Stock buybacks are one example of theory not quite holding up to reality. After the Securities & Exchange Commission issued a 1981 ruling which stated that companies will not be held liable for stock manipulation if they engage in repurchases of their own stock. Repurchases of common stock occurred before 1981, but it did not come with the explicit blessing from the SEC that civil and criminal charges for stock price manipulation would not apply.
Since then, there has been a significant debate about whether stock repurchases or significant dividend hikes are in the best interest of the shareholders. In the late 1990s, stock repurchases gained favor in corporate boardrooms, as stock options were tied to reaching earnings per share targets and the retirement of shares would help executives reach those target deals.
This is one of those big deal things in investing that you need to keep in mind–almost no executive is rewarded directly for maximizing the value of a stock program but does receive rewards for reaching a certain earnings per share hurdle. This encourages indiscriminate stock repurchases. And the reason I say “directly” is because some executive compensation plans do reward absolute stock price performance, and an effective stock repurchase program should enhance stock price performance provided the executive is there for a long enough time for the markets to be rational over the period in which he conducts these buybacks.
When the Bush tax cuts arrived in 2003, the buyback craze of the 1990s dampened as the incentive to raise shareholder dividends increased. Of non-retained earnings, about 35% was in the form of buybacks and 65% in the form of dividends in 1999. By 2003, buybacks were barely above 20% and dividends were around 80%. Now, 60% of non-retained earnings are stock buybacks and 40% are dividends. The 2012-2013 year marked the transition in which buybacks exceeded dividends in terms of capital allocation.
My ongoing concern about the rise of stock repurchases is two-fold: (1) The reduced focus on growing dividends removes a bit of the psychological advantage that enables shareholders to hang on through tough economic conditions as the arrival of cash reinforces the “realness” that can be lost when prices are falling; and (2) companies tend to be terrible at timing share buybacks, as they retire shares when the money flows in concurrently with high valuations and then have no excess cash to conduct buybacks when the stock is cheap.
That second is why I was critical of Emerson Electric last summer when it was buying back stock at $70 per share. It didn’t make sense–the company was great, probably one of the five best industrials to own for the long term, but the valuation didn’t make sense for buying back stock. Now, the price of the stock has come down to $43, and the buybacks are only occurring at ¼ the rate that existed at $70 per share. I do support well-executed buybacks like Berkshire Hathaway at 120% of book value, but there are too many companies that follow the Emerson Electric mold for me to welcome this trend.
Real estate investment trusts have long been a refuge for income investors that are skeptical of the effects of stock buybacks. That has been almost necessary by definition–REITs typically pay out 90% or more of income as dividends, and then issues new shares to fund acquisitions. Long-term share dilution is a regular part of the company’s ongoing story. I can find no REIT that existed in 2000 that doesn’t have at least double the share count in 2015.
But now, there is a growing trend that REIT investments too are engaging in the share buyback trend. Of REITs with a market cap over $1 billion, there are at least 22 that have announced stock buybacks in 2015. This is something I find unwise because: (1) it seems wasteful to repurchase stock when you have to turn around and immediately issue new stock, and (20 it is actually harmful because REITs are generally trading at premiums to cash flow that actually make REIT buybacks a modest penalty.
Take something like Simon Property Group. It is in just about every REIT mutual fund. It manages a good chunk of malls located in the United States. There are 1,100 malls in the country, and 207 of them have the Simon Property Group as the landlord. It turns out that being the landlord for malls is much more lucrative than being a tenant in one. Since the IPO in 1993, Simon Property has compounded at 16% annually. A $10,000 gentleman’s investment would turn into a quarter-of-a-million today.
The cash flow has improved from $4.96 in 2005 to $9.75 today. It’s still chugging along nicely. But here is my quibble: The company is now buying back stock even though it is expected to issue 10 million shares above the buyback amount in the next twelve months. That does not make sense to me. But it’s not a harmless error: The company is buying back stock at 19x funds from operations, even though it typically trades at 15x funds from operations when long-term interest rates are in the 5% to 6% range. It would take sustained low interest rates and higher than usual growth just for this decision to be neutral–anything less and this buyback will be a bit of value destruction for Simon Property holders.
There was a joke in the late 1980s that if Exxon did something different, soon every other company in the oil industry would do it, too. Exxon bought a fertilizer company, and shortly thereafter, Chevron and Royal Dutch Shell and ConocoPhillips owned fertilized companies as well. I’m not sure who the first mover in the REIT sector is, but a similar story is taking shape: Because some are engaging in stock buybacks now, a groupthink mentality has emerged in which all the billion-dollar players in the industry are joining suit.
But this is not a move in the interest of shareholders. Even with the recent declines in REIT valuations, there are still well above their ten year averages of price/funds from operations levels. Hopefully this buyback trend in the REIT sector will prove a fad that tapers off, as it doesn’t make sense in light of regular stock issuances nor does it make sense based on current valuations.
Originally posted 2015-09-25 21:51:00.
