As Peter Lynch said in his book, One Up On Wall Street, “Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why shouldn’t it invest in itself, just as the shareholders do?”
Lynch is viewed by many as the top mutual fund manager of all time. His average return while managing the Magellan from 1977 to 1990 was a staggering 29.2 percent. Share buybacks was one of his most important attributes when looking for stocks.
Warren Buffett, viewed by many as the best investor of all time, is also in favor of share buybacks. From 1965 to 2013 he has provided a 19.7 percent compounded annual return in Berkshire Hathaway’s book value. Buffett listed buybacks as factoring into his decision to buy IBM (IBM) stock in his 2011 letter to Berkshire Hathaway shareholders:
“In the end, the success of our IBM investment will be determined primarily by its future earnings. But an important secondary factor will be how many shares the company purchases with the substantial sums it is likely to devote to this activity. And if repurchases ever reduce the IBM shares outstanding to 63.9 million, I will abandon my famed frugality and give Berkshire employees a paid holiday.”
At the time of the letter, Berkshire Hathaway owned 63.9 million shares or 5.5 percent of the shares outstanding. A stock is ultimately worth the present value of its earnings. Buffett’s extreme scenario says that if IBM buys back all of the shares outstanding except for his, his 5.5 percent investment in the company would now lay claim to 100 percent of the earnings.
Now that we know that two of the best investors of all time factor stock buybacks into their analysis, why are buybacks important and how can these stocks be found?
Typically stock buybacks are funded from the company’s earnings. When a corporation earns a profit, it can return capital back to shareholders through dividends or buying back shares, or the company can use the money to expand current operations, fund new projects, or make acquisitions. The board of directors should allocate the profits to the areas that would bring the best return to shareholders.
Companies that are still in the growth phase will likely allocate most of the funds towards expanding operations or funding new projects. Based on the law of diminishing returns, only so much can be investing into operations until return on investment begins to decline. Once the decline gets to a certain point, the excess funds are better utilized when returned back to the shareholders.
When returning capital back to shareholders, the company can choose to pay a cash dividend or buy back shares. Buying back stock reduces the number of shares outstanding and the shares remaining lay claim to a bigger percentage of the earnings by increasing the earnings per share, and thereby, making the shares more valuable.
Buybacks can also be a tax advantage for long-term shareholders investing outside of tax sheltered accounts. Dividends are taxed the year that they are received, although most likely at a lower rate since many dividends are considered to be “qualified.” When a stock’s price increases due to a share buyback, the increase in value is taxed when the stock is sold. For long-term investors, the present value of the taxes that will be paid years into the future will be less than the taxes that have to be paid today on the dividends. Long-term capital gains are also taxed at a lower rate than short-term capital gains. Now for short-term investors (less than a year), the gains will be taxed within the year at the regular income tax rate and will actually be a disadvantage since if they received dividends instead, it would likely be at a lower tax rate.
Buybacks do not necessarily have to come from profits in the recent quarters. It could come from excess cash that has been sitting on the books, and some companies sell bonds to raise cash for buybacks. It’s a great sign if the company is buying back stock if management feels that it is undervalued and can generate better returns with just buying its own stock. Loews Corp (L) and Steel Partner Holdings (SPLP) are great examples. The chairmen of these companies plainly stated that they are buying back stock because it is undervalued and can provide a higher return for the shareholders. In fact, both of the stocks are trading at 25 percent discounts to their book values. The book value is generally what is left if the company sold off all of its assets and paid off all of its liabilities. A low P/B ratio is not always a good sign, so it is important to check the trend in book-value-per-share. If it is in rapid decline, then it might deserve to be that cheap. Looking at Loews and Steel Partner through the 10-year financials pages at GuruFocus, it can clearly be seen that the book values are still trending higher, making these stocks bargains.
It is a bad sign if a company keeps buying back stock at high prices. The point is to buy low and sell high. If the company is buying high, it is not creating value for the shareholders. One of the warning signs that will be displayed on a stock’s page at GuruFocus is if the company has been buying back its stock at high prices. Herbalife (HLF) has the warning on its page. By clicking on the warning, the analysis says, “Herbalife bought back shares. However, its track record of buying back shares is poor as the stock is now traded at -33.3% below its average buyback price.”
It can be either a good or bad sign if a company is issuing debt to buy back shares. The cost of capital can actually be lowered in that way since the cost of equity is generally higher than the cost of debt. The company needs to be careful not to negatively affect its liquidity, solvency, and therefore, its credit rating by doing so. Bed Bath & Beyond is an example of a good way to issue debt to buy back stock. It had no debt on the balance sheet along with $713 million in cash and generating lots of free cash flow along the way. The bonds that were sold were at an average interest rate of 4.83 percent. Using the U.S. corporate tax rate of 35 percent would make the cost of debt only 3.14 percent. Using CAPM, the cost of equity is 7.55 percent, meaning that Bed Bath & Beyond has effectively lowered its WACC (weighted average cost of capital) without hurting its balance sheet. Also, the stock is undervalued by 26 percent based on its earnings as displayed by the GuruFocus DCF Calculator.
If a company has a weak balance sheet and is raising debt to buy back stock, it is a bad sign. Keep in mind that when stock is bought back, cash is removed from the balance sheet, making it weaker. If the company has a weak balance sheet to begin with, it should not be buying back stock.
While looking at an individual stock’s summary page, you can get a quick view of how the company’s buyback program stacks up against the rest of the industry and also its own historical range. For further analysis, the 10-year Financials tab will display the number of shares outstanding for the past 10-years. Click on the line showing the number of shares outstanding to view a chart showing the overall trend. In this case a downward trending chart would be more beneficial for shareholders.
IBM
The All-In-One Screener at GuruFocus is a great way to find stocks that are buying back stock. Share buybacks can be screened for annual rates based on 1, 3, 5, and 10 years.
My own screen that I saved on the site searches for stocks with positive earnings, trading below book value, and have been buying back at least 5 percent of its shares. You can view the results of the screen here: Stock Buybacks Below BV. A screen can also be setup to find which companies the investing gurus hold that are buying back stocks. Here is an example of such a screen: Stock Buybacks Held By 10+ Gurus.
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