Share buybacks is when a company buys its own shares from the open market. There are plenty of reasons to do this, but if done unwisely, the results may be disastrous.
Plenty of Reasons
There are plenty of reasons for share buybacks. Here’s a few:
- By having a larger stake in the firm, it can be a preventative measure against an outsider taking a controlling stake.
- With less shares outstanding, the remaining holders have a higher portion of the earnings pie, usually elevating the stock price.
- Its an alternative to dividends: Laws may vary between countries, but typically dividends are taxed twice; Once on the regular operating profits, and a second time on dividends.
Obviously as intelligent investors, we are interested in management incentives. If a company is doing buybacks, are they doing them for the right or wrong reasons?
When Done Wrong
There’s nothing inherently wrong with share buybacks. But when mismanaged, the results are not pretty.
If there is an incentive for management to increase share price (aka. market cap), buybacks are a shortcut to this. In this situation, management is incentivized to buy with a disregard to price. Granted, it’s an easy sell to unsophisticated shareholders: “Less shares outstanding means a higher EPS for you, and an increased share price!”. Who’s gonna object? You can avoid this trap by looking into management incentives in proxy statements.
Buybacks via Leverage: Playing With Fire
A ginormous red flag is if a company is taking on debt to finance its share buybacks. Not only is the leverage a massive burden if things go wrong, but most likely the management has no concern for the buyback price. A perfect double whammy in the making.
As a rule of thumb, you’ll wan’t to stay away from over-leveraged companies anyway.
Share Buybacks Done Right
Now that we’ve looked at some of the bad, let’s get into the good. What you wan’t to see mentioned in company documents, is a statement on strategic buybacks. You wan’t the company to specifically mention that buybacks are an alternative, but only when the price is right (aka. undervalued).
If management understands that price and value are not always in equilibrium, share buybacks are an excellent way to reward shareholders. If the undervaluation is corrected, there’s a handsome profit to be made once the company resells to the market. As an intelligent investor, you are already equipped with an owner’s mindset. Thus you see the logic in management buying its shares at a discount instead of paying a dividend.
The Critics in the Mainstream
If you Google the term “stock buybacks politics”, you’ll see a consensus: “Stock buybacks only benefit Wall Street”, “Buybacks should be illegal unless there’s a $15,00 minimum wage” etc.
I’m not going to pick a side if buybacks as an activity is right or wrong. The question to me really boils down to the age old: What is the purpose of a firm?
To answer the above question, I’ll cleanse my libertarian goggles. If a firm states itself that it’s purpose is to make a profit, so be it. If a firm states something else, so be it. As a shareholder, it is my responsibility to know what I own. This means that I understand the incentives of its decisions. As a shareholder, I want management to be responsible with the company. My company, no matter if I own 1 share or 1,000,000.
If I believe an investment decision is better if the company behaves altruistically, that’s how I invest. A firm should choose itself what it wants its mission to be. If there is a demand for what the firm is offering, voluntary transaction will occur.
Conclusion
I digressed a bit in my last paragraphs, but I saw it as somewhat necessary. To conclude, you want to make sure the company is using its funds (your funds) intelligently. If it involves buybacks, make sure they understand the difference of price and value, and behave accordingly. Beware of leverage in buybacks, and know the management incentives.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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