What are the danger signs for cannibal strategies

[black-dog]

Seeing as the last thread on cannibals is ~5y old:

http://www.cornerofberkshireandfairfax.ca/forum/general-discussion/cannibals/20/

 

And Mohnish Pabrai & an analyst at Dhando Holdings have been publishing Uber Cannibals (first here: https://www.forbes.com/sites/janetnovack/2016/12/22/move-over-small-dogs-of-the-dow-here-come-the-uber-cannibals/#7f4910bd7f92, the new 2018-9 list of five here: http://www.chaiwithpabrai.com/blog/the-new-2018-2019-uber-cannibals4839631 )

 

I've always been Buffet-skeptical of companies buying their own stock back, but also, Munger says watch the cannibals, so I've been watching this Uber Cannibals strategy because it's easy enough to follow I'd be able to recommend it to people who want minimal effort strategies. (And also, because of that, doubling my skepticism, see: early Motley Fool)

 

Today seems to highlight one of the pitfalls of the approach: SNBR's been on a share buyback tear while hitting turbulence -- sales are flat, profit's falling, they're doing a supply chain transition -- and after missing earnings, the stock's down 15% as I type this. During the same period, they spent $75 million on share repurchases in the quarter... so not to be reductive, but they essentially set fire to >$10m.

 

So: what characteristics do you want to look for in a company that's buying back its stock to ensure the cannibal has good taste, beyond the obvious fundamentals like "are they borrowing like crazy to fund the buyback?"

 

(SNBR on their quarter: http://newsroom.sleepnumber.com/phoenix.zhtml?c=254487&p=irol-newsArticle&ID=2343283 )

[rb]

You don't want them to buy the stock at elevated valuations. But most importantly they need to have a strong business. I remember a few years back Weight Watchers bought back about 1/3 of their stock (with cash) right before earnings and stock price took a massive dive. You don't want your cannibal to do that.

[Jurgis]

You don't want them to buy the stock at elevated valuations. But most importantly they need to have a strong business. I remember a few years back Weight Watchers bought back about 1/3 of their stock (with cash) right before earnings and stock price took a massive dive. You don't want your cannibal to do that.

 

I agree with you. However, is it easy to predict that the business will take a dive? It's easy looking backwards by Monday Morning Quarterbacking, but is it possible going forward?

I guess you could argue BBBY was predictable. I am not so sure about Weight Watchers (disclaimer: bought low, sold low, have not followed afterwards, Oprah saved them from BK?). Haven't followed SNBR, so no comment.

 

Looking at:

 

    Sleep Number Corp. (SNBR) - I've looked at Tempurpedic when the stock dived. I don't particularly like the business segment. IMO the products are sleazy and overpriced. But then I'm cheap (got IKEA bed/mattress, totally happy with it). Other than that no comment.

 

    Corning Inc. (GLW) - I had a large position when the stock price was low, then sold out, then they went on tear... I'd guess they are at least somewhat cyclical, so they might be overpaying. I haven't looked at their recent numbers though. I think it's a good company although it might hit cycle when/if 4K TV adoption flatlines or drops. I'm speaking of the cuff though.

 

    PulteGroup (PHM) - home builder. If you expect something like 2008 crisis, then not a good company to invest. OTOH AFAIK housing starts have been low, so homebuilders may still have a lot of runway and it might not be overpaying... Have not looked deeper.

 

    Discover Financial Services (DFS) - somewhat strong number 3 (or whatever) CC business. Probably fair bet.

 

    Lear Corp. (LEA) - car parts? Cyclical. But I don't really know if they are heading for cyclical low and overpaying. Perhaps. Have not looked deeper.

 

And you know what? I can pretty much guarantee that it's not the "good/great" companies that will have best return in April 2019, when the cannibal strategy reallocates to new five...  8)

[no_free_lunch]

I don't know if there are any hard and fast rules.  I do try to look at the history of buybacks vs valuations.  If they only buy back stock when valuations are lower then that is interesting.  Some companies will flip between buying back stock and issuing stock depending on price, so it is not so simple as high buybacks.  It is critical that they use their brain and only buy when it makes sense.

 

I don't really understand the business so can't recommend it but ADS is a good example of opportunistic buybacks.  They did a lot during the GFC and when it went back up they stopped buybacks.  That is what I would look for.

[Cigarbutt]

As a simple investing rule, I would say that the "strategy" is likely to work until it doesn't as the concept of buybacks is quite institutional and pro-cyclical: IMO, in the main, firms tend to buy back a lot of shares when valuations are high and tend to scramble for capital (and shun buybacks) when valuations are low.

 

The basic rule seems to be that if:

1-the firm has excess capital

2-the shares trade at a discount to intrinsic value

 

then, you should buy shares alongside management. :)

 

IMO, lately, 1- has been the norm and 2- has been misunderstood.

 

Following is a link that is somewhat out-dated but still relevant about a company, which may not be relevant to the general universe of investments (good, because that is a reason that allowed such a high return from buybacks and maybe I should delete this paragraph), that continues to selectively and opportunistically use buybacks in order to maximize intrinsic value per share. It sells furniture and is relatively "unknown" relative to other competitors like Wayfair.

 

https://www.burgundyasset.com/wp-content/uploads/GrowthThatMatters-July2010.pdf

 

[ScottHall]

I like asset lite, high margin businesses like MAR. It has basically been a long term cost of capital arbitrage, gradually replacing equity with debt. It is very hard for MAR to lose money on an operating basis, though lodging itself is cyclical.

 

What is the cost structure of the business? Will operating leverage kill you if things turn sour (SHLD)?

[LC]

Lowe's (LOW) - homebuilding/renovation

NVR (NVR) - homebuilding/mortgages

The Hackett Group (HCKT)-business analytics

Select Comfort (SCSS)-mattresses

Willis Lease Finance (WLFC)-airplane engine leasing

 

Seems to me 3/5 are related to housing. Of the 5, Hackett group looks most interesting from a business perspective.

[Jurgis]

Lowe's (LOW) - homebuilding/renovation

NVR (NVR) - homebuilding/mortgages

The Hackett Group (HCKT)-business analytics

Select Comfort (SCSS)-mattresses

Willis Lease Finance (WLFC)-airplane engine leasing

 

Seems to me 3/5 are related to housing. Of the 5, Hackett group looks most interesting from a business perspective.

 

You're looking at the 2017 list that is no longer current one...  8)

[ScottHall]

Lowe's (LOW) - homebuilding/renovation

NVR (NVR) - homebuilding/mortgages

The Hackett Group (HCKT)-business analytics

Select Comfort (SCSS)-mattresses

Willis Lease Finance (WLFC)-airplane engine leasing

 

Seems to me 3/5 are related to housing. Of the 5, Hackett group looks most interesting from a business perspective.

 

Do you know much about NVR’s strategy? Tied to housing and cyclical but it is not a land bank, takes little capital to run the business.

[Contra123]

IMO the question posed by the OP might as well be rephrased into “how do you determine if mgt team are good capital allocators” or “how do you know mgt’s capital allocation skill won’t get worse”. That’s a super hard, broad question IMO that’s hard to get right even if you have decent access to mgt. IME what gets people comfortable is a sophisticated (often buyside) background of mgt team and nice IR slidedecks that have the right buzzwords and explain the allocation framework in the right way + good track record of timing the buybacks. For me personally, favorite warning signs include buybacks when leverage is creeping up and buybacks accompanied by high stock compensation / issuance to mgt.

[Contra123]

I’d also add that IMO “are shares trading at a discount to intrinsic value” is a question that I think mgt teams should not be focusing on when making repo decisions. IMO vast majority of mgt teams will be inclined to believe their stock is undervalued, all the time, even if they are heading up a secularly challenged biz like BBBY with accelerating negative topline growth and high fixed costs. It’s that cognitive bias, that denial, that eternal optimism. If instead mgt focused on facts e.g. consistent and  accelerating top-line growth with expanding margins based on easy-to-verify secular industry or demographic factors (even if those are well-understood) and mainly relied on the presence of those things to make buy-backs (eg vs dividends), I think the end result could be quite satisfactory.

[LC]

Scott - I have no idea about NVR other than what 10 min on google told me.

 

Contra - I totally agree. Management pretty much usually sucks. To be fair we are asking them to pretty much time the market, or to be professional investors in addition to managers. This is why I really like the dividend argument: it forces management to be prudent. They can either invest the remainder of their FCF or buy back stock - but the dividend makes it more difficult to do both. Therefore perhaps management puts a little more thought into their decision.

[ScottHall]

Scott - I have no idea about NVR other than what 10 min on google told me.

 

Contra - I totally agree. Management pretty much usually sucks. To be fair we are asking them to pretty much time the market, or to be professional investors in addition to managers. This is why I really like the dividend argument: it forces management to be prudent. They can either invest the remainder of their FCF or buy back stock - but the dividend makes it more difficult to do both. Therefore perhaps management puts a little more thought into their decision.

 

You might like this video about NVR.

 

[LC]

Interesting for sure. The only real takeaway was how they manage inventory. I'm curious because I have no idea as to how that works. And if it's so successful, why is nobody else doing it? Weird, but thanks for bringing it up!

[Jurgis]

Yeah, NVR is well known as the most conservative home builder with some nice characteristics (as shown in video). I've never invested on concerns similar to LCs: it seems like rather cutthroat industry and apart from conservativism, NVR doesn't seem to have a secret sauce, so why would they continue to perform well? But they do...

 

And, yeah, I knew about NVR in 2007-2008, I think I even had some at one point. Did not buy, did not hold...

[ScottHall]

Interesting for sure. The only real takeaway was how they manage inventory. I'm curious because I have no idea as to how that works. And if it's so successful, why is nobody else doing it? Weird, but thanks for bringing it up!

 

Path dependency and corporate fiefs IMO. The economy isn’t as efficient as most investors think

[thowed]

To be fair we are asking them to pretty much time the market, or to be professional investors in addition to managers.

 

I totally agree with this, and about dividends.  I read a piece by a great fund manager saying this, and arguing that a dividend should represent management's best estimate of their future FCF, which they are far more qualified to do than market timing or investing.

[Cigarbutt]

I’d also add that IMO “are shares trading at a discount to intrinsic value” is a question that I think mgt teams should not be focusing on when making repo decisions. IMO vast majority of mgt teams will be inclined to believe their stock is undervalued, all the time, even if they are heading up a secularly challenged biz like BBBY with accelerating negative topline growth and high fixed costs. It’s that cognitive bias, that denial, that eternal optimism. If instead mgt focused on facts e.g. consistent and  accelerating top-line growth with expanding margins based on easy-to-verify secular industry or demographic factors (even if those are well-understood) and mainly relied on the presence of those things to make buy-backs (eg vs dividends), I think the end result could be quite satisfactory.

 

Read from a recent Board of Directors corporate governance document discussing the share repurchase "revolution":

 

"Most directors who dispute the relevance of intrinsic value to buyback decision-making still support repurchasing shares, but they do not judge success based on stock price changes. “It’s not luck; it’s long-term confidence in your strategy and belief that you will create long-term value,” one director said."

 

"Company managers and directors are not smarter than the markets. Some directors go further and suggest that it is not possible for shares to be “undervalued.” “Assuming adequate disclosure, the board and management team are not smarter than the market as a whole,” one director said. Another noted, “If you believe in the efficient market theory as I do, the price accurately reflects value.”

 

...

 

The challenge may lie in the fact that the Board may have to look at the opportunity to buyback its own stock by comparing to other alternatives. So, if your stock is relatively "cheap", it must be hard to justify cash piling up.

 

Speaking of cannibal strategies, it looks like 2018 will be a landmark year:

 

https://www.forbes.com/sites/chuckjones/2018/03/16/2018-share-buybacks-could-exceed-800-billion-driven-by-overseas-cash/#29c9429139d9

 

BTW, ScottHall, thanks for the video about NVR, which is an interesting company. Liked it when they explain that the last two shareholders could be them and you. It seems to me that the true cannibals are those that are least promotional. In my experience, a rare combination.

 

 

 

[ScottHall]

I’d also add that IMO “are shares trading at a discount to intrinsic value” is a question that I think mgt teams should not be focusing on when making repo decisions. IMO vast majority of mgt teams will be inclined to believe their stock is undervalued, all the time, even if they are heading up a secularly challenged biz like BBBY with accelerating negative topline growth and high fixed costs. It’s that cognitive bias, that denial, that eternal optimism. If instead mgt focused on facts e.g. consistent and  accelerating top-line growth with expanding margins based on easy-to-verify secular industry or demographic factors (even if those are well-understood) and mainly relied on the presence of those things to make buy-backs (eg vs dividends), I think the end result could be quite satisfactory.

 

Read from a recent Board of Directors corporate governance document discussing the share repurchase "revolution":

 

"Most directors who dispute the relevance of intrinsic value to buyback decision-making still support repurchasing shares, but they do not judge success based on stock price changes. “It’s not luck; it’s long-term confidence in your strategy and belief that you will create long-term value,” one director said."

 

"Company managers and directors are not smarter than the markets. Some directors go further and suggest that it is not possible for shares to be “undervalued.” “Assuming adequate disclosure, the board and management team are not smarter than the market as a whole,” one director said. Another noted, “If you believe in the efficient market theory as I do, the price accurately reflects value.”

 

...

 

The challenge may lie in the fact that the Board may have to look at the opportunity to buyback its own stock by comparing to other alternatives. So, if your stock is relatively "cheap", it must be hard to justify cash piling up.

 

Speaking of cannibal strategies, it looks like 2018 will be a landmark year:

 

https://www.forbes.com/sites/chuckjones/2018/03/16/2018-share-buybacks-could-exceed-800-billion-driven-by-overseas-cash/#29c9429139d9

 

BTW, ScottHall, thanks for the video about NVR, which is an interesting company. Liked it when they explain that the last two shareholders could be them and you. It seems to me that the true cannibals are those that are least promotional. In my experience, a rare combination.

 

No worried, Cigar Butt. I like their videos; they have a lot of good ones.

[Spekulatius]

I don’t think that a cannibal stock is something to really look for, as a successful cannibal requires cooperation from Mr Market (with a low stock price at an opportune time) to work.

 

One can always synthesize  a cannibal stock itself, via additional purchases.  Most cases, stock purchases are done procyclical, when the company is flush, which tends to be when stock prices are high. The giveaway is that most mangement team measure stock purchases by the effort (we returned $X million to our shareholders to last year) rather than the result ( reduced our outstanding shares by X%), so thwt tells us already how they look at this.

[Gamecock-YT]

cyclical industries getting closer to the peak than the bottom. The airlines are a topical example, even though according to WEB: "this time is different".

[Cigarbutt]

https://fortunedotcom.files.wordpress.com/2018/04/2018-fortuna-buyback-roi-report.pdf

 

When looking at a specific investment and evaluating capital allocation, I tend to look at the way the firm does buybacks (when, how, price paid). Market permitting, cannibal-like or Singleton-like persistence is welcome.

 

Short version summary:

 

-buybacks are running very high.

-buybacks are pro-cyclical.

-timing of buybacks, in the aggregate, is not that significant except in downturns.

-not all buyers are winners.

-price is what you pay and value is what you get.

-the authors suggest to measure (and report?) a specific measure of return on buybacks.

 

Longer version (optional):

 

I thought this was a useful report even if there are some limitations (methodology, choice of 5-year periods, returns not compared to index returns, some conclusions about their aggregate “effectiveness” measure, 2017 as the end-year).

 

They show (figure 1) that firms that do significant buybacks, in the aggregate, have positive results in terms of returns in the last few trailing 5-yr periods. Not that surprising, given that the markets in general have done quite well. I searched for comparable trailing 5-yr returns for the S&P 500 (total return, annualized, %, dividends re-invested, not audited):

 

2003-7: 12,7  2004-8: (3,3)  2005-9: (0,8)  2006-10: 1,6  2007-11: (0,6)  2008-12: 2,9  2009-13: 18,7  2010-14: 15,3  2011-5: 12,3  2012-6: 14,1  2013-7: 14,9

 

Eye-balling the numbers, it looks that firms doing large buybacks had returns comparable (+/-) to firms not doing significant buybacks.

 

Where it gets interesting is in the individual results. Using 14,9% as the market cut-off for the average for the last five years, some firms did huge buybacks with share prices persistently going up and the ROI measures on the buybacks are mostly high, with variations due to “effectiveness” (timing issues). An argument could be made that recent returns have been more favorable than usual, historically speaking. We’ll have to see. Some of the buybacks resulted in low and even negative ROI numbers. Some could say that it is easy to look retrospectively and be critical. Fair enough but, even putting the issue of leverage aside, there are many names there that should have refrained from buybacks (more on that later). Appendix III contains a lot of interesting info. The list likely contains some of your favorite investments.

 

What’s the point?

 

1-institutional pressures versus capital allocation decision

 

For many reasons (operating factors, wages, low interest rates, low tax rates), corporations have been very profitable lately. Also, for reasons that should be discussed elsewhere, in the last few years, firms have returned to shareholders (dividends and buybacks) a significant amount of free cash flow and more while investing relatively little towards expansion capital expenditures. I seem to remember that even Mr. Buffett and Mr. Munger have said recently (in the last year or so?) that it may be eventually difficult to justify having a cash pile reaching 150 billion at the holding company. When he was CFO at Google, Patrick Pichette used to describe the “degrees of freedom” associated with high cash levels and how he had a problem (an enjoyable problem) finding ideas large enough (super high IRR projects with relatively low NPVs simply did not reach the agenda) to redeploy this immense amount of cash coming in weekly. Before he left, in 2015, the cash pile was growing in correlation to institutional pressures but he used to say that the “share price does matter”. With cash coming in, super low interest rates and relatively low opportunities to re-invest in operations, for the typical firm, the pressure must be incredibly high to buy back shares (whatever the price?).

 

2-how to evaluate the trigger (hurdle) to make a buyback and why Mr. Buffett has used the 1,2 rule

 

In the context of a capital allocation decision, cap ex projects and business acquisitions are associated with uncertainty. But the uncertainty related to what will happen to the stock price going forward is much higher (price may go up or down). Just think of stock market variations versus GDP variations. That’s because stock prices have two components (fundamentals and sentiment) and one of the components can be emotional. With the option pricing models, the expected volatility of the share price will tend to correlate with the price of the option. Using that notion, IMO this may explain why the decision to buy back share should be based on a discount to intrinsic value. Most would agree that the 1,2 rule used by Mr. Buffett corresponds to a discount to intrinsic value, especially if you agree that book value, as stated, has been understating more and more the intrinsic value. I submit that the optionality associated with keeping cash unless the share price trades at a discount may be a reason why Mr. Buffet has chosen, and maintained so far, the 1,2 rule. This ties in to the question of being fully invested and to the fact that one should not time the market if the return hurdle is met. IMO, many companies forget that rule now and buy back their shares at a premium to intrinsic value. Those companies should instead use the excess cash to pay dividends or even invest in index-funds in order to maintain flexibility. In practice, for my investments, if a firm that I’ve invested in starts to buy back shares at a premium to intrinsic value, I will simply lower my estimation of intrinsic value. That may trigger a sell order and it seems that, in the aggregate and over complete cycles, selling shareholders will tend to do better during buybacks.

 

3-the ROI measure on buybacks used as a periodic yardstick

 

Mr. Buffet talks about the one-dollar premise (retained earnings test) whereby retained cash flows should be eventually be rewarded (long term and over cycles) by the market (ie reflected by higher stock price) if the capital allocation decisions resulted in profitable operations. The same way, from now on, I will periodically evaluate more precisely how the ROI on buybacks for a specific company compares to overall market returns.