simply impossible because the lack of forward visibility shrouds any reasonable estimates in billowing clouds of uncertainty. In fairness managers are paid to manage, not to constantly figure out the real worth of their company. It’s just a shame they often can’t do either.

It’s also a curious anomaly that repurchases are common when stockmarkets are flying high and stocks highly valued and rare when they’re not. Again, possibly, there’s a rational reason for this – in times when stockmarkets are doing well management may feel particularly, if irrationally, confident in the future and feel obliged to find a way of deploying earnings rather than simply putting the cash in an interest bearing account somewhere. In any case the shadowy figures that run the securities industry tend to punish such actions: they reckon that such cash should be handed over to them in the form of fees for value diluting acquisitions.

So maybe, sometimes, repurchases of shares are based on factors other than managers’ personal self-interest. Certainly that’s what the managements will tell us, only the actual numbers imply something different. The actual numbers appear to suggest that managements are using stock repurchases to game the system and undermine shareholder value.

Management Greed

If we go back to 2007, a time that can now clearly be seen to have been a period of stockmarket overvaluation, US corporations spent nearly one trillion dollars on stock buybacks – roughly two thirds of net earnings that year. That’s an astonishing amount of money, most of it spent on overpriced stock.

In “Accounting Rules? Stock Buybacks and Stock Options: Additional Evidence” Paul Griffin and Ning Zhu have looked closely at the relationship between stock buybacks and CEO compensation and have found some interesting and suggestive correlations. Firstly they find that buybacks are a reliable indicator of share price movements. Unfortunately stock prices usually move down, not up, in the six months after a buyback.

Secondly the research finds that the decision to make a buyback and the amount of money deployed in the buyback is reliably correlated to the CEO’s stock option plan. All things being equal, the more stock options the CEO has the more likely the company is to engage in a really large buyback, regardless of the intrinsic valuation.

Not accounting for buybacks

There are a whole range of possible reasons for this behaviour including, of course, that the correlation is spurious. However, what seems to have happened is that the change in accounting rules on stock options around the turn of the century, forcing the recognition of earnings per share dilution caused by in-the-money options has led to an equal and opposite reaction – the use of company money to retire shares from the market. The buybacks, in essence, balance out the negative effect on earnings per share of stock option cost recognition.

Partly, the authors speculate, this is because of weak accounting mechanisms around buybacks which allow managements to avoid transparency on the issue. The resulting impact on the share price suggests that shareholders aren’t really fooled. Although this isn’t definitive it also suggests a reason why managements prefer stock buybacks over dividends – dividends dilute earnings per share, buybacks don’t.

Perverse Games, Again

All of which suggests – surprise, surprise – that managements in general and CEO’s in particular are gaming the system to their own advantage and against that of their investors. In general buyback companies tend to be smaller, in more leading edge industries and have significantly larger stakeholders on their boards. The lesson is that investors looking for long-term value should be extremely wary of companies with these characteristics because they may be diluting shareholders’ long-term gains in favour of their own short term benefit.

Of course, these are trends we’ve seen before. Developing perverse incentives to game the system is what most humans do given half a chance: it’s called self-interest, it was one of Adam Smith’s guiding principles and it's both legal and perfectly predictable. However, rewarding such behaviour with our money is to play the wrong game. Stock options are nearly always a lousy way of aligning management and shareholder interests: investors should minimise their exposure and maximise their own self-interest wherever possible.

Related Articles: Perverse Incentives are Daylight Robbery, Correlation is not Causality (and is often Spurious), Gaming the System


  1. One AIM company I researched had bought its own shares when the price was rising fairly strongly - then again when it was falling, having failed to reach the price of the CEO's options. About a month later, it seemed he had given up: the company raised £1.8m by issuing new shares at a still lower price.

    If share options are to be allowed at all there should at the very least be a minimum post-exercise holding period.