Stock buybacks have been prolific in the past 15 months. This aggressive repurchase strategy might not be as beneficial as the market wants us to believe. Analysts at Ned Davis Research estimates that the S&P 500 would be 19% lower than it currently is today if companies hadn’t repurchased any stocks.
In my previous Stock Buyback Frenzy article, I discussed all the advantages and positives implications that stock buybacks could have on you and the stocks you are investing in. In this article I will look at the other side of the stock buybacks, including execs looking for short-term stock jumps for their own personal gain, repurchasing stock when it is overvalued, fending off an aggressive acquirer, leveraged buybacks and more productive uses of cash.
Overvalued Stock Buyback
A firm repurchasing its shares at an over-inflated price is against the entire principle stock buybacks and will have an adverse effect on the firm. When a firm repurchases shares at a price above its fair value, it is deteriorating shareholders value by the amount above fair value the stock was repurchased at.
Even though the behind the boards effect of this transaction might be a bit convoluted it makes logical sense that a company should never buy back stock above its estimated fair value. The issue with this is that the “fair value” of a stock is a fairly ambiguous evaluation.
Stabilize a Firms Falling Price
If a firm’s stock is driving down and there is no immediate action they can take to reduce this slide, a company may decide to buy back stocks to artificially raise the EPS and in turn keep the stock price afloat.
In this scenario, stock buybacks are doing the same thing for a firm as the Federal Reserve buying up all the junk mortgage-backed securities did for the US economy.
Wells Fargo (WFC - Free Report) has been caught up in scandals for the past 2 years and has had to shut down 100s of branches and cut over 26,000 jobs. None the less, WFC has spent over $20 billion last year on stock repurchases just to keep their stock in demand. The stock is down just over 15% in the past 52-weeks but the returns would have been worse if it wasn’t for the accelerated stock repurchases. You can see the average number of share accelerating downward in recent months.
Executive Bonuses/Stock Options
Executive bonuses are tied up in one of many metrics, whether it’s business profitability, return on equity, or even share price appreciation. The latter two can have an adverse effect on management’s judgment of the “best” time to repurchase its stock. A company’s Board of Directors initially authorizes a stock repurchase program, but it is up to management’s discretion to decide when this buyback is most opportune.
If a firm’s management has their individual compensation tied up with their stock’s performance then they may make some selfish decisions for short-term gains sacrificing long-term performance. Management may decide to reject a project with a huge NPV because the profits won’t be realized for a couple of years in order to buy back stocks so they can receive a fat bonus check at the end of the year.
This is the same case with stock options, execs may decide to buy back stocks regardless of valuation to temporarily raise the price so they can cash out of their options.
Fending Off a Hostile Take Over
There are a couple of defense tactics that a company can use in order to obstruct a hostile takeover attempt. One is a leveraged buyback which not only raises the price of the stock that the acquirer wants to buy, but also puts a large amount of debt on the balance sheet that makes the acquisition much less attractive to an acquirer. This is a self-destructive strategy because once the bidder losses interest the company will likely have to re-issue shares at a lower price to pay off the new debt on its balance sheet and the overall financial position of the company will be worse.
A second strategy to thwart off unwanted acquires is for the firm to just repurchase the stock from the acquirer at a premium. This would also have an adverse effect on a firm’s balance sheet.
More Productive Use of Cash
Sometimes management doesn’t know what else to do with its extra free-cash-flow, so they decide to buy back stock, as opposed to a dividend which investors expect to be consistent. Even if the stock is undervalued at the moment, there still might be more productive uses for the extra capital, especially if the firm is still growing. Such as needed capital expenditures, further investing in R&D, investing in operational efficiency, or even acquiring a firm that could create long-run growth & synergies for the firm. Anything with a good positive NPV.
Apple (AAPL - Free Report) is a still growing tech giant, spent $74.25 billion on buying back stock when they should be investing more into their R&D department, the heart and soul of this firm’s future growth. Only $14.2 billion was spent on R&D in 2018 less than 20% of what Apple spent on stock repurchases.
Oracle (ORCL - Free Report) is another tech firm that is spending way too much on stock repurchases. They have spent almost 5x more on stock repurchases as they did on their entire R&D department in 2018.
These tech firms need to reprioritize their spending if they are going to remain leaders in their space. The progress of science and technology should be more important than short-term capital gains.
In my eyes, buying back stock is something you do when you have exhausted all other avenues. There are many new investment prospects for a growing company to invest in that will have a larger shareholder return than repurchasing stock.
There are a lot of ways to repurchase stock at the expense of the company and its shareholders. Look through a firms stock buyback history to see if they are repurchasing stock at good prices and ensure that the firm isn’t buying back stock using debt financing. You can also look through a firm’s 10-k to see how executive bonuses are structured to determine if there is any risk of an exec exploiting his/her power for short-term gains. Stock repurchases can be a sign of an undervalued stock but make sure your due diligence is done before deciding whether it is a solid indicator.
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