Credit Trends

Large Share Buybacks Again Prove They Are Misguided

As if we needed additional evidence large share buybacks are almost always a waste of corporate resources , I present a list of all companies having current market values of greater than $500MM that have repurchased at least 15% of their current market values and placed into treasury. As seen, the list includes many well known firms, including several that have bought back over 50% of their current market values. The average of these large firms have repurchased an astounding 36% of their current market value – yet, as opposed to their helping their shareholders-they have done the opposite-as their stocks have underperformed the return on the S&P 500!

As seen, stock buybacks have proved no refuge in a flat and falling equity market. The latest example is the current year, as the current quarter to date, with the S&P slipping 36 basis points thru last night’s close, the average of these firms has seen its stock fall by 52 basis points. Care for a longer time horizon?

For the past 5 years, the names on the list have returned 2.4% versus a return on the S&P 500 of 3.77%. To make matters worse, the list excludes those bankrupt or merged firms which repurchased large amounts of their own shares prior to their demise such as Bear Stearns, Lehman, and many, many others.

For the current quarter, Big Lots, Brunswick, Ferro,, Lamar Advertising, , Lenox Int’l, , Lexmark, Terex, Timberland have each fallen by greater than 20% this quarter.

I am not implying these firms will meet the same fate as Lehman, but rather time has proven again and again share repurchases, other than to perhaps offset stock based compensation, do not improve the lots of shareholders or bondholders. And for sound economic reason.

Share buybacks, like dividends must be rubber-stamped by Boards of Directors. They should understand that share repurchases, despite improving GAAP-based metrics do nothing to improve cash based return on invested capital.  On the contrary, by altering the financial structure, it often raises risk and hence, the cost of capital to the firm whose value they are entrusted to enhance. Value is created by adding to the capital base, joint ventures, increasing revenues, and by running the firm more efficiently-not by shrinking the equity cushion.

One lot whose fortunes share buybacks does improve are high paid executives whose bonuses and stock options are often based on GAAP accounting.

Warren Buffet recognizes this, and has never bought back a share of Berkshire. Adding to the capital base assets whose cash based return is safely and consistently above ROIC is a proven method for share outperformance over the long-term.

While part of the problem lies with shareholders themselves, as they continue to believe share buybacks “support the stock”, history has again clearly shown otherwise.

For a detailed example on why share buybacks do not increase ROIC, please contact CT Capital LLC and see “Security Valuation and Risk Analysis.”

Kenneth Hackel, CFA

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Over 90% of security analysts and companies which file with the SEC define free cash flow as cash flow from operating activities minus capital spending. This is incorrect. Of course, many firms tailor-make their own free cash flow definition.

It ignores the important misclassifications, one-time items, and areas of overspending as well as required spending (underpayments to pension plans, claims, etc.) that firms have not made, but need to.

A rather obvious example is that of Dr Pepper Snapple Group, which a simple investment screen would show as selling for 4x free cash flow. The reason is the recording as an operating cash flow activity one-time nonrefundable cash payments of $900 million from PepsiCo and $715 million from Coca-Cola, both recorded as deferred revenue.

Unfortunately, at CT Capital LLC, we come across a large number of less obvious and even “hidden”  within footnote and income statement items, activities which most analysts may not consider and which beefed up operating (therefore “free”) cash flows. For instance many firms bury asset sales and collections on insurance within broad classifications. Including these and other such items provides for a faulty appraisal of fair value.

For a complete discussion on this topic see Security Valuation and Risk Analysis..

Kenneth S. Hackel, CFA

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