Friday, June 05, 2015

Ten Reasons Stock Buybacks Are The Tool of Lazy Management

Stock buybacks are all the rage. There is even an investing newsletter called Total Yield that adds dividends and stock repurchases and uses that measure as a key criterion for investment decisions.
Despite its widespread popularity, I’m not crazy about stock buybacks. In fact, they are increasingly signs of dumb, lazy or incompetent management. Here’s why:

1.       They are frequently used as a palliative to offset bad news.  About to issue an earnings release with a sales decline and a miss to analyst estimates? Throw in a stock buyback to see if it will relieve some investor pain, or even better, moderate a certain stock price decline.

2.       It doesn’t return money to shareholders; it gives money to people who no longer want to be shareholders. Real believers in a company’s story want to hold the stock. Who sells into a buyback? People who no longer believe.

3.       It raises questions about management motives. The proxy report, with all those new government-required compensation disclosures, is now as long as or longer than the financial statements. Is management somehow incented on earnings per share growth? Even if revenue doesn’t grow? Even if earnings don’t increase- just shares decrease? Easy to bury that in those endless proxy statements.
4.       It raises this question-is this the best that management can do?  Aside from Apple and perhaps Microsoft, what company has more cash than it can readily deploy above its cost of capital? Now, I know that plenty of managers have wasted a lot of shareholders’ money on bad acquisitions (Time Warner/AOL), failed products (New Coke), and poorly executed international expansions (Target). If there is simply no place a company can find in its market space to put money to work with a reasonable expectation that it will return its cost of capital, then it is right to return it to shareholders. Otherwise, long-term holders want to see the money put to work.
5.       Special dividends are better. OK, there may be some minor personal tax rate differences. But companies like The Buckle [BKE: NYSE] and RLI Corp [RLI: NYSE] have a history of issuing special dividends when management believes they’ve accumulated excess cash. Since that really is returning cash to shareholders, isn’t that better?
6.       It indicates a lack of confidence in the future. A company sitting on a pile of cash that spends it on a buyback rather than increasing its dividend is signaling a lack of confidence in its future. It’s simple: they are afraid that they’ll have to cut the dividend in the future. Cutting dividends is always seen as a bad sign. As a result, companies hold back on dividend increases even when projections indicate the dividend can be supported. Instead, they execute a stock repurchase.
7.       Companies are horrible market timers. There is a lot of stock repurchasing going on at market tops; not so much at market bottoms. If a Board is just totally committed to buying back shares, it would be wise to use some simple timing criteria. If a company’s average PE over the last ten years is fifteen, and it is currently trading at a twenty-five multiple, it probably isn’t a good time to repurchase. But if it is trading at a price-to-earnings ratio of ten, it might indeed be an excellent time.
8.       Companies repurchase stock while sitting on other obligations. I find this one particularly troublesome. Further, elected and regulatory officials are actively aiding and abetting this behavior.  Some background: The Financial Accounting Standards Board (FASB), The Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA) and the Public Company Accounting Oversight Board (PCAOB) share ruling-making authority for accounting principles.  Full disclosure (confession?) I’m a member of the AICPA. Collectively, those bodies have made a complete mess of pension accounting and reporting. I will wager that ninety percent of sell-side analysts have little or no understanding of companies’ pension footnotes, or what pension liabilities really are. If, however, one parses through the recondite disclosures of a company’s pension assets and liabilities and concludes that the company is including a liability on its balance sheet, one may nevertheless find that company is repurchasing some of its outstanding stock. That is, rather than fully funding a liability that reduces the future value of the business and thereby increases shareholder wealth, it gives money to folks who no longer want to hold the stock. [An example: in the 2014 GE annual report, it states that “The GE Pension Plan was underfunded by $15.8 billion….at December 31, 2014”.  It also states: “We did not make contributions to the GE Pension Plan in 2014 and 2013. The ERISA minimum funding requirements do not require a contribution in 2015”. In the letter to shareholders, GE’s describes its plans to dispose of more of its financial services business. The proceeds of that disposition will be returned to shareholders in the form of stock repurchases. In other words, while sitting with a $15.8 billion problem, it is going to further reduce equity.] Now, why would I say that officials are actively abetting this activity? Because legislation allows companies to fund to a level found satisfactory under ERISA, even though actuaries find that amount insufficient. Skeptical of my point of view? Grab a few annual reports and spend some time actually trying to interpret the abstruse FASB/SEC mandated pension disclosures. Notice how optimistic some firms are about the long-term rate of return they expect on pension assets, even though interest rates on fixed income investments-a pension fund mainstay-bump along at record lows. Finally, the Federal Reserve, by manipulating interest rates rather than let markets determine rates, has become the enabler of the borrow-to-pay-dividends movement.
9.       Shareholders can borrow on their own.  Companies are now borrowing to pay dividends and buy back stock. If I want to pay myself a dividend, I can margin my shareholdings; I don’t need a company to do it. And I control the timing. And I can sell my stock in the market anytime I like. Saddling my equity position with future interest and principal obligations to fund a stock purchase doesn’t create any value.
10.   Reflect for a moment on why corporations exist. While they predate the mercantilist period, they began to be more widely used then, as a collection of individual investors could bear more risk than single investors. That is, corporations were formed to take risks. While one might not suspect that as consultants hustle “Enterprise Risk Mangement” programs, and companies hire more risk and compliance staff than sales and marketing folks, that nonetheless is their purpose. To take risks that individuals can’t afford.
Boards and CEOs, here’s what I believe is more appropriate:
Invest in the business. Search for growth opportunities. Look for productivity-enhancing investments. Energy reduction. Supply chain improvements. New product introduction.  

Cash burning a hole in your pocket? Lousy earnings release in your immediate future and you’d like to dilute its effect on your option value? Announce an increase in the dividend. Distribute a special dividend. But true up other obligations first. Clean up any old accounts payable. Fund your retirement liabilities like grown-ups. Settle outstanding litigation.  All those things will provide us owners with real value over the long term. 

Take some risks. Like these guys: Tesla. Google. Gilead. Chipotle. Whole Foods. Celgene. Continental Resources.  Give us more of that.


-          Gene Morphis