The Buyback Annoyance

Stock buybacks have been the craze over the past couple of years. Ever since the Fed has flushed the economy with cheap money, corporations have been using the funds to invest in their businesses to grow, spend on mergers and acquisitions, raising or issuing special dividends, and of course, the buyback annoyance – buying back its own company stock. While a majority of the investors and traders see that as a good thing, I see it mostly as an annoyance that does not achieve much more than some financial engineering.

The Buyback Annoyance

For the readers who are unfamiliar, buybacks – also called share repurchase, is where a company decides to purchase its own shares from the marketplace, thus reducing the number of outstanding shares. The reduced number of shares in the market is good for the key-stats in annual reports as it shows an increasing earnings-per-share (EPS) value and increases the value of the remaining shares in the market. Don’t get me wrong…there is a place for buybacks in the marketplace. Without any buybacks, shareholders would see their stock value depreciate as companies routinely issue more shares thus making the value of each share just a little bit less valuable. But my annoyance has been with the degree with which we see the buybacks occurring.

As a long-term investor, I’d rather see companies invest the surplus money in either: paying down debt, growing its business or acquiring new business segments to expand the horizons. Even issuing a one-time dividend would do better for long term shareholders. It has to be noted that companies resist committing to a bigger dividend increase, as dividend increases are normally considered permanent. But the buyback is attractive for the executives, board members and upper management – as they lavishly reward themselves with stock options. A short term fix and some financial engineering drives up the stock price providing the execs with more profits. This is the reason why you see a majority of senior execs selling their positions taking their profit off the table in the current market condition.

Instead of investing or paying down debt, if the company is buying its own shares and the insiders are selling, should you be buying?

The buyback movement reached fever pitch in 2013. In fact, I am of the opinion that buybacks are one of the main contributing factors for the all-time stock market highs. The following chart shows the list of largest buybacks in the market today. In fact, investors and traders can even target the companies that have a higher buyback plan by using an ETF – PowerShare Buyback Achievers Fund (PKW).

Stock Buybacks

Stock Buybacks

One company that has resorted to financial engineering for quarter after quarter is International Business Machines Corp (IBM) – and its only a matter of time before patience runs out. The company has seen declining revenues and cash holdings, while debt has continued to pile up. The company has been squeaking out quarters resorting to layoffs to keep the shareholders happy – and for the sake of the IBM shareholders, I hope management changes this path that they are heading down on.

On the other hand, General Electric (GE), with all the cash available, has been investing heavily into growing their business. GE is cutting losing business segments that are not lucrative anymore such as the appliance business, which it sold to Electrolux for $3.3B recently, and spun-off Synchrony Financial (SYF) – its retail finance arm. Instead, GE is now returning to its industrial roots and expanding into new horizons such as oil & gas exploration and pipeline infrastructure tech, green energy investments such as wind, solar and fuel cells etc. These are lucrative businesses and I fully support the management in their decision as a shareholder. Note that GE, like others, has a share repurchase plan – esp in 2013, GE has bought a lot of its own shares after selling its stake in NBC.

A plethora of companies have a history of buying at highs and selling at lows. This goes against any logic when it comes to good financial sense. When times are good and companies are flush with cash, like the current environment, the management authorizes buying its own shares and during lean times – after market crashes and/or recessions, the companies cut back on share repurchases. So, the question for the retail investors is: Instead of investing or paying down debt, if the company is buying its own shares and the insiders are selling, should you be buying? It comes as no surprise that smart investors such as Warren Buffett through his holding company Berkshire Hathaway holds a huge cash position (totaling $55B) in the current market condition – waiting for the right opportunity.

Conclusion

As a long term dividend growth investor, I’d rather invest in companies like GE than IBM. While IBM is a favorite amongst dividend growth investors, and for that matter, has a better track record than GE (which saw dividend suspension during the recent crisis), the future for GE looks brighter. My focus as a dividend growth investor is to own great companies and share the growing profits while I own them, instead of selling the shares and exiting the investment before I see any profit.

Full Disclosure: Long GE. My full list of holdings is available here.

33 thoughts on “The Buyback Annoyance

  1. Paapaa says:

    The important thing is: does the buyback also mean executive compensation plan or not?

    Share buyback can be very attractive from taxation point of view – at least in the country where I live. I’d much rather take buybacks than dividends. Any day.

    But if the money goes to executives I won’t like it. No matter if it is buyback or direct salary etc.

    • Paapaa, Most executives have performance-related pay packages and generally speaking, their performance tends to be measured by the stock performance. In addition, the executive paypackages include options or RSUs, so they will authorize buybacks to drive those values up. Like I said, buybacks have a place in the market place, but I think that the cash is better spent elsewhere.

      R2R

  2. I like this post R2R. I see too many companies focusing on share buybacks and there seems to be alot of pressure from the top to do so. I think it wasn’t too long ago where Apple was getting pushed to do more share buybacks by one of those activist investors. Sadly these companies can be bullied.

    • Thats right, Kipp. Activists like Icahn are in it for a quick buck. Unfortunately for the rest of us, he and similar others have enough firepower to buy a big portion and have his voice heard and pressuring the board. Apple, which has the biggest ever buyback in the market, has been a bit more smart about it – with issuance of long term debt, a great environment for bond issuers but not so much for the buyers. Although it seems like Apple has all the cash on hand, unfortunately, most of it is tied up overseas … it’ll be interesting to see what Apple will do that cash.

      R2R

  3. Very interesting read. Buybacks are touted as great for investors, but I certainly see your point here. As a long term investor as well, I can see how it is not as beneficial. However, short traders can definitely take advantage of it did quick profits, as you mentioned with the ETF. Thanks again!

    • Agent, buybacks are the craze these days. The smart companies are investing elsewhere or paying down debt…for others, the partying continues – for now. We will probably look back at this time later and wonder why they didnt take better steps.

      R2R

  4. Definitely see your point. I’d rather see companies paying back their debts or acquire other companies. I think buying back shares just an accounting trick so the company can effectively increase their EPS.

    • Just like individuals, companies should follow the mantra of either paying down debt or investing. Another company that pops into mind is QCOM – one of my holdings – has no debt and is investing heavily in future technologies to grow and stay ahead of the competition. Even after that, they have so much cash left over – and they have a share repurchase program, which I think is better than programs from companies like IBM.

      Best wishes
      R2R

  5. R2R,
    I don’t mind buybacks too much. Yes, I’d rather get the money as a dividend. But reducing the number of shares increases the amount of dividends that can be paid to existing shareholders in the long run. I don’t like seeing companies borrow money to buyback shares. The increase in buyback activity was probably partly due to low interest rates and companies borrowed. If mgt sees nowhere to invest, and they already pay a nice dividend and grow it, then I think buybacks can be a nice supplement to boost the share price and future payouts. Apple is a good example of a company that had the extra cash to do this. It also helps to maintain a base in during a downturn. Apple’s base was around $500 when buybacks kicked in significantly.
    -RBD

    • RBD,
      Yes, there needs to be balance…as I mentioned – there is a place for buybacks as you, as a shareholder, dont want to keep seeing your value erode as companies issue more shares. Retiring shares are a great tool for that. However, I disagree that companies have nothing else to invest in. There are always options and the ongoing M&A wave is proof of that. Apple, imo, has been smart about the program.

      Best wishes

  6. R2R,

    Interesting post!

    You can count me in as a shareholder who would rather see a larger dividend than a larger net buyback policy.

    However, buybacks aren’t all bad, and can actually be quite lucrative for both companies and shareholders. Every net share bought back reduces the number of outstanding shares, which means those that are remaining own a larger portion of the company. Furthermore – this is where dividend growth investors should be happy – the company can increase the dividend more aggressively, because there are less overall shares to pay out on. It’s like if you had 10 shares outstanding in R2R Inc. and bought back a share, you’d only have 9 shares left. Therefore, if you were paying $1.00 per share before (for a $10.00 cash outflow) you can now pay ~$1.11 (an 11% increase) without actually paying any more out than you were before.

    I think the “financial engineering” claim is only valid when a company is borrowing heavy amounts to finance buybacks. However, this is quite unusual. And it still generally promotes shareholder returns. Look at Philip Morris. They’ve been taking on low-interest debt to retire shares paying out a 4.75% dividend. Obviously an intelligent move on the behalf of management. And Buffett is actually a big fan of IBM’s buyback program, which he cited as one of the big reasons he invested in the company. Every share wiped out means he owns a bigger portion of the company. So that’s an interesting counterargument there.

    Finally, it’s not like buybacks don’t result in shareholder returns a lot of the time. Capital gains are the other half of total returns, once you factor out dividends. And as you quote:

    “I am of the opinion that buybacks are one of the main contributing factors for the all-time stock market highs.”

    Those all-time market highs are providing capital gains for total return investors, so there is a benefit there. Now, that’s not a benefit you or I can appreciate because we’re trying to accumulate cheaper shares and we’re not interested in selling for capital gains. But the returns are there for those looking. Besides, there’s no way to know whether or not spending that capital to “grow the business” (acquisitions, etc.) would have caused shares to appreciate as much as the buyback via the EPS growth. Really tough to say. But I would agree with scaling back buybacks for many companies and increasing the dividend payout.

    However, I do agree with you that buybacks are easy to manipulate. And a lot of management teams are bad at executing the buybacks at the most opportune times. Target is an example of this. They’ve muted the buyback program after the stock took a massive hit, while they were busy buying back shares at higher prices. So the timing for a lot of management teams could be definitely improved. Mostly, I’d prefer a consistent and conservative buyback policy, with a more aggressive dividend payout/dividend growth policy. And then the rest of the capital that’s ordinarily used to grow the business would remain the same.

    Best wishes!

    • Thanks for the interesting feedback and the counter arguments, Dividend Mantra. Some very good points. I think you are spot on that retiring shares will mean that the company can keep the same payout amount but will result in a higher return for each shareholder.
      The financial engineering argument is two-sided. Obviously theres some good ones and some bad ones. The reason why I dont like IBM is because of the rest of their books. That money could be well invested elsewhere – as IBM desperately needs to find new avenues…from a purely financial perspective, the company is doing ok, but as someone in the tech field, I find it amusing to watch IBM.

      Yes, buybacks do offer great potential for total capital gains. Again, you are right in pointing out that being DGIs, we want lower entry points for long term investments. For traders moving in and out, and for the executives exercising their options at the market tops, its a great way to take some money off the table. Funnily enough, the timing for most of the buyback programs follow the market – instead of the inverse.

      Thanks for stopping by and the great response.
      cheers
      R2R

  7. Like Dividend Mantra commented above, I don’t think buybacks are all bad for Dividend Growth investors. Consider the pizza pie analogy. Dividing a pizza into 6 rather than 8 slices ensures a larger slice — so each shareholder owns a slightly larger piece of the company after the buyback. Furthermore, as a shareholder, you benefit indirectly without having to pay taxes on that benefit. And in the long run, continued dividend growth is more easily ensured because the total dividend stash gets distributed to fewer shares.

    If done responsibly, increasing debt to afford share buybacks is not necessarily a bad thing, either. Borrowing money at a favorable, long-term interest rate and generating profits (or savings) in excess of the interest with little to no risk, is a great business model.

    Like you, I don’t like the idea of companies exploiting these benefits to line the pockets of executives. Also, buying back shares when shares are expensive seems like a fool’s errand.

    Thanks for a though provoking post!

    • Great pizza analogy, Ferdis. I might use that when talking about it in the future 🙂
      Yes, I agree that companies can be smart about the program instead of simply following the crowd and being pressured by activists. Its one way of taking advantage of the low interest rates. As a shareholder of the company, issuing debt with a similar low interest rate to channel it to dividends can be a smart move. I think the bottom line is – not all buybacks are created equal!

      R2R

  8. Nice post R2R! Interesting take on the share buyback strategies the companies employ.

    I’m with you on owning a company like GE over IBM! As a matter of fact, we do own GE in our family’s dividend portfolio. We couldn’t be happier with our purchase and long term prospects.

    Wishing you continued success in your journey! AFFJ

  9. Greatly said!
    I agree that buybacks can and are often used more to reward insiders, reward short term stockholders, to hide insane stock option plans part of executives package, to show better numbers to the profane investor and please wall street wolves than to reward dividend growth investors… I prefer more dividend over more expensive shares…

  10. I’ve always been baffled by the fact that companies will buy high and sell low! But, this makes sense that buybacks are designed to reward insiders! Love the new design, by the way!

  11. There are so many accounting, financial and balance sheet manipulations that companies can do to make their performance look better and many do (Nortel). Thankfully the accounting and regulatory bodies try to plug the loopholes but in some cases the horse has already left the gate. I think share buybacks have their place if done for the right reasons – extra cash not needed for investment but cannot justify a dividend increase would be sustainable. As a shareholder, I would prefer a buyback than a dividend increase that was later reversed. I still get the benefit (increased ownership) but no downstream negative consequences. Listen to me here, I sound like I know what I’m talking about! LOL. Still learning. Thanks for thought provoking article! 😀

    • You are more on the money than you give yourself credit, debs. You are spot on there and I agree with you. The current buyback phenomena reminds me of the old adage – “when everybody is thinking alike, nobody is thinking”.

      The article was meant to spark a thought process and a conversation – glad that you liked it 🙂
      R2R

  12. You mentioned all the reasons why I don’t plan on owning IBM. Plus, I work in software and we are trying to get away from the high priced IBM tools and go to free open sources ones, which are just as good.

    I have mixed feelings on share buybacks and would rather companies get rid of debt or hold onto the money during good times, instead of buying back over price companies.

    While the market is high, it doesn’t bother me much that insiders are selling their stock, so much of there worth is in the company. It times were bad, I may be think otherwise though 🙂

    I think I need to hunt down a list of companies that insiders are buying right now. That may be very insightful at market highs.

    Take care!

    • Likewise, I am in the software industry – and find IBM to be too big to move swiftly and take advantage of the changing market conditions…which is a priority esp in tech.
      Yes, looking at insider buying can be a good clue to guess whats brewing under the covers that the general public doesnt know. Case in point, Richard Kinder was buying KMI shares by the millions before they announced the merger deal. Good thing I loaded up on some KMI shares before they shot up 🙂 Still wish, I had bought more.

      R2R

  13. Nice article W2R. I wouldn’t mind buybacks as long as the company doesn’t reward its executives with stock options to offset the buybacks. Buybacks help the dividend investors to get a bigger slice of the dividends without increasing the payout ratio. And it also helps us to own a bigger portion of the company.
    But I agree with you on the fact that companies use buybacks as “financial engineering” and use it to show results that aren’t truly there. For example, IBM has purchased close to 20% of its outstanding shares in the last 2+ years as one of the means to achieve its $20 EPS target by 2015 rather than focusing on actually increasing the revenue and profits. I am totally fine with buybacks as long as the company is growing its revenue and profits. If the company is not able to do that consistently over a period of time and is using buybacks as a means to show EPS growth, then it is time for us to revisit being a shareholder.

    DGJ

    • You are spot on, DGJ. There are good and bad buybacks and trying to figure out which ones make more strategic sense as company owners is important. Companies like IBM having resorted to such mechanisms are the reason why I stay away from them.

      Thanks for stopping by and the input
      Best wishes
      R2R

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