Corequity provides independent, institutional equity valuation research. The results are used to screen for the best and worst values out of over 500 equities on a continuous basis. We have accumulated a proprietary database of historical monthly valuation data. For a brief background... http://corequity.blogspot.com/2013/05/some-background.html
Robert, I read with
great interest your recent blog post demonstrating the relatively low ROI's
required to replicate EPS growth from equivalent share buybacks.
Your analysis suggests profound flaws in the two most common rationales
corporate executives give for their share buyback programs
1.Our actions reward
shareholders by making their shares more valuable
2.Our stock is
undervalued. Our actions reflect management's confidence in our growth
potential
The first argument may
be true for EPS, but not for long term stock price appreciation. The second
argument is even more galling, as your analysis suggests exactly the
opposite. Given your results, the only logical explanation to go ahead
with an aggressive buyback program is that management actually doesn't
believe it can generate even modest returns on its cash from current
operations. Or said another way, management is in essence saying they are
giving money back to shareholders because they have run out of ideas on how to
generate attractive returns within the company. Or course, the more
likely explanation for share buybacks is management bonus kickers based
on EPS. So much for CEO's and boards acting in the best interest of
shareholders.
I teach business
strategy in the MBA program at Columbia Business school where I share a
perspective that effective capital allocation is one of the most important
responsibilities of the CEO. To illustrate the point, I point to IBM who
has skewed its use of capital (including debt financing) towards share buybacks
at the expense of value-creating investments in R&D and capex. As a
result, IBM's R&D lags its technology peers, and not surprisingly (despite
aggressive acquisition activity), its revenues have declined for 15 straight
quarters. The attached figure graphically depicts these trends.
HP is another case of
the folly of favoring share buybacks over R&D in the tech industry.
Carly Fiorina is often criticized for her disastrous acquisition of Compaq, but
her successor Mark Hurd also deserves notoriety for slashing HP's R&D
expenditures while sizably expanding HP's share buyback program.
Shareholders who
maintained their investments in both of these companies through their periods
of substantial share buybacks have not fared well.
I'd be curious to
learn whether you've done any analysis tracing the stock price performance
(relative to the S&P 500) of companies who have been most active in stock
buybacks. Has management unwittingly practiced buy high/sell low?!
Marissa Mayer, chief executive of Yahoo.CreditRamin Rahimian for The New York Times
It is one of the great investment conundrums of our time: Why do so many stockholders cheer when a company announces that it’s buying back shares?
Stated simply, repurchase programs can be hazardous to a company’s long-term financial health and often signal a management that has run out of better ways to invest in the business.
And yet investors love them.
Not all stock repurchases are bad, of course. But given the enormous popularity of buybacks nowadays, those that are harmful probably outnumber the beneficial.
Those who run companies like buybacks because they make their earnings look better on a per-share basis. When fewer shares are outstanding, each one technically earns more.
But a company’s overall profit growth is unaffected by share buybacks. And comparing increases in earnings per share with real profit growth reveals the impact that buybacks have on that particular measure. Call it the buyback mirage.
Consider Yahoo. The company bought back shares worth $6.6 billion from 2008 to 2014, according to Robert L. Colby, a retired investment professional and developer of Corequity, an equity valuation service used by institutional investors. These purchases helped increase Yahoo’s earnings per share about 16 percent annually, on average.
But a good bit of that performance was the buyback mirage. Growth in Yahoo’s overall net profits came in at about 11 percent annually.
Given these figures, Mr. Colby reckoned that Yahoo, if it had invested that same amount of money in its operations, would have had to generate only a 3.2 percent after-tax return to produce overall net profit growth of 16 percent annually over those years.
Some companies argue that the money they spend repurchasing stock is a shrewd use of their capital. And given Yahoo’s track record in recent years, its management team seems to have had a hard time identifying profitable investments.
But Mr. Colby pointed out that buybacks provide only a one-time benefit, while smart investments in a company’s operations can generate years of gains.
Yahoo declined to comment on its buybacks.
This analysis may be of interest to Starboard Value, an activist investor that is a large and unhappy Yahoo shareholder. On Thursday, Starboard nominated nine directors to replace the company’s entire board, saying its current members lack “the leadership, objectivity and perspective needed to make decisions that are in the best interests of shareholders.”
In a statement, Yahoo said, “The board’s nominating and governance committee will review Starboard’s proposed director nominees and respond in due course.”
Yahoo is not alone. Mr. Colby conducted a cost-benefit analysis of 26 companies buying back stock versus using that money to invest in a business.
He found that McDonald’s was another problematic example. Since 2008, McDonald’s has allocated almost $18 billion to buybacks. This has helped produce 4.4 percent increases in annual earnings per share over the period. To equal that growth in overall earnings, the company would have had to generate just a 2.3 percent return on the money it spent buying back stock, Mr. Colby estimated.
Last November, Moody’s Investors Service downgraded McDonald’s unsecured debt rating, citing its plans to increase its borrowings in part to fund future buybacks.
Becca Hary, a McDonald’s spokeswoman, said the company had a “balanced and disciplined capital-allocation strategy that promotes long-term value for our shareholders.” She cited McDonald’s plans to invest $2 billion to open a thousand new restaurants and “to reimage 400 to 500 locations” domestically.
In an interview, Mr. Colby said his research “confirms my suspicion that while buybacks are not universally bad, they are being practiced far more broadly and without as much analysis as there should be.”
Perhaps the crucial flaw in buybacks is that they reward sellers of a company’s stock over its long-term holders. That’s because a company announcing a repurchase program usually sees its stock price pop in the short term. But passive investors, such as index funds, and other long-term holders gain little from the programs.
Especially problematic are buybacks financed with borrowed money; repurchases of stock made at prices above its intrinsic value are also unwise.
Another hazard: companies that spend billions to repurchase stock without substantially shrinking the number of shares outstanding. That’s because in these circumstances, prized corporate cash is used to buy back shares that offset stock grants bestowed on company executives in rich compensation plans.
And there are plenty of companies whose buybacks have simply left them with less money to invest in more promising opportunities.
“By throwing away money on buybacks, companies are giving up on the ability to grow in the future,” said Michael Lebowitz, an investment consultant and macrostrategist at 720 Global in Chevy Chase, Md.
At last, some investors are stirring on this issue. Domini Funds, a mutual fund company, and the A.F.L.-C.I.O.’s investment funds have submitted shareholder resolutions on share buybacks at 3M, Illinois Tool Works, Target and Xerox this year.
The proposals ask the companies to adopt a policy of excluding the effect of stock buybacks from any performance metrics they use to determineexecutive pay packages.
“We’re not against buybacks,” said Adam M. Kanzer, a managing director at Domini. “The question is at what point do buybacks become excessive and when do they undermine the long-term value of the company?”
At 3M, for example, research and development expenditures plus strategic acquisitions have totaled $22 billion over the last five years, Mr. Kanzer said. In the meantime, the company’s buyback program has cost $21 billion.
“When the buyback almost equals all the other expenditures, it makes sense to ask questions about whether there’s a more constructive way to invest that capital,” Mr. Kanzer said.
Asked about these questions, Lori Anderson, a 3M spokeswoman, referred me to the company’s proxy filing, which stated, “We believe these concerns are unfounded, as demonstrated by our long-term track record and our balanced capital-allocation approach.”
A group of institutional investors will also convene soon to examine the pros and cons of buybacks. The Shareholder Forum, which conducts independent programs to provide information that helps investors make sound decisions, is starting a new program on the topic.
“You really have to ask why a company’s board decides to return a big chunk of capital instead of replacing managers with ones who can figure out how to develop the operations,” said Gary Lutin, who oversees the Shareholder Forum.
“If the board doesn’t think it’s worth investing in the company’s future,” Mr. Lutin added, “how can a shareholder justify continuing to hold the stock, or voting for directors who’ve given up?”
The Undervalued Screen was up an average of +2.9% while the
Overvalued were down -0.6% relative to the S&P 500 in February. This represents quite a change from January.
The gains and losses of those
stocks leaving the screens are even more dramatic. Stocks leaving the UV gained 8.2% relative
while those leaving the Overvalued declined by 9.3%.
There has been a significant change in the market's appreciation of value in equities this month. As noted below in the February 1st comment on January's results, the Overvalued had outperformed the Undervalued list by 4.7%. This has now reversed and the December Undervalued list is now 2.0% ahead.
This is also reflected in the Screens from January 31st where the Undervalued has outperformed its opposites by 4.9% this month. This indicates a definite change in the tone of the market.
The
goal in buying back shares in a company is to increase the growth rate of the
earnings per share. However, there is no
benefit accruing to the growth in Net Profit which is unaffected. This analysis calculates the after tax return
on the funds used in the buyback program that would be necessary to grow the
Net Profit at the same rate as the EPS.
Clearly this is a desirable goal and the rates required are surprisingly
low which suggests that the buyback programs are a poor use of resources.
Imagine if the shareholders of
Bed Bath & Beyond were asked a question in 2008.
“Would you prefer to have growth
in Net Profits of 9% or 17% in the next seven years, assuming that the growth in earnings per share would be the same?"
Surely
they would have elected the higher net profit (i.e. more money) and you would
think that management would too but you would be wrong.
In the
period between 2008 and 2015, BBBY bought back 38% of their outstanding stock
at a cost of over $6 billion dollars. (That turns out to be equal to the total
net profit during the entire period.) We
calculate that the company would only have needed to earn 6.9% after tax on those
funds to grow their Net Profit at the same rate as the earnings per share which
was 17.3%. In 2015, the difference in Net Profit would
have been $1,300 million vs $800
million. That is $500 million more in one
year (over 60% and growing!) if management successfully reinvested the funds at under 7% instead
buying their own stock.
I should
point out here that I don’t think that BBBY is a bad company but rather one of
many that are following a very bad practice.
As shown
in the following table, BBBY is not alone. Most of these companies[2]
would only have to earn a fraction of what they achieved to have made
significantly more money for their shareholders. This is shown in the last column (MP/NP)
where the range of missed profits is from 8 to 101% of Net Profits in 2015.
Home
Depot (HD) is another good example. They
bought back 27% of the shares outstanding in 2008 at a cumulative cost of $29
billion. EPS grew at 16.8% while Net
Profit grew at only 12.5%. Had they
reinvested those funds at 6.3% after tax, they would have had grown their Net
Profit at the same 16.8% and earned close to $2 billion more in 2015 Net
Profit. That is close to a third more
than they actually earned.
One
possible explanation is that management is motivated to increase their
incentive remuneration by increasing the growth of earnings per share without risk.
However these companies justify their buyback programs, it is clear that most would
need only a small ROI to enhance the shareholders’ real returns. Seven out of these 12 examples have a
required return to balance EPS growth of under 7 % with Allstate (ALL) and
Kimberly-Clark (KMB) being the lowest.
Alternatively,
in cases like some Banks, the reason might be that they can’t re-invest at even
the minimum required return. However, this
explanation would be just as detrimental to the stock.
I
recently was with the CEO of an international firm that employees 70,000
persons world-wide, has a market cap of $24 billion and whose stock gained 330%
in the last 7 years. I asked him if his
company had bought any stock back and his answer was: “Non - it is better to finance growth which
will generate long term returns.”
Stocks with a Value Line Safety Rank* of 3, 4 & 5 contribute to our performance measures for the Under- and Overvalued stock screens. Stocks with a Rank of 1 or 2 do not contribute to any appreciable amount. The latter are characterized as having above average market capitalization and yield. They account for 35 % of the observations in our monthly analysis of 500 equities over the last 11 years.
Using the quartile rankings for Valuation Return/Risk (VR) and the ratio of Estimated earnings/ Normalized earnings (E/M), we compare the average of next month's Relative Strength for quartiles 1,1 (Overvalued) vs 4,4 (Undervalued). As shown in the first example, the average Undervalued stock outperforms the S&P 500 by 44 basis points while the Overvalued underperform by 6 bp. The resulting spread of 49 bp translates into an annual 6.10%.
Screening
for Safety Rank of 1 and 2 only reduces the
spread to only 0.01% or 0.13% pa. This strongly suggests that, on average, these stocks are more efficiently
priced.
Screening for Safety Rank of 3, 4 and 5 only improves the spread to 0.57% or 7.03% pa. The rank of 3 alone, which has 58% of the observations, has a spread which is even higher at 0.63% or 7.84% pa suggesting that the middle ground, in terms of quality is the most inefficiently priced.
Robert L. Colby
November 11th 2015
* The Safety Rank is computed by
averaging two other Value Line indexes the Price Stability Index and the
Financial strength Rating. Safety Ranks range from 1 (Highest) to 5
(Lowest).- Value Line
The returns from the Undervalued and Overvalued lists are compared to the 10 year returns in the Globe & Mail univerese of US equity funds. Without income or management fees the average annual returns of +9.29% and +4.89% would have ranked in the 97th and 42nd percentiles for a spread of 55.
This compares to the 99th and 39th percentile ranks respectively for 10 year results a year ago.
We compared the stocks in the S&P 500 Buyback ETF (SPYB), of which we cover 66 out of 100, to our universe of approximately 500 stocks to evaluate what they achieved for the money they have spent.
The bottom line is that it appears that the buyback programs have bought very little benefit, if any.
This table compares the median values of the SPYB stocks to our Universe.
First, the SPYB stocks are undervalued by 7% as indicated by VR or Valuation Return/Risk. What is the point of spending money to goose your stock price if your stock is remains undervalued ?
Their growth rate (RR, or Reinvest Return) is a percentage point better than average but this likely is entirely attributable to the deductions from book value due to buying back shares above book value (its called 'decimating the denominator' and is good for executive compensation bonuses).
Not shown in the table are the median P/Es which are 13.1x vs 15.1x for the universe!
The result of the higher return and lower P/E is a shorter Payback (PB) for the Buyback stocks, i.e.8.0 vs 8.5 years. These stocks are cheaper!
It is interested to note that the median target Payback (NM) for all stocks is 103% of the S&P 500's while the Buyback stocks' target is only 95% which suggests lower long term valuations.
Finally, it is worth noting that the median market cap of the buyback stocks is double that of the and is just over the line into the 4th quartile. As shown in the preceding post, the 4th quartile market caps have a slightly negative VR so it can't be argued that the lack of demonstrable benefit from the buyback programs is attributable to being big caps.
In short there is no evidence here that they have achieved any benefit from spending all that money on buying back their stock.
October 29th Addendum: Performance
One argument in favor of buyback programs is that the reduction in shares leads to higher eps growth and, hopefully, higher stock prices. However, this isn't working right now. This Yahoo graph shows that the SPYB ETF has underperformed the S&P 500 by close to 6% in the last 6 months.
Growth is undervalued by the market today. The lowest quartile in Reinvestment Return (RR) has a median VR of - 9% while the top quartile median is +11%. There is little difference across the Yield quartiles but when added to RR, we get an even higher discrimination over the combined IR (Inherent Return) which is RR + YLD
Low Payback shows the best disparity in value of +54% vs +31% for IR
The ratio of Estimate/Normalized earnings (EM or E/M) shows the best values at the least attractive end of the range while the small Market Caps are more undervalued that Large Caps by 7%.
NB Quartile ranks go from low to high.
Value by Sector is summarized in this table -
The best values are in Basic Materials, Financial and Industrial Sectors while the worst is the Utilities.
Value has been driving the equity market for a while now. The Undervalued are comprised of the top quartile of both the Valuation Return (VR) and the Estimate/Normalized Earnings (EST/MPEPS or E/M or 4,4). They are in a positive trend of +4.3% pa, relative to the S&P 500, while the Overvalued's (1,1) downtrend is 3.9% pa for a spread of 8.2%. The spread is even higher using the Universe as the standard.
In May, the UV stocks were up 4.5% while the OV declined 1.1% for a spread of 5.6% in one month.
So far in June (to June 24th intra-day), there has been a reaction to last month's gains and the Overvalued are up 2.5% relative to the market. The Undervalued are down fractionally.
For a list of the screens, email robertlcolby@gmail.com
I was asked recently to explain more fully what caused the most recent performance anomalies of the Under- and Overvalued screens.
The chart below shows the performance of the Undervalued and Overvalued screens relative to our universe of approximately 500 equities. The Undervalued are comprised of the top quartile of both the Valuation Return (VR) and the Estimate/Normalized Earnings (EST/MPEPS or E/M).
Since inception in 2004, the Undervalued have outperformed the universe by 2.30 % points pa while the Overvalued under-performed by 3.23 % for a spread of 5.53% pa*.
However, there are three anomalous periods where investing in value bore a cost. The first is the sub-par performance of the Undervalued from May 2008 to December 2008 (months 43 to 50). The second, also affecting the Undervalued, started in January 2012 and lasted until April 2013 (months 88 to 103). Finally, the third anomaly is the superior performance of the Overvalued which took place between September 2011 and February 2014 (83-112).
The following is an analysis of the causes of the two most recent periods of sup-par performance.
Undervalued (88-103)
This table shows the undervalued stocks which were screened in months 88-103. The column on the right shows the cumulative Relative Strength to the S&P that the individual stocks contributed over the 15 month period. The worst 6 equities, 12% of the total number, account for 84% of the decline of 18% relative.
The column on the right above is shown in the graph below. It illustrates that relatively few stocks accounted for the poor performance. This is also shown by the median of all of the cumulative relative returns which is close to zero.
Looking at the performance by Sectors, Basic Materials is overweighted and is also had the worst performance. Technology has an equal weighting but is also a major contributor.
Looking at the individual stocks, a common characteristic is the secular (vs cyclical) decline in the estimated earnings in the months following being screened. Where this occurs, it shows up as a decline of the normalized earnings (MPEPS - red line). The following individual equity graphs show the Estimated earnings (EST), normalized earnings (MPEPS) and the implied earnings (IEPS). The green bars indicate the months that the equity was screened.
CAT is an exception in that there is little decline in the normalized earnings suggesting the decline in estimates was more cyclical. The majority suffered a secular decline in earnings.
Overvalued (83-112)
The superior performance of the Overvalued screens in months 83-112 somewhat overlaps but has a substantial positive median return. Here the median cumulative Relative Strength of all stocks screened is +5.7%, or an average of 0.74% per month.
The top and bottom screened equities by total Relative Strength are shown here (the file below is complete)
Sector weighting and performance is shown here and it is clear that Consumer Cyclicals had a lot to do with the positive performance of the Overvalued screens. They had twice the weighting and strongly positive relative strength.
As it turns out, there was (and is) a huge bet on Home Building and Building Supplies.
Examples of the top contributors are:
KBH's estimates do rise to the level of Implied Earnings. This is the only one where the earnings estimates rose to the level of implied earnings when screened although normalized earnings remains well below implied.
LEN has rising earnings estimates but implied earnings remain well above.
In this instance, the majority of these stocks benefited from expectations that failed to materialize, some of which persists to the present.
* The Universe did 2.18% pa better than the S&P 500, very similar to an unweighted S&P 500 return.
