Stock repurchases, makes sense?

[Cigarbutt]

Here’s a link:

https://assets.realclear.com/files/2017/12/757_stockbuybacks.pdf

 

The article goes against many assumptions that I hold now concerning share buybacks:

Assumptions:

1-share repurchases may occur at the expense of other productive investments.

2-repurchases are done using debt (too much).

3-often, firms buying their own shares pay too much?

 

The first assumption is weak and there just may be not as many opportunities for net capital investment and that may change. The article shows a different perspective overall.

 

Mr. Buffett tells us that buying back shares makes sense when 1- the market is valuing them at less than IV and 2- the company has no other pressing need for cash. Valid points.

 

I understand also that there must be an irresistible urge to spend cash when it builds up at the head office and today’s credit is so easy but I wonder if the typical firm does a good job with capital allocation to share repurchases these days.

 

Concrete example and questions

 

Have been following Dollarama (DDL-TSE). For those who don’t know, this is a growing Canadian-based dollar store chain. Long history, IPO in 2009 and pretty much flawless execution since then. Amazing case study so far in free cash flow generation and capital allocation. They have started a gradually increasing (in terms of size and PE paid) share repurchase program which has been financed also through growing debt. In the last few years, they paid a price with a PE around 25 to 30 using debt with very low effective rates. The PE now stands around 38-40.

 

Questions    (Keeping in mind the 1,2 rule to BV that BH uses)

 

-Can one “stretch” the rule when deciding to buy or keeping a firm in a portfolio that is buying back at relatively high levels?

 

-To what extent one can “stretch” the limit of debt incurred to finance those buybacks?

 

I am asking the questions because if you follow the arguments that stocks are inexpensive because interest rates are low and if you adhere to the Modigliani-Miller theorem for the capital structure, then, theoretically, there is no limit. No?

 

I submit it must be difficult (relatively speaking) being a CFO these days.

Let the good times roll.

 

[Cigarbutt]

Follow-up.

A link from Paul Kasriel.

https://www.financialsense.com/paul-kasriel/dont-expect-investment-boom-if-corporate-tax-rate-cut

 

I think Mr. Kasriel was the in-house economist at Northern Trust and have read his pieces for a long time. His work is typical for an economist with everything that it entails but his research is fact-based and premises are well defined. He is also quite candid which is unusual in these circles.

 

From the above, one may suspect that companies will end up with more cash but the excess liquidity may be channeled to more expansive (expensive?) share repurchases.

For better or for worse.

[DTEJD1997]

It seems to me that all too frequently, share repurchases are poor uses of shareholder capital...AS they seem to be done at prices that are frequently WAY TOO HIGH.

 

I think you also have a conflict of interest (management vs. shareholders).  Management may get paid or get bonuses if share price is X.  Thus, management will do absolutely everything in their power to get it to there.  This can include buying back shares going into cyclical/industry downturn.  They are spending shareholders money to help get their bonus.

 

If share buybacks are done well, they are great...but it is hard to do.

 

Contrast that with dividends...I actually prefer dividends in most cases.

[Uccmal]

It seems to me that all too frequently, share repurchases are poor uses of shareholder capital...AS they seem to be done at prices that are frequently WAY TOO HIGH.

 

I think you also have a conflict of interest (management vs. shareholders).  Management may get paid or get bonuses if share price is X.  Thus, management will do absolutely everything in their power to get it to there.  This can include buying back shares going into cyclical/industry downturn.  They are spending shareholders money to help get their bonus.

 

If share buybacks are done well, they are great...but it is hard to do.

 

Contrast that with dividends...I actually prefer dividends in most cases.

 

I agree with this.  Give me the excess cash and I can choose to invest it the way I want.  I think if the US stopped taxing dividends twice, and operated like we do in Canada then more US companies would pay higher dividends like they used to. 

 

Often times the CEOs and CFOs operating public companies do not have an investor mindset.  If fact just the opposite.  They execute stock buybacks when the cash is plentiful, and of course the stock is high.  Rather than saving for a rainy day.  IMO, very few are good at this.  Mostly, stock buybacks are used to sop up dilution used for compensation purposes.  Then the CEO trumpets how much stock they bought and then we check the share count and it is unchanged or higher. 

 

It takes huge discipline to value invest in your own stock, when the chips are down, and everything is looking dreary.  Dividends on the other hand tend to instill discipline.  If your shareholder base expects a dividend increase every year, you are going to deliver or watch your stock price really tank. 

[Viking]

I think what the big US banks have been doing the past couple of years represents a good example of how to return cash to shareholders. They have focussed on share buybacks versus dividends to take advantage of their low stock prices. As their stock prices rise I expect them to shift and maximize dividend payouts, likely +40%. CCAR announcements in June this year should continue the trend of higher total capital return and materially higher dividend payouts. The well run companies like JPM and BAC are finding a way to grow top line and return close to 100% of earnings to investors; crazy.

 

The red flag for me is when companies borrow heavily over many years (lever up their balance sheet) to retire shares to juice earnings per share (typically to hit earnings per share targets given to the financial community). The business then hits a rough patch, the shares crater and long term investors are left wondering what went wrong as they are left with an impaired company with limited options financially and a share price significantly below their entry point. IBM and GE come immediately to mind. The pain lasts for years.

[Cigarbutt]

"I think what the big US banks have been doing the past couple of years represents a good example of how to return cash to shareholders. They have focussed on share buybacks versus dividends to take advantage of their low stock prices. As their stock prices rise I expect them to shift and maximize dividend payouts, likely +40%. CCAR announcements in June this year should continue the trend of higher total capital return and materially higher dividend payouts. The well run companies like JPM and BAC are finding a way to grow top line and return close to 100% of earnings to investors"

 

Viking,

I don't disagree, just want to expand further.

Today, finished a biography about John Pierpont Morgan, the guy who focused on character over money and property.

Agree with the second paragraph as buybacks often are found, after the fact, to be counter-cyclical.

 

Have studied the TARP period and, if you read the Federal Reserve Bulletins of commercial banks up to 2007, the comments suggest that there were no significant problems brewing on the asset side and no particular concern about capital levels (and implicit ability to return capital). Then, it took a while to "adjust" buybacks and especially dividends. And we know that capital flow changed direction (recovery funds, secondary offerings and else) in the following months.

I understand that US commercial banks have "repaired" their balance sheets and stress tests have been improved with the influence of Basel III and the various capital buffers and countercyclical provisions. So the banks should be more solid going forward? Can't the static balance sheet assumption prevent detection of liquidity risks in certain instances?

Really, the underlying question: Have banking institutions learned from the GFC?