In 1841, Charles McKay wrote his famous book “Extraordinary Delusions
and the Madness of Crowds”. Its
first volume dealt with economic manias and bubbles, the most famous of which,
to that date, had been the Dutch tulip mania.
Manias, being born from mass human behavior, have endured as exemplified by the Internet and “eyeballs” stock craze at the turn of last century. Over the last decade, another one has flourished and while its cost has already been high, we likely haven’t paid the full bill yet. I am talking about stock buybacks.
This mania is insidious and rarely makes headlines: after all, it is easier to laugh at hapless retail investors riding the latest wave of euphoria for Covid-19-proof stocks or for cloud-centric IPOs. Large companies are managed by cooler heads, have carefully crafted operating procedures and vigilant boards of directors to rein in overly optimistic CEOs, or do they?
The truth is many companies have bought back their stock, and over the last 30 years, those that did have seen, in the aggregate, their share price perform better than those that didn’t. In part, this is explained by the fact that the better companies generate more cashflows (with which to buyback shares) and their better share performance also reflects their better businesses.
The stock buyback movement has accelerated over the years. While the ratio of buyback value to market (S&P500) hasn’t changed much since 2004 at around 3% p.a., the timing of these buybacks has been poor: companies backed the truck as market indices soared (see below) but stepped back when valuations were attractive.
Furthermore, more and more buybacks are funded by debt as opposed to free cashflows (see below).
The table below maps the trends in shares outstanding (in millions)/long-term debt outstanding (in billions of US$)/net worth (in billions of US$) for a cross section of US blue-chips.
|
|
2010 |
2012 |
2014 |
2016 |
2020 (e) |
|
American Airlines |
|
|
697/16.2/2 |
461/22.5/3.8 |
515/30/(4.5) |
|
Boeing |
735/11.5/2.8 |
756/9/5.9 |
707/8.1/8.7 |
617/9.6/0.8 |
566/60/(13) |
|
Corning |
1,561/2.3/19.4 |
1,470/3.4/21.5 |
1,271/3.2/21.6 |
926/3.6/17.9 |
761/7.5/13.3 |
|
Emerson Electric |
753/2.5/9.8 |
724/3/10.3 |
697/2.4/10.1 |
643/1.9/7.6 |
595/1.2/8.5 |
|
McDonald |
1,054/11.5/14.6 |
1,003/13.6/15.3 |
963/15/12.9 |
819/25.9/(2.2) |
744/35/(10.5) |
|
Microsoft |
8,668/4.9/46.2 |
8,381/10.7/66.4 |
8,239/20.6/89.8 |
7,808/40.8/72 |
7,571/59.6/118.3 |
|
Regeneron |
87/0/0.5 |
95/0.3/1.2 |
102/0.1/2.5 |
106/0.4/4.5 |
105/0.7/12 |
Source: Valueline.
The above table deserves a few comments.
First, shares outstanding reflect the issuance of new shares and corporate
buybacks, so that annual buybacks are generally higher than the difference in year-end
outstandings. Second, the table shows
long-term debt outstandings with no mention of cash holdings which reduce net
debt levels.
As to the companies listed: American Airlines filed for Chapter XI in December of 2011 and emerged from bankruptcy in December of 2013. Nevertheless, in 3 years (2014-2016) it repurchased at least 1/3 of its common shares outstanding and despite generating an aggregate of $13 billion in earnings and $17 billion in cashflows, it increased it long-term debt by 39% or $6.3 billion.
On the surface, although Boeing share count was reduced by 16% through 2016 and 41% through 2019, the company seemed to have acted reasonably since its long-term debt actually decreased over the 2010-2016. Not so. By the end of 2019, debt had risen by 73% from 2010 levels, and by the end of 2020 it is expected to rise another 200%! Worse, to support its massive share buybacks and the payment of dividends, the company diverted funds which normally would go to investments in new products and manufacturing excellence.
This is apparent in the table below. Over the 2016-18 period, Boeing used 88% of its cashflows to buyback stocks and pay dividends, leaving very little for productive investments.
|
Cashflow from Operations |
Dividends + Stock Buybacks |
End of Year Cash |
Cumulative use
of cashflows for dividends and buybacks |
|
|
2016 |
$10.5 bn |
($9.4 bn) |
|
($9.4 bn) |
|
2017 |
$13.3 bn |
($12.3 bn) |
|
($21.7 bn) |
|
2018 |
$15.3 bn |
($12.8 bn) |
|
($34.5 bn) |
|
2019 Q1.[1] |
|
|
$6.8 bn |
|
McDonald pushed the envelope even further, spending 158% of its operating cashflows on dividends and buybacks over the 2016-2018 period. From 2010 to 2020, its share count will have dropped by 29% and its long-term debt will have tripled! It almost paid the price when Covid-19 wrecked financial markets this last March. Had the Fed not injected trillions in liquidity, McDonald could have faced real difficulties. Unlike Boeing though, its capital investment needs follow a shorter cycle and are more discretionary in nature.
|
McDonald |
Cashflow from
Operations |
Dividends + Stock
Buybacks |
End of Year Cash |
Cumulative use of cashflows for dividends and
buybacks |
|
2016 |
$6.3 bn |
($14.2 bn) |
|
($14.2 bn) |
|
2017 |
$5.8 bn |
($7.8 bn) |
|
($22 bn) |
|
2018 |
$7.2 bn |
($8.5 bn) |
$2.7 bn |
($30.5 bn) |
Microsoft on the other hand is one of the few companies which could afford large buybacks yet did them in a measured way (12% over the 2016-2020 period); its net worth more than doubled, unlike the others which shrank. Finally, while its long-term debt grew exponentially to $60 billion, it held $134 billion in cash on 6/30/19.
|
Microsoft |
Cashflow
from Operations |
Dividends
+ Stock Buybacks |
End
of Year Cash |
Cumulative use of cashflows for
dividends and buybacks |
|
2017 |
$39.5 bn |
($22.8 bn) |
|
($22.8 bn) |
|
2018 |
$43.8 bn |
($22.4 bn) |
|
($45.2 bn) |
|
2019[2] |
$52.2 bn |
($32.2 bn) |
$133.8 bn |
($77.4 bn) |
Last, but not least in the first table, is Regeneron, a biotech company which has famously focused on R&D and been dismissive of short-term move in its stock prices. This strategy has probably impacted its market valuation, but rock-solid financials allowed Regeneron to sail through the recent crisis and to keep putting money where it has great expertise, i.e. the discovery of new drugs[3].
This buyback mania is dangerous in many ways. First, it represents an apparently easy and safe way to boost financial results by reducing the number of shares outstanding and boosting earnings per share. The problem is that this fix is difficult to abandon once used a few times.
It reinforces management’s focus on short term results, with the danger that a transparent result-booster like buybacks may incentivize management to look for other financial performance levers in accounting, purchasing, etc. which can become questionable.
Another problem with buybacks is that they tend to detract management from an essential responsibility, that of assessing the risk-reward of long-term investment decisions and making such decisions. This was, I believe, an issue with Boeing and its 737 Max: massive stock buybacks funded by starving new product development provided immediate financial benefits while the development of a new airplane was fraught with risks (even if these risks were in a field where Boeing was an expert and world leader).
Besides diverting funds, excessive reliance on buybacks eventually affect a company culture: short-termism, avoidance of risks and eventually responsibilities. Once this sets in, reforming a corporate culture can take very long and be quite disruptive: bringing in a new CEO from outside is easy, changing the rest of senior management takes time, can be operationally costly and doesn’t insure that lower rank employees will trust, accept or understand what is now expected from them.
Extremely low interest rates have been a huge factor in this buyback mania. As they remain low, companies pile on debt which they can easily service. But even if interest rates don’t rise any time soon, these last few months have shown that a sudden crisis can abruptly zap fixed-income investors’ appetite for anything but risk-free US treasurys.
The smartest financial minds can’t successfully time their buybacks. Last year, Liberty Global tendered for $2.5 billion of its own shares, repurchasing them at around $27. The stock price never reached that level since and stands at $20.50 today. During the first quarter of this year, Liberty bought back $500 million at around $16.50 per share. $3 billion in buybacks which, so far, have been value destructive.
For the foreseeable future, the Fed seems able and willing to cast a wide safety net. But the draw of near-zero interest rates is still alive, as is the desire to beat short-term earnings per share expectations. Caveat emptor.
