Monday, January 23, 2006

What Makes Buybacks Effective Part II

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.
Warren Buffett
BerkshireHathaway 1984 Annual Report

I recently explored the notion of the stock buybacks:

What Makes Buybacks Effective?

This post essentially reviewed a Business Week article on buybacks that appeared in the January 23rd edition. My belief is that share buybacks need analysis as far as their “value-added” strategy. The questions that buybacks pose are: Is the company buying back stock below intrinsic value, is it reducing its cost of capital by restructuring its balance sheet, or is it merely sopping up stock that it issues through the exercise of (primarily) executive stock options?

This morning, I found that Michael Mauboussin, now of Legg Mason (working with Bill Miller, portfolio manager estraordinaire) and formerly of CSFB where he was one of very few Wall Street portfolio strategists that I read regularly, has put together a lengthy treatise on share buybacks.

He provides much historical content on the use of dividends versus share buybacks as ways to return capital to shareholders.

He utilizes one over-riding principle that echoes Buffett’s 1984 quotation:

“We can define a principle to serve as a universal yardstick for judging the rationale and attractiveness of a buyback program:
A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.
The first part of this principle—“a company should repurchase its shares only when its stock is trading below its expected value”—suggests management should act as a good investor by buying the stock when the price is below the value. Objective, analytical managers likely understand the business and its prospects better than outsiders, positioning them well to make this value-versus-price judgment. If price is truly below value, a buyback transfers wealth from selling shareholders to continuing shareholders. The resulting increase in expected value per share holds with management’s objective to maximize shareholder value for its continuing shareholders.
The principle’s second part, “no better investment opportunities are available,” addresses a company’s priorities. Buybacks may appear attractive, but reinvesting in the business may provide a better opportunity. Value-maximizing companies fund the highest return opportunities first.”

I hope you will find this rather lengthy discussion worthwhile!

Michael Mauboussin


At 10:45 AM, Blogger The New Wall Street CEO said...

While I agree that certain buybacks can be very beneficial, I have often found that companies tend to buy back shares for the wrong reasons. As the new accounting standards come into play, forcing companies to take stock options into account, I have seen in a trend in buybacks. Often companies are not buying back their shares because they feel they are undervalued or have strong financials, but rather they are doing so to hide the effects of granting stock options. While the buy backs are reducing shares outstanding, the option grants increase shares outstanding, often canceling each other out. While we like buy backs when executed for the right reasons, it is neccessary to see that buy backs are not in place to simply mask the effects of excessive stock grants.

The New Wall Street

At 10:36 AM, Blogger Prasanth said...

Interesting. I recently invested in a company after a lot of painsaking research but what clinched the deal was that the company announced a buyback at 20 % above the current market price. Now the first part of Buffett's comment reassures me but the second part worries me !!


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