The Share Buyback Mania
3/30/2020
Research by Felipe Pardo and Roberto Cortes, Stern Value Management
Bad financial advice is a feature of history—“Pets.com? It’s a sure thing. Didn’t you see their Super Bowl ad?”—and the last decade had a few for sure. Our favorite has to be the advice given by the so-called finance gurus to senior management teams: “Buy back your shares. It’s a sure way of driving up your share price!”
In our dealings with management teams, I cannot recall one CEO failing to mention that they have received such advice from Wall Street. While we have done our best to persuade CEOs that share buyback’s magical effect on share prices is akin to their favorite team winning because they wore their lucky socks, we have unfortunately failed more times than not, as our new research into buybacks shows.
We studied the Dow 30 components over the last five years and calculated the value creation/destruction from their share buyback efforts. For this we considered the average price at which the shares were initially bought and then the average price at which subsequent shares were issued. Our study finds that as a whole, Dow 30 firms have destroyed a total of $4 Billion. The number goes up to $8B if we incorporate the opportunity cost.
If judged solely on their share buyback strategy and performance, almost all Dow 30 CEOs should be fired. And why shouldn’t they? Isn’t capital allocation the CEO’s main job? And isn’t share buyback a major capital allocation decision? CEOs will argue that they followed the gurus’ advice and that they were assured buying back shares was the right thing to do.
The issue is that CEOs were convinced, incidentally by the same gurus, that Earnings Per Share (EPS) drives share price performance. The advisors argued that since buying back stock reduces the share count, the EPS ratio grows and so does the share price. You may perceive that nothing happens to the company’s fundamentals, no increase in market share, no efficiencies, no improvements in productivity—just good old fashioned financial alchemy.
But unfortunately, something does happen to the company’s fundamentals. By allocating capital towards buying back shares, either the firm’s operations are deprived of cash to fund its value- creating projects—those projects that provide a return above the cost of capital—or the firm’s leverage increases as management borrows funds to pay for the buybacks or the value-creating projects.
Fast forward to current times and see how this financial hocus pocus got companies in a bind. Funds used to buy back shares could be very useful today, especially for firms like United Airlines (UAL) that is on the verge of bankruptcy. UAL will be bailed out by the government with no consideration or penalty for its disastrous financial decision making, but others may not be so lucky. Our research shows that of the Dow 30 components, 29 purchased back shares over the last five years, and I am sure most would love to have that cash back.
To clarify, buying back shares is not, on its own, a terrible idea. Buying back shares is an important capital allocation decision and a key way of returning funds to shareholders. The problem is when shares are purchased with the objective of magically driving up share prices; especially when a CEO has his incentive compensation package largely driven by share price appreciation or, even worse, EPS growth.
Your share buyback strategy should be based on a robust financial and risk analysis—an analysis that considers the firm’s intrinsic value, taking into account its strategic plans and its potential future cash needs given adverse operating conditions and Black Swan events. If the firm’s intrinsic value per share is above its current share price and future cash needs are lower than the current cash balance, the firm should go ahead and purchase back shares.
After all, once the firm starts executing its strategic plan and the market more fully incorporates that into its forecasts, the firm’s share price will appreciate. It is at this point that the firm could consider issuing new shares if it believes it warranted. The firm would have bought low and issued high, generating additional value for its shareholders.
The recession or depression that will likely follow COVID-19 will involve significant government bailouts, probably more than what is now waiting to be voted in Congress. If firms are bailed out, proposals like the one set forth by Dallas Mavericks owner Mark Cuban, where a rescued firm cannot buy back shares ever again, at least merit consideration. After all, why should the taxpayer be on the hook when the firm could have been better prepared to face a COVID-19 type situation?
We propose that if a firm receives government funds, the bailout should cover mid- and lower- level employees (including a restatement of share options if any were provided) and suppliers, but not senior management, shareholders, or bondholders. After the crisis is averted, taxpayers should come first. Firms should not be able to purchase back any shares for a period of ten years or until all government funds plus interest are paid back. Following this period, it will be restricted to purchase only up to 2% of its shares a year up to a total of 10% over a ten-year period. Share-based compensation will not be allowed until the government is repaid.
The lesson to be learned here is that there are no shortcuts to long-term shareholder value creation, but as many firms are learning, there is an express way to bankruptcy, and that could involve falling for the share buyback fallacy.