In theory, buybacks can create more aggregate wealth than dividend payments because ordinary dividends get taxed at income tax rates while stock repurchases evade the reach of Uncle Sam. And the effectiveness of a stock buyback program is contingent upon the corporate management team getting the valuation. If you buy back stock when it’s cheap, you create value. If the stock is expensive and you repurchase stock, then you destroy value. That is why I have a special respect for Warren Buffett’s commitment to only repurchase Berkshire shares when it trades 1.2x book value or less–it is an implementation of the valuation requirement that is a necessary prerequisite for stock buybacks to create wealth.
Generally, the corporations that are most naturally suited to run successful buyback programs are those with large cash hoards, cheap access to borrowing, and/or stable cash flows even at the low points of the business cycle. Corporations that are cyclical in nature face an obstacle in running an effective buyback program because cash for buybacks is most readily available when the business is performing well and the stock price is high, but are more hard-pressed for cash when profits are down and the stock is cheap.
This requires a management team to be excellent stewards of capital by letting cash pile up during the good times so that it can be deployed during the bad times. It requires discipline, but if executives are going to make millions, it should be part of the job description.
To get an idea for how difficult it is to run an exemplary stock repurchase program, take a look at the history of Home Depot (HD) stock.
In 2007, it had 1.69 billion shares of stock. Profits were at $4.2 billion per year. When the recession came, profits fell to $2.8 billion. The stock price fell from $42 to $17. The valuation was at 9x earnings.
Guess how many shares Home Depot management decided to reduce the share count by while the stock was cheap? Z-z-zero. None. Nada. Home Depot carried 1.69 billion shares through 2008, 2009, and 2010. The average price of the stock during this time was $23.43 per share.
Now, the price of Home Depot stock is at $130 per share. The valuation is at 21x earnings, and this is the highest valuation that Home Depot has ever experienced since becoming a large-cap stock with the exception of the 1998-1999 period.
So, what does Home Depot do now that the stock is moderately expensive? It is buying back stock aggressively, retiring three hundred million shares in the past four years. The average price is $98.22.
When the stock was at $23 eight years ago, Home Depot didn’t elect to repurchase any shares. Then, when the stock quintuples in price, the buybacks occur at an aggressive price. If I were Home Depot management, I’d shore up the balance sheet which currently has $4 billion in cash against $20 billion in debt. I would use the strong balance sheet to go on the offensive and repurchase stock during recessions, and I would refrain from doing so now when the valuation is high.
So why don’t they do that? Because you get the boost to earnings per share growth. EPS of 10% can be reported as 12%, and management receives extra cheers in the short run. But it is an example of seeking short-term praise at the expense of the long-term best interest.
None of this is to say that Home Depot is a bad investment. It does have extraordinary earnings growth characteristics over the course of a full business cycle, and its business model requires physical visits for precision that gives it an advantage against rising e-commerce competition. However, the likely success that Home Depot shareholders will receive will be in spite of its buyback allocations, not because of it.
Originally posted 2016-12-02 13:15:35.
