Friday, January 27, 2017

The Mechanics of Stock Buybacks

Conclusion: From the Shareholders perspective most Stock Buybacks produce little benefit when compared to investing the same funds in the company. They produce a onetime gain in Earnings per Share (usually small) but contribute nothing to the growth of the Net Profit or Market Capitalization.  If a company is truly unable to successfully invest the Buyback funds in its business, it would be much better for the majority of shareholders to receive a Special Dividend.
For the twelve months ending September 2016, total share buybacks were close to $600 billion for the S&P 500 companies.  This is an enormous amount of money being 66% of the earnings and only slightly less than Fixed Capital Expenditures in the same period.  The average buyback program resulted in a “buyback yield” of just shy of 3%[1].  This resulted in a very modest annual decline in the shares outstanding which led to an equally modest one time gain in Earnings per Share for the Shareholders, i.e. the vast majority who did not sell their shares. 
Because Buybacks and Dividend Yield are considered to be returns to the Shareholder they tend to be lumped together in statements like the “Total Shareholder Yield is currently close to 5% comprised of a 2% dividend yield and a 3% buyback yield”.
This is very misleading.  The source of funds for Buybacks are the earnings and deprecation which should be first and foremost compared to what they would have achieved if invested.
A 3% “Buyback Yield” is greatly inferior to investing in the company’s business, acquisitions, or a Special Dividend which would be shared by all Shareholders in hard dollars as opposed the soft dollar benefit attributable to fewer shares.
Here is an example of a typical S&P 500 equity. It has a market cap of $15 billion; its shares are at 15x earnings and it buys back 3% of its outstanding shares.  This is compared to a hypothetical but typical Investment producing 3% in the 1st year, 8% in the 2nd and 10% thereafter.

The share purchase of 3% of the float produces a 3.5% pop in the EPS on day one.  Annualized that is 3.5% in the first year, 1.7% per annum in the second and so on.  By the second year, the Investment produces a higher return.  By the 7th year, the Investment led to a Net Profit of $985m which is almost double the first year’s investment while the Buyback produced zero contribution to Net Profit.
Were the stock price reduced by half and the Buyback amount kept the same you would get the following result.

The original gain in EPS is increased to 7% but it soon pales by comparison to the Investment.
Using the original price of $15 and twice the buyback funds ($1,000m), the result would be the same as in Example 1 but the dollar gain in the Net Profit from Investing would double as twice the funds were used.

These hypothetical examples illustrate the mechanics of stock buybacks.  Now let us look at two actual examples. 
 The first is Apple as it is listed as the most aggressive in terms of dollar amount of funds spent on buybacks in the last 12 months[2].

Despite Apple having spent the over $30 billion, it confirms the disadvantages of Buybacks compared to Investments.  In this case we used the average Return on Capital that they earned from 2009-15.
Now let us look at one of the most aggressive buyback programs in terms of the percentage of stock that was bought.  Corning Inc. purchased over 20% of their outstanding shares in the last 12 months[3] which produces an initial gain of 27% in EPS on day one.

However, even this aggressive program fails by comparison to the Investment after year three even though their Return on Capital is only average.
One of the reasons that investors are not more critical of stock buyback programs may be because of by doing it year after year management creates the illusion that it is compounding.  As shown here, the transactions are still a series of simple interest transactions. 
The proof of this is found in the Net Profit Test. It answers the question:
What is the Required Rate of return on an Investment of the funds, that would grow the Net Profit at the same rate that the EPS grew due to fewer shares.  Like Apple, the answer is surprisingly low in most instances.  We analyzed 30 Stocks whose buyback programs resulted in a median decline of 25% of their outstanding shares from 2008 to 2015. The median Required Return would have been only 4.9%. 
The median growth rate for their EPS was 7.7% pa while the Net Profit grew only at 2.4%.  Instead, by investing at less than 5%, the Net Profit would have been 42% higher in the 7th year. Over the seven years the cumulative gain in Net Profit would have been 1.8x the original investment.
It doesn’t make sense to put the growth of Earnings per Share ahead of the growth of Net Profit and as a result, Market Capitalization.

© 2017 Robert L. Colby                                                            Contact: robertlcolby@gmail.com




[1] FactSet Buyback Quarterly December 19 2016  www.factset.com/buyback
[2] FactSet
[3] FactSet
[4] http://corequity.blogspot.com/2016/04/the-net-profit-test-comparing-buybacks.html
[5]

Monday, January 2, 2017

Performance of November 30th Screens in December

The November 30th Undervalued stocks outperformed their counterparts by +3.3% to -1.5% for a spread of +4.8%.

It should be noted though that the Overvalued have over 50% of their representation in the Energy Sector which could lead to underperformance if, for example, energy stocks get a significant lift from positive ETF cash flows