Buy back shares or Invest in growth?

[permabear]

If management is sitting on cash and the stock is undervalued, how exactly should they make the call between buying back stock or investing organically/through M&A?

 

Would you look at EPS accretion? Or compare your firm's EV/EBITDA to that of your target? Would you value your firm and see what implied discount it trades at, and use that as your expected return? Return on capital? etc.

 

Appreciate any suggestions. Thanks

[SpecOps]

It depends whether the manager is objective enough. What I mean is that every CEO and senior manager has a direct incentive to fund growth, as it increases company earnings and hence their remuneration. So a manager will not always act in the shareholders best interests.

 

But if they were objective then imo it comes down to what will be the intrinsic value per share after each option is completed. For example a share buyback might reduce share count and hence increase IV per share by 5% say. This can usually be calculated without explicitly knowing what IV per share is.

 

Calculating the IV added by organic growth is more difficult, if not impossible. If it was as simple as spend $x now to increase earnings by 5% permanently then it's straight forward to say IV has increased by 5%. But sometimes that 5% will be compounded year after year before reducing back to nothing. For example you may acquire new customers, who then generate more sales through word of mouth, but eventually the advertising push is a distant memory and sales will revert back to a new equilibrium. Some may look at a company's ROIC to judge how much each $ invested earns, but its not always so straightforward. For example Apple has huge ROIC, but if they invested $100bn into their business in a year, they wouldn't earn their ROIC on it.

 

So I think my conclusion is that in most cases its impossible to know which is going to be better long term, but for the most part the managers will choose growth because it benefits them the most. I think it's rare that managers are accosted by shareholders for spending too little on organic growth, more often they are accosted for wasting money on unprofitable growth or expensive acquisitions.

[orthopa]

If the stock is truly undervalued I don't see how you could go wrong buying stock. Especially when you almost assuredly know you will be paying a premium with an acquisition.

[Pelagic]

If the stock is truly undervalued I don't see how you could go wrong buying stock. Especially when you almost assuredly know you will be paying a premium with an acquisition.

 

I would agree and think this is probably right the majority of the time. The one exception is in a broad market decline a company with a lot of cash on hand might be able to acquire companies within its circle of competence that allow for more growth than simply cannibalizing itself would. There's a Buffett quote I've always enjoyed that goes something along the lines of "when BRK has a lot of cash it starts to burn a hole in my pockets, Charlie tells me to go to the bar instead". Investing in growth, either organically or through acquisitions is incredibly tempting for CEOs because not only does it offer increased earnings but it's something the CEO can point to and say "I did that", their legacy at the company if you will. Finding a CEO who either has the patience to wait for the really good opportunities when they come around or the confidence to sit back and admit that returning money to shareholders is the best bet isn't easy yet it is a hallmark of many of the greatest CEOs.

[tede02]

I agree with most of the comments here. 

 

I think it really just comes down to opportunity cost.  If you are weighing a stock buyback against a specific acquisition, what offers the most attractive risk/return opportunity?  That seems to me to be the fundamental question. 

 

It seems like stock buybacks are very hard to accomplish at good prices.  Most businesses have cash and profits at the top of the business cycle.  That likely corresponds with a high stock price.  When the economy contracts, stocks can get cheap but most companies want to hang on to cash and de-lever.

 

It seems Steve Jobs missed out on a big opportunity to buy back a lot of Apple.  The story I've read is when he started running into the problem of having too much cash, he called Buffett and asked what to do.  Buffett asked him if his stock was undervalued and he replied "yes".  Buffett suggested he buy-back company stock but Jobs never acted on the advice. 

 

I also wish Berkshire would have bought back more stock a few years ago when it was trading around book value.  Buffett knew the company was significantly undervalued (and said as-much) yet he only bought back a trivial amount in the open market and a block of shares from an old shareholder who died. 

 

[rpadebet]

If one is completely rational about this, the choice is between investing in your own business (share buy backs) and investing in an outside business (investing for new potential growth).

 

As always you should pick the one with best value (considering growth profile, market opportunity, cheapness, moat, operational improvements etc). Think of it like an outside investor choosing between the two businesses at the prevailing prices. You should pick the one which you think can do best for the portfolio in future. The only difference being you have operational control over the two businesses. Your existing business is probably a devil you know and the new business is a devil you don't know.

 

 

[Guest longinvestor]

............

I also wish Berkshire would have bought back more stock a few years ago when it was trading around book value.  Buffett knew the company was significantly undervalued (and said as-much) yet he only bought back a trivial amount in the open market and a block of shares from an old shareholder who died.

 

Buffett is / has been always in the mode of deploying capital elsewhere. Only in the last few years did he even start talking about buying back shares. It is far easier and better for BRK to buy their shares back in big blocks and single transactions like he did in 2011. The trading volume is so low that it will take years for them to buy meaningful # shares in the open market. When they announced that single transaction, the market quickly bid up the stock above the then-new 1.2xBV floor.

 

I believe the best scenario for Berkshire would be if the stock keeps trading not far from 1.2xBV; As the IV diverges from BV and gets to, say, 2.0-2.5 xBV, they announce a new significantly higher buy back threshold. Give them time to execute the buy back. And it will get interesting if a number of other BRK billionaires' estates get settled around the same time. Single transactions they love.

 

In the annual letter, WEB kinda telegraphed that the buyback would be something his successor would deal with, 10 to 20 years hence. There will likely be massive buyback. If and only if buybacks at big discounts to IV cannot happen for whatever reason, will there likely be a dividend. Tough for the BRK CEO making that decision.